Tariffs, vertical specialization and oligopoly

Abstract

We examine optimal tariffs in an environment with vertical specialization where the Home country specializes in final goods and the Foreign country specializes in intermediate inputs. A matched Home–Foreign pair bargains simultaneously over the input price and the level of output, and competes a` la Cournot with other matched pairs in markets. We find that the optimal Home tariff rate is strictly decreasing in the bargaining power of Home firms, and an increase in the Home firms׳ bargaining power might therefore raise Foreign profits. Under an endogenous market structure with entry followed by matching, the relationship between bargaining power and output is non-monotone if the demand function is strictly concave or convex. This in turn induces a non-monotone relationship between the optimal tariff and bargaining power for a class of demand functions. For linear demand, free trade is optimal irrespective of bargaining power. We show that non-monotonicity result is retained under endogenous bargaining power.