A model of endogenous protection with heterogeneous firms

What is the relationship between imports and protectionist trade policies? The standard approach to this question in the international trade literature is to treat trade policies as exogenous variables and focus on the effects of changes in trade policies on other economic variables.  Yet trade policies are the outcome of a decision-making process that is in turn influenced by the very economic variables the policies are designed to shape.  This paper introduces a new theoretical model designed to disentangle the simultaneous relationship between imports and protection. It marries the political apparatus of the “Protection For Sale” framework to a model of trade featuring heterogeneous firms, monopolistic competition, fixed and variable trade costs. In this type of model, domestic firms compete with foreign firms, consumers view domestic and foreign varieties as imperfect substitutes, and barriers to trade affect both the extensive and intensive margins of trade.  This model provides a richer economic environment than appears in the existing political economy literature, generating industries whose structure and organization vary even in the absence of political trade barriers. The crux of the model is the simultaneous existence of ‘natural’ barriers to trade (barriers that are beyond the control of economic or political decision-makers) and political trade barriers (barriers that are set by the authority of the government and are subject to political pressure).  The resulting equilibrium and comparative static effects point up two important theoretical results: (i) a negative relationship between fixed trade costs and the equilibrium level of protection and (ii) a nonmonotonic relationship between the equilibrium levels of the import-penetration ratio and protection. Consequently, this paper emphasizes industry-level variation in fixed trade costs as an explanation for the coincident observations of both positive and negative correlations between import penetration and protection.