International trade policy towards domestic monopolies and domestic oligopolies

International trade policy has focused mostly on policy choice in the presence of homogeneous good domestic monopolies. It is shown that in a differentiated goods oligopoly, where firms invest in process innovation and later compete in the market, optimal trade policy and welfare outcomes are strikingly different. Welfare can increase over free trade and taxing (or subsidizing) output may even become a dominant strategy for both countries. The prisoners dilemma nature of policy games under domestic monopolies is never observed for domestic oligopolies. Policy choice is determined by the number of firms in both countries and the degree of product differentiation. When a country has one domestic firm, (and increasing the number of foreign firms) the choice of policy instrument is always a subsidy or to remain inactive. However, if one increases the number of domestic firms to two, then a country taxes, subsidizes, or may not promote R&D or output depending on the number of firms in the other country and the degree of product differentiation in a non-linear way. Further, the results are robust to Cournot or Bertrand competition.