Maggi - Strategic Trade Policies With Endogenous Mode of Competition

American Economic Association
Strategic Trade Policies with Endogenous Mode of Competition

Author(s): Giovanni Maggi
Source: The American Economic Review, Vol. 86, No. 1 (Mar., 1996), pp. 237-258
Published by: American Economic Association
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Strategic Trade Policies with Endogenous

Mode of Competition
By GIOVANNI MAGGI *
Thispaper develops a model of capacity-pricecompetitionin which the equilibrium
outcome rangesfrom the Bertrandto the Cournotoutcome as capacity constraints
become more important.This model is employedto reexamineaspects of strategictrade-policytheoryand, inparticular,the theory'swell-knownsensitivityto the mode
of oligopolistic competition.Among other things, the analysis identifies a simple
single-ratepolicy, namely,capacitysubsidies,which can increasethe homecountry's
income regardless of the mode of competition.This suggests that the presence of
critical informationalconstraintsneed not diminishgovernments'incentivesto distort the internationalcompetition.(JEL D43, F13, L13)
Since its very inception, the theory of strategic trade policy has attractedmuch attention
and much criticism. The "skeptical" view of
strategictradetheory is well representedby the
following statement, taken from a recent article of Paul Krugman (1993 p. 363):
cal. Focusing on the empirical evidence first,

the results in this area, while negative, are far
from conclusive. The impact of export policies
on national incomes has been evaluated using
"calibration" models, rather than estimation
procedures that employ real data. Most trade
economists interpret these quantification exercises with caution, allowing for a wide margin of error. Overall it is safe to say that the
jury is still out for the empirical evaluation of
trade policies.
A potentiallymore damagingcriticismraised
against strategic trade models is of theoretical
nature. It is pointed out that their conclusions
rely heavily on the assumption that governments have complete information about the
markets targeted for intervention. This criticism is all the more relevant because the predictions of the theory are very sensitive to the
particularitiesof the markets. One key sensitivity of the strategic-trade models concerns
the mode of competition: if firms compete in
quantities,the optimal policy tends to be a subsidy to the home firm (James A. Brander and
Barbara J. Spencer, 1985), but if firms are
price-setters the optimal policy tends to be a
tax (Jonathan Eaton and Gene M. Grossman,
1986). If a government lacks information
about the exact nature of competition, trade
policies based on the wrong beliefs can be
harmfulfor the home country:for example, an
export subsidy reduces the home country's
welfare if firms compete in prices.
After several years of theoretical and

empirical investigation, it has become
clear that the strategic trade argument,
while ingenious, is probably of minor
real importance. Theoretical work has
shown that the appropriatestrategictrade
policy is highly sensitive to details of
market structure that governments are
unlikely to get right, while efforts to
quantify the gains from rent-snatching
suggest small payoffs.
Two lines of criticism can be detected in the
above quote: one empirical and one theoreti*
Department of Economics, Princeton University,
Princeton, NJ 08544. I gratefully acknowledge financial
supportfrom the Alfred P. Sloan Foundationand the Center for Economic Policy Research (CEPR) at Stanford. I
am grateful to Robert W. Staiger for his constant encouragement and help. I thank Dirk Bergemann, Avinash
Dixit, Mario Epelbaum, Gene Grossman, Thomas
Hellmann, Kenneth Judd, Paul Milgrom, Andr6s
Rodrfguez-Clare, Peter Thompson, Ernst Ludwig von
Thadden, and seminar participantsat Stanford University
and the University of Chicago for helpful discussions and
comments. I also thank an anonymous referee, whose
comments led to substantialimprovement of the paper.
237
238
THE AMERICANECONOMICREVIEW
These theoretical findings-the policy sensitivity and the informational requirements

that this sensitivity implies-have generally
been interpretedas striking a devastatingblow
to strategic-tradetheory, as either a normative
or a positive theory. Thus far, however, the
theoretical literaturehas fallen short of a rigorous examination of the implications of this
form of incomplete information on trade policy issues. Arguably, an importantstep toward
a better understandingof this issue is to introduce explicitly the policymakers' informational constraints in the trade-policy models,
in order to address the question of whether
governments are still driven to intervene in the
international competition even when they do
not know the natureof the firms' oligopolistic
conduct.'
The present paper takes a step in this direction. The analysis is in three stages. First, a
new model of oligopoly is developed, in which
the mode of competition is traced back to a
structuralparameter, whose level determines
whether the outcome more resembles price or
quantity competition. This model is then employed to analyze strategic trade issues in a
complete-information environment. The final
step is to examine trade policies when the
government is uncertain about the mode of
competition.
The mode of competition, ratherthan being
identified with the variablechosen by the firms
(price or quantity), is determined endogenously by the importance of capacity constraints. Unlike more traditional models of
capacity-constrained price competition (such
as David M. Kreps and Jose A. Scheinkman,
1983), capacity commitment is not modeled
as an inflexible constraint: firms can produce
in excess of capacity, but at a higher marginal
cost; the additional cost of producing above
capacity is the parameterthat captures the importance of capacity constraints.Firms set capacities at the first stage and then compete in
prices given the cost curves generated by their
' LarryD. Qiu (1994), Maggi (1992), and Lael Brainard

and David Martimort(1992) examine strategic trademodels in which governments lack information about cost or
demand parameters but do not address issues of uncertainty about the mode of competition.
MARCH 1996
choice of capacity. The model predicts that the

equilibriumoutcome ranges from the Bertrand
to the Cournotoutcome as capacity constraints
become more important. In this perspective,
the mode of competition is identified with the
extent to which firms can mitigate price competition through their capacity choices, and it
becomes a continuous variable rather than a
binary variable, thus capturing intermediate
situations between the pure Bertrand and
Cournot cases.
The model can also be contrasted with the
conjectural-variations model, which is a
common way to parameterize oligopolistic
conduct.2 The similarity between the two
models lies in the fact that the mode of competition is ultimately indexed by a single parameter, and the equilibrium prices and
quantities range from the Bertrand to the
Cournot outcome as this parameter varies.
The model proposed here, however, has a
dual advantage over the conjectural-variations
model: first, the mode of competition is indexed by a structural parameterwhich is (at
least in principle) observable, whereas the
conjectural-variationparameteris not even observable in principle; and second, it is based
on game-theoretical foundations, which are
lacking in the conjectural-variationsmodel.
When oligopolistic competition is modeled
in the way described above, new insights arise
about the role of strategic trade policies. One
interesting point is the following. Capacities
are strategic substitutes, yet it is not always
desirable to induce an expansion of the home
firm's capacity: this is true only if capacity
constraintsare importantenough, but when capacity constraints are less important it is optimal to induce a contraction of the home
firm's capacity (and output). This result can
be understoodintuitively in the following way.
In this model, capacity is an imperfect commitment device thathelps the firm to limit production and sustain higher prices. When this
commitment device is effective enough, it is
optimal to encourage a capacity expansion by
the home firm in order to induce a contraction
of the foreign firm. However, if capacity is not
2 See Carl Shapiro (1989) for a concise exposition of

the conjectural-variationsmodel.
VOL. 86 NO. 1
MAGGI: STRATEGICTRADEPOLICIES
a very effective commitment device, it is desirable to tax the home firm's output, in order
to provide the home firm with some additional
commitment ability.
The last step of the analysis is to reexamine
the "infonnational" criticism of the strategictrade theory. As already pointed out, output
policies are potentially harmful for the home
country if the mode of competition is unknown. However the analysis identifies a simple single-rate policy, namely, subsidies to
investment in capacity, which are (weakly)
beneficial to the home country regardless of
the mode of competition: a small capacity subsidy is strictly beneficial if capacity constraints
are important enough, and it is neutral if capacity constraints are less important. Moreover, this is true regardless of the specific
values of demand and cost parameters. This
result suggests that investment policies are less
sensitive than output policies to the specific
characteristics of the market: governments
may have incentives to distortthe international
competition even when they lack information
about all the relevant parameters of the targeted industry.3
A capacity subsidy can be interpretedas any
policy that encourages expansion of the domestic firms' productive base. Examples include incentives for investment in new plants
and machinery,either by direct subsidies or by
indirect means such as low-interest loans or
tax credits. Gary C. Hufbauer and Joanna S.
Erb (1984) report anecdotal evidence of such
policies in several countries. For example,
they report Alan K. Wolff's ( 1983, pp. 7-8)
description of "industrial-targeting" policies
pursued by the Japanese government in industries like computers, microelectronics, robotics, machine tools, and aerospace: "... with the
help of government grants and loans, and the
cooperation of the banking system, large new
investments are made in advanced production
equipment...."
One possible criticism to the approach followed in this paper is that it abstractsfrom the
3 This result is consistent with Kyle Bagwell and

Robert W. Staiger's (1994) analysis of strategic subsidies
to R&D investment. They find that the optimal R&D policy is independent of the mode of competition.
239
political-economy motivations that often lie

behind tradepolicies. One might argue that the
reason governments intervene in spite of all
their informationalconstraintsis that in reality
the motivations behind trade policies are
chiefly "political." The insights of this paper
however should be viewed as complementary,
not in contrast, to the political-economy explanations of trade policies: the point of the
paper is to show that the presence of stringent
informational constraints need not reduce the
governments' economic incentives to distort
the firms' competition, and this is potentially
important for the interpretationof real trade
policies.
. Another paper that examines strategic trade
policies under "endogenous" mode of competition is Didier Laussel (1992), who employs Paul D. Klemperer and Margaret A.
Meyer's (1989) model of supply-function
competition; Laussel does not consider informational issues. Since the supply-function
model can be viewed as an alternativeway to
endogenize price versus quantity competition,
one might wonder whetherthe supply-function
model could be helpful in examining the issue
of uncertaintyabout the mode of competition.
It should be noted first that, in the supplyfunction model, single-rate subsidies/taxes
(which affect the level of the firm's marginal
cost) have no impact on the equilibriumprices
and quantities:making the home firm more or
less aggressive does not per se influence the
equilibrium outcome. Only nonlinear subsidies/taxes (which affect the slope of the
marginal-cost curve) can affect the equilibrium outcome. Hence the supply-function
model does not seem suitable for examining
the "traditional" sensitivity issue of singlerate subsidies versus single-rate taxes (or, in
other words, the Brander-Spencer vs. the
Eaton-Grossman policy), which is the focus
of the present paper: the Brander-Spencerand
Eaton-Grossman cases are not encompassed
by the Laussel model, while they constitute the
benchmarks of the present model.
The paper is organized as follows. In
Section I the oligopoly model is developed.
Section II examines optimal trade policies
under complete information.Section Im examines trade policies under incomplete information. Section IV containsconcludingremarks.
240
I. Preliminaries: Price versus Quantity

Competition
The Cournotmodel of quantity competition

has been the subject of considerable criticism
in the theory of industrial organization. If
taken literally, the Cournotmodel assumes that
firms dump their productionon the marketand
that an auctioneer determines the price that
clears the market. In most industries there is
nothing that resembles an auctioneer, and
firms use prices as a strategic variable. The
Cournot model has been recently reinterpreted
as the reduced form of a richer game, in which
firms can commit to capacity levels prior to
setting prices (Kreps and Scheinkman,1983) .4
The common assumption of these models is
that the cost of producing beyond capacity is
infinite; that is, capacity imposes a strict
constraint on production. These capacityconstrained models, however, present a few
unsatisfactoryfeatures, aside from the dubious
realism of the assumption of infinite cost of
productionbeyond capacity. First, they predict
that for certain regions of capacities the price
subgame has only a mixed-strategy equilibrium. This equilibrium does not possess the
"no-regret" property:afterprices are realized,
a firm will generally like to change its price;
if one believes that prices can be changed
much more quickly than capacities, this prediction is problematic. Furthermore,the prediction aboutthe emergence of Bertrandversus
Cournot outcomes is of an all-or-nothing nature: the equilibrium is Bertrand or Cournot
depending on whether or not the industry is
characterized by capacity constraints; these
models do not capture situations that lie between these two extremes.
Rigid capacity constraints are not the only
way to formalize the notion of quantity competition. As Jean Tirole (1988 pp. 217-18)
observes, " [i] n most cases, firms do not face
4 For the Cournot outcome to obtain, several assumptions must be satisfied: efficient rationing, perfectly substitutable products, and symmetric costs. If any of these
assumptions does not hold, the Cournot outcome may not
obtain. See for example Carl Davidson and Raymond
Deneckere (1986) for the extension of the KrepsScheinkman model to different rationing rules.
MARCH 1996
rigid capacity constraints. ... More generally,

what we mean by quantity competition is really a choice of scale that determinesthe firm's
cost functions and thus determines the conditions of price competition." Here I follow this
more "flexible" approach,modeling capacity
as an imperfect commitment device. This
modeling approach will generate price subgames with unique pure-strategy equilibria
and will yield richer predictions as to the determinants of the mode of competition, while
at the same time simplifying the mathematical
structureconsiderably. Consider two firms that
produce (symmetrically) differentiated products, and assume that demand is linear for each
= a - b1p' + b2p-',
product:q' = D(pi,p-)
i = 1,2, b, > b2 > 0.5 On the cost side, assume
that each firm can produce at constant marginal cost c up to the capacity level k and
incurs an additional cost 0 for each unit produced in excess of k. The "short-run" marginal cost is thus given by
c
for
qi
c + 0
for
qi > k.
MCi9
The "short run" total cost is

T
cq'
forq'
TC9Q
1
ck' + 9(qi
ki') for qi > kI'.
The unit cost of capacity is assumed to be

constant and is denoted by c0, so that the total
cost of capacity is given by TCi = cok'. The
"long-run" marginal cost is therefore given
by c + c0. For the firm to have an incentive to
invest in capacity, the long-run cost must be
lower than the cost of producing in excess of
capacity; therefore, I will assume c0 ' 0
throughoutthe paper.
This cost structureadmits several interpretations. One is that the firm can produce k units
of the good "in house," and if it wants to produce more than k it has to incur a higher cost
' I will point out how results can be generalized to nonlinear demand functions in later footnotes. In order to
economize on space and algebra, I will generally use the
notation D(p', p-') ratherthan the explicit linear notation.
VOL 86 NO. I
(e.g., because it has to purchase inputs from

outside the firm, or it has to subcontract part
of the production process). An alternative interpretationis that 0 may represent the cost of
overtime work; under this interpretation,the
value of 0 would be influenced by such factors
as the degree of unionization of the industry:
the presence of a union may raise the cost of
overtime work, thus making capacity constraints more inflexible. In all cases, k represents the "maximum efficient scale" of
production, and the parameter 0 captures the
importance of capacity constraints in the industry.6I assume that 0 has the same value for
the home and the foreign firm, but the model
can be easily extended to allow for differences
in the importance of capacity constraints
across countries.
The game consists of two stages. In the first
stage, firms simultaneously choose capacities.
In the second stage, afterobservingboth capacities, firms simultaneouslychoose prices, then
produce to satisfy demand. Firm i maximizes
total profits, given by xr' = p'D(p', p-i) TC9 - TC. If the firm produces at capacity
(q' _ k'), which will always be the case in
equilibrium,the profitfunction reduces to 7r'=
(pi
c - co)D(p,
pi).
It will be useful to define a "Bertrand"

benchmark and a "Cournot" benchmark for
this game. Since the long-run per-unit cost is
given by c + co, the relevant Bertrandbenchmarkis the one-shot game in which firms have
constant marginal cost c + co and compete in
prices, while the Cournot benchmark is the
one-shot game in which firms have constant
marginalcost c + co and compete in quantities.
The mechanism through which capacity
commitment,can mitigate price competition is
6A similar cost structure is postulated in Avinash

Dixit's (1980) model of entry barriers.Dixit's model differs from the present one not only because one firm (the
incumbent) enjoys a first-mover advantage, but because
firms compete in quantities, not in prices, after the investment stage. Another key difference is that Dixit assumes
0 = co: investment in capacity has the characterof a pure
sunk cost, whereas in this paper investment has a costsaving function. Staiger and Frank A. Wolak (1992), in
the context of a capacity-constrainedgame with demand
uncertainty,make a similar assumption of "flexible" capacity constraints: after the realization of demand, firms
can add to the initial capacity but at a higher cost.
241
intuitive. By choosing scale k, a firm generates

a disincentive for itself to produce more than
k at the following stage, and this commitment
device is used strategically to sustain higher
prices. The parameter 0 measures the effectiveness of this commitment device, thereby indexing the mode of competition: I will show
that as 0 increases the outcome of the game
(prices, quantities and profits) moves from the
Bertrand benchmark to the Cournot benchmark. The Bertrandoutcome obtains for 0 =
co, and the Cournot outcome obtains for 0
higher than some critical level 9C.
This result is broadly consistent with the results of Klemperer and Meyer (1989) and
Kenneth L. Judd (1989), in spite of the very
different structureof these models: both models find that a critical factor in determiningthe
nature of competition lies in the convexity of
the cost curve, with higher convexity pushing
toward the Cournot outcome. In the model
proposed here, the total cost of production is
piecewise linear but globally convex, with a
higher 0 implying higher convexity: here too,
higher convexity of the cost curve pushes the
equilibrium closer to the Cournot outcome. In
this sense, the present model, in spite of its
static and very stylized structure,seems to capture some essential elements of more fully
fledged models of oligopolistic competition.
A. The Price Subgame
The first step is to derive the subgame reaction function of each firm given the installed
capacities. First define: r'(p-'; x)
that is, the
argmaxp(p - x)D(p, p'),
Bertrandreaction function when marginalcost
is constant at x. Also let: pi = 'V(p-'; ki) be
defined implicitly by D(p', p -) = k', which
representsthe price combinations such that the
demand for firm i is constant at k'; in other
terms, i(p`; ki) is an isoquantity curve.7 It
is easy to verify that &4Vlap` > ar'/jp-F.
The following lemma derives the subgame reaction function, denoted by pi = R'(p-'; ki)
(see Figure 1).
'The closed-form expressions for r' and 4'1 are
r'(p-';x) = (a + b2p-')/2b, + x/2 and VD(p-';k') = (a +

b2p-' -k')Ib,.
THE AMERICANECONOMIC REVIEW
242
pz
R1(p2;k1
r1(p2;
C)
1(p2;
r2c
k1)
+0)
FIGURE
1.
THE SUBGAME REACTION FUNCTION
LEMMA 1:
R'(p'; k') = r'(p'; c)
bJ'(p-; kl)
R'(p'; k')
ri(p -;
<
1(p-';
C) s
1,(p;
where
r'(p-'; c)
k')
(branch 1)
where
k') '
r'(p1;
c + 0)
(branch 2)
R (p';
k')
JV(p-'; k')
r' (p;
>
c + 0)
where
r'(p'-; c + 0)
(branch 3).
The proof of Lemma 1 is intuitive. Given

p, firm i chooses the optimal point along its
residual demand curve. This choice can be described as picking the quantity level at which
firm i's residual marginal revenue curve, say
MR j, crosses its marginal cost curve MCi. If
p' is low, so that 4V(p'; k') < r'(p'; c),
MR rcrosses MCi where MCi = c, so the bestresponse price coincides with the Bertrand
best-response price for constant marginal cost
c, namely, r'(p'-; c). This explains "branch
1" of R'. If p-' is intermediate, so that r'(p'-;
c) s 1?'(p'; k') c r'(p-'; c + 0), MRi
crosses MCi at its vertical segment, where
qi = k'; thus, firm i's best-response price is the
one that keeps q' constant at k', namely,
MARCH 1996
VJ(p `i; k'). This explains "branch 2" of R'.

Finally, if p-' is high, so that 4iV(p` ; k') >
r'(p'; c + 0), MR' crosses MCi where MCi =
c + 0; hence the best-response price coincides
with the Bertrandbest-response price for constant marginal cost c + 0, that is, r'(p-i; c +
0). This explains "branch 3" of R'.
The equilibrium of the price subgame is
given by the intersection of the two subgame
reaction functions. One can check that the
slope 0R'1/p -i lies between 0 and 1 for any
pair of capacities. This implies that for any
pair of capacities the subgame admits a
unique pure-strategy equilibrium.8
It may be interesting to relate this result to
the well-known fact that pure-strategyequilibria (in prices) often fail to exist in Bertrandcompetition games with homogeneous goods
and rigid capacity constraints (e.g., Kreps and
Scheinkman, 1983). The nonexistence problem is caused by two features of these models.
One is product homogeneity, which implies a
discontinuity in the residual demand function.
The other is that the production cost is infinite
for output in excess of capacity. This implies
that consumers must be rationed for certain
ranges of prices, and the demand "spillovers"
from one firm to the other may imply profit
functions that are not quasi-concave. In the
model proposed here, neither of those features
is present, since I assume differentiated goods
and firms do not have to ration consumers
(since the marginal cost of production is finite
for any production level); hence, profit functions are continuous and quasi-concave, and a
unique pure-strategyequilibrium exists.9
x For nonlinear demand functions, Lemma I and the

uniqueness of a pure-strategyequilibrium in the subgame
still hold as long as: (i) products are substitutes and own
effects dominate cross effects in demand, so that the slope
of 1Dis between 0 and 1; (ii) the Bertrandreaction function
(for constant marginal cost) is upward-sloping and "stable," meaning that its slope is also between 0 and 1; (iii)
if p-i is increased, firm i's optimal point on its residual
demand curve entails a higher price and a higher quantity.
One can show that this implies 09V/0p-' > Or'/0p`.
9 When products are differentiated and capacity constraints are rigid, price subgames may or may not have
pure-strategy equilibria. A model with this structure is
examined by James W. Friedman(1988). Friedmanshows
that in this case profit functions may or may not be quasiconcave: if the demand spillover (generatedwhen one firm
VOL. 86 NO. I
B. The Full Game

I now solve for the subgame-perfectequilibria of the whole game. I first examine the case
in which firms have symmetric demand and
cost functions and then generalize the results
to the case of asymmetric firms. Let {pb(x),
qb(x)1 and {pc(x) qc(x)1 denote, respectively, the Bertrand and Cournot price and
quantity when both firms have constant marginal cost x. As already argued, the relevant
benchmarksfor this game are the Bertrandand
Cournot prices and quantities when x = c +
co. I assume that output is positive at the
benchmark Bertrand and Cournot equilibria.
Given the linear-demand specification, this is
ensured if c + co < a/(b - b2).
It is first useful to compare the Bertrandand
Cournot benchmarks in price space. The
Bertrandprice pb(c + co) is given by the intersection of the two curves r (p2; C + co) and
+ co) (point B in Figure 2). The
r2(pl;c
Cournot price pc(c + co) can be identified
graphically if one first defines a new curve.
Suppose firm i chooses the optimal price pair
taking the rival's quantity as fixed, say, at k-i.
This entails choosing the point of tangency between firm i's highest isoprofit curve and the
k').l0 As k'
rival's isoquantity 4i(pi,
changes, this tangency point traces a curve in
price space, which I denote by 0i(p i; c + co)
(this curve can be seen in Figure 3, together
with another curve to be defined later). The
curve C can be interpreted as representing
"Cournot conjectures" in price space." The
Cournot price pair is given by the intersection
of O' and C2 or, equivalently, the point at
which each firm's isoprofit is tangent to the
rival's isoquantity (point C in Figure 2).12 It
A
243
should be noted that the curves r' and C' are

in general not parallel. With linear demand,
one can check that Orl/Op' < Ci/Opi.13
C. SymmetricEquilibria
For expositional purposes I first look for
symmetric equilibria. Asymmetric equilibria,
which can arise for certain parametervalues,
are discussed in the next subsection. The next
proposition establishes that the game admits a
unique symmetric equilibrium.As 0 increases,
this equilibrium moves from the Bertrand
point B to the Cournot point C. In particular,
the Bertrand outcome obtains when 0 = co,
and the Cournot outcome obtains when 0 is
higher than a critical level OC,defined implicitly by pb(c + OC) = pc(c + co) (it can be
shown that this equality defines a unique OC).
For intermediate levels of 0, the symmetric
equilibrium price is given by the Bertrand
price for marginalcost (c + 0), that is, pb(c +
0). This result is recorded in the next proposition, whose proof can be found in the Appendix, along with all other proofs of the
paper.
PROPOSITION 1: If firms are symmetric,
the game admits a unique symmetricsubgameperfect equilibrium. This equilibrium entails
[p b(C + 0)
0 < OC
if
co
if
oc
if
co-
if
k= D(p, p)
qb(C
-
rations its customers) is small enough relative to the degree of product differentiation, the quasi-concavity of
profit functions is preserved, and the price subgame may
admit pure-strategyequilibria.
'?When I use the term "isoprofit" without further
specification I am referringto the "long-run" profit function, 7r'= (p' - c - c)D'(p', p-').
" The closed-form expressionfor C' is C'(p-'; c + co) =
[bb2p-i + ab1 + (c + co)(b2 - b2)]1/(2b2- b2).
12 With linear demand, the Bertrand price is always
lower than the Cournot price. With nonlinear demand, the
Bertrandprice is lower than the Cournot price underfairly
pC(c + co)
[p
+ 0)
qc(c + co)
-
<
0C
oc
(c + co)]k.
Proposition 1 suggests that the parameter0,

which measures the importance of capacity
general conditions; a sufficient condition, for example, is
that the Bertrandand Cournotprices are unique, as shown
in Xavier Vives (1985).
'3 With linear demand, the condition for r' to be flatter
than e' is b2 < 2b1/1F,which is always the case, since
b2 < b.
cost c + 0, that is, pb(c + 0), as long as this

price does not exceed the Cournot price.
In sum, the choice of capacity is an imperfect commitment to limit production and raise
prices. The higher is 0, the more effective is
this commitment device, and the higher is the
price that firms can sustain.
p2
r (p2;
C + C.)
,)1(p2;
k')
2(p'
k2
'r
D. Asymmetric Equilibria
r2(pl;
C.)
FIGURE 2. THE BERTRAND AND COURNOT BENCHMARKS
constraints, indexes in a naturalway the mode

of competition, from the case of pure price
competition (Bertrand) when H = co, to that
of pure quantity competition (Cournot) when
0
MARCH 1996
244
c 14
The intuition for this result is the following.

In the absence of capacity constraints, the
equilibrium is given by the Bertrandprice, at
which each firm's marginal benefit from lowering the price ( and increasing its market
share) equals the marginal cost of expanding
production. The Cournot price cannot be sustained as an equilibrium, because at this price
a firm's marginal benefit from price-cutting
outweighs the marginalcost of expanding production. Now suppose that 0 is high enough
and capacities are set at the Cournot level.
Now the marginalbenefit from price-cutting is
outweighed by the marginal cost of expanding
production beyond capacity; therefore, the
Cournot outcome can be sustained as an equilibrium. In general, the highest price that can
be sustained is the one at which the marginal
benefit from price-cutting equals the marginal
cost of expanding outputbeyond capacity, c +
0. But this is equivalent to saying that firms
can sustain the same price as if they were competing 'a la Bertrand with constant marginal
14 Proposition 1 holds also with nonlinear demand, under the assumptions spelled out in footnote 8.
For a certain parameterrange, the game also

admits asymmetric equilibria, as well as the
symmetric one just characterized. To identify
these additional equilibria, I need to introduce
some more notation. I will use r'(0) as a shorthand for r'(p'-; c + 0). For a given 0, consider the point of tangency between firm i's
highest isoprofit curve and the curve r-i(0).
As 0 changes, r-'(0) is shifted, and this tangency point traces a curve in price space. I
denote this curve by S'(p'; c + c(). This
curve is linear, it lies between r'(c0) and Ci,
and it can be shown that its slope is intermediate between the slopes of r'(co) and ci (see
Figure 3). Also, letp5 denote the (symmetric) price at which S' crosses the diagonal,
and let OS (< c) be the value of 0 such that
pb(c + 0) = pS. The game admits asymmetric
equilibria when 0 lies in the interval (OS, OC).
If firms are symmetric, for 0 E (O', Qc) the set
of equilibrium prices is given by
7
{(p', p2): p'

'r-(0)
pi c ci p
r1(0), Sc
-ir-^-i
p'
lor i= 2}
The structure of this set is illustrated in

Figure 4. Note that the only symmetric point
in F is pb(c + 0).16 It turns out, however, that
1 The closed-form expression for S3 is S'(p-i; c + cO)

2b,b2p- Y(4b2 - b2) + ab, + (c + co)(2b2 - b2)2. If
demand is not linear, 3i still lies between r' and C, provided the assumptions of footnote 8 are met, but the slopes
of these curves may be rankeddifferently. The qualitative
results of the model are not affected, however.
6 The reason a point like Q in Figure 4 constitutes an
equilibrium can be explained heuristically as follows. The
capacity levels that sustain Q as equilibrium prices are
such that 4V and 12 trace through Q; call these capacities
kQand kQ.Given kQand kQ,prices Q clearly constitute an
VOL. 86 NO. I
robust equilibria of the game (bold characters

denote vectors).
p
c + Co)
r'p;
c + c0)
S'(p2
C+ CO)
lC(p2;
l
PROPOSITION 2: If firms are symmetric,

the robust equilibriumprices are given by:
?~~~~(D2
(p; k2 1)
(i) the symmetric equilibrium: p = min

{pb(c + 0), pc(c + co)), and
(ii) p = zi, i = 1, 2, if E (s, Ov].
k2")
~~~~(2(p1;k2)
r2(p';
I
--
___
2(p1;
- - - -
- - - -
245
c + 6")
r~~2(pl;
C ? 9')
At any equilibrium, capacities are given by
k = D(p).
2p;C + Co)
p
FIGURE 3. THE CURVES C AND 3
I will now generalize the previous result to

allow for asymmetric costs or demand functions, but first I need to define one more
curve. Let R'(p -') denote the lower envelope
of the curves r'(0) and Ci: Ri(p-)
min{r'(p-'; c' + 0), C'(p-; c' + c')} Notice that, if firms are symmetric, the intersection between R' (p2) and R2(pl) is given by
the symmetric equilibrium, min {pb (C + 0),
pc ( c + co)). The next proposition describes
the set of robust equilibria allowing for asymmetric firms. In it, the definitions of point z'
and the set F are analogous to the definitions
in the case of symmetric firms. The proof follows logic similar to that of Proposition 2 and
is omitted.
=
most of the asymmetric equilibria are not robust to a small perturbation of the model,
namely, an approximationof the marginal-cost
function with a close-by smooth function. The
only asymmetric equilibria that survive this
perturbationare points z' and z2 (see Figure4),
where z' is the intersection between r"(0) and
Moreover, these points constitute equils
ibria only when 0 lies in the interval ()V, C),
where Ovdenotes the value of 0 such that point
z'Ilies on c&(one can check that OS< Ov< Oc).
When H > C)V,the points z' and z2 fall outside
F; hence, they are no longer equilibria of the
game. The next propositiondescribes the set of
PROPOSITION 3: The robust equilibrium

prices are given by:
(i)
the intersection of R'(p2)
and
(ii) z' if z'
equilibrium of the subgame. The question is: why are kQ
and kQequilibrium capacities? (i) Given kQ, firm 1 would
like to implement the Stackelberg point on firm 2's subgame reaction function, R2(p'; k2) - R2, by suitable
choice of k'. Since RQ has a kink at Q, and firm l's isoprofit is tangent to R2 at that kink, firm l's Stackelberg
point is given by point Q; hence choosing kQ is optimal.
(ii) Given kQ, firm 2's Stackelberg point lies somewhere
on R'(p2; kQ)above Q; however, no point above r2(0) can
constitute an equilibrium (this follows directly from
Lemma 1). Thus firm 2 cannot do better than inducing
equilibrium prices Q, by setting capacity k .
17 There is no simple intuition for this result, but the
reason an equilibrium like Q in Figure 4 is not robust is
that this equilibrium relies heavily on the presence of a
kink in firm 2's subgame reaction function R2. If the marginal cost curve is approximated with a smooth function,
R2 also becomes smooth, and the equilibrium breaks
down.
and R2(p'),
e F (i = 1, 2).
At any equilibrium, capacities are given by
k = D(p).
E. Comparative Statics
Before turning to trade policy issues, it is
worth pointing out some comparative-statics
implications of the model that may be of interest for oligopoly theory. The first one
concerns the impact of the parameter 0 on
equilibrium prices, quantities, and profits. As
0 increases, prices and profits increase (and
quantities decrease) for both firms, unless 0
is sufficiently high, in which case further
THE AMERICANECONOMIC REVIEW
246
p2
/I2
|() /
p1
FIGURE4. THE ASYMMETRICEQ2uILIBRIA
changes of 0 have no impact. When there are

multiple equilibria, this statement holds for
each equilibrium. In sum, the model predicts
that when 0 is higher ( i.e., when capacity constraints are more important), the outcome
tends to be less competitive. This prediction of
the model is potentially testable, to the extent
that 0 can be quantified. This is in sharp contrast with the conjectural-variations model, in
which the parameter that indexes oligopolistic
conduct is not even observable in principle ( let
alone its problematic interpretation).
The second interesting implication of the
model concerns the impact of the cost of capacity co,. The existing models of capacityconstrained price competition suggest, in Jean
Tirole's ( 1988 p. 217) words, that "the
Cournot-outcome results are more likely to
hold when the investment cost c,, is high." I
The idea is that, when capacity constraints are
rigid, a high cost of capacity co generates
a large discrepancy between first-period (ex
IxIn this statement, Tirole refers to the class of twoperiod games in which firms choose (rigid) capacities in
the first period and prices in the second period. In Kreps
and Scheinkman (1983), the equilibrium outcome coincides with the Cournot outcome regardless of co, but as
soon as one introduces asymmetries in the firms' costs,
rationingrules different from the "efficient" one, or product differentiation, the equilibrium may not coincide with
the Coumot outcome if c( is relatively small, whereas the
Coumot outcome obtains if co is high enough.
MARCH 1996
ante) costs and second-period (ex post) costs;

hence it induces a higher willingness to
"dump" existing capacities (charge marketclearing prices). The present model suggests
a qualification to this view. Focusing for simplicity on the symmetric equilibrium price,
p = min { pb(c + 0), pc(c + co)}, forgiven
0 an increase in co can only increase the divergence between the equilibrium price and
the Cournot price (and introduces no divergence if 0 is high enough).'9 The intuition is
that here capacity is only an imperfect commitment device: if co is high, so that there is a
large discrepancy between ex ante and ex post
costs, firms are more likely to produce beyond
capacity at the second stage, and hence are less
willing to dump the existing capacities.
II. Strategic Trade Policy under Complete
Information
Suppose a home firm and a foreign firm

compete on a third market, and assume that
the firms' products are consumed only in the
thirdcountry, so that there are no consumption
effects for the exporting countries.20The firms
are assumed to have identical costs of production and capacity.
The model focuses on unilateral trade policies, but the key insights of the analysis should
carry over to the case of bilateral intervention.
The home government is allowed to use two
policy instruments:output-per-unitsubsidies,21
which affect the production cost c, and
apacity-per-unit subsidies, which affect the
cost of capacity co. The government's objective is given by the domestic firm's net profits,
that is, its total profits minus the subsidy pay-
19 To see this, note that for 0 < 9 an increase in co does

not affect the equilibrium,pb(c + 0), while it increases the
Coumot price, pc(c + co). For 0 > 9c, the equilibrium is
+ co); hence an increase in co introduces no
pc(c
divergence.
20 This assumption, which is equivalent to assuming
that markets are segmented, is made to isolate the profitshifting motive for trade policy from issues of terms of
trade and correction of monopoly distortions. The insights
offered by the model carry over to situations where other
motives for trade policies are also present.
21 1 will generally speak of subsidies, with the understanding that a negative subsidy represents a tax.
VOL. 86 NO. I
ments (whether positive or negative) from the

government.
The trade-policy game consists of three
stages: in the first stage the home government
commits to a policy scheme, which is observed
by both firms; in the second stage firms simultaneously choose capacities; and in the
thirdstage firms simultaneously choose prices.
What is essential for the analysis is that the
government has superior commitment ability
relative to the domestic firm. This assumption
is adequate for countries that have stable and
credible governments, but in other situations
this may not be a good descriptionof the tradepolicy game. The examination of alternative
timing assumptions is potentially interesting,
but beyond the scope of the present paper.
Before proceeding, I need to clarify the
methodology of the analysis to follow. Examining the impact of unilateraltrade policies
amounts essentially to a comparative-statics
exercise on the equilibria of the oligopoly
game: one needs to understandhow changes
in the home firm's productioncost or capacity
cost affect the outcome of the game, and in
particularthe home firm's net profits. In the
last section I showed that when 0 E (Os, Ov)
absent trade policy, the game admits two
asymmetricrobust equilibria as well as a symmetric one. In order to evaluate the effects of
tradepolicies, I make two assumptions:(i) absent tradepolicies (i.e., when firms have symmetric costs) firms focus on the symmetric
equilibrium. (ii) small changes in parameters
have small effects on the equilibrium selected
by the firms. Formally speaking, if ai denotes
the vector of relevant parameters and Pe(a)
is the equilibrium price correspondence, the
firms' equilibrium selection pe(a) E Pe(a) is
restricted to be continuous in a .22,23
Together, these assumptions make it possible to examine the impact of subsidies and
22
Notice that a continuous selection from a correspondence exists whenever the correspondence is lowerhemicontinuous. In my model, the (robust) equilibrium
correspondence is continuous in the underlying parameters; hence a continuous selection exists.
23 An equivalent way of phrasingthis restrictionis with
reference to the players' expectations: if I expect you to
play pe when parametersare et, my expectation about your
action can change only slightly if et changes slightly.
247
taxes even for the multiple-equilibriumrange

of parameters. For example, the assumptions
imply that, for 0 E (OS,Ov), absent trade policy, firms focus on the point of intersection
between r'(p2; c + 0) and r2(p'; c + 0); and
if an output subsidy s is given to the home
firm, firms focus on the point of intersection
between r1(p2; c - s + 0) and r2(pI; c + 0).
I now turn to the analysis of strategic trade
policies. The existing strategic-tradeliterature
has pointed out that output subsidies tend to
be optimal when firms compete in quantities
(if these are strategic substitutes), and output
taxes tend to be optimal when they compete in
prices (if these are strategic complements). In
the present model capacities are strategic substitutes (as will be seen shortly),' while the
price subgame is one of strategic complements. This might suggest that there is scope
for capacity policies as distinct from output
policies, and perhaps that the optimal trade
policy might entail both an output tax and a
capacity subsidy. In contrast with this intuition, I will show that: (i) capacity subsidies
are redundantif output subsidies are set optimally (thus there is no loss of generality in
restricting attention to output policies); and
(ii) the optimal output subsidy is negative for
low values of 9, 0 for an intermediatevalue of
9, and positive for high values of 9, equalling
the Eaton-Grossman(negative) subsidy when
0 = co, and the Brander-Spencersubsidy when
0 is high enough.
Here I illustrate the effects of small output
subsidies/taxes; the optimal trade policy is
fully characterized in Proposition 4. The
reader can refer to Figure 5, where ri(0) is
used as shorthandfor r1(p-1, c + 0). Also recall the definition of the curve 31 (drawn in
Figure 3) and of Os,the value of 0 such that
r1(0) intersects g1 on the diagonal. Consider
first the case 0 < OS.Absent trade policy, the
equilibrium is given by the intersection between r'(0) and r2(9). An output tax shifts
r1(0) to the right, thus moving the equilibrium
point upward along r2(9). Since the laissezfaire equilibrium point lies on the left of
the curve g the home firm's net profits increase upward along r2(9). Hence an output
tax is beneficial.
Next consider the case 0 = Ss. In the absence of trade policy, the equilibrium point
248
+ 0) is also the tangency point between

the home net isoprofit and r2(0); hence, an
output subsidy or an output tax would result
in lower net profits for the home country. A
laissez-faire approachis optimal.
Suppose now 0 lies in the interval (9S, Oc).
In the absence of trade policies the symmetric
equilibrium is again given by the intersection
between r1(0) and r2(0), but now to the right
of the curve S1; hence an output subsidy,
which shifts r1(0) toward the left, is desirable.
Finally, suppose 0 > 9c. The no-intervention
equilibrium is given by the intersection of C1
and C2, that is, the Cournot point. A positive
output subsidy shifts C1to the left, so equilibrium prices move down along C2. But home
net profits increase in this direction; hence, an
output subsidy is again desirable.
The reason why capacity policies are redundant is that output policies turn out to be sufficient to implement the optimal price pair.
Thus a capacity policy cannot do any better.
Proposition 4 characterizes the optimal
complete-information trade policy as a function of 0. Let s *(0) denote the optimal output
subsidy, 5BS the Brander-Spencer subsidy
when firms play Cournot and have constant
marginal cost c + c0, and 5EG the EatonGrossman (negative) subsidy when firms play
Bertrand and have constant marginal cost
ph(c
c + CO.
PROPOSITION 4: (i) Output policies can

do everything that capacity policies can. (ii)
The optimal outputpolicy entails
s*(9) < O
for
co
s*(O) = O
for
0 =S
s*(O) > 0
for
0 > S
Furthermore,s*(9) =
s*(9)
sBSfor
5EG
0 < Os
MARCH 1996
competition and pure quantitycompetition are

special cases of Proposition 4: when 0 = co,
the optimal tax is equal to the Eaton-Grossman
tax;when0
OC, the optimalsubsidyis equal
to the Brander-Spenceroptimal subsidy.24

Notice that the result of Proposition 4 bears
a superficialresemblance to the result that obtains from a conjectural-variationmodel (see
e.g., Eaton and Grossman, 1986). In that
model, whether the government subsidizes or
taxes the home firm, or does not intervene at
all, is determined by the conjectural-variation
parameter:the subsidy is at a maximum under
"Cournot conjectures," is zero under "consistent conjectures," and is negative under
"Bertrand conjectures." In my model of imperfect quantity commitment, the strength of
the commitment (0) determines the optimal
strategic distortion of incentives. A stronger
(weaker) capacity commitment yields the
same result as a small (large) conjecturedvariation of the rival's output. The case of "consistent conjectures" corresponds to the case:
0 = O9.
The model suggests new insights about the

role of strategic distortionsof the firms' incentives. The existing literature (in particular,
Jeremy I. Bulow, John D. Geanakoplos and
Klemperer [1985] and Drew Fudenberg and
Tirole [1984]) has identified a simple principle to predict the nature of the optimal incentive distortion:a more (less) aggressive behavior is called for when the firms' choice
variables are strategic substitutes (complements). I will refer to this as the "BGK-FT
principle" of strategic distortions.
Can the BGK-FT principle help predict the
natureof optimal tradepolicies in this setting?
The answer is no. For example, in this model,
capacities are strategic substitutes, yet it is not
for 0 = co and
0 O?
2
Proposition 4 establishes that output taxes

are called for when capacity constraintsare not
very important,and output subsidies are called
for when capacity commitment is effective
enough. When capacity constraints are of intermediate strength, a laissez-faire policy is
optimal. The textbook results for pure price
24When H lies in (9S, 9V), so that multiple (robust)

equilibria arise, Proposition 4 uses the assumptionthat the
equilibrium selection is continuous in the trade-policy parameter (and symmetric, absent trade policy). While this
continuity assumption seems quite naturalfor small subsidies/taxes, it might be considered more problematic for
large policy changes. If one remains agnostic about the
effects of large policy changes in the presence of multiple
equilibria, one should weaken Proposition 4 for the interval HE (9S, 9V) to read "a small outputsubsidy is beneficial
to the home country."
VOL. 86 NO. 1
always desirable to induce an expansion of the

home firm's capacity: if 0 < O'it is optimal to
induce a contraction of the home firm's capacity (and output). The reason the BGK-FT
principle is of little guidance for understanding
optimal trade policies in this setting is the following. Since the principle is based on the assumption that firms play a one-shot game, it
can be applied only to the reduced-formgame
in capacities; hence, it can yield predictions
~ ~~~~~~2(o)O
only about capacity policies when outputpolicies are not available. To draw out the relationship between the present model and the
BGK-FT principle, it is helpful to focus first
on an amended version of the model, in which
governments are allowed to use only capacity
policies. This game is also interesting in its
own right, since export subsidies (but not casubsidies) are prohibited by GATT.25
pacity
/~~~~
p2
A.
; /
/a/~~~~~
B~~~~~
B.
r)
(0)( Si
A. Capacity Policies Only
~~~~~~C2
/
1/
r~~~~~2(o)
/~~~~~~~~
/~~~~
S
._--- B/
p 1
p2
C.
249
Ci
ri (0)
In this section I analyze the effects of capacity policies when output policies are not
available, explain why capacity policies are
less effective than outputpolicies (even though
capacities are equal to outputsin equilibrium),
and discuss the logic of optimal trade policies
in this setting. Letori (ki, k-i) denote firm i's
reduced-form profit function in terms of capacities. In order to relate the results to the
BGK-FT principle, one needs to sign the
externality effect 07ri /Ok- and the slope of
the capacity reaction function 0k1/0k-1.
A complete characterizationof these signs
for all capacity levels turns out to be complex,
but to make the importantpoints it suffices to
characterize them around the (laissez-faire)
symmetric equilibrium point, k .
LEMMA 2: Around the laissez-faire equilibrium point, capacities are conventional and
Wtrntfpaio V,h.Vtitfuft.V 26
FIGURE5. THE EFFECTSOF SMALLOUTPUTSUBSIDIES/

TAXES: A) THE CASE H < HS;B) THE CASE H C (HS,HC);
C) THE CASE H > HC
25In spite of the GATT ban, however, it is important

to understandthe governments' incentives to use export
policies, for at least two of reasons: (i) the GATT law is
not directly enforceable, and hence it is importantto analyze the incentives of governments to violate the agreements; (ii) governments are often able to offer subsidy-like
policies that fall in the gray area of the GATT law.
26 If the reduced-form profit functions or the capacity
250
(i) (O1rICik
(ii)
)Ike
(0k0/0k`C)Ike
c 0.
The intuition for result (i) is very simple:

an increase in a firm's capacity gives this firm
an incentive to expand its production and
lower its price in the second period, thereby
harming the rival firm. The intuition for result
(ii) is more subtle. For 0 > OC,firms can sustain the Cournot outcome, and the intuition is
the same as for why quantities are strategic
substitutes in the Cournot model. For 0 < OC,
ke = qb(c + 0) andpe = pb(c + 0). If a firm
increases its capacity above qb(c + 0), this
gives both firms incentives to lower prices below pb(c + 0) in the subgame (both prices
face downwardpressurebecause they are strategic complements). Anticipating this, the rival firm is induced to reduce its capacity in
order to counter this downward pressure on
prices.
Having established that capacities are both
conventional and strategic substitutes, I now
consider the effects of capacity policies. The
BGK-FT principle, applied to this game, implies that a small capacity subsidy, which
reduces the home firm's cost of capacity, is
beneficial for the home country, provided c0
affects the equilibrium capacities. The interesting point here is that, for 0 < OC,small
changes in c0 do not affect the (symmetric)
equilibrium ke = qb(c + 0); hence, small capacity subsidies are neutral.On the other hand,
for 0
2 OCa smallcapacitysubsidydoes affect
the equilibrium and is beneficial to the home

country.
Of course, these results for the capacitypolicy-only game are entirely consistent with
the BGK-FT principle. However, the logic that
governs strategic trade policies when output
policies are available is very different from
the BGK-FT logic, and it requires a different
line of intuition.
The key point is to understandwhy output
policies can do more than capacity policies.
Capacity policies can affect only the capacity
reaction function of the home firm, not that of
the foreign firm. Outputpolicies, on the other
reaction functions are not differentiable,these signs apply

to both the left derivative and the right derivative.
MARCH 1996
hand, affect the second-period incentives of

the home firm, and this feeds back to affect the
capacity reaction functions of both the home
firm and the foreign firm.
In particular,taxing the home firm's output
reduces both firms' incentives to build capacity,27 and for low levels of 0 this is beneficial
(to both firms). This explains why for low levels of 0 it is optimal to induce a contractionof
the home firm's capacity (through an output
tax), even though capacities are strategic
substitutes.
The logic of strategic trade policies when
both capacity and output policies are available
admits a very simple intuition. The government wants to induce less (more) aggressive
behavior when 0 is low (high), and the intuition is the following. Capacity-setting is used
by the firms as a commitment to limit production, and the parameter0 measures the effectiveness of this commitment device. When this
commitment device is not very effective, an
output tax by the home government provides
the home firm with some additional commitment ability, inducing a furthercontraction of
capacity. However, if capacity performs its
commitment function effectively enough, the
government finds it optimal to induce an expansion of the home firm and a contraction of
the foreign firm. In sum, whether the home
firm should be encouraged to expand or to
contract can be understood not by looking at
whether capacities are strategic substitutes or
complements, but rather by looking at the
effectiveness of capacity as a commitment
device.
Another insight provided by the model,
which the BGK-FT principle could not suggest, is the following. A priori, one might expect the optimal policy to entail an output tax
coupled with a capacity subsidy, since prices
are strategic complements and capacities are
strategic substitutes;in other words, one might
27To see this, start from the equilibrium of the nonintervention game and introduce an output tax, which increases the home cost of production. If capacities were
unchanged, both firms would charge higher prices in the
subgame and would produce below capacity. Anticipating
this, however, both firms will reduce their capacities in the
first period, to avoid capacity idleness.
VOL. 86 NO. 1
expect the two policies to be complementary.

However, the model yields quite different results. For example, if 0 > Octhe two policies
are perfectly substitutable, both serving the
purpose of inducing the home firm to increase
its capacity and output (recall that for 0 > Oc
the purpose of tradepolicy is to shift the curve
C (p2;
c + co) leftward; since the parameters
c and co affect this curve only through their
sum, controlling one is equivalent to controlling the other).28
Before turning to issues of uncertainty,it is
worth pointing out an implication of the model
concerning the value of incumbency, or capacity leadership. Suppose that firm 1 (the
"incumbent") builds capacity at t = 1, firm 2
(the "entrant") chooses its capacity at t = 2,
and firms simultaneously choose prices at t =
3. Furthersuppose that firms have symmetric
costs. I do not intend to analyze fully this leadership version of the model here, but one interesting result can be easily shown: when 0 is
low (namely, when 0 : 9S) the leader's optimal capacity level is just the simultaneousmove equilibrium capacity qb(c + 0); hence,
incumbency has no value.29 To understand
This suggests a point about the role of strategic costreducing investment. Within a simple Cournot model, the
BGK-FT principle implies that a firm has an incentive to
"overinvest" in cost-reducing activities, provided quantities are strategic substitutes. As Tirole (1988) notes, this
is less clear when "quantity" competition is interpreted
as capacity-pricecompetition. Suppose activity A reduces
the productioncost, c, and activity A2reduces the capacity
cost, c0. In this case, "we would predict strong strategic
investment ... when this investment reduces the cost of
accumulating capacity. In contrast, a firm may be less eager to reduce production costs and trigger tough price
competition ..." (Tirole, 1988 pp. 327-28). In other
words, Tirole's conjecture is that a firm might want to
"overinvest" in A2,but perhaps "underinvest" in A1. The
analysis of the last section does not support this conjecture. Suppose that H is high, so that firms behave like
Coumot competitors, and that the two activities Al and A2
have independentand convex costs. Then a firm will want
to overinvest both in Al and in A2. Once again, one must
be careful in extending the BGK-FT principle to the
capacity-price game.
29To see this, consider the (unique and symmetric)
simultaneous-move equilibriumcapacity, ke = qb(c + 9),
and check whether firm 1 would like to commit to a different level of capacity, taking into account firm 2's optimal response. Since the equilibrium prices cannot lie
outside the region UB ={p' < r'(9), p2 ? r2(9)}, the best
28
251
why incumbency has no value, recall the traditional argumentfor why a Stackelbergleader
wants to commit to a higher quantity than the
Cournot level: increasing production slightly
beyond the Cournot level entails a first-order
benefit due to the contractionof the rival's output, and a second-orderloss because the leader
is moving away from its own reaction function. In the capacity-price model, when 0 is
low the loss from expanding capacity is firstorder, because firms are at a "kinky" maximum, and when 0 < 9S it actually outweighs
the benefit.30Incumbency becomes valuable
only as 0 becomes high, that is, if capacity
constraints are importantenough.
This allows me to make a further point
about the role of trade policies. In most
strategic-trademodels, the government intervention accomplishes exactly what the home
firm would accomplish were it in the position
of a Stackelberg leader. In the present model,
if 0 is low, trade policy can accomplish more
than capacity leadership, and the reason is that
(as pointed out before) an output policy can
affect both the home and the foreign capacity
reaction function. In contrast,a capacity leader
cannot influence its rival's reaction function.
III. TradePolicyunderUncertaintyAbout
the Modeof Competition
The previous section has pointed out thatthe
optimal trade policy depends critically on the
mode of competition, determined by the importance of capacity constraints. In practice, a
government is likely to have limited information about the technological characteristicsof
the targeted industry, and consequently it
might not know whether firms behave more
firm 1 can possibly do is to implement the point of tangency between its highest isoprofit curve and region UBO.
But, since H ? 9', firm l's isoprofit curves are flatterthan
r2(0); hence, such point of tangency is given by pb(c + 9),
the simultaneous-move equilibrium.To implementpb(c +
0), it suffices for firm 1 to pick capacity qb(c + 9); hence,
the outcome of the leadership game is the same as that of
the simultaneous-move game.
30 Notice that, if the marginal-cost function is approximated with a smooth function, the leader's capacity will
be approximatelyequal to the simultaneous-move equilibrium capacity, and the value of incumbency will be of
second-order magnitude.
252
like price-setters or like quantity-setters. As

the "informational" criticism of strategictrade theory points out, if the home government does not observe the value of 0, trade
policies can be harmful if based on the wrong
beliefs about 0. Consider an outputtax: the net
profits of the home firm will increase for low
values of 0, but for high values of 0 the tax
will be harmful. The same reasoning applies,
reversed, to an output subsidy. In sum, any
output policy can result in a reduction of the
home country's income if it is based on the
wrong beliefs about 0.
The point of this section is to identify a simple single-rate policy that (weakly) increases
the home country's income regardless of the
mode of competition. In particular, a small
single-ratecapacity subsidy increases the home
country's income for high values of 0, leaving
it unaffected for low values of 0. This is true
for any values of the demand and cost parameters; thus a capacity subsidy can be an attractive form of intervention even for a governmentthat has no informationabout the specifics of the targeted market.
This result is a straightforwardconsequence
of the analysis in Section 1I-A. There I argued
that a small capacity subsidy is strictly bene-
ficial if 0
9C,
encouragingan expansionof
the home firm's capacity and a contraction of

the foreign firm's capacity. For 0 < OC,on the
other hand, the (symmetric) equilibrium capacities and prices are given by (pb(c + 0),
qb(c + 0)). This equilibrium is not affected
by the capacity subsidy; hence, net profits are
also unaffected. The following proposition
summarizes the result.
PROPOSITION 5: A small single-rate capacity subsidy (weakly) increases the home
country's income, independently of the demand and cost parameters of the model. In
particular, it is strictly beneficial for 0 2 OC
and neutralfor 0 < Oc.
The result that capacity subsidies are
(weakly) beneficial regardless of the mode of
competition is consistent, in a broad sense,
with Bagwell and Staiger's (1994) analysis of
R&D subsidies. They consider purely costreducinginvestments, and one of their findings
is that the optimal investment policy is inde-
MARCH 1996
pendent of the mode of competition. In the

present model, investment in capacity is also
a form of cost reduction, although it takes a
different form: by building capacity k the firm
lowers the cost of producing the first k units
of output, while in Bagwell and Staiger the
firm can reduce the marginal cost uniformly
by investing in R&D. Both results suggest that
investment policies are considerably less sensitive than output policies to the nature of
product-marketcompetition. In my model, this
happens because capacity subsidies are more
selective than output subsidies: they induce an
expansion of the home firm only when capacity constraints are important and a more aggressive behavior is beneficial, not when it is
harmful.
It should be emphasized that the notion of
capacity subsidy adoptedhere requiresthat the
subsidy affect co without affecting the shortrun marginal cost c + 0. The most naturalinterpretationof this kind of policy is in terms
of subsidies to investment in new plants and
machinery (in the form of direct subsidies,
subsidized loans, or tax credits), but one can
think of other policies that have the effect of
lowering the long-run cost of production,
without affecting the short-runmarginal cost.
For example, if the number of workers can be
interpretedas the firm's "capacity," subsidies
tied to the wages paid by the firm (e.g., a reduction in the firm's share of social-security
payments) can be interpreted as a capacity
subsidy.3'
A naturalextension of the model is to allow
the government to design more sophisticated,
incentive-compatible trade policies. In my
working paper (Maggi, 1995), the government is allowed to design menus of two-part
3'To see this, suppose that labor (L) is the only factor
of production and that the firm can change its price more
quickly than it can change L. Let wo denote the cost of
labor per unit of output, and let q = f(L) be the production
function. Producing more than fiL) requires subcontracting production, which costs H > wo per unit of output.
Finally, suppose workers must be paid in full even if they
'Arepartially idle, that is, if q < fiL). In this case, the
number of workers L can be thought of as the firm's "capacity," with a unit cost of wo. The marginal cost of production is zero if q ' f(L), and Hif q > f(L). In this setting.
any policy that reduces the base wage wo can be interpreted as a "capacity" subsidy.
VOL. 86 NO. 1
policies, composed of an output subsidy/tax

and a lump-sum transfer,which can induce the
home firm to reveal its information about 0.
This extension of the model strengthens the
conclusions of the previous analysis: not only
does the informationalconstraintnot diminish
the scope for strategic trade intervention, but
it may even augment the policy distortion relative to the complete-information case. More
specifically, if firms behave like quantitysetters the home firm gets subsidized to the
same extent as under complete information,
and if firms behave as price-setters the home
firm gets taxed to the same or to a largerextent
than under complete information. However,
the informationalrequirementsfor this kind of
policies are stringent: the distribution of the
key parameterhas to be common knowledge,
and the government must have precise information about all the cost and demand parameters. This may help explain why such policy
menus are rarely observed in practice, and
why governments seem to prefer simpler trade
policies.
IV. Conclusion
Precise information about the nature of oligopolistic conduct in internationalmarkets is
crucial to determine the "appropriate" trade
interventions,but governments are unlikely to
have this information.The analysis of this paper has suggested that, in spite of such critical
informational constraints, individual governments may still be driven to intervene in the
internationalcompetition. In particular,I have
argued that there exist simple single-rate policies, namely, subsidies to the firms' productive capacity, which can increase the home
country's income without requiring any information about the particularitiesof the market.
In view of the analysis, the "'informational"
criticism of the strategic-trade-policy theory
appears less important than previously envisioned. It must be emphasized that this does
not amount to a more "activist" view of international trade; in fact, the results of the
model should be interpreted in the opposite
way: they should be taken as a warning that
informational constraints are not likely to remove the individual governments' economic
incentives to engage in export policies. There-
253
fore, they strengthen-not weaken-the case

for international institutions like the GATT,
which are intended to promote cooperative
agreements among governments.
APPENDIX
PROOF OF PROPOSITION 1:
I will focus separately on the two cases.
1. Case 0 < OC.-First notice that, given
capacities k' = k' = qb(c + 9), Lemma 1
ensures that the unique equilibriumof the subgame is given byp' = p2 = pb(C + 0). Next
I will focus on capacity choices. The first step
is to show that, for any given k-', firm i
chooses k' so that in the subgame equilibrium
it will produce at capacity: k' = q=
D(pi, p'). In other words, the equilibrium
prices must lie on "branch 2" of firm i's subgame reaction function R'. I will argue by contradiction.Suppose first that k' > q': then, the
equilibrium prices must lie on "branch 1" of
firm i's reaction function; but then firm i can
slightly reduce k' without affecting the equilibriumprices, and incurringlower costs. Now
suppose that k' < q': then, the equilibrium
must lie on "branch 3" of firm i's reaction
function; hence, firm i can increase k' without
affecting prices, and saving costs. Therefore,
it must be k' = q .
Next I formulate firm i's capacity-choice
problem given k-'. Firm i's problem can be
described as selecting the price pair that maximizes profits (p' - c - co)D(', p -') subject
to two constraints: that the price pair lies on
the rival's price reaction function R -'(p ; k-)
and that it lies in the band between r'(p -'; c)
and r (p -; c + 9). These constraints can be
thought of as "implementability" constraints:
firm i can induce, by suitable choice of k', all
price pairs that satisfy these two constraints
(and only those price pairs); this is an
immediate consequence of Lemma 1. The
optimal level of k' is then the one that implements the optimal price pair, namely, k' =
D(pi, pi). Formally, the best-reply capacity
is determined as k (k- ) =D(p
(k- ),
satisfies
p-'(k )) where (p'(k), p-'(k))
max(p'
P'p
co)D(p',p-)
254
any k-', firm i sets k' so that qi = k' in the

subgame equilibrium. Next, I will check that
firm i's best response to k-' = kc is given by
kc (see Figure A2). Firm i chooses the best
price pair on R (p; kc) such that r'(p-'; c)
p' c r'(p-'; c + 0). Noting that "branch2" of
R-'(p'; k) is given by a segment of 41Y`(p';kC)
and contains the Cournot point C (this follows
2)p;+
from 0 < 9c), and since C is the point of tangency between firm i's highest isoprofit and
(J-', it follows that C is firm i's optimal price
(p;C +c)
pair, and that the optimal capacity is given by
kC. The same reasoning applies for the other
C + Co)
r~~~~~~~~~2(pl;
firm. That (kc, kC) is the unique symmetric
equilibrium readily follows from the fact that
the Cournot equilibrium is unique.
p2
r1(p2;
r1(p2;
co)
c+
MARCH 1996
//c
FIGURE Al.
SYMMETRIC EQUILIBRIUM,
< HC
subject to
(Al)
R (p'; ki)
r'(p ; c) c pi c r'(p'; c + 9)
(A2)
Notice that, if one lets Q (k-') denote the set

of price pairs that satisfy (Al) and (A2), firm
i's problem can be viewed graphically as picking the point of tangency between its highest
isoprofit curve and Q'(k- ). Next I will check
that, when the rival's capacity is qh(c + 0),
firm i's optimal capacity is also qh(c + 0).
First note that the set Qi(qb(c + 0)) is given
by a segment of the line J-'(p'; qh(c + 9)),
whose highest point is (ph(c + 0), pb(c + 0))
(bold segment in Figure Al). Since the point
(ph(C
pb(C
0),
0))
lies lower on the di-
agonal than the Coumot point C, firm i's isoprofit at this point is flatterthan (J(p'; k-');
therefore the point (ph(C
+
9), pb(c + 0)) is
firm i's optimal choice, and the capacity level
that implements this point is given by k1 =
D(ph(C
0),
ph(C
0))
qb(c
+ 0).
It is
easy to show that this is also the unique symmetric equilibrium.

2. Case 099 . -Let kc qc(c + c) and
pC pc(c + co). Following the same logic as
in the previous case, one can establish that (a)
given capacities (kc, kC) the unique equilibrium of the subgame is (nC- nC)- and (b) for
Here I present a sketch of the proof; the
complete proof can be found in my working
paper (Maggi, 1995). The proof is in two
parts: derivation of the equilibrium set and
analysis of the perturbedgame.
Startingwith the original game, the first step
is to establish two necessary conditions for an
equilibrium. Defining B0 as the region southwest of the r'(0) curves [pi c r'(0), i = 1, 2]
and Zas the region southwest of the ci curves
[pi
C', i = 1, 2], the first step is to show
that equilibriumprices must satisfy the following two conditions: (N I ) pC E B0 and (N2)
z.
pC E
Next, three cases must be analyzed
separately:
1. Case 0 c 9s. Let po denote the vector
(ph(c + 0), p0(c + 0)). It is already known
from Proposition 1 that pb, the intersection between r'(0) and r-'(0), is an equilibrium. One
can further show that there can be no other
equilibria than p^(c + 9).
2. Case 9 E (9S, 9c). Since firms are symmetric, one can focus on the region p1l p 2
the same arguments apply to the region p'1
p2, with labels reversed. The first step here is
to show that any point in F is an equilibrium.
Consider an arbitrary point Q in F (see
Figure 4). The capacity levels that sustain Q
as equilibrium prices are such that the isoquantities 1' and J2 trace through Q. Call
these capacities k' and k , the corresponding
isoquantities JQ and 4JQ, and the implied subgame reaction functions RQ and RQ. First notice that, given k' and k , the firms' subgame
255
VOL. 86 NO. I
MCi (q1; k')
p2
r (p;
C + 0)
4c l
B|
,:B
rI(p2;
(p 2;
,r1_
kc)
o//
[c
C + Co)
/o1o
~~~2(pl;kc)
A2.
fn(q)
ki < q<
ki +
C+ 0
qi'2 k'+
lln
l/n
wherefn(q') is a monotonic, smooth function

= c andfn(k' + l/n) = c +
satisfyingfn(k')
c + co)
r2(p~~~r1;
SYMMETRIC EQUILIBRIUM, 0 > Oc
reaction functions cross at Q; hence Q constitutes equilibriumprices for the subgame. Next,
check that k' and k2 constitute equilibriumcapacities. Focus on firm 1 first: given kQ,
and the subgame reaction function RQ that
it induces, firm 1 seeks to implement the
Stackelberg point on RQ by suitable choice of
k1. Noting that RQ is kinked at Q and that firm
l's isoprofit is tangent to R4 at the kink, it
follows that Q constitutes the Stackelberg
point for firm 1; hence, choosing kQ is optimal.
Next focus on firm 2: given R4, firm 2's
Stackelberg point lies somewhere on RQ
above Q; however no point above r2(0) can
be implemented (this follows directly from
Lemma 1). Thus, firm 2 cannot do better than
implementing point Q; hence choosing k2is
optimal. One can further show that no point
outside F can be an equilibrium or, equiva-
lently, that the conditionsp2 =

C2
p l rX(9),p2
C andp X
r2(p1;c + 0)
p1
FIGURE
qi
r2(o),
C,
Sl
are all
necessary for an equilibrium.

3. Case 9 : Oc.-From Proposition 1, it is
known that the Cournot point (i.e., the intersection of ci and C-i) is an equilibrium. It is
fairly easy to verify that there can be no other
equilibrium for this range of 9.
I will now turn to the issue of robustness of
equilibria for the range 0 E (9S, Oc). Consider
the following sequence of smooth functions
converging to the step function MCi:
0. The structureof the argumentis as follows:

first I show that for n large enough there can
be no equilibria outside small neighborhoods
of p(c + 9), z1, and z2; then I argue that an
equilibrium exists in each of these neighborhoods, provided 0 E (Os, 9v] If 0 E (9v OC)
z' and z2 fall outside F, and the only robust
equilibrium is the symmetric one.
Let R (p-'; ki) denote firm i's subgame reaction function when MCI (qi; k') is the marginal cost curve. R' (p -; ki) is monotonic and
smooth, and it converges to R'(p -; k') as n
co. Let
-'(p1; k') denote the part of R' that
connects the two linear branches r'(O) and
r'(9).
First notice that for any finite n, an equilibrium need not entail q' = k'. It can be shown,
however, thatVnmust tracethroughthe equilibrium point; that is, it must be p' = 4(D(p i; k')
at equilibrium. Let k' = on,(p1, p-1) denote
the value of k' such that JV, traces through
(pi, p-i)* Note that (p' converges to D' as n
p'; ki) denote firm i's profits
oo. Let Vrn(p',
when MCq is the marginal-cost curve, and let
qrn(p1p i) _ irn(pi p i; (pn(p1i pi))* If
one defines an iso-7r' curve as the locus of
points where 7r1(p1,p-i) is constant, firm i's
problem can be described as picking the point
of tangency between firm i's highest iso-7rn
curve and its rival's subgame reaction function
Rn-, subjectto the constraintr'(p'; c) ? pi
r'(p1; c + 9)
Focusing on the regionp l c p2, the key step
is to show that for n large enough there are no
equilibria outside small neighborhoods of Z2
and p', denoted respectively by N6(z2) and
N6(p'). Suppose by contradictionthat there is
an equilibrium point V outside N6(z1) and
N6(p) . There are four possible cases. (i) Suppose V is in F. Since R 2 is smooth and coincides with r2(0) at V, it must be that R2 has
the same slope as r2(0) at V. But the iso-7rn
256
curve at V is steeper than r2(0) for n large

enough; hence firm 1 has an incentive to deviate and choose a lower price on R', a contradiction. (ii) Suppose V is in the interior of
B0. The curve V l must trace through V, and
the iso-ir' curve at V is steeper than V; hence
firm 2 has an incentive to deviate and choose
a higher point on I, a contradiction. The remaining possibilities are (iii) V lies to the left
of g', and (iv) V is outside B0. These two
possibilities are easily contradicted, leaving
only the possible equilibria in N, (z') and
Np(p'). The final step of the proof, which is
not reported here, is to show that there exists
an equilibrium in each of the three neighborhoods N6(p') and N6(z') (i = 1, 2) if 0 E
(OS, Ov). The result then follows by noting
that, as n approaches infinity, these neighborhoods collapse, respectively, to the points pa
and z' (i = 1, 2).
I will first derive the optimal output policy
and then argue that capacity policies are redundant.
1. Case 0 < OS.-Since in equilibriumit
must be thatp2 < r2(O) (from condition (Ni )
in the proof of Proposition 2), the government
can do no better than implementing the point
of tangency between the home firm's highest
net isoprofit curve and r2(0) or, equivalently,
the point of intersection between r2(0) and
S (say, point p *). To implement point p * it
suffices to shift r1(0) outward,just enough to
cross r2(0) at p *. This can be accomplished
by an appropriateoutput tax. Using Proposition 3 one can show that, under such output
tax, p * is the unique equilibrium of the firms'
game.
For the extreme case 0 = c0, recall that the
Eaton-Grossman
equilibriumpointis given by the
tangency between the home firn's highest net
isoprofitcurve and the curve r2(cO); hence, the
government'soptimal point coincides with the
Eaton-Grossmanpoint, and the output tax that
implementsit is just the Eaton-Grossmantax.
2. Case 0 = 0s.-By
the same logic as in
the previous case, the government can do no
better than implementing the point of intersection between r2(0) and S1. But this coincides
with the laissez-faire equilibrium, so no intervention is required.
MARCH 1996
3. Case 0 E ('S, 9v). The point of intersection between A'and r2(0) is the government's preferredprice pair, by the same logic
as in cases 1 and 2. Since by assumption, absent trade policies, firms focus on the intersection of r' (0) and r2(0), and since the equilibrium selection is continuous in the trade
policy parameter,the preferredprice pair can
be implemented by shifting r'(0) inward, in
such a way that it crosses r2(0) at the preferred
price pair. This can be accomplished by offering the home firm an appropriate output
subsidy.
4. Case 0 E (0V Oc).-Recalling
the definition of
9v
from Section I-D, in the case
r2(0) and S' intersect each other above C2.

From conditions (Ni ) and (N2) (see the proof
of Proposition 2), the government can do no
betterthan implementingthe point of tangency
between the home firm's highest net isoprofit
curve and the curve min{r2(9), C2}; such
a point is given by the intersection between
r2(0) and C2. By the same logic as in the
previous case, the preferredpoint can be implemented by shifting r' (9) throughan appropriate output subsidy.
5. Case 0 :- Oc.-Absent intervention, the
equilibriumis given by the Cournotpoint, that
is, the intersection of C' and C2. Since in
equilibrium it must be p2 < Ce2, the government can do no better than implementing the
point of tangency between the home isoprofit curve and C2. This is the Brander-Spencer
equilibrium price pair. The government can
implement this point as the unique equilibrium
of the firms' game by shifting C' inward,
through an appropriateoutput subsidy (equal
to the Brander-Spencersubsidy).
That capacity policies are redundantfollows
from the logic of the above argument:an output policy always exists that implements the
optimal price pair. Therefore a capacity policy
cannot do any better.
PROOF OF LEMMA 2:
The proof of part (i) is straightforwardand
left to the reader.For part (ii), to analyze firm
l's optimal response to a change in firm 2's
capacity, it is convenient once again to work
in price space.
1. Case 0 < 9s.-The (laissez-faire) equilibrium capacities k' are such that the iso-
VOL. 86 NO. I
quantities 4" and 4)2 trace through the

equilibrium point pb (c + 0)). An increase in
k2 from its equilibrium level shifts 2 downward, say, to 42D. This amounts to lowering
"branch 2" of firm 2's subgame reaction
function. Firm l's optimal response to this
change is to select the most profitable, implementable point on firm 2's new subgame reaction function. Such point is given by the
intersection between 4'22 and r'(0). Since
firm l's output decreases moving down along
r'(0), firm I's optimal capacity decreases as
well. Now consider a decrease in k2 starting
from the equilibrium level. This shifts 4)2 Up_
ward, say, to 4'2 1. It is easy to see that, after
this change in k2, firm l's optimal price pair
is still given by pb(c + 0), and its optimal
capacity does not change. I conclude that, for
this range of 0, capacities are (weak) strategic
substitutes around the equilibrium.
2. Case 0 E (OS, Oc).-The logic is the
same as in the previous case, except that now
firm l's isoprofits are steeper than r2 (0)
aroundthe equilibriumpointpb(c + 9). When
k2 is increased, firm l's optimal change in k'
is identical to that in the previous case. On the
other hand, when k2 is decreased and 4)2 iS
shifted upward, firm l's optimal price pair
moves leftward along r2(6); since firm l's
output increases in this direction, firm l's optimal capacity increases as well. For this range
of 0, capacities are (strict) strategic substitutes
around the equilibrium.
3. Case 0 2 Sc.-For
this range of 0, firm
l's isoprofit curve through the equilibrium
point pb(c + 0) is tangent to 4'2. When k2
increases, 4)2 iS shifted downward.In response
to this change, firm l's optimal price pair
moves down along C'. Since firm l's output
decreases moving down along C , firm I's optimal capacity decreases as well. On the other
hand, if k2 is decreased, 2 is shifted upward,
and firm l's optimal point moves up along C';
hence firm I's optimal capacity increases.
Thus, for this range of 0, capacities are (strict)
strategic substitutes around the equilibrium.
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Maggi - Strategic Trade Policies With Endogenous Mode of Competition

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American Economic Association

Strategic Trade Policies with Endogenous Mode of Competition

Strategic Trade Policies with Endogenous

cal. Focusing on the empirical evidence first,

After several years of theoretical and

These theoretical findings-the policy sensitivity and the informational requirements

' LarryD. Qiu (1994), Maggi (1992), and Lael Brainard

choice of capacity. The model predicts that the

2 See Carl Shapiro (1989) for a concise exposition of

3 This result is consistent with Kyle Bagwell and

political-economy motivations that often lie

I. Preliminaries: Price versus Quantity

The Cournotmodel of quantity competition

rigid capacity constraints. ... More generally,

The "short run" total cost is

ki') for qi > kI'.

The unit cost of capacity is assumed to be

(e.g., because it has to purchase inputs from

It will be useful to define a "Bertrand"

6A similar cost structure is postulated in Avinash

intuitive. By choosing scale k, a firm generates

'The closed-form expressions for r' and 4'1 are

r'(p-';x) = (a + b2p-')/2b, + x/2 and VD(p-';k') = (a +

THE AMERICANECONOMIC REVIEW

THE SUBGAME REACTION FUNCTION

The proof of Lemma 1 is intuitive. Given

VJ(p `i; k'). This explains "branch 2" of R'.

x For nonlinear demand functions, Lemma I and the

B. The Full Game

should be noted that the curves r' and C' are

Proposition 1 suggests that the parameter0,

cost c + 0, that is, pb(c + 0), as long as this

FIGURE 2. THE BERTRAND AND COURNOT BENCHMARKS

constraints, indexes in a naturalway the mode

The intuition for this result is the following.

For a certain parameterrange, the game also

{(p', p2): p'

The structure of this set is illustrated in

1 The closed-form expression for S3 is S'(p-i; c + cO)

robust equilibria of the game (bold characters

PROPOSITION 2: If firms are symmetric,

(i) the symmetric equilibrium: p = min

At any equilibrium, capacities are given by

I will now generalize the previous result to

PROPOSITION 3: The robust equilibrium

the intersection of R'(p2)

At any equilibrium, capacities are given by

THE AMERICANECONOMIC REVIEW

FIGURE4. THE ASYMMETRICEQ2uILIBRIA

changes of 0 have no impact. When there are

ante) costs and second-period (ex post) costs;

Suppose a home firm and a foreign firm

19 To see this, note that for 0 < 9 an increase in co does

ments (whether positive or negative) from the

taxes even for the multiple-equilibriumrange

+ 0) is also the tangency point between

PROPOSITION 4: (i) Output policies can

competition and pure quantitycompetition are

OC, the optimalsubsidyis equal

to the Brander-Spenceroptimal subsidy.24

The model suggests new insights about the

Proposition 4 establishes that output taxes

24When H lies in (9S, 9V), so that multiple (robust)

always desirable to induce an expansion of the