Revisiting Strategic Protectionism in Network Markets

Nigar Hashimzade and Haoran Sun

arXiv:2603.29542. Earlier version: CESifo Working Paper No. 12592 (2026)

Abstract

This paper studies the welfare effects of an industrial policy targeting a sector with network externalities in a two-country model with strategic trade and R&D investment. When externalities are weak or the goods are close substitutes, the business-stealing effect dissipates more surplus than the externality creates. Under sufficiently strong externalities and weak substitutability or complementarity of the goods, industrial policy competition can make both countries simultaneously better off compared to the laissez-faire outcome because of the mutual business-enhancement effect. The case is stronger for product innovation than for process innovation, as the former directly affects the demand and triggers a stronger network effect than the latter which operates indirectly through the industry supply. Thus, the network externalities create an opportunity for win-win industrial policies, but its realisation depends on the market structure and the nature of innovation.

Why this matters 

The status of industrial policy as a centerpiece of economic governance is not a new phenomenon, but rather a returning one. In the decades after the Second World War, governments in both advanced and developing economies routinely used tariffs, subsidies, public procurement, and directed credit to promote domestic industry and technological upgrading (Juhász et al., 2024; Aiginger and Rodrik, 2020). By the 1980s and 1990s, however, industrial strategy had fallen out of favour across much of the developed world. Globalisation, trade liberalisation, and growing scepticism about the state's ability to "pick winners" shifted the consensus toward market allocation and away from selective intervention (Pack and Saggi, 2006; Krueger, 1990). That consensus has now weakened sharply. The COVID-19 pandemic exposed the fragility of global supply chains, while geopolitical rivalry and concerns about technological sovereignty have made dependence on a small number of foreign suppliers appear increasingly costly (Millot and Rawdanowicz, 2024). As a result, governments across the major economies have become willing to intervene directly in production, innovation, and market structure in sectors viewed as strategically important.

Semiconductors provide the clearest example. The US CHIPS and Science Act of 2022 committed approximately $52 billion to domestic semiconductor manufacturing, while the EU Chips Act aims to mobilise more than €43 billion (European Commission, 2023). These initiatives combine support for domestic production with measures that disadvantage foreign rivals, including tariffs, digital services taxes, regulatory compliance costs, and export restrictions. The model in this paper captures the revenue-based side of this policy mix, in the form of R&D subsidies to domestic firms and a tax on the foreign firm's domestic sales. A central finding is that the welfare consequences of this policy competition depend on three factors acting together: the strength of network externalities, whether innovation is cost-reducing or quality-enhancing, and the degree of product differentiation. When network externalities are weak, policy competition lowers aggregate welfare, because the foreign country's loss outweighs the home country's gain. When they are strong and innovation is quality-enhancing with sufficiently differentiated goods, both countries can be simultaneously better off than under laissez-faire, and the optimal import tax can turn into an import subsidy. The results also extend to settings where foreign and domestic goods are complements rather than substitutes, as in semiconductor supply chains where foreign fabrication and domestic chip design are used jointly in downstream industries.