# **An Evaluation of Neutral Trade Policy Incentives Under Increasing Returns to Scale**

Jaime de Melo and David Roland-Hoist _...in developing countries where protective barriers are high and there is bias against the exportsofmanufactured goods, the limitations of domesticmarketsgenerallypermnitonly the consruction of plants that are below optimum size. By contrast, the disadvantages of small national markets are surmounted in countries where low protective barimers and the lack of bias against exports perm it efficient-scale operations through specialization according to comparative advantage..._ _Balassa (1971, 78-79)_ New developments in the theory of international trade often suggest, implicitly or explicitly, that in an imperfectly competitive environment, government intervention may be needed to achieve optimality. The most celebrated example in this new literature is the profit-shifting argument of Brander and Spencer (1984). Anotherexample, perhapsmorewidelyapplicable, is the argument developedbyKrugman (1985) showing that protection can serve as an export promotion policy under certain circumstances. These arguments have fostered a literature on strategic trade theory, which deals with conditions of imperfect competition between international trading partners. 1 The trade and development literature, on the other hand, concentrates on the implications of imperfectly competitive domestic markets.

In the first of Balassa's (1971) comparative studies on trade policies in developing countries, he argued (in the passage quoted above) that the small size of domestic markets in developing countries was a hindrance to the exploitation of scale economies. He recommended policies to promote exports as a way to break this bottleneck. In his second comparative study of trade policies in semi-industrial countries (Balassa 1982), he ascribed the superior performance of the outward-oriented development strategies in East Asia to the provision of equal incentives to sales on the home and export markets (that is, to the avoidance of home-market bias). Further, in recognition of the learning effects and externalities that accompany the establishment of new industries, Balassa (1975) recommended tempo! ary protection to new activities, which would be gradually scaled down to an across-the-board protection level of about 10 percent. In favorirg market neutrality, Balassa is not only applying the principle of nondiscrimination, but he is also emphasizing trade policy rules, or rules of thumb, that have low administrative costs and do not depend on econometric evidence for their administration.

In this paper, we explore the robustness of these strategies in a setting that is representative of semi-industrial market structures and conduct. We recognize that production in some industrial sectors takes place under increasing returns to scale and that pricing in tradable sectors distinguishes between domestic and export markets. The home country is assumed to be a price-taker in both import and export markets. Thus terms of trade are fixed, and we rule out the possibility of strategic trade policy to exploit monopoly power in international trade (the possibility of using trade policy to shift profits to domestic firms). (By contrast, the strategic trade literature assumes that oligopolistic interactions occur in