International Trade with Domestic Regulation under Asymmetric Information: A Simple General Equilibrium Approach∗

Abstract: This paper investigates the consequences of designing domestic incentive regulation under asymmetric information in the general equilibrium context of an open economy. We discuss the implications of such incentive regulation for international spe-cialization and the conditions for trade openness to be still welfare-improving. More specifically, we append to an otherwise standard 2 × 2 Heckscher-Ohlin model of a small open economy a continuum of intermediate sectors producing non-tradable goods used in tradable sectors. Those goods are produced by local firms which are privately informed on their technologies but are regulated by a domestic regulator. Even when domestic regulation is optimally designed at the sectoral level, asymmetric information generates distortions which cannot be corrected. The small country becomes relatively richer in the factor which is informationally sensitive so that asymmetric information might reverse patterns of trade. Free trade is Pareto-dominated by autarky when it exacerbates the distortions due to asymmetric information. As an aside, our methodology provides a con-strained First Welfare Theorem under asymmetric information of general interest beyond our trade model