Optimal Domestic Regulation and the Pattern of Trade

This Paper analyses the impact of asymmetric information within countries on the pattern of international trade. We append to the standard 2×2 Heckscher-Ohlin model of a small economy a continuum of sectors producing intermediate non-tradable goods. Those goods are produced by monopolies having private information on their technologies. With asymmetric information and under optimal regulation, production in these sectors is inefficiently low. The small open country is relatively richer in the factor that is more intensively used by the privately informed sectors. Asymmetric information can reverse the country’s pattern of comparative advantages. Due to the existence of information rents in these sectors, the economy does not only receive the standard factor endowments (capital and labour) but also an ‘informational endowment’ which boosts demand for tradable goods. Free trade with optimal regulation is Pareto dominated by autarky with optimal regulation when, under asymmetric information, there is a reversal of comparative advantages. This result suggests that optimal ‘behind-the border’ regulatory policies cannot be considered separately from trade policy instruments, when regulation is characterized by serious problems of asymmetric information.