Protection without Discrimination

This paper shows that domestic regulations may fully respect the non-discrimination principle of the WTO and still act as a protectionist device. The core mechanism is a profit shifting effect between firms within sectors. By increasing production costs of all operating firms in a market, domestic regulations force the least efficient firms to exit, increasing market shares of surviving firms. This generates protectionism in the aggregate if it forces relatively more foreign firms to exit, or if domestic firms are relatively more efficient. Introducing political economy motives in the model, this paper shows that trade liberalization increases the use of domestic regulations in the non-cooperative equilibrium, because it improves their protectionist effect. Moreover, a trade agreement may be welfare reducing if governments only care about the most efficient firms. If thefirm productivity distribution differs across countries, the low productivity country cannot retaliate to a non-discriminatory protectionist policy from the high productivity country. In this context, a Pareto improving trade agreement requires an international income redistribution between countries, which is at odds with the principle of reciprocity in trade negotiations. These results may help explaining why recent trade negotiations are proven difficult and face increasing opposition