The endogenous formation of sustainable trade agreements.

• Author: Bang Nielsen, Mette Ersbak
• Pages: 61(34)

Resumen. Este artículo se refiere a la formación de acuerdos endógenos de libre comercio en un modelo de competencia imperfecta entre tres países. Teniendo en cuenta que la literatura ha ignorado en ocasiones el requisito de sostenibilidad en las áreas de libre comercio, el artículo propone una estructura para predecir qué acuerdos comerciales se forman cuando la sostenibilidad es explícitamente incluida como una restricción en la formación de acuerdos cooperativos. Se encuentra que la introducción de un requisito de auto-ejecución reduce el alcance general de los acuerdos comerciales y que las áreas comerciales preferenciales pueden ser stepping stones o stumbling blocks, dependiendo de la demanda relativa entre los países.

Palabras clave: acuerdos comerciales, uniones aduaneras, ALCs.

Clasificación JEL: F13, F15.

Abstract. This paper addresses the endogenous formation of trade agreements in a three-country model of imperfect competition. While the requirement of sustainability of preferential trade areas has often been ignored in the literature, I construct a framework for predicting which trade agreements form when sustainability is explicitly included as a constraint on the formation of cooperative agreements. It is found that the introduction of a self-enforcement requirement reduces the overall scope for cooperative trade agreements, and that preferential trade areas can be stepping stones or stumbling blocks depending on the size of relative demand between countries.

Key words: trade agreements, customs unions, FTAs.

JEL classification: F13, F15.

1. Introduction

   Between 1948 and 1994, the GATT received 124 notifications of regional trade agreements (RTAs) related to trade in goods. In the first seven years after the creation of the WTO in 1995, the notification of more than 130 additional agreements covering trade in goods and services followed. In 2003, more than 150 RTAs were in force, and the number was expected to rise to around 300 in 2007 if the trend then continued. The vast majority of these agreements are either customs unions (CUs) or free trade areas (FTAs). (1)

   The proliferation of preferential trade agreements (PTAs) implies the presence of major incentives to enter such agreements. A growing literature tries to identify these incentives, explain how the formation of PTAs affect welfare of members as well as non-members, and predict the impact of PTAs on the organization of the world trading system. This literature can broadly be divided into two approaches. (2) The traditional one follows Viner (1950) and examines the effect of exogenously specified PTAs on the welfare of members and non-members. (3) The second, and more recent, approach models the endogenous formation and stability of PTAs in order to understand how the pattern of trade agreements can be expected to develop over time. Especially interesting is the question of whether PTA formation will speed up the process towards global free trade or end up blocking the process in order to preserve preferential gains. The stepping stone/stumbling block idea was introduced by Bhagwati (1991), and has been the topic of several papers including Ludema (1994), Bagwell and Staiger (1997a, b), Yi (1996), and Krishna (1998).

   This paper emphasizes the latter approach in that it provides a first attempt to predict which trade agreements result when the formation of PTAs (and free trade) is endogenous and all agreements must be self-sustaining. In particular, I determine the welfare effects of eight different trade agreements (namely the non-cooperative, 3 FTAs, 3 CUs, and free trade) (4) in a three-country model of imperfect competition and endogenous tariff setting. I use welfare comparisons to determine the individual countries' preferences over trade agreements and find conditions for agreements to be sustainable in a standard infinitely repeated game framework with Nash punishment. The core solution concept developed by Riezman (1985) is applied to the model, and the idea expanded to a dynamic framework in which trade agreements are restricted to those that are sustainable and therefore will be observed: while Riezman assumes that "some" mechanism will make the trade agreements of the core binding, I explicitly model sustainability in order to make everything endogenous, self-sustainable and optimal. These requirements reflect the facts that countries voluntarily choose to make a trade agreement, that they cannot prevent other countries from cooperating, and that real world trade agreements face enforcement problems which should be dealt with theoretically. An important methodological contribution of the paper is to introduce the core as an equilibrium selection tool which helps determine the trade agreement(s) most likely to form among all self-sustainable agreements.

   One example of how self-enforcement cannot be taken for granted is the Andean Community. It started in 1969 with the signature of the Cartagena Agreement between Bolivia, Chile, Colombia, Ecuador, and Peru, aiming at the creation of a CU. Though successful at first, problems started in the late 1970's when members failed to comply with the agreement due to pressure from domestic interest groups "unhappy with the differences in short-term costs and benefits flowing from the integration process". (5) Unresolved disputes along with the oil crisis worsened the situation, and the Pact was virtually dead until a fundamental change towards free market-oriented policies was adopted in the early 1990's. Since then, integration has enhanced. First with an FTA structure but then with gradual integration towards a CU. (6)

   Naturally, the failure of the Community in the 1980's was not only due to Latin countries being "too impatient". However, the attempts to start and later restore the Community do imply an incentive to cooperate which history tells us did not lead to cooperation. In this way, the example shows that the sustainability of PTAs should not simply be assumed, and that an incentive to cooperate does not always equal the ability to do so.

   As for multilateral agreements, enforcement has improved significantly in later years through the dispute settlement body of the WTO. But since a dispute can still take more than one year to settle, countries continue to have an incentive to cheat to obtain short term gains- and still do cheat as has been the case with the US recently.

   The idea of using core theory to predict which trade agreement form when countries are free to make agreements endogenously was developed in Riezman (1985). He considers a three country- three goods pure exchange economy where countries differ in endowments only. CUs are seen as coalitions in the core, and the formation of these modelled in a two stage game. First, a coalition is chosen based on core theory. Second, optimal tariffs are chosen given the coalition. The resulting agreements are stable in the sense that no other coalition which yields higher welfare to all members of that coalition can form. It is assumed that there exists a mechanism so that agreements are binding. This gives a natural interpretation of the core, namely that agreements in the core will be observed.

   Riezman's idea was subsequently expanded in Krishna (1998), which considers a three-country oligopolistic trade model with several firms in each country, and takes a political economy approach where producer lobbies' preferences are determinant for trade policy. It is found that the more trade diverting an FTA is, the more likely it is to be supported by its members because trade diversion towards products produced by members move the game from being close to zero-sum (members gain in their partner's market but lose in their own) to being positive sum (members gain more in their partner's market and lose less at home at the expense of the third country). It is also found that the more trade diverting a block is, the more likely it is to be a stumbling block to free trade.

   While the above coalition formation games are static, Freund (2000) expands the model of Krishna (1998) to a dynamic framework to show that multilateral tariff reductions (which are assumed binding) increase both the incentive for PTAs and the likelihood that these are sustainable. Sustainability for PTAs is, as here, defined in a standard repeated game framework. The incentive for PTAs is shown to depend on the relative size of two effects: the efficiency effect of free trade- the gains from the increase in competition following full trade liberalization-, and the redistributive effect of PTAs--the diversion of profit loss to the outsider country, whose output contracts when the PTA is formed.

   Finally, Yi (1996) studies the stability of CU structures in an N country model under two different rules: "open regionalism" under which coalitions can form freely provided no outsider is excluded, and "unanimous regionalism" under which an outsider country can join a CU iff all existing members agree to this. He finds that open regionalism supports free trade, while unanimous regionalism typically supports two CUs of asymmetric size in equilibrium. Furthermore, CUs are stepping stones towards free trade under open regionalism, but can be stumbling blocks under unanimous regionalism.

   These papers all yield interesting results, but what is also evident is that at least some coalitions, once made, are assumed binding. As noted by Syropoulos (1999), this approach is customary in the literature. Indeed, Baldwin, in his infamous (1995) domino-paper does not account for why the open regionalism rule is applicable. Bagwell and Staiger (1997a, b) argue that enforcement is important and require multilateral agreements to be sustainable but still let CUs form exogenously and expand at random. Krugman (1991) considers symmetric CUs, but does not account for their sustainability. The present paper shows that this approach can be misleading in that predictions of which trade...