-12-

Thc same pattem of welfare estimates emnerges under the assumption of contestable markets. I lowever, because we have assumed a greater degree of unexploited economies of scale, the magnitudes are larger than in table 2. There is a welfare gain of 2.7 percent of base year GDP to be reaped from subsidizing export sales of sectors with increasing returns to scale. Note the superiority of export subsidization over import protection, which springs from our assumption that exporters face a perfectly elastic foreign demand whereas dorrmestically produced goods face a downward sloping domestic demand curvc. 1-ence thc incentives created by export subsidization are more direct than those created by protection fordomestic sales. V/hik' the export demand specification deserves furtherscrutiny, it appears to correspond to the expericnce of countries that have followed an export-led development strategy.

In the contestable-market scenario, neutrality produces the largest welfare gains from trade incentives to sectors with increasing returns to scale and sustains the recommendations of Balassa (1975, 1989). In the case of Cournot competition, under the assumptions about firm entry, subsidization of exporls dominates the alternativeof providing equal incentives to domestic and exportsales. This occurs becausewc have assumed that subsidies to exportsdo not give rise to profits (and hence do not inducefirm entry) vhereas protection on the domestic market gives rise to profits and induces firmentry. Aswesaw above, tirm entry results in scalc efficiencv losses, an effect that comesout clearly in the caseof protection to domestic salcs. In that case, tariff protection results in a welfare loss that exceeds 1 percent of GDP.

It is obvious that the results under Cournot competition are quite sensitive to the determinants of the number of firms-about which little is known. In the simulations reported here, we have attempted to portray the stylized facts suggested by the comparative studies of foreign trade regimes in developing countrics. These studies reveal that countries that have followed import-substitution industrialization stratcgies have often tended to provide made-to-measure protection for all domestic activities. This protection has, in turn, tended to create excess profit opportunities from domestic sales. When pushed to the cxtr, me, exccssivc across-the-board protcction of industrial activities has been shown to result in excessive firm entry.

We concludc by comparing ncutrality of incentives with optimal trade policy. The "optimal" trade policv package is obtained by maximizing the value of the utility function for the representative consumer, taking tariffsas givcen and export subsidies as endogenous policy instruments. To facilitate the comparison uith the rcsults in table 2, we fi-x all import tariffs at 10 percent for all sectors.

The results of the calculation of these "optimal" trade policy packages appear in table 4. Note first that undcr the assumption of constant rcturns to scale in all sectors, the numerical calculations confirm the well-known rcsults predictcd bv Lcrncr (1936), namely that across-the-board tariff and export subsidics at the same rates arc cquivalent to free trade.<sup>9</sup> Note also that the equivalent variation measure achicvcs a maximum of zero in this case because departure from free trade cannot be beneficial under constant returns to scale.

Under increasing rcturns to scale. Lcrner svmmetrv still holds: across-the-board tariffs and export subsidies at the samc rate are equivalent to free trade. But, as the pattern of export subsidy figures shows, neutrality is no longer optimal. Two results stand out in the contestable-market case. First, as expected, optimalitv rcquircsthatgrcaterincentivesbeprovidedtosectorswithincreasingreturnstoscale. Second, the diffcrcncc in wclfare henef its is small between optimal trade policy and the rules of thumb advocated by Balassa (1975. 1989)- across-the-board protection (withequal incentivestoexports) formanufacturing activities. Here.optimalitvdominatestherulcofthumbofincentiveneutralitybylessthanlObasispoints.