Capacity Constraint, Export Subsidies, and World Recession

This paper adds a capacity constraint to Brander and Spencer’s (1985, JIE) model to reexamine the optimal trade policy. It shows that if the capacity constraint is effective, the optimal export subsidy rate is negatively related to an increase in demand. This result is not only contrary to that derived under the Brander-Spencer model without a capacity constraint, but also explains why a country increases its export subsidy rate during an economic recession. More specifically, it is found that when the capacity constraint is ineffective, the domestic optimal subsidy rate remains unchanged regardless of the size of the capacity. On the contrary, as the capacity constraint becomes effective, the domestic optimal export subsidy rate decreases with the size of the capacity. Moreover, when the capacity constraint is effective, for an increase (a decrease) in demand in the export market, a government should decrease (increase) the optimal export subsidy rate. This result is striking as it can explain why a government, while confronting a recession in an export market, will offer a higher subsidy rate to its export industries that are subject to a capacity constraint such as the iron and steel industry, and why firms with a lower capacity utilization rate will be granted a higher subsidy rate. Our analysis also points out that traditional strategic trade models that do not take into consideration the capacity constraint are not suitable for export industries that are subject to a capacity constraint.