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Trade, Foreign Investment, and Industrial Policy for Developing Countries 4061

are national or international we have to allow for the possibility that a country’s IP
hurts other countries. Consider a model with two countries (A and B) and two goods
(1 and 2). As above, good 2 exhibits Marshallian externalities. In this context, IP entails
a shift from an equilibrium in which countries are not specialized according to their
comparative advantage to one in which they are. Clearly such a shift increases world-
wide efficiency. What happens to welfare in each of the two countries? First note that
the country that implements IP (country A) experiences an increase in productivity in
industry 2. If the terms of trade did not change, country A would be better off (as in
Section 2.1.2). But if A is not small, then the relative price of good 2 will fall, and this
will erode some of A’s productivity gains. Even if A was so large that the terms of trade
were now equal to its domestic prices, however, it would still gain, so country A nec-
essarily gains from IP.26 This is a simple application of Helpman and Krugman’s (1985)
proposition that a country necessarily gains from a move to an equilibrium in which it
allocates more resources to a sector with positive externalities. For the other country
(country B) welfare can decrease. To see this, note that for this country the effect of
IP is exactly the same as the effect of an increase in productivity in industry 2 in coun-
try A. This could be either positive or negative for country B. For example, if the
opportunity cost of good 2 in country A is just barely lower than the opportunity cost
of good 2 in country B when both countries fully exploit the Marshallian externalities,
then it is clear that country B loses from the IP implemented in country A.
Different results arise when IP is geared toward the appropriation of rents or broad
(interindustry) externalities associated with certain goods, as in the literature on strate-
gic trade policy (see Brander, 1995). In this case, the use of IP by different countries
entails essentially a zero-sum game, or worse, as it could lead to an allocation of
resources in which countries are not specialized according to comparative advantage.
Consider next the model where IP entails industry-specific collective action. If
collective action is costless, then the answer is very simple: IP necessarily increases global
welfare, although it may hurt another country by worsening its terms of trade. Things
become more interesting when collective action entails costs. If countries bargain effi-
ciently among themselves regarding trade barriers, then (by definition) only IP that
increases global welfare will be implemented. One could optimistically argue that global
negotiations that include trade and other policies actually take into account the ability of
countries to implement IP, and that the resulting agreements allow only policies that
increase global welfare. In this case, countries that can follow IP that increases their
own welfare but lowers global welfare would be paid (perhaps though better trade access
to other countries) not to do it, and countries that can implement IP that lowers national
welfare but increases global welfare would be paid to do it. In fact, this is the way that
trade agreements work in Bagwell and Staiger’s (1998) model of GATT.
Bagwell and Staiger show that as long as countries choose their policies while dis-
regarding their effects on international prices, then they will lead to a globally efficient