Optimal domestic regulation under asymmetric information and international trade: a simple general equilibrium approach

We investigate the design of domestic incentive regulations in a small economy opened to trade and its implications for international specialization and for trade openness to remain welfare‐improving. More specifically, we append to an otherwise standard 2 × 2 Heckscher‐Ohlin model of a small open economy a continuum of intermediate sectors producing nontradable goods used in tradable sectors. Those goods are produced by privately informed regulated firms. Asymmetric information induces distortions with general equilibrium impacts. The small economy becomes relatively richer in the informationally sensitive factor so that asymmetric information might reverse trade patterns. Free trade is Pareto‐dominated by autarky when it exacerbates agency distortions.