Uncertainty Resolution and Strategic Trade Policy in Oligopolistic Industries Mustafa Caglayan* Abstract This paper investigates a government’s choice of strategic trade policy when the domestic firm observes a private noisy signal about the stochastic market demand while in competition with a rival firm. The gov- ernment chooses between quantity controls and subsidies to maximize profits of the domestic firm. Assum- ing that firms compete à la Cournot in a third country, it is shown that the optimal trade policy depends not only on demand uncertainty but also on the predictability of the true market demand by the firms. 1. Introduction Governments frequently use strategic trade policies to give a competitive edge to their domestic firms competing in world markets. The well-known Brander and Spencer (1985) model shows that a government adopts an export subsidy if the domestic firm competes with a foreign firm in terms of quantity. Subsequently, Eaton and Grossman (1986) demonstrated that an export tax is the optimal policy when the domestic firm competes with a foreign rival in prices, and Klette (1994) explored the robustness of conclusions concerning the choice of trade policy (taxes and subsidies) in a broad class of models. Cooper and Riezman (1989; CR hereafter) argued that constraining a gov- ernment’s trade policies to only subsidies (or taxes) is unrealistic. Using a model similar to that proposed by Brander and Spencer (1985), CR investigated the trade-off between subsidies and quantity controls under demand uncertainty.They showed that, although quantity controls are the dominant form of policy intervention in more stable markets, demand uncertainty in the output markets can cause governments to shift from quantity controls to subsidies. This paper, too, investigates a government’s choice of trade policies when there is demand uncertainty. CR assumed that although the government does not know about the demand uncertainty, firms can have perfect knowledge about market demand. However, this assumption is very stringent and unrealistic. Given the global nature of markets it is unlikely that firms could have perfect information on market variability. This constitutes the principal departure of this paper from the CR model: firms do not have complete information on market variability.To keep the model tractable,I assume two symmetric risk-neutral Cournot firms, one in country i and the other in country j. Each firm produces a homogeneous good sold only to consumers residing in a third country, and each firm observes a common noisy signal which carries some informa- tion about the stochastic market demand. 1 Under these circumstances, strategic trade policy differs from that of CR. The information content of the signal (alternatively the variance of the noise) affects the firm’s ability to predict demand accurately and hence the government’s decision. Review of International Economics, 8(2), 311–318, 2000 © Blackwell Publishers Ltd 2000, 108 Cowley Road, Oxford OX4 1JF, UK and 350 Main Street, Malden, MA 02148, USA * Caglayan: Koc University, Cayir Caddesi no. 5, Istinye, Istanbul 80860,Turkey.Tel: (90-212) 229-3006 x465; Fax: (90-212) 229-1971; E-mail: mcaglayan@ku.edu.tr. The author would like to thank James Anderson, Richard Arnott, Chong-en Bai, John Barkoulas, Christopher F. Baum,Andy Chen, Neslihan Ozkan, and an anonymous referee for their helpful comments on earlier versions of this paper. The general disclaimer applies.