Growth and Welfare in a Small Open Economy

We construct a model of growth based on endogenous technological change in a small, open economy. Entrepreneurs develop new intermediate products whenever the present value of potential profits exceeds the cost of R&D. Diversity of intermediates contributes to total factor productivity in the production of final goods. The economy produces two such final goods, and trades these at exogenously given world prices. We study the welfare implications of R&D subsidies and commercial policy. There exists an optimal subsidy to R&D that speeds growth relative to the market-determined rate. The optimal subsidy achieves the first-best rate of growth, but not the first-best level of welfare. Small tariffs and export subsidies also affect both growth and welfare. Growth may increase or decrease, depending upon which sector is promoted by the trade policy. But an increase in the growth rate is neither necessary nor sufficient for a trade policy to improve welfare. Finally, we compare tariffs and quotas, when the latter give rise to rent-seeking behavior. The diversion of resources from innovative activities to rent seeking can have dire implications for growth and welfare.