Endogenous Choice of Reciprocal Trade Policies With Network Externalities

ABSTRACT This paper examines how network externalities shape the strategic interaction of trade policies between home and foreign countries. Incorporating reciprocal trade policy into an import‐competing model under Cournot and Bertrand competition, we show that the endogenous choice of trade policies depends critically on the strength of network effects. Under Cournot competition, weak network externalities yield an Intervention–Non‐intervention outcome, where the home country imposes tariffs while the foreign country opts for free trade. However, when network externalities are sufficiently strong, two equilibria arise: Intervention–Non‐intervention or Non‐intervention–Intervention, implying that the home country may prefer free trade. Under Bertrand competition, strong network externalities lead the foreign country to subsidize exports rather than impose an export tax. Moreover, depending on the degree of network effects, three distinct equilibria emerge. These findings suggest that when network externalities are strong, the trade policy preferences of the two trading countries converge, making an equilibrium in which the home country adopts free trade and the foreign country pursues export subsidies Pareto optimal.