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Krugman's First Mover Advantage Theory

A rather recent justification for nationalist trade policy has been advanced under the appellation “strategic trade theory” by James Brander, Barbara Spencer, and Paul Krugman, among others. Consider a world of rapid technological change in which internal economies of scale commonly create the conditions for a monopoly or oligopoly. Internal economies of scale mean that average costs decline indefinitely as output increases to a large share of the market. The world market is taken to be too small, at least for a time, to accommodate more than one, two, or three producers operating at minimum average cost (Newman, 2009). Thus, efficiently low production costs can be achieved only at the risk of establishing a monopoly or tight oligopoly.

FIGURE 1 Strategic trade theory. The first and second numbers are payoffs for Airbus and Boeing, respectively.

For simplicity, let us consider the payoffs from possible development of a new type of aircraft. There are two potential producers, say Boeing and Airbus, operating in different parts of the advanced world. Neither cooperates with the other, but both are large enough to attract the solicitous attention of their national governments (Varadarajan & Shankar, 2008). The payoff matrix, displaying the results of possible pure strategies from the two players, is the common game-theory device to appraise this situation (Figure 1).

For example, if Boeing decides to produce the aircraft, while Airbus does not, Boeing's profits are a healthy 100 units, from which it presumably pays a fraction in taxes. The matrix is taken to be symmetric, so it is completely arbitrary which producer has a “first- mover advantage,” if either does. Nonetheless, it is not certain that either producer, acting alone, would decide to produce, even though society would benefit if one or both did. Either producer would presumably export aircraft to the whole world and make a handsome (taxable) profit doing so. Its potential rival would not lose by that, at least not at first. However, if both Boeing and Airbus are so chary of risk that they adopt the extreme strategy of minimizing their maximum loss (the so-called “maximin” strategy of minimum regret) then neither will produce, to the loss of the whole world. On the other hand, if one firm could credibly threaten to produce regardless of its rival's reaction, it could preempt the market (Suarez & Lanzolla, 2007).

Now suppose that one government, aware of the situation, offers a subsidy of at least 5 units to its “national champion.” If the French subsidize Airbus, then the “produce” strategy becomes dominant. It is better than not to produce regardless of what Boeing does. Once Airbus (or Boeing) begins to produce on account of a subsidy, it will not be in the interest of Boeing (or Airbus) to follow suit because of the certain loss. The sole producer could then easily repay the state subsidy out of normal profits and still be better off than it would have been before. A policy of subsidizing the “national champion,” even ...