Injury-Based Protection with Auditing under Imperfect Information.

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Injury-Based Protection with Auditing under Imperfect Information.

Philippe Kohler [*]

Michael O. Moore [+]

We analyze optimal protection when a benevolent government must maintain nonnegative domestic profits and when the domestic import-competing firm has private information about its costs. A costly audit mechanism can deter strategic manipulation of this private information. We show that a high penalty/low probability of investigation is optimal when the shadow price of the firm profit is low compared with the audit cost. A low penalty/high probability of investigation is optimal when there is a low investigation cost and a high shadow price of firm profit. In this latter case, the trade authority obtains truthful announcements by directly auditing the firm.

1. Introduction

This article focuses on the use of signals to limit distortionary protection when a domestic firm has private information about injury from foreign competition. We assume that a domestic authority is mandated to use trade policy to maintain domestic production while minimizing costs to domestic consumers. The presence of asymmetric information about domestic production costs means that the firm will have an incentive to overstate the harm it is suffering from imports. We analyze how the authority can use an incentive device to punish a firm if a costly audit determines that the firm has overstated its injury. An incentive-compatible mechanism is derived consisting of a probability of audit, a tariff, and a penalty that will insure that the firm does not retain informational rents associated with the private information.

This basic problem of an authority assessing domestic injury arises in a number of critical trade policy contexts. The two most prominent examples in the World Trade Organization (WTO) system are safeguard mechanisms and unfair trade remedies (i.e., antidumping and countervailing duty investigations). In both types of administered-protection cases, a domestic trade authority must determine whether injury beyond some critical level has occurred before WTO-consistent protection can be imposed. The information used to evaluate injury is provided by the affected domestic industry, which has an obvious incentive to overstate the harm caused by foreign competition. Given that these types of contingent protection procedures are the single most important form of protection under the WTO system, potential misuse of private information is of great importance.

There are two strands of relevant literature. The first considers strategic behavior in the specific context of administered protection. The second concerns information asymmetries in more general trade policy outcomes.

The former strand has focused on strategic behavior between firms to exploit administered protection procedures. Prusa (1992) shows how antidumping cases in home and foreign firms can manipulate contingent protection to enforce collusion. Staiger and Wolak (1991) study how antidumping acts as a cartel-enforcing device in a noncooper...

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