Domestic Monopoly as a Domestic Distortion

Trade theorists have recognized for at least thirty years that domestic monopoly may cause a "domestic price distortion" with the result that a country's foreign trade is not optimized under laisser—faire conditions. Surprisingly, no one appears to have investigated the question as to how the monopolistic distortion could persist under conditions of free trade. Within the framework of conventional trade theory the case of a domestic monopoly is an empty box, as the alleged distortion disappears without intervention when free trade exists. The distortion can, however, be resurrected by assuming either a less than perfectly elastic supply of imports or imperfect substitutability between domestic and imported products. The distortion is likely to be important during periods of underutilized capacity when import-competing producers refuse to cut domestic prices to the level of short-run marginal cost. The theoretical argument has several important implications for trade policy in the post-Tokyo-Round era