Infant Industry Protection Revisited

International Economic Journal
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Infant Industry Protection Revisited
Professor Aditya Bhattacharjea
To cite this article: Professor Aditya Bhattacharjea (2002) Infant Industry Protection Revisited,
International Economic Journal, 16:3, 115-133, DOI: 10.1080/10168730200000024
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INTERNATIONAL ECONOMIC JOURNAL
Volume 16, Number 3, Autumn 2002
INFANT INDUSTRY PROTECTION REVISITED:

ENTRY DETERRENCE AND ENTRY PROMOTION WHEN A FOREIGN
MONOPOLIST HAS UNKNOWN COSTS
Downloaded by [Indian Institute of Management - Indore] at 13:28 11 December 2017
ADITYABHATTACHARJEA*
Delhi School of Economics
In 1791, Alexander Hamilton suggested that assuring protection to domestic entrants

could pre-empt entry-deterrence by foreign firms. This paper reformulates his
argument in game-theoretic terms with asymmetric cost information, imposing the
requirement that both the foreign firm's threat and the home government's promise of
protection should be credible. It derives a simple optimal tariff formula that depends
only on the expectation of foreign costs. It then shows that this tariff can lead to
welfare-decreasing entry, but only if the foreign firm is relatively inefficient. However,
if the formula is applied with dynamic consistency, and is rationally anticipated by both
foreign and domestic firms, it prevents foreign entry-deterrence and improves domestic
welfare. [F13, 0191
1. INTRODUCTION
The ancestry of the infant-industry argument for protection is usually traced to

Alexander Hamilton's Report on Manufactures, submitted to the Congress of the
United States in 1791. The received wisdom amongst economists is that
Hamilton's case rested on what today would be called dynamic increasing returns
to scale, but this begs the question of why an infant industry cannot finance its
early losses by borrowing against its own future profits. If imperfect capital
markets or externalities are to blame, then government intervention should be
targeted to redress these problems through capital market reforms or Pigouvian
subsidies. Tariffs, in contrast, impose a by-product consumption distortion and
do not provide any incentive for the "infant" to grow up.
Standing aside from this debate, I take for my starting point in this paper a very
different argument for infant-industry protection, buried in an obscure passage of
Hamilton's Report:
Combinations by those engaged in a particular branch of business in one country, to
frustrate the first efforts to introduce it into another, by temporary sacrifices,
*Valuablecomments of two anonymous referees are greatly appreciated. Of course, 1 alone

remain responsible for any error.
116 ADITYA BHATTACHARJEA
recompensed perhaps by extraordinary indemnifications of the government of such

country, are believed to have existed, and are not to be regarded as destitute of
probability. The existence or assurance of aid from the government of the country, in
which the business is to be introduced, may be essential to fortify adventurers against
the dread of such combinations, to defeat their effects, if formed and to prevent their
being formed, by demonstrating that they must in the end prove fruitless. (Quoted in
Stegeman, 1996: 88)
Translated into the language of modem economics, this embryonic model of

strategic behavior is nearly two centuries ahead of its time. Hamilton is arguing
that infant-industry protection serves to overcome limit-pricing of exports, by
which foreign monopolies ("combinations") deter entry by domestic firms.
Moreover, anticipated assistance from the home-country government precludes
this behavior and promotes entry. This is quite independent of any scale
economies or capital market imperfections.
While Hamilton might thus be regarded as the founder of what is now known
as strategic trade policy (STP), his formulation of the problem is open to several
objections from the modem theorist. First, the foreign firm might not in fact find
it profitable to maintain the limit price if entry does occur. The maintenance of
the pre-entry price after entry (an assumption known as the "Sylos postulate" in
the industrial organization literature) is a non-credible threat which will not
deceive a rational entrant, and an equilibrium with limit-pricing is then not
subgame-perfect. Indeed, two early models of entry-deterrence in an
international trade context, by Brander and Spencer (1981) and Davies and
McGuinness (1982), were based on this kind of non-credible threat. Second,
although the theory of STP has shown that some tariff is usually optimal in an
international oligopoly setting, the level that is optimal once the entrant comes in
may not be high enough to justify entry. That is, Hamilton's entry-inducing tariff
policy may not be time-consistent, and again the rational entrant should see
through such a non-credible promise of protection. Third, even if the tariff is
time-consistent, it might induce inefficient entry that actually reduces home
welfare as it is conventionally measured in modern economics, although obviously
Hamilton was using other criteria. These three considerations call for the game-
theoretic reformulation of Hamilton's argument attempted in this paper.
It is now universally recognized that an incumbent firm's pre-entry price has
no effect on a potential entrant's post-entry profits, and hence on the entry decision,
unless some commitment mechanism is explicitly modeled, or unless the price
signals some private information that affects the entrant's calculations. It is this
second modification that is used here, in an attempt to "rationalize" Hamilton by
"internationalizing" the well known model of Milgrom and Roberts (1982), which
also permits us to examine asymmetric information in this setting. This yields a
finding of independent interest. In the course of deriving a time-consistent post-
entry tariff that can be rationally anticipated by both the incumbent and the entrant,
section 2 of this paper derives an optimal tariff formula that is robust across a
INFANT INDUSTRY PROTECTION REVISITED 117
subset of the most commonly employed models. In particular, the formula is

independent of domestic costs and the degree of substitutability between domestic
and foreign products, and it depends only on the expectation of foreign costs. It
is also invariant as between foreign monopoly and Cournot duopoly.
Proceeding backwards in the usual game-theoretic manner, sections 3 and 4
model entry and entry deterrence when this optimal tariff is anticipated in the post-
entry d;opoly. In section 3, I compare the private profitability and social

desirability of entry, and show paradoxically that welfare-reducing entry is
possible only when the foreign firm is relatively ineflcient. The explicitly
dynamic model of section 4 allows the foreign firm to signal its private cost
information to deter entry. It is shown that such behavior is prevented by a time-
consistent tariff policy, utilizing the tariff formula derived in section 2. Entry
induced by this policy is also shown to be welfare-increasing. Hamilton's insight
is thus shown to be consistent with modern game-theoretic microfoundations and
also standard welfare calculations.
In relation to other research, this paper fills a gap in the STP literature, which
ranges widely over models with static market structures or free entry. Only a
handful of papers attempt to model entry deterrence or exit inducement in an
international context. Entry deterrence by the government of the exporting
country, whether by denying access to its own market as in Dixit and Kyle (1985),
or by subsidizing exports to a market threatened by entry as in Collie (1992),' has
been modeled, with attention to time-consistency issues. However, the optimal
policy response to entry-deterring behavior by foreignfirms has not been modeled
' since Brander and Spencer's attempt. The importance of credible commitment
has been highlighted in several STP models, most recently in a series of papers
culminating in Neary and Leahy (2000), which summarizes the earlier
contributions and provides a unifjring framework, although this is for models of
export rivalry in a "third market". The issue had earlier been explored by Wright
(1995) in the import policy context in respect of the credibility of making
protection contingent on cost reduction by an infant industry. In the model to be
developed below, it is the entry of the domestic firm itself that raises problems of
credible protection.
This paper also conforms to another recent trend in the STP literature, in that it
models the strategic use of asymmetric cost information in import policy. This
was extensively analyzed earlier in respect of export policy,2 and in the context of
regulation of transfer pricing of intra-firm trade by multinational corporations:
but only a few recent papers seem to have dealt with it in an import policy setting
h here is a hint of this in Hamilton's reference to "extraordinary indemnifications", although

this would now be inconsistent with the GATT prohibition of export subsidies, and will not be
pursued in this paper.
2 ~ e Collie
e and Hviid ( 1993), Neary (1994), Qiu (1994), and Brainard and Martirnort (1996,
1997).
3 ~ oexample,
r Raff (1994) and Gresik and Nelson (1994).
with "arm's length" trade, typically in two-period signaling models. In Collie

and Hviid (1999), the home government uses a tariff to signal a domestic firm's
costs to its foreign rival. Closer to the concerns of this paper, Hartigan (1994)
has a foreign firm with private cost information engaging in predatory dumping in
the first period to signal low costs and induce the exit of a domestic rival, in order
to gain a monopoly position in the second period. The home government
imposes an anti-dumping (AD) duty equal to the difference between the prices that
the firm charges in the home and foreign markets. Crucially, this duty is assumed
to be both credibly committed4 and also sufficient to ensure the viability of the
home firm. More recently, Herander and Kamp (1999) have deployed the
Milgrom-Roberts model in a setting that is the mirror image of the one I have in
mind: they model a domestic incumbent who attempts to deter a foreign entrant by
signalling low costs in the first period. They examine the effects of different
levels of a tariff that remains committed for both periods. In neither of these last
two papers is there any claim that the tariff policy is optimal for the market
structure of that period. In the model to be developed below, the optimality of
the tariff gives it credibility, and I demonstrate (rather than assume) that it is
adequate to guarantee the profitability of the entrant in a situation that would
otherwise be conducive to entry-deterrence by the incumbent.
In other related work, Kolev and Prusa (1999a) have an optimizing government
confronting a foreign monopolist with private cost information, but no threat of
entry. Here the monopolist raises its first-period price to signal higher costs and
elicit a lower tariff. Kolev and Prusa (1999b) introduce a domestic rival, and
interpret the foreign firm's price-enhancing (output-restricting) signal as a
voluntary export restraint aimed at moderating the home government's optimal
tariff, which they interpret as an anti-dumping duty. The home firm learns the
foreign cost independently, so the signal is again directed exclusively at the home
government. In contrast, I investigate the strategic use of private cost
information when both the tariff and the home firm's entry decision are
conditioned on the foreign cost. This introduces a tension into the foreign firm's
problem: it needs to signal higher costs to the government in order to secure a
lower tariff, but lower costs to the home firm in order to deter its entry. Section 4
resolves this conflict, as well as the theoretical problems with Hamilton's
argument.
2. THE OPTIMAL DUOPOLY TARIFF WITH UNKNOWN COSTS I
In order to derive the optimal tariff in the post-entry situation, I begin with the
standard international duopoly (SID) model which has been widely used in the i
4 ~ assumes,
e not unreasonably, that AD procedures make the threat of the duty credible.
However, an AD action depends on demonstrable injury to a domestic firm,which is not yet in
existence in the entry-deterrence story of our model.
STP literature, modifying it to allow for private foreign cost information. A

domestic and a foreign firm compete as a differentiated-product Cournot duopoly
in the domestic market, setting quantities independently of market conditions in
the rest of the world (the segmented markets assumption). Following Dixit
(1988), the representative consumer has the quasi-linear utility function
0= U(x, y) + z, tvhere
U(x, y)=a,x+a,y-(bxx2 + byy2+2/cXy) / 2
I
Here, x denotes the consumption of the home-produced variety and y the foreign
variety of the good produced under imperfect competition. z is the consumption
of a numeraire good produced and sold competitively at an exogenous world price.
All parameters are strictly positive, with k representing the degree of
substitutability between home and foreign varieties. Assume
with equality in the case of perfect substitutes. This utility specification

I generates linear inverse demand functions
and
With the quasi-linear utility function, an exact measure of consumer surplus is

given by
On the supply side, the two firms have constant per-unit costs c, (< a,) and c,
(< u,), the latter defined to include transport costs, over the relevant range of.
outputs. The foreign firm's cost level is private information, but the distribution
from which it is drawn by 'Nature' is common knowledge, as is the level of

domestic costs and all demand parameters. Cost and demand parameters are
constrained to ensure interior solutions for all possible realizations of cost.
Explicit parameter restrictions for this are developed below.
The home government imposes an import tariff o f t per unit before the firms
decide their quantities. The tariff is set to maximize the expectation of the
standard social welfare function, consisting of the unweighted sum of consumer

surplus, domestic profits and tariff revenue?
Assume to begin with that the two firms know each other's cost level, but the
government does not know the foreign cost.6 With firms competing in quantities,
the equilibrium quantities for a given tariff level can be easily obtained as:
x = [2b, (ax- q ) - k(a, - c, - t)] / H
where H = 4b,b, - k 2 is strictly positive, from (2). From (5) and (6), social
welfare can be written
so that
'~amiltonhad actually suggested using the tariff revenue to subsidize domestic production,
offsetting the rise in domestic prices that would otherwise hurt consumers. Dixit (1988)
formally established that a tariff combined with a production subsidy to the domestic firm
maximizes home welfare. However, this becomes quite intractable with unknown costs. Also,
for reasons spelt out in more detail in Bhattacharjea (!995), subsidies are impractical in this
context.
6 ~ h iassumption
s is partially relaxed in section 4, where the home firm is also uninformed of
the foreign cost before entry.
dW ( p , -ex)-+t-+y
--
dt "
dt dt " 21 I--
To maximize expected welfare, using the linearity property of the

differentiation and expectation operators, we solve dE(W/dt = E(dW/dt) = 0.
Substituting (7) and (8) into (3) and (4) gives reduced-form expressions for
expected equilibrium prices, which can in turn be substituted, along with the
relevant derivatives, into (10). This expression simplifies dramatically to
Equating to zero gives the optimal tariff formula
Five of the seven parameters of the model have dropped out in this formula. This
yields
PROPOSITION 1. The optimal tar@ formula in the SID model with unknown
costs depends only on the expectation of foreign costs, and is independent of both
domestic costs and the degree of substitutability between home and foreign
varieties.
In fact, k = 0 is a 3pecial case of this model, with no substitutability, which is

equivalent to both firms monopolizing independent product markets. Thus, (12)
is also the optimal tariff on a foreign monopolist with unknown costs, derived
independently by Kolev and Prusa (1999a).
PROPOSITION 2: The optimal tar@ in the SID model with asymmetric cost
information is the same as for a foreign monopolist with unknown costs.
These propositions are specific to the SID model, and do not survive the
introduction of non-linear demand and costs, or more firms, or conjectures other
than ourn not.' Although they do not therefore solve the information problems
inherent in the strategic trade literature, they do achieve what physicists might call
"weak unification" of a commonly-used subset of models in that literature. The
next two sections assess the social desirability of domestic entry by making
welfare comparisons between foreign monopoly and duopoly, utilizing this
invariance of the optimal tariff formula.
3. THE OPTIMAL TARIFF AND INDUCED ENTRY /
Can inefficient entry be induced by the optimal tariff! Consider a situation in

which the home market is initially monopolized by a foreign firm. (12) indicates
that a tariff o f t * is optimal, but by Proposition 2, a potential domestic entrant can
rationally anticipate that a welfare-maximizing government will maintain the same
tariff after entry. Entry will occur if it is privately profitable, that is, if the
entrant's anticipated profits n x \ t * exceed the fixed costs of entry, F It will be
socially beneficial if the gain in welfare under duopoly as compared to foreign
monopoly exceeds F, that is (W, - W,) It* > F. Therefore, ineflcient entry will
occur if and only if n,l t* > F > (W, - W,) 1 t*. In order to assess this possibility,
continue to assume that the firms know each other's costs but the government does
not know the foreign cost, so the duopoly interaction takes place under t* as given
in (12). Define the function
Inefficient entry is possible only if R < 0. The reduced-form expressions for

prices and outputs derived above can now be substituted into n, = (p, - c,)x, and
into the expression for Wd that can be obtained by substituting (1) into (9).
Similarly, W, can be obtained by setting x = 0 in (1) and (9) and inserting the
standard expressions for (foreign) monopoly price and output. Putting these three
terms together in (13) gives R in terms of the exogenous demand and cost
parameters. The sign of this complicated expression, much less that of its expected
value, cannot be determined. However, with t* given by (12), we can obtain some
features of R as a function of c, to prove another unexpected result. First, from (7)
and (8) we can obtain bounds on c, that ensure interior solutions to the duopoly:
7 ~ h tariff
e formula (12) and Propositions 1 and 2 extend results derived in Bhattacharjea
(1995) to the case where foreign costs are unknown to the home government.
I
I Assume that the support and expectation of the probability distribution of

I foreign costs is such that cymCn <c, < E,, so that the firms always produce
positive output in duopoly, although the home firm may not be able to recover its
entry costs. We then obtain the following features of the R (c,) function:
I
(i) For c, = E(c,)
I
which is strictly positive, by (2).
(ii) Q is strictly concave in c,:
(iii) It can also be shown that the function Q (c,) has two roots, the smaller of
which is c, = c , ~ , ~ .The latter can be seen directly by noting that as c, tends to
C~mzn
which gives the comer solution, the duopoly outcome tends to the foreign
monopoly outcome, and domestic profits disappear. Consequently, from (13), R
tends to zero. If the larger of the two roots is less than q, then R < 0 for larger
values of c,. Although the implied restriction on the parameters required for this
possibility is too complicated to have any easy interpretation, it can be shown that
R < 0 for values of c, close to Cy with E(c,) close to c , ~ , ~ .
From these three properties we can conclude that the graph of R (c,) is an
inverted U, and if at all R is negative, it can only be at values of c, > E(c,). This
gives us
PROPOSITION 3. Entry induced by a tariff t* based on expectedforeign costs

can be socially ineficient only if the foreign Jirmk actual cost level is above its
expected value.
That is, contrary to what one might expect, domestic entry reduces welfare
only if the foreign firm is relatively ineficient. Although entry is always more
profitable when the realized foreign cost is higher, (15) shows that it necessarily
results in a welfare gain if the tariff is based on actual costs. Therefore, the
possibility of a welfare loss arises only from a tariff based on expected costs.
The reason is that if the foreign firm has above-average costs, then a tariff set on
the basis of (12) is higher than optimal, attenuating the welfare gain even as it
promotes entry.
Note that Proposition 3 provides only a necessary condition for inefficient

entry; entry may still be socially beneficial for above-average realizations of c,.
The reason is that the entrant, apart from the profits that justify its own entry, also
provides externalities to consumers in the form of a pro-competitive impact on the
foreign price and also greater variety. Since these externalities are not taken into
account by the entrant, such beneficial entry might not occur even if R > 0, for a
range of entry costs such that (W, - Wm) t* > F > zIlt*. In this case, further
assistance to the domestic firm is warranted, but since foreign costs are unknown
to the government, it will not know when such assistance is justifiable.
4. STRATEGIC ENTRY DETERRENCE 1
The framework employed thus far has not allowed the credibility issue posed
in the Introduction to be incorporated into the analysis, nor has the foreign firm
been allowed to use its private cost information strategically. Now consider the
possibility that the domestic firm is also uninformed of the cost level of the
foreign firm, which can then attempt to deter domestic entry by signaling lower
costs via limit pricing, as in Milgrom and Roberts (1982). The additional
complication in the present setting is that lower costs attract a higher tariff, from
(12). In the two Kolev and Pmsa papers (1999a, 1999b) which investigate this
without the possibility of domestic entry, the foreign firm has an incentive to
signal higher costs to elicit a lower tariff. The Milgrom-Roberts and Kolev-
Prusa stories individually make for complicated models that ultimately rely on
numerical simulations to demonstrate the existence and welfare properties of
signaling equilibria, even with linear demands and constant costs. However,
combining the two stories actually turns out to be relatively simple. I show that
the necessary conditions for a limit-pricing equilibrium become mutually
incompatible when the home government revises its tariff on the basis of the cost
information that the incumbent needs to signal to deter entry. Consequently, no
such equilibrium exists, and one need not enter into a discussion of the out-of-
equilibrium beliefs that are needed to support the signaling equilibria, and the
refinements that are needed to eliminate multiplicity. This complicated and
controversial terrain is bypassed by the result to be derived below.'
'standard game-theoretic solutions to such signaling games require, at a minimum, that

players can recognize dominated strategies and anticipate that others will not use them. As
Cooper et al (1997) show, this is not how actual subjects behave, in experiments using a
First, substituting the optimal tariff formula (12) into (7) and (8) and taking
expectations gives expressions for expected quantities as functions of expected
foreign cost. We can then obtain an expression for domestic profits as a function
of E(c,), and using the linearity properties again,
since the expression in square brackets is positive for an interior solution. Thus,
it seems that the foreign firm still has an incentive to signal lower costs to deter
entry by the domestic firm, even though lower costs invite a higher tariff. This is
because from (12), adjustment of the optimal tariff offsets only one-third of the
perceived reduction of the foreign cost level.9 However, such signaling requires
setting a price that is lower than the one which maximizes static monopoly profit,
and this sacrifice must be weighed against the gain from deterring entry.
In order to investigate this, consider now a two-period setting, with the foreign
firm's costs initially known only to itself. The expectation of the distribution
from which it is drawn, as well as domestic costs and all demand parameters,
remain common knowledge. In period 1, the foreign firm is a monopolist, and
chooses a quantity to export to the home market, where some non-prohibitive
tariff tl is in effect. Observing this choice of quantity, the home firm and
government update their assessments of the foreign cost level. In period 2, the
home firm decides on whether to enter, and then the government imposes a revised
tariff. If entry occurs, the firms compete as a Cournot duopoly in period 2,
otherwise the foreign firm remains a monopolist. In each period, the tariff is
committed before the output decision of the firm(s).1 Assume, as in Milgrom
and Roberts (1982), that the incumbent's costs are revealed if entry takes place.
This means that any duopoly interaction takes place under symmetric information.
For the present, I work with a stripped-down homogeneous product version of
the model of the earlier sections, so that henceforth a, = a, = a, and b, = b, = b = k.
(It will be shown that the main result carries over to the case of differentiated
products.) Suppose foreign costs are known to be drawn from a distribution that
simplified Milgrom-Roberts model similar to the one in this paper. Even with adaptive
learning, convergence to the predicted equilibrium occurs very slowly, if at all.
' ~ i x i t(1988) obtained this result as a special case of his demonstration that foreign export
subsidies should be only partially offset by a domestic countervailing duty. He did not
however emphasize that an optimal tariff like (12) must already be in place for the partial
countervailing result to hold.
'1n the terminology of Neary and Leahy (2000), the government is assumed to be able to
commit intra-temporally (within a period), but not inter-temporally.
yields a cost level that is high (cH) with probability h and low (cL)with probability
1-h. Normalize cL = 0. Also, let the two realizations of foreign costs straddle
the (known) domestic cost level. As before, relative cost levels are constrained
to ensure interior solutions to the duopoly in all states of nature, should entry occur.
Under free trade, the home firm's duopoly operating profits are assumed to cover
its entry costs if the foreign firm is high cost, but not if it is low cost. Thus,
where the superscript refers to the foreign cost type and the subscript x to the
domestic firm.
I shall not explain the various incentive-compatibility constraints that yield the
equilibria of the Milgrom-Roberts model with two types of incumbent, since they
are well-known from Tirole (1988); see also Herander and Kamp (1999). I focus
initially on a separating equilibrium, in which the foreign firm's behavior in period
1 enables the home firm and government to infer its type, so that h is updated to 0
or 1 for period 2. No-one is fooled, and the second-period duopoly outcome is
then described by the homogeneous-product versions of (7) and (8), with type-
contingent full information tariffs tH or k given by substituting cHor cLfor E(c,) in
(12). The home firm will not enter if the resulting profits do not cover its entry
costs.
Consider two of the necessary conditions for a separating equilibrium with the
low-cost type signaling its cost level by charging a price lower than its static
profit-maximizing price, modifying them to take into account the government's
tariff response. First (compare eqn. 9.11 in Tirole),
where M represents monopoly profits, which always pertain to the foreign firm, 3
its duopoly profits, and superscripts its cost type as before. Period 2 profits are
discounted by a factor of S The left side of this inequality represents the profits
of a type H which deters entry by mimicking the monopoly pricing behavior of a
type L in period 1, even though it attracts a higher tariff tL in period 2. The right
side represents its profits if it were to maximize its first-period monopoly profits,
revealing high costs and thereby inviting a duopoly in the second period. If (20)
is satisfied, then type L must deviate below its first-period profit maximizing price
in order to credibly signal its low costs.

Secondly, entry deterrence also requires that the entrant, convinced of the
incumbent's low costs, will not be able to cover its entry cost even under the
I
higher tariff the government consequently imposes:
Technically, (20) and (21) are both necessary for an entry-deterring perfect
Bayesian equilibrium in which the low-cost type must charge a price below the
price that maximizes its first-period monopoly profit, and all agents' strategies are
optimal given their beliefs, which are consistent in a Bayesian sense with the
actions observed under those strategies. I show in the Appendix that (20) and
(21) are mutually incompatible. The intuition behind this result is as follows.
(20) implies a minimal market size a 2 3cH relative to costs for entry-deterrence
to be worthwhile, or alternatively a maximal spread between the incumbent's two
cost types (recall that cL has been normalized at zero) relative to market size so
that it is not too costly for a type H incumbent to mimic a type L. However, this
requirement also increases the magnitude of the optimal tariff, k = aI3. With a
dynamically consistent tariff policy, it turns out that the condition necessary to
make signaling worthwhile also makes tariff-assisted entry profitable. Signaling
low costs is therefore pointless.
It is important to be clear about what exactly has been proved here. Demand
may of course be too low relative to domestic costs to justify entry even with the
higher tariff, so entry is "blockaded" and limit-pricing is unnecessary. It may on
the other hand be high enough to encourage entry even if the government remains
passive. What has been demonstrated above applies to an intermediate situation.
If market size is large enough to make signaling worthwhile for the incumbent,
then it is also large enough for the entrant to cover its fixed costs, aided by the
higher optimal tariff that signaling elicits. Further, with entry inevitable, and
costs being revealed after entry, the government can calibrate its period 2 tariff
precisely to the foreign cost level. Thus, a low cost incumbent also gains nothing
by signaling high costs in period 1 to attract a lower tariff. Since neither type
gains from pretending to be the other, and signaling involves a first-period
sacrifice of profits, both types can do no better than to produce their myopic
monopoly profit-maximizing quantities in the first period.
Before completing the description of the equilibrium and its welfare properties,
I show that the market size restriction that ruled out an entry-deterring separating
equilibrium also precludes a pooling equilibrium. The latter would require both
incumbent types to sell the same output in period 1, and the uninformed entrant,
unable to update its information, would then make its decision on the basis of the
prior E(c,.). If it enters, the foreign firm reveals its costs, and the government
imposes the appropriate type-contingent tariff. If not, t* is imposed in the second
period. The usual pooling equilibrium that survives the intuitive criterion is one
in which both types pool at the monopoly price of Type L. This requires a
condition resembling (20), but with t* rather than tL in the second term:
Since t* < tL,this change necessarily raises the value of MH in the second term of
(20), so if (20) is satisfied, so is (20a). Instead of (21), we now have
However, it has already been shown that if (20) holds, then (21) does not, and
thus (21a) cannot hold either. It cannot hold even if the government does not
learn the entrant's costs after entry, so that (21a) is conditioned on the tariff t*
from (12), based on the unchanged prior E(c,) > cL. This is because by (17),
expected domestic profits incorporating the optimal tariff are rising in E(c,).
Thus, if (20) holds, (21) is violated, and so is (21a), whether the government
updates its prior or not. Since entry cannot be deterred, the incumbent can again
do no better than sell the type-contingent monopoly quantity in the first period.
The candidate pooling equilibrium is thereby destroyed.
The only sequentially rational equilibrium, then, is what is sometimes called a
no-distortion separating equilibrium. The two incumbent types produce their
static profit-maximizing output levels in period 1, from which the government and
home firm correctly infer the true type. In period 1 the uninformed government
can therefore impose t, = t * , the average tariff (12) based on such non-distorting
behavior and the expectation of costs. (The Appendix also shows that condition
(20) is independent of the first-period tariff.) In period 2, with cost information
revealed, the government imposes the type-contingent tariff, and the home firm
enters. From the homogeneous-product version of (15), privately profitable entry
under such a tariff is always welfare-improving when tl is also based on known
costs; it must be so a fortiori if t, = t* is suboptimal because costs are unknown
in period 1. ( W, in (13) is lower, and therefore R is higher.)
These results carry over to the case of differentiated products. By Proposition
1, the anticipated period 2 optimal tariff is the same for differentiated and
homogeneous products. For any given level of tariff and home and foreign costs,
greater differentiation enables the domestic firm to earn higher profits, so if entry
was profitable with homogeneous products, it will be even more profitable with
, product differentiation. It can be shown that dW, / d k < O , so that greater

( product differentiation (represented by lower k) increases welfare. Thus we
finally get:
PROPOSITION 4. The optimal tar@ formula (12), applied with dynamic

consistency,prevents foreign entry-deterring behavior: Whenever entry occurs, it
is welfare-improving.
1 5. CONCLUSIONS
In the course of exhuming Alexander Hamilton's two century old argument for
protection, this paper has established some intermediate results of independent
interest. It has derived an optimal tariff formula for a foreign monopolist whose
costs are unknown to the home government, and shown that it remains unchanged
in the presence of a domestic Cournot competitor, independent of the degree of
product differentiation and domestic costs. It has also shown that entry of such a
domestic firm under this tariff regime will be socially inefficient only if the
foreign firm is relatively high-cost. Finally, it has restated Hamilton's argument
in modern terms, and shown that anticipation of a dynamically consistent tariff,
based on the government's updating of its information, does indeed "fortify
adventurers against the dread of such combinations ... demonstrating that they
must in the end prove fruitless". It has also shown that domestic entry under
such conditions is always welfare-improving."
Note that Hamilton actually wrote of "combinations", which have been
interpreted here as monopolies. Bagwell and Ramey (1991) showed that
allowing for multiple incumbents (as opposed to multiple types of a single
incumbent) in the Milgrom-Roberts model makes coordinated limit-pricing
impossible, and separation occurs at non-distorted oligopoly prices. However,
Martin (1995) modified this result, showing that coordinated limit-pricing can
occur if the incumbents are allowed to have different costs. (Multiple potential
entrants can obviously be accommodated in this model, since only the most
efficient one need be deterred.)
The highly simplified linear demand and cost structures used in this paper were
inevitable (and even they created algebraic difficulties). However, it is true that
the partial equilibrium setting does not permit questions of income distribution and
intersectoral resource allocation to be raised. It is worth recalling that in the
century after Hamilton's Report, the policy of industrial protection adopted by the
II
What could not be examined, due to the prohibitively complicated algebra, is whether a
policy of government non-intervention could be even better. This possibility arises because
limit-pricing by the foreign firm benefits consumers in the first period, and this might outweigh
the loss of domestic profits and consumer surplus arising from the preservation of foreign
monopoly in the second period.
United States led to recurring political conflicts between different interest groups,
including an outcry against the so-called "Tariff of Abominations" in 1828 by the I
agricultural exporters of the American South. The intention of this paper was
only to set Hamilton's argument on acceptable microfoundations, not on a pedestal.
APPENDIX: Proof that (20) and (21) are incompatible
Substituting the optimal full-information tariffs for the second period, tH = (a-
cH)/3 and tL = a n , into the standard profit-maximizing expressions for prices,
output and profits under monopoly and duopoly, (20) becomes
Solving this as an equation, and noting that all the terms are strictly convex in a,
this implies
for the positive square roots. (The quadratic form under the square root sign can be
shown to be positive.) Notice that tl drops out in (A2). For reasons that will
become clear in a moment, subtract 3cHh r n both sides of (A2) and simplifl, to get
We want to show that the right side of this is non-negative. Suppose not. Then 1
3J6(5cH- 6cJ2 + 7 2 ( ~ <~&(29cH

) ~ - 6c,)
Both sides being positive, squaring preserves the inequality, and yields (after some
I simplification)
The expression on the left is a quadratic form in cH and c, that can be shown (by
calculating eigenvalues) to be positive definite for 6 ~ ( 0 , 1 ) , or positive
semidefinite for 6 = 1, contradicting our supposition. Thus, ultimately (20)
implies
1 Now consider
The first term in the numerator is non-negative, from (A6). As for the second
term, since we have assumed that the home firm is competitive with the high-cost
foreign firm in the post-entry duopoly under free trade, the numerator of the
expression for its C:ournot output (a + cH - 2c,) > 0. Adding six times this to
(A6) gives 7a + 3cH- 12cx>0. Thus, fi-om (A7), nf (tL)> nXH (0). But the
latter is greater than F, from (19). This contradicts (21). QED.
It can be shown that (A6) also suffices to ensure that all the monopoly and
duopoly profit expressions involved in (20) and (21) are positive at the relevant
optimal tariffs.
REFERENCES
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and Hviid, Morten, "Export Subsidies as Signals of
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Mailing Address: Professor Aditya Bhattacharjea, Delhi School of Economics,

University of Delhi, Delhi 110007, INDIA. F a : 91-11-766-7159, Email:
adityaacdedse. ernet.in

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International Economic Journal

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Infant Industry Protection Revisited

Professor Aditya Bhattacharjea

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INFANT INDUSTRY PROTECTION REVISITED:

In 1791, Alexander Hamilton suggested that assuring protection to domestic entrants

The ancestry of the infant-industry argument for protection is usually traced to

*Valuablecomments of two anonymous referees are greatly appreciated. Of course, 1 alone

recompensed perhaps by extraordinary indemnifications of the government of such

Stegeman, 1996: 88)

Translated into the language of modem economics, this embryonic model of

subset of the most commonly employed models. In particular, the formula is

entry d;opoly. In section 3, I compare the private profitability and social

h here is a hint of this in Hamilton's reference to "extraordinary indemnifications", although

with "arm's length" trade, typically in two-period signaling models. In Collie

2. THE OPTIMAL DUOPOLY TARIFF WITH UNKNOWN COSTS I

STP literature, modifying it to allow for private foreign cost information. A

U(x, y)=a,x+a,y-(bxx2 + byy2+2/cXy) / 2

with equality in the case of perfect substitutes. This utility specification

With the quasi-linear utility function, an exact measure of consumer surplus is

from which it is drawn by 'Nature' is common knowledge, as is the level of

standard social welfare function, consisting of the unweighted sum of consumer

x = [2b, (ax- q ) - k(a, - c, - t)] / H

To maximize expected welfare, using the linearity property of the

Equating to zero gives the optimal tariff formula

In fact, k = 0 is a 3pecial case of this model, with no substitutability, which is

3. THE OPTIMAL TARIFF AND INDUCED ENTRY /

Can inefficient entry be induced by the optimal tariff! Consider a situation in

Inefficient entry is possible only if R < 0. The reduced-form expressions for

I Assume that the support and expectation of the probability distribution of

(ii) Q is strictly concave in c,:

PROPOSITION 3. Entry induced by a tariff t* based on expectedforeign costs

Note that Proposition 3 provides only a necessary condition for inefficient

4. STRATEGIC ENTRY DETERRENCE 1

'standard game-theoretic solutions to such signaling games require, at a minimum, that

in order to credibly signal its low costs.

, product differentiation. It can be shown that dW, / d k < O , so that greater

PROPOSITION 4. The optimal tar@ formula (12), applied with dynamic

APPENDIX: Proof that (20) and (21) are incompatible

3J6(5cH- 6cJ2 + 7 2 ( ~ <~&(29cH

Informed Policymakers," Journal of International Economics, February 1997,

Manchester School, June 1992, 136- 15 1.

Raff, Horst, "Incentive-compatible Regulation of Foreign-owned Subsidiaries: A

Mailing Address: Professor Aditya Bhattacharjea, Delhi School of Economics,

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