"Multilateralism, Regionalism, and the Sustainability of 'Natural' Trading Blocs"

Transcription

1 "Multilterlism, Regionlism, nd the Sustinility of 'Nturl' Trding Blocs" y Eric Bond Deprtment of Economics Penn Stte June, 1999 Astrct: This pper compres the mximum level of world welfre ttinle in n incentive comptile, multilterl trde greement etween 4 countries with the mximum ttinle when pirs of countries form preferentil trde greements. It is shown tht in world where ll countries re symmetric nd export single good to the rest of the world, preferentil greements cn sustin lower triff rtes thn multilterl greements, lthough multilterl greements will yield higher welfre if the discount prmeter is sufficiently high. Under trde pttern where countries import single product, multilterl greements dominte in sustinility nd welfre for ll discount prmeters. Trnsporttion costs tht mke intercontinentl trde more costly thn intr continentl trde re introduced to exmine whether nturl trding locs re more ttrctive. It is shown tht higher welfre levels re sustinle with regionl prmeters for ll discount prmeters. Also, the existence of trnsport costs expnds the rnge of discount prmeters for which preferentil rrngements re preferred to multilterl greements when multilterl greements re constrined to n MFN principle.

2 I. Introduction Sustntil ttention hs recently een focused on whether regionl trde greements hve fvorle effects on the world trding system nd should e encourged, or whether new inititives for trde lierliztion should e restricted to multilterl trde greements tht pply the MFN principle. This pper ddresses the question y exmining model in which countries cnnot write enforcele contrcts on triffs, so tht trde greements must e self-enforcing greements tht re supported through repeted interctions etween the countries. Although numer of ppers hve exmined the effect of preferentil rrngements on the multilterl trding system under the ssumption tht multilterl trde greements must e self-enforcing (e.g. Bgwell nd Stiger (1997,),(1999), Bond nd Syropoulos (1995), Bond Syropoulos nd Winters (1998)) 1, ll of these pper hve ssumed tht memer countries cn commit to triff rtes in the preferentil trding rrngement. Thus, fundmentl symmetry in commitment power is ssumed etween preferentil greements nd the multilterl trding system. The purpose of this pper is to compre preferentil nd multilterl trde greements in n environment where oth types of greements must e self-enforcing in repeted gme etween the prticipting countries, so there is no exogenous difference in commitment ility etween preferentil nd multilterl greements. A simple 4 country trde model is exmined. A multilterl greement is trde greement etween ll 4 countries in tht is required to stisfy the MFN principle, with devition y ny country eing punished y reversion to the one shot Nsh equilirium y ll prticipting countries. A preferentil greement equilirium is one in which two pirs of countries form preferentil 1 Bond nd Syropoulos (1995) exmine how n increse in the size of trding locs ffects multilterl coopertion in mny country world. Bgwell nd Stiger (1997,) exmine chnges in trde reltions over time etween two countries when preferentil trding greements with outside countries, either free trde res or customs unions, re nticipted in the future. Bgwell nd Stiger (1999) nd Bond nd Syropoulos (1999) exmine how the existence of preferentil rrngements etween two countries ffects trde reltions with third. 1

3 trde greements tht give discrimintory triff reduction to memer countries, with devitions punished y reversion to the Nsh equilirium of the one shot gme y the memer countries. The question to e exmined is whether the level of world welfre tht cn e sustined under the multilterl trding system is higher thn cn e ttined if insted the world were divided into symmetric PTAs. Two sic sources of difference etween multilterl nd regionl greements will e exmined. The first is due to difference etween the devition nd punishment effects under the respective types of greements in the cse which ll countries re symmetric. It will e shown tht in the cse where ech country hs comprtive dvntge in single good which it exports to the rest of the world, the minimum sustinle triff on trde etween the countries is lwys lower under preferentil trde greement thn under multilterl greement. This ility to sustin lower triffs under the preferentil greement results from strtegic spillovers etween the preferentil trde groups during the punishment nd devition phses. However, this ility to ttin lower triffs under preferentil greements must e weighed ginst the fct tht the discrimintory nture of these greements results in lower welfre t given greement rte. It is shown tht when oth of these fctors re comined, multilterl greements will dominte unless disounctors re quite low. In contrst, in the cse where ech country imports single good from ll other countries, the minimum sustinle triff under multilterl greement is lower thn tht under preferentil greement. In this cse there is strtegic independence etween locs in the preferentil cse, so tht multilterl greements enefirom hving superior punishment power. These two cses illustrte how the pttern of trde influences spillovers etween preferentil greements, nd hence the sustinility of triffs under preferentil greements. The second source of symmetry etween the greements is otined y giving the trde model regionl structure: the four countries re divided etween two continents, with trnsport costs incurred on trde etween continents ut not within continents. It is shown tht in this cse the existence of trnsporttion costs gives n dvntge to preferentil greements over multilterl greements when the 2

4 discount prmeter is low, regrdless of the pttern of trde, ecuse of the requirement tht multilterl greements stisfy the MFN principle. Multilterl greements stisfying the MFN principle must impose the sme triff on ll countries, even though devition incentives my differ cross the prtner countries, which mkes sustining of multilterl greements more difficult. However, when weight plced on the future is high this effect is dominted y the superior welfre effects of the multilterl greeement. The cse with regionl differences in trde costs lso rises the question of whether the preferentil trde equilirium is etter when there re regionl prtners or distnt prtners. It is shown thor oth ptterns of trde, the equilirium with regionl trde locs yields higher welfre. This result is due to the fct tht the regionl greement hs lower externl triffs thn does the preferentil greement with distnt country. This nlysis contriutes to the literture on 'nturl trding locs,' which hs een concerned with whether there is presumption tht triff reductions with nery prtners re welfre improving. Krugmn (1991), Frnkel Sten nd Wei (1995), nd Bhgwti nd Pngriy (1996) hve exmined this question y considering whether exogenously given preferentil triff reductions re welfre improving in model where there re differing levels of trnsport costs etween trding prtners. The nlysis in the present pper differs in tht ttention is focused on preferentil reductions tht re greements tht re self-enforcing. Section II of the pper presents the trde model for the cse where ech country exports single good, nd compres sustinility of multilterl nd preferentil greements in the sence of trnsport costs. Section III nlyzes the cse of inter-continentl trnsport costs. Section IV exmines how the results re ffected y ltering the pttern of trde so tht ech country imports single good from ll other countries. Section V offers some concluding remrks. II. Multilterl nd Regionl Trde Agreements in the Symmetric Cse 3

5 We exmine 4 country, 4 good trde model in which countries re symmetric. The four country frmework is dopted ecuse it is the simplesrmework in which to compre multilterlism with regionlism when there is more thn one regionl trding loc. The demnd for good in country i is D i ' " & p i, where p i is the price of good in country i. Ech country i hs n endowment of X of good i nd 0 of goods i. Letting t i denote the specific triff imposed y country i on imports of good, p i ' p % t i for i. It will e ssumed tht countries cnnot levy export txes, so t i / 0 for ll i. The equilirium prices will e ' " & (X % i t i ) /4 nd p i ' "& X&3t i % k i t k /4 for i. p In n importing country, the socil surplus otined from imports of good is the sum of consumer nd producer surplus for triffs tht re not prohiitive will e i S i (t i, k i t k ) ' m " p i "&u du % t i "&p i ' (X% k t k ) 2 & 16(t i )2 32 for 3t i & t k # X. (1) k i Surplus in the importle sector is concve in the country's own triff, t i, nd incresing nd convex in the triff of other importing countries for triffs re less thn the prohiitive vlue. The surplus in the exporting country in sector is the sum of consumer surplus nd endowment income S k t k ' m " p "&u du % Xp ' "X % ( k t k ) 2 & 6( k t k )X&7X 2 32 for k t k # 3X. (2) Surplus in the export sector is convex nd decresing in the triffs of importing countries for triffs elow the prohiitive level. Letting t i e the vector of triffs imposed y country k on goods k, welfre of country i cn e expressed s 4 W i (t 1,t 2,t 3,t 4 ) ' The free trde welfre level is "X - X 2 /8. '1 S i (t i, k t k ) (3) In the sence of trde greement, countries re ssumed to ply one shot triff setting gme. 4

6 Country i will choose t i to mximize W i, given t k. The triff t i will e chosen to mximize (1), which yields the optiml triff formul t i ' (X % k i t k ) /15 (4) Using the symmetry of countries, (1) - (4) cn e solved for the unique Nsh equilirium triff nd welfre levels, t N ' X W N ' "X & X 2 % 3 t N 2 (5) 13 8 These welfre functions generte the usul prisoner's dilemm feture of trde negotitions: unilterl triff reductions will e welfre reducing ut ilterl or multilterl triff reductions hve the potentil to enefit ll countries. It is well known tht repeted interctions etween prties cn e used to support pyoffs to the prties tht Preto dominte those otined in the one shot gme. A trde greement will e modeled here s coordintion mechnism in which prties choose triffs tht re to e sustined under the greement nd punishments tht re to e imposed on ny memer countries tht devite from the greement. A prticulr choice of triffs in trde greement will e incentive comptile if the pyoff to setting the triffs specified under the greement exceeds tht otined y deviting nd then suffering the specified punishment. A. Multilterl Trde Agreements A multilterl greement will e 4 plyer repeted gme in which ech country i chooses t i to mximize W i. It will e ssumed tht the triff rtes chosen under multilterl trde greement stisfy the MFN principle, which requires country i to extend triff reductions to ll trding prtners (i.e. t i ' t i k for ll i nd k, i). This restriction is imposed ecuse it hs een cornerstone of the GATT negotition process. It will e ssumed tht mong the sustinle trde greements stisfying the MFN principle, multilterl negotitions result in the selection of the symmetric trde greement tht mximizes the welfre of representtive memer country. The ssumption tht the triff greement 5

7 chosen is not Preto dominted seems nturl in n environment where the choice of triff rtes is mde in pulic forum where countries cn negotite. The symmetry of pyoffs to countries under the greement reflects the underlying symmetry of the model, nd cn e thought of s resulting from symmetric rgining power of the countries. Finlly, it is ssumed tht in the event of devition y memer country, the country is punished y infinite reversion to the one shot Nsh equilirium of the triff gme. Under multilterl trde greement, the ssumption tht trde greements re symmetric nd stisfy the MFN principle mens tht trde greement will consist of single triff rte which pplies to ll imported goods pplies to ll imported goods for ll countries, ' or ll i, nd i. Sustituting these ssumptions into (1)-(3), the pyoff to representtive country under multilterl trde greement tht specifies n import triff of t will e W m (t) ' "X & X 2 %3t 2 /8 (6) Since welfre is decresing in the triff rte, the memer countries will choose the lowest triff rte tht is incentive comptile. An greement with triff t will e incentive comptile if the gin to country from deviting during the current period is less thn the present vlue of the loss during the punishment phse. If country i were to devite from this greement, it would impose the optiml triff (4) on ll of its t i importles nd receive pyoff of ( t i (2t),2t) for ech i. The export sector pyoff would e S i unffected y the devition. The gin from devition in the current period is G m (t) = (X - 13t) 2 /160. Following devition, the deviting country will receive the Nsh equilirium pyoff in ll susequent periods. This yields loss of L m (t) = 3(X 2-169t 2 )/1352. Incentive comptiility requires tht G m (t)# *L m (t)/(1-*) where * is the discount rte. The function G m (t) is decresing nd convex on [0, t N ] with G m (t N ) = 0 nd G m '(t N ) = 0. L m (t) is decresing nd concve on [0,t N ], with L m (t N ) = 0 nd L m '(t N ) < 0. It then follows thor * > 0, there will exist n intervl of triffs contined in [0,t N ] t which the incentive 6

8 comptiility constrint is stisfied. If * $ 169/229, free trde will e incentive comptile. For lower vlues of the discount prmeter, the minimum level of the triff tht is incentive comptile cn e otined y solving for the vlue of t t which the incentive constrint holds with equlity, t m min ' mx X(169 & 229*) 13(169 & 109*), 0 (7) Note tht the minimum sustinle triff will e n incresing function of the mgnitude of the gins from trde, s represented y X. Although the losses during the punishment phse re incresing in X, the gins from devition re lso incresing in X nd the ltter effect is dominnt. B. Preferentil Trde Agreements A preferentil trde greement, on the other hnd, will e modeled s sitution where country plys repeted triff-setting gme with prtner countries ut plys one shot gme with outside countries. In order to mintin symmetry of the preferentil greements, we will restrict ttention to the cse in which ech country is involved in preferentil greement with one other country. The purpose of this is to strcrom mrket power issues tht result when preferentil rrngements crete n symmetry in the reltive size of countries or trding locs. 2 It will e ssumed tht the preferentil trding rrngement tkes the form of free trde greement (FTA), rther thn customs union, so tht countries do not coordinte in their choice of externl triffs. 3 Note tht there is some use of 2 Bond nd Syropoulos (1996) focus on the difference in mrket power effects etween expnsion in the solute size of trding locs (holding reltive size constnt) nd increses in reltive size of trding locs in the cse where locs tke the form of customs unions. 3 If insted the countries chose to form customs union, they would cooperte in the choice of externl triff s well. Since the customs union would choose the externl triff to mximize union welfre, the union will tke dvntge of its mrket power nd set higher externl triffs thn would customs union, s emphsized y Kennn nd Riezmn (1990). While this effect is fvorle for customs union for given level of the externl triff imposed y the other union, the Nsh equilirium when oth unions re setting their externl triffs will involve higher externl triffs for oth unions. It 7

9 terminology in referring to this s FTA, since trde is not necessrily free within the preferentil trding greement, ut it highlights the ssumption mde regrding the formtion of externl triffs. 4 The structure of triffs with preferentil trde greement is illustrted in Figure 1, where it is ssumed tht country 1 (3) forms n FTA with country 2 (4). The FTA etween countries 1 nd 2 will involve coordintion on the triffs t 2 1 nd t 1 2 imposed on trde with ech other, with ech country choosing its externl triffs. As in the cse of multilterl greement, it will e ssumed tht the memer countries re treted symmetriclly so tht the sme triff, denoted, is imposed y ech country on trde with its prtner, nd tht this triff is not Preto dominted y nother sustinle triff. This is illustrted in Figure 1 where the internl triff etween 1 nd 2 is denoted denoted in equilirium., nd tht etween 3 nd 4 is. These triffs re not necessrily equl, lthough we will show elow tht they will e equl In trde with the outside countries, 1 nd 2 will individully choose optiml externl triffs. For country i (i = 1,2), its triff on trde with outside country ( = 3,4) will e chosen to mximize S i (t i, %t k ), where k = 1,2 nd k i. By the symmetry of the countries, iollows tht the externl triff will hve common vlue t of ' t i for i = 1,2 nd = 3,4, which is the solution to t of ' t( of %t. Sustituting from (4) yields n expression for country's externl triff s function of the other FTA's internl triff. ) t of ( ) ' %X 14 Clerly, this formul lso yields the externl triff of representtive memer of the other FTA, (8) t of ' t of ( ). cn e shown tht when oth customs unions cn commit to internl nd externl triffs, the Nsh equilirium externl triffs is X/6. Since this triff level is sustntilly higher thn in the Nsh equilirium (5), it results in world welfre level tht is lower thn W N. In light of this negtive spect of customs unions, we will concentrte here on the cse of FTAs. 4 Preferentil trde greements often involve firly lengthy dustment periods for internl triffs nd my exclude some commodities, so tht internl lierliztion my not e complete in prctice. 8

10 Eqution (8) cn e used to derive the pyoff to country 1 s function of the triffs chosen the two FTAs. Country 1 will receive S 1 2 (,2t of ( )) on imports from its prtner nd S 1 1 ( %2t of ( )) on exports. On trde with outside countries, 1 receives surplus of surplus of S 1 k (t of ( ), % t of ( )) for k = 3,4. Sustituting into these expressions from (1), (2), nd (8) yields pyoff of W f (, ) ' "X % &25X 2 &24 X&82( )2 %30 %15( ) (9) Welfre of country 1 will e decresing nd concve in the triff tht it negotites with country 2, nd will e incresing nd convex in the triff set y the other FTA. The ltter resulollows from the fct tht increses in rise country 1's externl triff, which leds to greter surplus on imports from outside countries. This mens tht trde lierliztion y the one FTA will hve negtive effect on the welfre of the other FTA. The fct tht W f is decresing in mens tht the prtner countries will lwys choose the lowest sustinle internl triff in their negotitions, since the triff of the other FTA would e treted s given in ny triff negotitions etween the prtner countries. We now exmine the sustinility of n internl triff. If country 1 devites from its FTA, it will impose its optiml triff on imports from country 2, given tht countries 3 nd 4 re chrging triff of t of ( ) ). Triffs y country 1 on imports from 3 nd 4 re unffected, ecuse these triffs re lredy est responses to. This yields gin from devition of G f ( ) = S 21 ( t(2t of ( )),2t of ( )) - S 21 (, 2t of ( )) = 2(X- 13 ) 2 /735. In the punishment phse, the FTA etween countries 1 nd 2 hs collpsed, so tht these countries revert to chrging sttic optiml triffs on imports from the former prtner. Since countries 3 nd 4 re lso imposing optiml triffs on these goods, the mrkets for goods 1 nd 2 will e chrcterized y trde wr in which ll countries impose t N = X/13 in these mrkets. Even though countries 3 nd 4 re not prties to the FTA etween 1 nd 2, they will contriute to the punishment indirectly ecuse the increse in triffs y the prtner countries will led to rise in triffs 9

11 y the outside countries from (9). The mrkets for goods 3 nd 4 re unffected y this trde wr, ecuse 1 nd 2 re lredy imposing optiml triffs in these mrkets. The loss to the deviting country during the punishment phse is L f ( ) = [S 2 1 (, 2t of ( )) -S 21 (t N, 2t N )] + [S 11 ( +2t of ( )) - S 11 (3t N )] = (t N - )(197X +533 )/1274. Note tht since oth G f nd L f re independent of, the sustinility of one FTA is independent of the triff chosen y the other FTA. 5 An FTA equilirium will e sustinle if G f (t) # *L f (t)/(1-*). Using rguments similr to those for the multilterl cse, there will exist vlue min for * > 0 such tht n FTA is incentive comptile for ll t 0 [ min, t N ]. 6 Solving for the vlue t which the incentive constrint holds with strict equlity, we otin X(676&3631*) min (*) ' mx 13(676&61*), 0 (10) For * > 676/3631, free trde etween the FTA memers is incentive comptile. Since the sustinility prolem is symmetric for oth FTAs nd ech will choose the minimum level sustinle triff, the level of world welfre tht is sustinle with FTAs is otined y evluting (9) t ' '. The resulting welfre level cn then e compred to tht sustinle under min (*) multilterl greement, otined y evluting (7) t t min (*). There will e two conflicting effects present in the comprison of world welfre under the two regimes. The first is thor given level of the triff under the trde greement, the multilterl system yields higher world welfre thn does the FTA. If we evlute (9) t common greemenor ech FTA, we otin 5 In prticulr, we not hve to worry out the possiility tht collpse of one FTA cretes domino effect on the other FTA in the following period. 6 The function G ( ) is non-incresing nd convex for t 0 [0, t N ] with G f (t N ) = G f '(t N ) = 0. L ft (t) is decresing nd concve function for t 0 [0, t N ] with L ft (t N ) = 0. If G f (0) > L f (0), then there will e unique vlue t 0 (0, t N ) t which the constrints hold with equlity when * > 0. If G f (0) # L f (0) then free trde is sustinle. 10

12 W f (, ) ' "X % &25X 2 %6tX&67( ) (11) Compring (11) with (6) yields W m (t) > W f (t,t) for t 0 [0,t N ). Welfre of the representtive country with FTAs is concve in t nd is mximized t = 3X/67. This contrsts with the multilterl cse, where the welfre of the representtive country is mximized t t = 0. This follows from the fct tht when n FTA reduces its internl triff, the externl triff decreses ut y smller mount. The verge level of triff flls ut the difference etween the triffs increses. The former effect rises world welfre, ut the ltter effect decreses welfre. For sufficiently low triffs, the ltter effect will dominte nd world welfre will fll when internl triffs re reduced. In prticulr, the welfre level with free internl trde will e "X - 25X 2 /196, which is less thn the Nsh equilirium level of welfre from (4). On the other hnd, it cn e seen y comprison of (6) nd (9) tht min (*) # t M min (*) for * 0 [0,1]. The enefit of deviting from n FTA is less thn tht of deviting from nd multilterl greement ecuse the country is lso deviting in only one mrket. However, the losses in the punishment phse re lso lower ecuse the punishment occurs in only one mrket. This result suggests tht the punishment is reltively more severe in the FTA cse. A contriuting fctor to the severity of the punishment in the FTA is tht the non-memer countries will lso increse their triffs in the punishment phse. There is thus fvorle punishment phse spillover from the other countries. It is cler thor vlues of * $169/229 the multilterl system must dominte the regionl one, ecuse glol free trde will e sustinle. On the other hnd, it cn e estlished using (7), (8), (11) nd (12) tht MW f (t N,t N ) M % MW f (t N,t N ) M M min (0) M* > dw m (t N ) d min Mt m min (0) M* >0. This ensures tht the FTA system must yield higher welfre thn the multilterl system for vlues of * in the neighorhood of 0, where coopertion is very difficult to sustin. Figure 2 illustrtes W m ( ) nd W f ( ) for the cse t m min min 11

13 where X = 13 nd " =5, which yields t N = 1 nd W N = In this cse, the FTA yields higher welfre level for * <.15. The fct tht the pyoff under the FTA is decresing for * 0 [.1,.19] results from coordintion filure ssocited with the FTA cse. The mximum pyoff under preferentil rrngements is ttined when = 2X/13 =.58 in this cse, which is supportle for * >.1. The FTA equilirium would yield higher pyoffs if the internl triffs were held t.58 for * >.1. However, ech FTA will tret the internl triff of the other FTA s given nd will choose the lowest sustinle triff. Similr conclusions were otined for other vlues of X. The result tht ilterl greements llow countries to sustin lower triffs thn do multilterl greements my seem somewht surprising. For exmple, Mggi (1999) hs illustrted how multilterl punishment schemes my result in more effective punishment of countries in cse where there is n symmetry in trde ptterns which prevents one country from effectively punishing prtner tht devites from ilterl greement. In tht model, the coordintion of punishments llows the devitor to e punished y third country. In the present model, the punishmenollowing the devition from regionl greement is eqully effective with tht in the multilterl cse ecuse of the strtegic inerctions etween locs. This llows the sustining of lower internl triffs under the regionl greement. However, III. Trnsporttion Costs Between Continents The nlysis of the preceding section ssumed tht the countries hd symmetric trding reltions with ll prtner countries. In this section we introduce regionl structure with n symmetry in trde reltions due to trnsporttion costs. The world is ssumed to e divided into two continents, with two countries locted on ech continent. There is cost of c per unit on ny goods imported from country on the other continent, ut zero trnsport cost on goods coming from the country on the sme continent. 7 These prmeter vlues yield Nsh equilirium triff rte of 100% nd welfre loss of the Nsh equilirium reltive to free trde of pproximtely 1%. 12

14 In this section we nlyze how the results of section II regrding the reltive enefits of multilterl trde greements nd FTAs re ffected y this trnsport cost structure. The demnd nd supply structure for ech good is ssumed to e identicl to tht in previous sections. Since ech exporter sells to two countries on the other continent, the price of good in the exporting country will e p ' " & (X % i t i % 2c) /4. The price in the importing country will e p i ' p % t i % c i, where = c if i nd re on different continents nd 0 otherwise. Sustituting c i these results into the definitions of surplus in (1) nd (2) S S i (t i, c i, k i (t k %c k )) 2c% k t k ' "X % ' u u&8t i 32 for u / X% k i (t k (2c% k t k ) 2 & 6(2c% k t k )X&7X 2 32 %c k )&3(t i %c i ) $ 0 for 2c% k t k # X (12) where the inequlity constrints reflect the requirement tht trde rriers nd trnsport costs not e so high tht trde is eliminted. Ntionl welfre will e the sum of the sectorl surpluses. yielding The optiml triff formul with trnsport costs is otined y mximizing with respect to, t i (c i, k i (t k %c k )) ' (X & 3c i % k i (t k %c k )) /15 (13) Compring with (4), it cn e seen tht the existence of trnsport costs leds to higher triffs on goods from the sme continent nd lower triffs on goods from the other continenor given level of triffs y other countries. This follows ecuse the trnsport costs tend to lower (rise) the elsticity of demnd for goods from the sme (other) continent y incresing (decresing) the volume of trde t given triffs. Since there is n symmetry etween countries in this cse, the Nsh equilirium triffs imposed on the regionl trding prtner (denoted y r) will differ from those on the distnt prtner (d). Solving for the S i t i 13

15 equilirium triffs yields t Nr ' X 13 % 3c 26 ; t Nd ' X 13 & 7c 52 ; W N ' "X % 1293c 2 &344X 2 &1344cX 2704 (14) Nsh equilirium triffs on regionl trding prtners will e higher thn those on the distnt prtners. Under multilterl trde greement, we continue to impose the requirement tht the sme triff e imposed on imports from ll prtner countries. Utilizing (14) for the cse of t i = or ll i yields n expression for welfre under multilterl trde greement, W M (t,c) ' "X & X 2 %3t 2 &4c(X&c) 8 for t < X & 2c (15) Triff levels exceeding X - 2c would never e chosen under multilterl greement, ecuse they would eliminte trde with the distnt country. A deviting country will impose optiml triffs on imports, with the optiml triffs differing etween regionl nd distnt prtners. If these optiml triffs re sustituted into the import surplus expressions, we otin gin from devition of G M (t,c) = [3(X-13t) 2 +4c(3c + 13t -X)]/480. The effect of trnsport costs is to reduce the gins from devition iff t < (X - 6c)/13, which implies tht increses in trnsport costs rise the incentives for multilterl devitions when triffs re close to the Nsh equilirium vlues. In prticulr, note tht in the previous exmples the gins from devition were equl to zero t the Nsh equilirium triff. In the present cse the Nsh triff differs cross countries, so with the MFN principle in plce the gins from devition re minimized t t = X/(13+c/9). Under the ssumption of reversion to the one shot Nsh equilirium in the punishment phse, the per period loss punishment phse is the difference etween (17) nd W N, L M (t,c) = [3(X 2-169t 2 )/1352]+c(59c-8X)/2704. Increses in trnsport costs will reduce the losses from punishment iff c < 4X/59. These results on devition nd punishment phses suggest non-monotonic reltionship etween 14

16 trnsport costs nd the sustinility of coopertion. When triffs re high (i.e. in the neighorhood of the non-coopertive Nsh equilirium) nd trnsport costs re low, the gins from devition re incresed nd the losses from punishment re decresing in the level of trnsport costs. Both of these forces will tend to mke coopertion hrder to sustin s trnsport costs rise. These effects re reversed for low triffs. These effects cn e formlized y solving for the minimum discount prmeter for which triff t cn e supported under multilterlism, * M (t,c) ' G M (t,c) L M (t,c) % G M (t,c) ' 169 3(13t 2 &X) 2 %4c(3c%13t&X) (687X 2 %13182tX%55263t 2 )%c(3798c%8788t&916x) (16) In light of the complexity of this expression, the reltionship etween trnsport costs nd the minimum discount prmeter cn est e seen y plotting (16) for severl different triff levels. Figure 3 illustrtes the minimum discount prmeter for the cse in which X = 13 nd c 0 [0,5], which yields Nsh triff of 1 when there re no trnsport costs. For reltive low triff off.1, the minimum discount fctor is monotoniclly decresing in c. For higher triffs of.5 nd.8, the minimum discounctor initilly decreses in c nd then increses in c. A second point to note regrding (16) is the sustinility of triffs for very low vlues of the discount prmeter. In the expressions for minimum sustinle triffs in (8) nd (11), the minimum sustinle triff pproches the Nsh equilirium triff s * 6 0. This follows ecuse oth the gins from devition pproch zero more rpidly thn do the losses from punishment s t pproches the Nsh level. However, with trnsport costs there is difference etween the Nsh triffs imposed on distnt nd regionl prtners. Since multilterl greements must utilize n MFN principle, there is no single triff tht will drive the gins from devition to zero. This results in the minimum discounctor eing ounded wy from zero when trnsport costs re positive. This is illustrted in Figure 4, which shows the reltionship etween the minimum discount prmeter nd the level of triffs for lterntive levels of 15

17 trnsport costs. With c =.1, there is no single triff level tht cn e supported for * <.05. When c = 5, multilterl coopertion cnnot e supported for * <.49. Thus, multilterl coopertion ecomes incresingly difficult to sustin for high levels of trnsport costs ecuse the MFN principle ecomes significnt constrint on the ility to sustin coopertion. B. Free Trde Ares We next exmine the sustinle triffs etween memer countries in the cse where countries pir up nd form free trde res. Under n FTA, memer country plys repeted gme with the prtner country, while imposing n optiml triff ginst non-memer countries. In the sence of trnsport costs, it did not mtter how the countries pired up ecuse the trde flows were symmetric etween ll pirs of countries. When inter-regionl trnsport costs re introduced, the greement will differ depending on whether the prtner country is on the sme or different continent. Therefore, we will consider sustinility of coopertion for oth types of FTAs. First consider the optiml triff imposed on trde with outside countries. If country 1 forms n FTA with country 2, which is locted on the sme continent, then it will impose n optiml triff on trde with oth of the distnt countries s illustrted in Figure 1. Using the sme logic s in the derivtion of (9), we otin t ofr (,c) ' % X & 2c 14 The externl triffs of regionl FTA prtners re decresing in the level of trnsport costs. Using (17), the pyoff to country 1 under regionl FTA cn then e derived s in (10), where (17) is the internl triff of country 1's FTA nd is the triff of the other country's FTA. 2 W fr (,,c) ' "X %&25X &24 (X&2c)&82( )2 %30 (X&2c)%15( ) %96c(c&X) (18) 16

18 Welfre of loc is decresing in its own triff for X $ 2c, condition which is required for intercontinentl trde to occur, so loc will lwys choose the lowest sustinle internl triff. Welfre is decresing in the internl triff of the other loc. This welfre level cn e compred with tht otined if country 1 chooses to form n FTA with country 3, which is locted on the other continent. This cse is slightly more complicted ecuse the externl triff of 1 on imports from country 2,, will differ from tht on imports from 4, ecuse t ofd 2 t ofd 4 of the difference in trnsport costs. In the mrkeor good 2, country 1's triff is est response to the greement triff etween 4 nd 2 nd the optiml triff imposed y 3 on 2. By the symmetry etween 1 nd 3, 3's triff on 2 will e the sme s 1's triff on 4, so t ofd 2 ' t(0, %t ofd 4 %2c). In the mrkeor good 4, country 1's triff on distnt non-memer is the est response to the greement triff imposed y 2 on 4 nd the optiml triff on regionl non-memer imposed y 3 on 4 (which will equl t ofd 2 y the symmetry etween 1 nd 3). This yields t ofd 4 ' t(c, %t ofd 2 %c). Solving these two equtions simultneously, we hve t ofd 2 (,c) ' %X 14 % c 8, t ofd 4 (,c) ' %X 14 & c 8 (19) The externl triff on the regionl non-memer will e higher in equilirium thn tht on the distnt nonmemer. Note thor given level of n greement triff etween the prtners, ll externl triffs re higher under n FTA with distnt prtner thn with regionl prtner. This results from the fct tht countries impose higher triffs ginst nery countries in this model, nd this effect spills over to ffect ll externl triff levels under FTAs with distnt prtners due to the complementrities etween triffs. In the cse of n FTA with distnt country, country 1 receives surplus of S 3 1 (, 0, (,c) + t ofd 2 (,c)+c) on imports from the prtner country, S 21 ( (,c), 0, + (,c)+2) from the regionl nont f t ofd 2 t ofd 4 memer, S 31 ( (,c),c, (,c) + +c) from the distnt non-memer, nd S 11 ( + (,c) + t ofd 4 t ofd 2 t ofd 2 t ofd 4 t ofd 4 17

19 (,c)+2c) from the export sector. Solving yields W fd (,,c) ' "X % &25X 2 &24 X&82( )2 %30 X%15( ) % c(1519c&1568x) 3136 (20) W fd lso hs the property of eing decresing nd concve in nd incresing nd convex in. Due to the symmetry of the incentive constrints etween the two FTAs nd the fct tht ech FTA will choose the minimum sustinle triff, we will hve = in ny FTA equilirium involving either regionl or distnt FTAs. One wy to illustrte the difference etween the two types of FTAs is to compre the welfre of representtive country under the two different types of preferentil rrngements, holding the internl triff constnt cross the two regimes. Sutrcting (20) from (18) yields W fr (,,c) - W fd (,,c) = c(32x + 17 c )/3136. With c > 0, the welfre under n FTA with regionl prtner will e higher thn thor distnt prtner for ny greement triff tht is less thn X/6 + 17c/192. Since this will hold for ny triffs tht re elow the Nsh equilirium level, FTAs with regionl prtners dominte those with distnt prtners t given greement triff. The reson for the dominnce regionl greements is tht the externl triffs imposed when countries form FTAs with distnt prtners re higher thn those when countries form FTAs with regionl prtners. This increse in world triffs will mke regionl FTAs more ttrctive, given the level of the internl triff. We now turn to the sustinility of triffs under the respective types of FTAs. It cn e shown using similr rguments s in the derivtion of (11) tht the minimum sustinle triff with regionl FTA will e 8 8 With regionl FTA, there is devition gin of G mr (c,t r ) = 338(t nr - ) 2 /735 nd punishment loss of L mr (c,t) = (t nr - )(394X c)/2548. With distnt prtner FTA, the devition gin is G fd (c, ) = 2704(t nd - ) 2 /5880 nd the punishment loss is L fd (,c) = (t nr - )(788X c)/5096. In ech cse, there will e n intervl of sustinle triffs [ min,t N ] for ny * > 0 with (25) nd (26) eing the minimum vlues in the respective cses. 18

20 r min 52X % 78c & (7262X & 5487c)*/26 (*) ' mx, 0 (21) 676 & 61* Triffs elow the Nsh equilirium triff rte will e sustinle for very low discount prmeters ecuse (21) is decresing in * with r min (0) = t nr. For the cse of n FTA with distnt prtner, the minimum sustinle triff is d min 52X & 91c & (14524X & 9037c)*/52 (*) ' mx, 0 (22) 676 & 61* d min is decresing in * with d (0) = t nd. Sutrcting (22) from (21) yields r fd (*) & t > 0. The min min min (*) difference reflects the fct tht in generl it is more ttrctive to devite from trde greement when c is lower, so coopertion is esier (i.e. lower triffs re sustinle) with distnt prtner. These results suggest conflicting effects in the evlution of the ttrctiveness of regionl nd distnt FTAs. The FTA with regionl prtner provides higher pyoff t given internl triff, ut t given discount prmeter the regionl FTA will not e le to support s low triff rte. Sustituting (21) nd (22) into the respective welfre functions (18) nd (20), we cn derive the difference in welfre etween the regionl nd distnt FTA t given * to e '(*) ' W fr (*) & W fd (*) ' 15c* (146692%20933*)X & (107315%14185*)c 52(61* & 676) 2 (23) '(0) = 0 ecuse oth types of FTAs yield the Nsh equilirium pyoff t * = 0. For * > 0, the sign of this expression will e determined y the sign of the term in rckets. By (12), X $ 2c is required for there to e imports from distnt countries. This conditions is sufficient to ensure tht the rcketed expression in (23) will e positive for ll * 0 [0,1], so tht FTAs with regionl prtners will lwys e preferred to FTAs with distnt prtner. 19

21 These results re consistent with the notion tht "nturl trding locs" etween neighoring countries re more likely to e welfre improving. It should e noted tht the exercise considered here differs from tht performed y Frnkel, Stein nd Wei (1995) nd Bhgwti nd Pngriy (1995), who consider the effect of preferentil reductions from n initil point of equl triffs. Frnkel, Stein nd Wei utilize generl equilirium model with constnt elsticity of sustitution models nd find significnt rnge of prmeter vlues for which regionl greements re preferred. Bhgwti nd Pngriy, on the other hnd, use model with liner excess demnds nd find preference for triff reductions with distnt prtner. In the exercise eing considered in this pper, triffs ginst regionl nd distnt countries would not e the sme in the initil equilirium ecuse of the different degree of mrket power creted y trnsport costs. The regionl FTA hs the dvntge of eliminting wht would otherwise e reltively high triffs ginst nery prtners. Figure 5 illustrtes the difference in pyoffs etween the regionl FTA, distnt FTA, nd multilterl system utilizing the sme prmeter vlues s in Figure 3, ut with n intercontinentl trnsport cost of c = 2. Figure 5 shows how the regionl FTA domintes the FTA with distnt prtners. Second, it illustrtes how the existence of trnsport costs etween countries expnds the rnge of discount prmeters for which preferentil greements yield higher welfre, since multilterl greements cnnot e sustined for * <.39 in this cse. IV. Sustinility nd the Pttern of Trde The model utilized to derive the results of the previous section ssumed tht ech country exports single good to ll other countries. One impliction of this ssumption is tht goods from one country do not compete directly with goods from other countries. In this section we consider n lterntive endowment structure in which country i hs supply of X/3 of good i nd 0 of good i, with the demnds for ech good in country i eing given y D i ' " & p i s in the previous section. This model, which is used y Bgwell nd Stiger (1998) to nlyze interctions etween multilterl nd 20

22 preferentil rrngements in 3 country model, llows direct competition etween imports from different countries nd thus yields more direct ppliction of the MFN principle. However, it lso ffects strtegic interctions etween the preferentil trding groups y mking the externl triffs of preferentil trding rrngements independent of the triffs of the other locs. Let denote the triff imposed y country on imports of good from country i nd the T i trnsport cost etween country i nd, so tht the price of good in country i will e c i p i ' p & T i & c i. The mrket clering conditions yield equilirium prices p ' "% i (T i % c i ) & X /4 nd p k ' " & X % 3(T k %c k ) & k i, (T i % c i /4. For country i, the surplus from exportle ( i) is the sum of consumer surplus nd endowment income,. S i (T i,c i k i, (T k %c k )) ' 1 2 X%3(T i %c i )& k i, (T k %c k ) 4 2 % X 3 "& X%3(T i %c i )& k i, (T k %c k ) 4 (24) Surplus in the importle sector is the sum of consumer surplus nd triff revenue. Imports of good from country i e M i ' X/3 & D i. Evluting this expression t the equilirium prices, surplus in the importle sector will e S (T ) ' 1 2 X & i (T i %c i ) 4 2 % i T i X 12 & 3(T i %c i )& k i, (T k %c k ) 4 (25) where T is the vector of triffs T i for i imposed y country. The condition tht triffs e non- prohiitive on imports of good from country i is tht T i # X%3 k i, (T k %c k ) /9. yields %c i The optiml triff imposed y on i is otined y mximizing (25) with respect to T i, which T i ' T(c i, k i, c k, k i, c k ) ' x&33c i %15( k i, c k )%27( k i, t k ) 69 (26) 21

23 The optiml triff imposed on imports from country i depends only on triffs imposed y country on imports from other countries, so tht there is strtegic independence etween triffs imposed y the countries. This contrsts with (4), where increses in the internl triffs of one loc rise the optiml externl triff of the other loc. A. Trde Agreements with Zero Trnsport Costs First consider the cse in which c i = 0 for ll i nd, so tht ll countries re symmetric. Using the MFN principle, multilterl greement will involve the choice of single triff T i 'T for ech country. The symmetry ssumption will result in doption of the sme triff y ll countries, T = T. If we sum the sectorl pyoffs from (24) nd (25) for the cse of symmetric multilterl greement, we otin the pyoff to the representtive country to e W M (T M ) ' " & (X%3(T M ) 2 )/8 (27) This pyoff is identicl to tht otined in the previous cse, with welfre decresing nd concve in i. The Nsh equilirium triffs re otined y solving (26) for with = 0, which yields T N = X/15 for ech country y symmetry. A devition from multilterl greement will involve setting optiml triffs on imports. Since optiml triffs re independent of the triffs imposed y other countries, country 1 will impose the Nsh equilirium triffs when it devites from the greement, which gives gin from devition of G(T M ) = 15(T N - T M ) 2 /32. The punishment will e permnent reversion to the Nsh equilirium triffs y ll countries, which yields per period punishment of L(T M ) = W(T M ) - W(T N ) = 3((T N ) 2 -(T M ) 2 )/8. Solving for the minimum sustinle triff yields T c i T M X(5 & 9*) min (*) 'mx 15(5 & *), 0 (28) Any triff on the intervl [ T M min (*), T N ] is sustinle, nd multilterl greement will choose the 22

24 minimum sustinle vlue to sustin. Free trde is sustinle for * $ 5/9. Next consider the cse in which there is n FTA etween countries 1 nd 2 with n internl triff of, nd n FTA etween 3 nd 4 with n internl triff. Given this triff on imports from country T f 2, country 1 will choose its triff on imports from 3 nd 4 ccording to the optiml triff formul (26). Using the symmetry of countries 3 nd 4, the triff on imports from 3 nd 4 will hve common vlue, denoted T of, which is the solution to T of ' T(0,T f of %T ). Solving using (26) yields T of ' 27T f %X, 42 which will lso e the externl triff imposed y country 2 on imports from 3 nd 4. Under the FTA, country 1 will receive pyoff of S 1 2 (T f of,0,2t ) on exports to the prtner, S 1 of of (T,0,T %T f ) on exports to non-memers for = 3,4, nd S 1 1 (T f of,0,2t on imports. Summing cross sectors using (24) nd (25) yields ) T f W f (T f,t f ) ' " % 221X 2 %X(12T f &18T f )&468(T f )2 %9(T f ) (29) Welfre of the FTA is concve in its own internl triff, nd is mximized t T f = X/78. This mens tht when the FTA chooses its own internl triff, treting T f s given, it will choose the greter of the minimum sustinle triff nd X/78. (29) lso shows tht welfre of the FTA is convex nd decresing in the internl triff of the other loc over the relevnt rnge (i.e. T f # T N ). This occurs ecuse when the other FTA lowers its internl triff, its optiml externl triff is lso reduced, creting spillover enefit to the rest of the world. Finlly, note tht if we evlute (29) using common vlue T f ' T f ' T f for the internl triffs of the FTAs, world welfre will e monotoniclly decresing in T f on [0, T N ]. These results regrding world welfre under FTA internl triffs provide severl contrsts with those otined in the previous cse where countries were specilized in exporting, represented y (9) nd (11). First, in tht model lowering of n FTA's internl triff cused negtive spillover to the other FTA, ecuse it rised the price of imports from FTA memers. In contrst, in the present cse with 23

25 competing exporters, there is positive spillover etween FTAs from internl lierliztion. Second, in the specilized exporter model world welfre under symmetric FTAs ws mximized t positive triff, wheres in the present model world triff is mximized if oth FTAs choose internl free trde. This difference is due to the fct tht in the model with competing exporters, reductions in the internl triff result in much more ggressive reductions in the externl triffs thn in the cse of specilized exporters, resulting in lower level of world trde rriers. The complementrity etween internl triff reductions nd externl triff reductions is much stronger in the present cse. Finlly, in the cse with specilized exporters the welfre of n FTA is highest t internl free trde, given the internl triff of the other FTA. This mens tht in tht cse FTAs would choose internl triffs tht re elow the level tht mximizes world welfre ecuse they fil to internlize the negtive spillovers of their policy on other countries. In contrst, in the present cse the FTAs choose n internl triff tht is ove the socilly optiml level, ecuse they fil to internlize the positive spillover effects of their triffs on the other FTA. We now turn to the sustinility of internl triffs under FTAs. The gin from devition under n FTA is G f (T f ) = 5(T N - T f ) 2 /14, while the loss from punishment is L f (T f ) = W f (T f, ), - W f ( T N, ) = (8X+195T f )(T N - 15T f )/735. Due to the strtegic independence of the triffs in this cse, the triffs of the other FTA re unffected during the punishment phse. The triff tht will e chosen y the FTA will e the greter of its minimum sustinle triff, which solves (1-*)G f (T f ) -*L f (T f ) = 0, nd X/78. This yields T f T f T f (*) ' mx X(35&51*) 15(35&9*), X 78 (30) Compring (30) with (28), we otin T f (*) & T M min (*) $ 0, with strict inequlity holding for * > 0. Note tht this contrsts with the result of the previous cse, where minimum sustinle triffs were lower under the FTA. One of the contriuting fctors to this result is tht the rest of the world does not prticipte in the punishment phse in the cse where there re competing exporters. Thus, punishment in 24

26 the multilterl cse is more effective thn punishment in the regionl cse. It is cler from (27) nd (29) tht W M (T) > W f (T,T) for T 0 [0,T N ) nd tht W f (T,T) is decresing in T for It then follows from the ove result tht W M (T M min (*)) > W f (T f (*),T f (*)) for * > 0. Thus, multilterlism lwys domintes regionlism in the cse with zero trnsport costs. B. Trde Agreements with Inter-Continentl Trnsport Costs We now extend the nlysis to consider the cse in which there re inter-continentl trnsporttion costs of c etween countries on one continent (1 nd 2) nd those on the other (3 nd 4). There were two min results from the cse in which exporters re specilized. The first ws tht the presence of inter-continentl trnsport costs creted rnge of discount prmeters in the neighorhood of * = 0 for which no trde greements tht dominte the one shot Nsh equilirium re sustinle, due to the MFN restriction imposed on multilterl greements. In contrst, no such rnge existed for FTAs. The second result ws thor * > 0, higher welfre level cn e sustined under regionl FTA thn under n FTA with distnt prtner. In this section we show tht oth of these conclusions continue to hold under the pttern of trde with competing exporters. In the sence of trde greement, the Nsh equilirium triffs ginst the distnt countries, t Nd, nd the regionl country, t Nr, cn e solved using (26) to e T Nr ' X%3c 15, T Nd ' 2X&9c 30 The optiml triff ginst the nery prtner is higher thn tht ginst the distnt prtner, s in the cse with specilized exporters. It cn e shown in the multilterl cse tht the minimum discount prmeter consistent with given multilterl triff (31) * M (T,c) ' 3 (15t 2 &X) 2 %4c(21c%15t&X) 3 (3X 2 &50TX%75T 2 )%c(212c%100t&12x) (32) As ws the cse for (16), the difference in Nsh triffs etween countries when c > 0 mens the numertor 25

27 of this expression cnnot e driven to 0 for ny T. Therefore, there will e n intervl of vlues of * in the neighorhood of 0 for which no MFN greement is sustinle. In contrst, FTAs will e le to support triff lierliztion in the neighorhood of * = 0 ecuse of their discrimintory nture. For the cse of regionl FTA etween countries 1 nd 2, we otin the externl triff (T ofr ) nd welfre (W fr ), given the internl triff of the other loc ( T f ), to e W fr (T f,t f T ofr f (T f 27T,c) ' % X & 18c 42 f 12T,c) ' "X % (X%3c&39T f )%9T f (8c%15T f &2X) %(720c 2 &276cX&221X 2 ) 1764 (33) Welfre of the FTA is mximized when its internl triff is (X + 3c)/78. For the cse of n FTA etween countries 1 nd 3, we otin externl triffs ginst the regionl non-memer (T ofr ), the triff ginst the distnt non-memer (T ofd ), nd welfre (W fd ) to e f T ofr (T f 2X%54T,c) ' 84 %33c, T ofd (T f,c) ' 2X%54T f %&9c 84 W fd (T f,t f,c) ' "X % &884X 2 &24T f (2X&9c&78T f )%36T f (2(X%c)%T f %15c(201c&80X) 7056 The externl triff on the regionl non-memer will e higher in equilirium thn tht on the distnt nonmemer. Welfre of n FTA is mximized t n internl triff of (2X-9c)/156. Using (33) nd (34), W fr (T f,t f,c) - W fd (T f,t f,c) = c(32x + 192T f - 45c)/2352. With c > 0, the welfre under n FTA with regionl prtner will e higher thn thor distnt prtner s long s X > 45c/32. In order for trde to e possile etween continents, we must hve X > 6c, so this condition will (34) 26