Profit-shifting and Welfare Enhancing Trade Protection: An Incomplete Contracts Model

I develop a model of trade in final goods and inputs that differ in hi-tech intensity between a developing country –the South– and a developed country –the North–. I show that trade protection is welfare-improving for the South within a setting of incomplete contracts. I employ two standard strands of competing arguments: protection will foster industrial linkages between input producers and distort domestic prices in favor of comparative disadvantage industries. The industrial linkages will increase producers’ surplus by shifting profits, but the distortions will reduce consumers’ surplus by increasing domestic prices. The former effect will be stronger than the latter effect in industries where the comparative disadvantage of the South is sufficiently low. The range of protected industries and the tech-intensity of the average protected industry will decrease with the overall South’s comparative disadvantage.