delivers an equilibrium price рн = c∕θ for the domestic firms and a higher price
p for all the other international firms through a positive export subsidy. In
Appendix D I explicitly derive this optimal export subsidy as:
*
H=
pH
-c
θ
1 + (pH) 1-θ (p-c)θ
>0
(16)
Here the intuition is simple and I will explore it in further detail. The free
entry condition pins down the price index P and the price of the foreign firms
independently from the domestic subsidy. This implies that the subsidy can be
chosen to maximize the profits of the domestic firm net of the cost of the subsidy
taking as given the aggregate price index. This is the same as directly choosing
the price of the domestic firm without a subsidy to maximize profits while
ignoring the effect of the price choice on the price index. Such a choice delivers
a lower price than the one chosen by foreign firms, since those firms take in
consideration the effect of their price on the aggregate price level and an increase
in the latter raises their demand level and hence their profits. Consequently in
equilibrium the domestic firm undercuts its competitors and obtains a larger
market share, but this is possible only in presence of a positive export subsidy,
which reduces the effective marginal cost of production and hence induces a
lower mark up for the national firm. The gain in market share is however
sufficient to create positive profits for the national firm.
2.3 Discussion
Beyond subsidization, many other trade policies can affect the profits of export-
ing firms: for instance, policies which increase demand for the domestic product,
promote domestic R&D or reduce transport costs for exporting firms (Spencer
and Brander, 1983). A main example of the latter kind is given by investments
in infrastructures for international communication networks, but more indirect
examples include the establishment of easier business connections with other
countries, reduction of bureaucracy for export duties and even the development
of trade and currency unions to reduce import tariffs and uncertainty costs re-
lated with the exchange rate. In Appendix C I show that when entry in the
international markets is free, under weak conditions there are stronger incentives
for governments to invest in these forms of strategic export promotion .14
14 Notice, however, that improvements of infrastructures may have a bilateral impact, both
on domestic exporters, but also on foreign firms that want to enter the domestic market.
The entry of foreign firms, or the change in the market share of foreign firms following an
improvement in infrastructure will have an impact on the survival of domestic firms, on the
total number of domestic firms, and hence on the number of domestic exporters. In that
respect, looking at the endogenous entry of domestic firms in the export market, may modify
the predictions of the current model.
14