Endogenous Tariffs in the Presence of Multinationals

This paper analyzes the effect of the presence of multinational firms on endogenous tariff rates, using an analytically solvable two-country model with fixed terms of trade. Noncooperative tariffs are lower in the presence of market-seeking (horizontal) foreign direct investment (FDI). Such firms avoid trade and entail a loss of tariff revenues for importing countries. In the case of low-cost-seeking (vertical) FDI, the results are less clear-cut and the noncooperative tariff rate can turn out to be a subsidy. The world-welfare-maximizing policy is an import subsidy.