Injury-Based Protection with Auditing under Imperfect Information

We analyze optimal protection when a benevolent government must maintain non-negative domestic profits and when the domestic import-competing firm has private information about its costs. A costly audit mechanism can deter strategic manipulation of this private information. We show that a high-penalty/low-probability of investigation is optimal when the shadow price of the firm profit is low compared with the audit cost. A low-penalty/high-probability of investigation is optimal when there is a low investigation cost and a high shadow price of firm profit. In this latter case, the trade authority obtains truthful announcements by directly auditing the firm.