Free Trade Vs. Strategic Trade: A Peek into Pandora's Box

We investigate whether a welfare-maximizing government ought to pursue a programme of strategic trade intervention or instead commit itself to free trade when, in the former case, domestic firms will have an opportunity to manipulate the government’s choice of the level of intervention. Domestic firms may over-invest in physical and knowledge capital in a regime of strategic intervention in order to influence the government’s choice of subsidy. In the event, a commitment to free trade may be desirable even in settings where profit-shifting would be possible. We analyse the desirability of such a commitment when the government is well informed about firms’ types and actions, and when it suffers from an informational disadvantage.