Trade Policy under Asymmetric Information

Abstract

The main purpose of this paper is to investigate the effect of a foreign output on the optimal tariff when the domestic government and firm have asymmetric information about the foreign firm's cost.
We assume that the foreign firm exports the domestic market over two periods. In the first period, the firm exports as a monopolist under a constant tariff. In the second period, the domestic firm enters its market. After observing the level of imports, the domestic government forms beliefs about the type of firm exporting its market and selects a per unit tariff. Given the chosen tariff, the foreign firm competes the domestic firm a la Cournot. Since the domestic firm does not know the true cost of the foreign firm, it maximizes its expected profit.
At the pooling equilibrium, the low-cost foreign firm constraints its first period output. At the separating equilibrium, it expands its first period output.
The low-cost foreign firm constraints its first period output if it regards its second period profit as important.