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This paper investigates the interplay of trade and terrorism externalities under free trade between a developed nation that exports a manufactured good to and imports a primary product from a developing nation. A terrorist organization targets both nations and reduces its attacks in response to a nation's defensive counterterrorism efforts, while transferring some of its attacks abroad. Terms-of-trade considerations lead the developed nation to raise its counterterrorism level beyond the “small-country” level, thus compounding its overprovision of these measures. By contrast, the developing nation limits its defensive countermeasures below that of the small-country level. This asymmetry is a novel finding. The analysis is extended to include proactive countermeasures to weaken the terrorist group. Again, the developed country raises its efforts owing to the terms-of-trade externality, which now opposes the underprovision associated with proactive efforts. A second extension allows for several developing-country exporters of the primary product.
