Strategic Delegation and the Formation of Preferential Trade Agreements

Transcription

1 Strategic Delegation and the Formation of Preferential Trade Agreements Giovanni Facchini, Peri Silva, Gerald Willmann February 21, 2008 Abstract While the number of preferential trade agreements has greatly increased over the past two decades, most existing bilateral arrangements take the form of free trade areas, and less than ten percent can be considered fully fledged customs unions. This paper develops a political economy of trade model under imperfect competition to provide a positive explanation for the prevalence of free trade areas. In our three country model, a representative from each prospective member country is elected to determine the tariffs to be applied on imported goods. Under a customs union, the necessity to coordinate tariffs leads voters to strategically delegate power to more protectionist representatives. Contrary to most of the existing literature, strategic delegation may then lead to the result that free trade areas raise welfare relative to customs unions. Moreover, the model also indicates that free trade areas are more likely to be politically viable than customs unions. JEL classification numbers: F10, F11, F13 Keywords: Strategic delegation, Preferential Trade Agreements. Peri Silva acknowledges financial support from the College of Business and Public Administration at the University of North Dakota. The views expressed here are those of the authors and do not necessarily reflect those of the institutions with which they are affiliated. University of Essex, Universitá degli Studi di Milano, Centro Studi Luca d Agliano, CEPR and CES Ifo; gfacch@essex.ac.uk. University of North Dakota, and Centro Studi Luca d Agliano. Gamble 290 L. Centennial Drive, Grand Forks, ND 58202, USA; phone: ; peri.dasilva@mail.business.und.edu. K. U. Leuven and CES Ifo, Hogenheuvelcollege Naamsestraat Leuven, Belgium; phone: ; fax: ; gerald.willmann@econ.kuleuven.be.

2 1 Introduction In the last two decades the world economy has witnessed an impressive increase in the number of preferential trade agreements that entered into force. Interestingly, as reported by the World Trade Organization 1 ninety percent of the preferential trade agreements that were in force in 2007 have taken the form of free trade areas, while only ten percent of the existing bilateral agreements take the form of customs unions. 2 Although these figures clearly indicate that free trade areas are more popular than customs unions, to the best of our knowledge the literature so far has not offered a systematic explanation for this stylized fact. The aim of this paper is to develop a political economy of trade model under imperfect competition to explain the formation of preferential trade arrangements and to compare the social welfare effects and political viability of free trade areas and customs unions. A large literature has considered various aspects of the formation of preferential trade agreements. In particular, recent results compare the social welfare effects of free trade areas and customs unions. Ornelas 2007 uses an oligopolistic model to show that customs unions raise social welfare relative to free trade areas in member countries. He concludes that the creation of customs unions can be used by relatively small countries to induce nonmembers to support multilateral trade liberalization. Saggi 2006 uses a similar oligopolistic competition model to show that customs unions raise social welfare relative to free trade areas in member countries. Differently from Ornelas 2007, he concludes that customs unions and free trade areas can be thought of as stumbling blocs for multilateral liberalization, since they increase the incentives faced by member or non-member countries to abandon the multilateral liberalization initiative. Notice that tariffs in Ornelas 2007 and Saggi 2006 are chosen in order to maximize social welfare. Other papers investigate the political viability of free trade areas. Grossman and Helpman 1995 and Krishna 1998 show that welfare reducing free trade areas are politically viable in economic settings where pressure groups are important determinants of free trade area 1 See: http : // e/region e/region e.htm. 2 Partial scope agreements as defined by the WTO were not considered in this calculus. The WTO recognizes that there were 197 preferential agreements in force by the end of 2007.

3 formation. Key to these results is the assumption that tariffs on non-member countries are frozen at the pre-formation levels. On the contrary, Ornelas 2005 shows that if postformation external tariffs are endogenously determined, then the political viability of welfare reducing free trade areas is critically undermined even in the presence of pressure groups. In this case, he shows that the government may end up not endorsing welfare enhancing free trade areas but, at the same time, cannot endorse welfare reducing ones when pressure groups do not influence the government s decision to create a free trade area. 3 To analyze the political desirability of a free trade area and a customs union, we develop a simple three country model, in which two potential member countries strategically interact to choose the tariff levels to be implemented vis à vis each other and the third country, while the rest of the world implements most-favored-nation tariffs. The game has four stages. In the first stage, we assume that given the status quo situation most-favored-nation tariffs, each member country holds a referendum to decide whether a free trade area or a customs union will replace the status quo trade policy. If the status quo emerges as the preferred policy in the referendum, then every country maintains its most-favored-nation tariffs. Otherwise, we have the following sequence of events. In the second stage, voters in each country elect a representative who will choose the tariff level vis à vis the rest of the world in the third stage of the game. Free trade will instead prevail between the preferential trade agreements member countries. In the fourth stage, firms compete in quantities, taking as given the trade policy that has been set during the third stage. We solve the model by backwards induction starting at stage four. Ownership of the oligopolistic firm is unevenly distributed among the citizenry, and in our setting the individual with the median ownership share turns out to be the pivotal player. Assuming that the median voter receives a fraction of the profits that is lower than the fraction accrued to the average citizen, we are able to relate the distribution of income in a particular country to the choice of trade regime. Notice that differently from the 3 Facchini and Testa 2006 investigate the political economy of the formation of common markets. They conclude that politically viable common markets must enhance the protection received by some factors of production. Thus, they argue that there exists an intrinsic tension between social desirability and market integration. 2

4 previous literature, representatives choose tariffs taking into account their policy preferences instead of social welfare. The median voter takes this into account in choosing the country s representative. The supply side of the model presents geographically specialized production patterns since each perspective member country produces different subsets of the final goods. These assumptions allow us to establish several interesting results. In particular, we find that the necessity to coordinate tariffs in customs unions leads voters to strategically delegate power to very protectionist representatives. This result is not true for free trade area formation. In contrast to the literature, we are then able to show that strategic delegation may lead to a situation in which free trade areas raise welfare relative to customs unions if the degree of income inequality is sufficiently small. Moreover, we are able to show that free trade areas raise welfare relative to the status quo situation independently of the distribution of income, while customs unions decrease welfare relative to the status quo if the degree of income inequality is sufficiently small. The model is also used to investigate the political viability of preferential trade agreements. In the first stage of the game, each member country holds a referendum to decide whether a free trade area or a customs union will replace the status quo trade policy. The political viability of preferential agreements depends on how they affect the median voter s indirect utility function. Since the median voter receives a share of profits lower than the average share of profits distributed in society, profits derived from high tariffs are less important in the context of political viability than in social welfare. Then, we conclude that customs unions are not politically viable independently of the distribution of income, while free trade areas are politically viable if income inequality is sufficiently low. Moreover, the results indicate that only welfare-enhancing free trade areas are politically viable. These results are robust to the introduction of asymmetries in the size of the market in the non-member country, as well as to differences in the distribution of income across member countries. The rest of the paper is organized as follows. In section 2 we describe the model, determine the equilibrium prices and quantities under different trade policy regimes, and compare the 3

5 social welfare effects of different preferential trade agreements. Section 3 investigates the political viability of preferential trade agreements. Section 4 examines the political viability of the different preferential trade arrangements, while in section 5 we extend our analysis by introducing asymmetries in the size of member and non member countries, as well as in the income distribution. Section 6 concludes our paper. 2 The Model In order to analyze the formation of a preferential trade agreement, we consider a three country setting. Country A and country B are perspective members, while country F is an aggregate entity that stands for the rest of the world. Moreover, we assume that there are three goods: good 0 is the basic good that is produced in all three countries, is freely traded, and serves as the numéraire; goods 1 and 2 are both produced by duopolies with one firm being located in the foreign country and the second in member country A good 1 or member country B good 2 respectively. 4 marginal cost c in terms of the numéraire. Oligopolistic firms produce goods at a constant Introducing notation that will prove useful later on, let x i s,d denote the quantity of good i produced in country s and consumed in country d. Note that our geographically specialized production pattern within the prospective preferential trade agreement PTA implies that x 1 B,d = x2 A,d = 0. Each country can apply tariffs on trade with its partners unless a preferential trade agreement is in place. These assumptions imply that the markets for goods 1 and 2 are segmented. 5 Denote the tariff applied by country d in {F, A, B} on imports from country s in {F, A, B} by t s,d, where clearly t d,d = 0. Country d s vector of tariffs is described by t d = t A,d, t B,d, t F,d. The tariffs can be written in matrix form by t = t F, t A, t B where the tariffs on products traded between PTA members is zero. 4 We will relax this assumption in section 5. 5 If a preferential trade agreement is in place and member countries external tariffs are different, then we assume that rules of origin are applied to prevent the duty free transshipment of goods between countries A and B. 4

6 Let the population in each country consist of a continuum of individuals of mass one. Individuals differ in how much of a stake they own in the profitable duopolists. We denote by γ s,l the fraction of the oligopolistic sector s profits allocated to individual l in country s. We assume that the oligopolistic sector s distribution of profits coincides in countries A and B. Without loss of generality, we index individuals in ascending order, and normalize the fraction of the profit that is received by the average voter to one γ = 1. Typical wealth distributions then imply that the median voter s share is less than one γ m 1. Clearly, the lower the share of profits received by the median voter, the greater is the level of inequality, which is measured by 1 γ m. Dutt and Mitra 2002 define income inequality in a similar way. Preferences are the same across countries and individuals and can be described by the following quasi-linear, additively separable utility function: u x = x 0 + i u i x i 1 where the subutility functions are described as u i. = Hx i xi2, implying that the demand 2 for goods 1 and 2 are linear and take the form x i = H p i. Given the above utility function, the indirect utility of individual l in country s can be written as follows: v t,γ s,l = u x i t s p i s t s x i s t s + t i d,sx i d,s t s + γ i s,lπ i s t 2 d i where the first term represents consumer surplus, the second tariff revenues and the third the share of profits of sector i π i s t = d [ p i d c t i s,d] x i s,d allocated to individual s in country l and where x i s = d xi d,s. We consider a four stage game of trade policy among the three countries where different types of preferential agreements can be formed between countries A and B. i In the first stage, each member country holds a referendum to decide whether a free trade area or a customs union will replace the status quo most-favored-nation tariffs trade policy. If the 5

7 status quo situation emerges as the winner in the referendum, then countries maintain their most-favored-nation MFN tariffs. Otherwise, we have the following sequence of events. In the second stage, the population of each country elects a representative who will, in the third stage, decide the countries tariffs. If a preferential agreement is in place then the representatives of countries A and B decide tariffs on country F. In this case, the formation of a free trade area FTA does not require cooperation between elected representatives to decide tariffs on country F, while the formation of a customs union does. In stage four, firms compete in quantities taking as given the trade policy that has been set during the third stage. We solve the model by backwards induction starting at stage four. 2.1 Fourth Stage: Production and Consumption Choices We compare in this model the effects of the formation of different preferential trade agreements between countries A and B. In the fourth stage of the model, firms have to make production choices taking as given the tariff matrix t. If a preferential agreement between countries A and B is in place then t i AB = ti BA = 0 for all i. Otherwise, countries apply MFN tariffs on imports. Notice that country F applies MFN tariffs on goods imported from countries A and B. The application of a MFN tariff on goods imported from countries A and B does not affect the equilibrium in these two countries, since markets are segmented in this model. Thus, country F s trade policy does not change throughout the analysis. We are able then to focus on the market equilibrium in countries A and B. In general terms, country s s firm producing good i solves the following problem with respect to country d s market: max x i s,d [ ] p i d c t i s,d x i s,d where we have omitted the fact that quantities and prices are a function of the tariffs, in order to save on notation. The first order condition is given by 6

8 p i d x i s,d x i s,d + p i d = c + t i s,d for all d 3 In this section, we focus on the equilibrium for country A but a similar analysis applies to country B. Using our assumption of linear demand, equation 3 implies that x 1 A,A = x 1 F,A + t 1 F,A x 2 B,A x 2 F,A = t 2 F,A t 2 B,A 4 where we use the fact that country A does not produce good 2. Equilibrium conditions 4 and the linear demand function allow us to use equation 3 to obtain the following equilibrium prices and quantities H + t 1 F,A c H + t 2 F,A 2t 2 B,A c x 1 A,A = 3 H 2t 1 F,A c x 2 B,A = 3 H + t 2 B,A 2t 2 F,A c 5 x 1 F,A = 3 H + t 1 F,A + 2c x 2 F,A = 3 H + t 2 F,A + t 2 B,A + 2c p 1 A = 3 p 2 A = 3 where we assume that H > c. Notice that expressions 5 can be used to determine equilibrium prices and quantities when a preferential agreement is in place as well as when most-favored-nation tariffs are implemented. 3 Second and Third Stages: Determining Tariff Policy In the third stage the elected representatives determine the trade policy of countries A and B. We will consider different scenarios with respect to trade policy determination. First, we will determine the MFN tariffs since they will serve as the benchmark for other policies. Second, we will consider trade policy when the countries form an FTA. In this case, representatives 7

9 do not cooperate when they choose the tariffs of each member country vis à vis country F. Next, we investigate the role of cooperation in shaping trade policy. In this context, cooperation will be interpreted as the formation of a customs union between countries A and B. 3.1 Status Quo Policy: Most-Favored-Nation Tariffs In our model, the status quo corresponds to the situation where every country chooses non-discriminatory tariffs t i B,A = ti F,A = ti A. The choice of non-discriminatory tariffs follows a similar decision process as other policies. The population of each country elects a representative who is responsible for choosing the tariff level to be applied on imports from other countries. In this case, the objective of each representative is to find non-discriminatory tariffs that maximize the representative s welfare, given the tariffs chosen by other countries. We represent the share of the representative s profit by using hats and continue focusing on the solutions for country A. The MFN tariffs correspond to the solution of the following problem. max v t, γ A for i = {1, 2} 6 t i A where the indirect utility function is described in 2. Note that the MFN tariff applied on imports of a particular good is the same, no matter which is the country of origin of that particular good. This allows us to drop the exporting country index. The first order conditions of the representative s problem with respect to t 1 A and t2 A follows: can thus be written as p1 x 1 A x 1 t 1 A + x 1 F,A + t 1 F,A A A t 1 A p2 A x 2 x 2 t 2 A + x 2 A + t 2 F,A A A t 2 A + γ A π 1 A,A t 1 A + x2 B,A t 2 A = 0 = 0 7 8

10 where we used the fact that x 1 B,A = x2 A,A = 0. Notice that country A s representative does not take into account the effect of the tariff change on the profits of country B s firm. We can use the equilibrium price and quantities described in 5 to obtain H + t 1 A c γ 3 A 4t 1 A = 0 H t 2 A c t 2 A = 0 3 From the last two expressions we can obtain the following equilibrium tariffs. MF N,1 ta = H c γ A 11 2 γ A MF N,2 ta = H c 4 8 It is clear from 8 that the choice of tariff in country A does not depend on the identity of country B s representative, and this will play an important role in the political process. As it turns out, in this case the effect of trade policy on the partner s firm is not internalized. Moreover, the tariff applied on goods imported from country F in the sector where there is no domestic firm operating, does not depend on the fraction of profits accrued to the representative. The next question is to determine the identity of the voter which represents each member country. The set-up of the problem allows us to invoke the median voter theorem to determine who represents each perspective member country. The median voter s second stage problem can then be written as follows: max v t MF N γ A, γ B, γ m A γ A 9 where t MF N γ A, γ B indicates that the MFN tariff is the result of the identity of both per- 9

11 spective country s representatives. The first order condition of problem 9 is the following: v t MF N γ A, γ B, γ m A i MF N,i ta MF N,i ta γ A } {{ } Term 1 where Term 2 is equal to zero since + i tmf N,i B γa v t MF N γ A, γ B, γ m A MF N,i tb MF N,i tb γ A } {{ } Term 2 = 0 10 = 0 following the expressions in 8. Moreover, N,1 N,2 tmf A tmf A from the equilibrium conditions described in 8 it is evident that γa > 0 and γa = 0 so that equation 10 can be re-written as v t MF N γ A, γ B,γ m A = 0. The latter expression can be written as MF N,1 ta MF N,1 H + ta c 1 + 2γ m MF N,1 A 4tA = 0 3 MF N,1 We can substitute ta as described in 8 which will yield γ A = γ m A Thus, the median voter in each country does not delegate power. Clearly, the median voter does better by simply representing her own interests since she has no influence on the partner s decision in this case. It is also important to note that market segmentation is important for explaining this fact. The equilibrium MFN tariffs are then expressed by MF N,1 ta = H c 1 + 2γm 11 2γ m MF N,2 ta = H c 4 11 where similar expressions apply to country B. In this case, our geographically specialized MF N,1 MF N,2 MF N,2 production pattern implies that ta = tb and ta = t MF N,1 B in equilibrium. 10

12 3.2 Non-Cooperative Preferential Agreement In this section, we investigate the formation of a free trade area F T A where each country s representative determines the tariff of each country taking as given the partner s tariff. Thus, the problem faced by country A s representative can be described by max v t, γ A 12 t i F,A The first order conditions of the non-cooperative problem can be written as follows: p1 x 1 A x 1 t 1 A + x 1 F,A + t 1 F,A π 1 A,A F,A + γ F,A t 1 A F,A t 1 F,A p2 x 2 A x 2 t 2 A + x 2 F,A + t 2 F,A F,A F,A t 2 F,A = 0 13 = 0 where the first order conditions described in 13 differ from the MFN tariffs first order condition see 7 since country A does not impose import duties on goods originating in country B. Using the equilibrium solution displayed in 5 into 13 yields H + t 1 F,A c γ 3 A 4t 1 F,A = 0 H + t 2 F,A c 4t 2 F,A = 0 3 This expression can be used to obtain the following tariff equations. t F T A,1 F,A = H c 2 γ A γ A t F T A,2 F,A = H c

13 where similar expressions apply to country B if we substitute γ A for γ B. In this case, our geographically specialized production pattern implies that t 1 F,A = t2 F,B and t2 F,A = t1 F,B in equilibrium. The next question is to identify which voter represents each member country. We apply the median voter theorem to determine who represents each member country. The median voter s second stage problem can then be written as follows. max v t F T A γ A, γ B, γ m A γ A 15 The first order condition of problem 15 is the following: v t F T A γ A, γ B, γ m A i t F T A,i F,A t F T A,i F,A γ A } {{ } Term 1 + i v t F T A γ A, γ B, γ m A t F T A,i F,B t F T A,i F,B γ A } {{ } Term 2 = 0 16 Following the expressions in 14 and applying the same rationale used in the solution of the MFN tariffs allow us to yield that γ A = γ m A Thus, the median voter in each country does not delegate power. The equilibrium tariffs are then expressed by t F T A,1 F,A = H c 1 + 2γm 11 2γ m t F T A,2 F,A = H c Similarly, we can solve country B s median voter problem to obtain that t F T A,1 F,A = t F T A,2 F,B and t F T A,2 F,A = t F T A,1 F,B. Note that comparing the expressions in 11 and 17 we have that t F T A,1 F,A = t F T A,2 MF N,1 F,B = ta = t MF N,2 B. However, the external tariffs do not depend on the 12

14 representative s identity if the country does not produce a good. Thus, t F T A,2 F,A = t F T A,1 F,B < MF N,2 t A = t MF N,1 B. This inequality is caused by the decrease in importance of the external tariff to the median voter once the partner country receives preferential access to the domestic market. The latter represents what is called in the literature the tariff complementarity effect. Note that the effect of trade policy on the partner s firm is not internalized in the non-cooperative solutions. We turn then to the study of cooperative preferential agreements. 3.3 Cooperative Solution We interpret cooperation as the formation of a customs union between countries A and B. The main characteristic of customs unions is that member countries set their external tariffs jointly. We follow most of the literature in modelling the choice of external tariffs as the maximization of the aggregate welfare of the representative voters. 6 max v t, γ A + v t, γ B for i = {1, 2} 18 t i In the second step of the model, the representatives may not coincide with the average or median voters and tariffs applied on trade with country F are equal t i = t i F,A = ti F,B across countries but not necessarily across sectors. Therefore, the first order conditions of problem 18 can be simplified and expressed as p1 A t 1 x1 A + x 1 F,A + t 1 x1 F,A π 1 A,A + γ t 1 A = 0 19 t 1 p2 A t 2 x2 A + x 2 F,A + t 2 x2 F,A π 2 B,B + γ t 2 B = 0 t 2 where we clearly need among other things that x 1 A = x1 B, x2 A = x2 B, π1 A,A = π1 A,B, and 6 In a model with strategic delegation,willmann 2005 assumes that legislators maximize their aggregate welfare when choosing the most-favored-nation tariffs for a small economy. Similarly, Grossman and Helpman 2005 assume that the legislative majority maximizes its aggregate welfare when choosing most-favorednation tariffs for a small economy. Ornelas 2007 and Saggi 2006 model the choice of common external tariffs to maximize the aggregate welfare of the countries. In this case, the representative voter would correspond to the average voter in our paper. 13

15 π 2 B,A = π2 B,B in equilibrium. Using equilibrium conditions 5 and rearranging them we can obtain the following: H + t 1 c γ 3 A 4t 1 = 0 H + t 2 c γ 3 B 4t 2 = 0 These expressions can be solved to yield that t CU,1 = H c γ A 11 2 γ A t CU,2 = H c γ B 11 2 γ B 20 where superscript CU denotes customs unions. It is clear from 20 that the greater the share of profits received by the elected representatives, the higher the tariff applied on trade with non-members. The second stage problem can be summarized by the following expression: max v t CU γ A, γ B, γ m A γ A 21 The first order condition of this problem is given by v t CU γ A, γ B, γ m A where we used tcu,2 γ A which implies that equation 22 yields into equation 22 yields the following: t CU,1 t CU,1 γ A = 0 22 = 0 following 20. We know that tcu,1 γ A 0 using expression 20, v = 0. Substituting equilibrium conditions 5 t CU,1 H c 1 + 4γ m 11 4γ m t CU,1 =

16 We can substitute t CU,1 using expression 20 to obtain the following relationship γ A = 2γ m 24 which indicates that the median voter strategically delegates power to a representative whose fraction of the oligopolistic sector s profits is twice his own fraction 7. We can substitute the relationship in 24 into expression 20 to find common external tariffs equal to t CU,1 = H c 4γm γ m t CU,2 = H c 4γm γ m Welfare Comparison In this section, we compare the welfare levels that can achieved in the three possible scenarios we have considered, i.e. the creation of a Free Trade Area or Customs Union and the status quo. By comparing the right hand side of equations 17 and 25, it is clear that the common external tariffs under a customs union are higher than the external tariffs in FTAs, independently of the distribution of income, since they both depend on the median voter s share of economic profits. This result is well known, and has been obtained for instance by Freund 2000 and Ornelas However, strategic delegation implies that the representatives in the case of customs unions differ from those in free trade areas. Since they seek to maximize their own interest when choosing external tariffs, this might lead to a decrease in overall welfare when moving from free trade areas to customs unions. Welfare in member countries is measured using the average voter s indirect utility function, v t, γ. Using external tariffs described by expressions 17 and 25, and applying equilibrium price and quantity described in expressions 5, allow us to obtain the following welfare measures: 7 As we discuss below, this result is not sensitive to changes in the number of foreign firms. 15

17 v t CU, γ A = 1 = v t F T A, γ A = 1 = H c γ m 16γ m2 11 4γ m 2 + π 1 A,F 26 H c γ m 68γ m γ m 2 + π 1 A,F where π 1 A,F does not change due to market segmentation. The expressions 26 can be used to show that v t F T A, γ A > v t CU, γ A for cases where the difference between the fraction of profits received by the median voter and by the average voter is sufficiently small. This yields the following results: Proposition 1 In the context of a representative democracy, free trade areas raise member countries welfare relative to customs unions as long as the fraction of profits received by the median voter γ m is sufficiently close to the fraction of profits received by the average voter γ = 1. Proof. The difference between v t CU, γ A and v t F T A 32H c 2 γ, γ A equals m 208γ m3 3432γ m γ m γ m2 66γ m If we assume that γ m > 0 then the solution to 208γ m3 3432γ m γ m 7986 = 0 indicates the value for γ m such that v t CU, γ A = v t F T A, γ A. Only one of the solutions is between zero and one: γ m = Thus, for < γ m < 1 we have that v t CU, γ A < v t F T A, γ A. Otherwise, v t CU, γ A > v t F T A, γ A. The intuition behind Proposition 1 is the following. Equation 2 indicates that aggregate welfare can be described as the sum of consumer surplus, profits and tariff revenues. Since common external tariffs are higher than external tariffs in FTAs, consumer surplus profits is lower higher in customs unions than in FTAs. In principle, the comparison of the sum of these two terms yields ambiguous results, but it can be shown see Appendix that the sum of consumer surplus and profits is higher in customs unions than FTAs. Tariff revenue is then key to explain Proposition 1. If the degree of inequality is low < γ m < 1 then common external tariffs are high enough to lead to a substantially low level of imports 16

18 from non-members. In this case, the tariff revenues in customs unions is sufficiently lower than in FTAs. Consequently, member countries welfare decreases when moving from FTAs to customs unions. 8 Before investigating the political viability of FTAs and customs unions, it is important to understand the changes in welfare when moving from a situation where MFN tariffs are applied status quo situation to a situation where a preferential trade agreement between A and B is in place. Using external tariffs described by expressions 11 and applying equilibrium prices and quantities described in expressions 5 allow us to obtain the following welfare measure: v t MF N, γ A = 1 H c γ m + 12γ m2 = γ m 2 27 We can use expressions 26 and 27 to show the following result. In what follows the status quo situation corresponds to the application of MFN tariffs. Proposition 2 In a model of representative democracy, the creation of a free trade area raises member countries welfare relative to the status quo situation regardless of the fraction of profits received by the median voter γ m. However, if the share of profits received by the median voter is sufficiently close to the share received by the average voter, then a customs union decreases member countries welfare relative to the status quo situation. Proof. The difference between v t F T A, γ A and v t MF N, γ A equals 91H c 2 > 0. Thus, 1936 it is positive independently of the income distribution. The difference between v t CU, γ A and v t MF N, γ A equals H c γ m γ m γ m3 +832γ m γ m γ m γ m γ m γ m +8γ m2 2. The solution to = 0 indicates the value for γ m such that v t CU, γ A = v t MF N, γ A. Only one of the solutions is between zero and one: γ m = Thus, for < γ m < 1 we have that v t CU, γ A < v t MF N, γ A. Otherwise, v t CU, γ A > v t MF N, γ A. 8 In this model, tariff revenue in customs unions is lower than in FTAs if < γ m < 1. 17

19 The result comparing welfare levels between the status quo and the FTA can be understood in the following way. We continue using country A s example to explain our results. In our model, country A s MFN tariff on good 1 is equal under both scenarios. Thus, there are no welfare differences related to the consumption of good 1 in country A. The profits of the firm that produce good 1 in country A increase since it has preferential access to country B s market after the formation of the FTA. In the case of good 2, country A just relies on imports to meet its demand. Since country A s MFN tariff on good 2 is higher than its tariff when an FTA is in place, and country B s firm have duty free access to country A s market when an FTA is in place, it can be easily shown see Appendix that the gains in consumer surplus obtained from FTA formation are lower than the losses in tariff revenue. However, the profit increase of the firm that produces good 1 in country A more than compensates for the welfare losses in the market for good 2. Thus, Proposition 2 shows that an FTA raises the welfare of member countries with respect to the status quo. The case of changes in welfare due to the formation of customs unions follows an explanation similar to the one provided in Proposition 1. The common external tariff applied on imports of good 1 is higher than the MFN tariff applied on imports of this good by country A. Thus, the price of good 1 is higher in country A when a customs union is in place than in the status quo situation. In this case, one can show that the sum of consumer surplus and profits related to good 1 is higher when a customs union is in place. In the case of good 2, prices can be higher or lower depending on the degree of inequality. The sum of consumer surplus and profits across goods is positive, independently of the level of inequality. Then, changes in tariff revenue are again key to explain the result. If the degree of inequality is low i.e., < γ m < 1 then the common external tariffs are sufficiently higher than MFN tariffs leading to lead to a substantial fall in the quantity imported from country F compared to the MFN level. The latter generates a decrease in tariff revenues and, consequently, in welfare, when member countries move from the status quo situation to a situation where a customs union is in place. 18

20 4 First Stage: Political Viability of PTAs In this section, we focus on the first stage of our model to study the political economy of preferential trade agreements. We assume that given the status quo situation MFN tariffs, each member country holds a referendum to decide whether an FTA or a customs union will replace the status quo trade policy. If countries A and B decide to form a preferential agreement, then voters choose the representative that will decide trade tariffs as described in the previous section. Otherwise, the status quo trade policy remains in place. The set-up of the problem allows us to conclude that the median voter is pivotal in the referendum process. Median voters can choose one out of three strategies in the referendum, {Status quo, FTA, CU}. Since the decision to form a preferential agreement is simultaneous, then an FTA CU is established if {FTA, FTA} {CU, CU} is a Nash equilibrium of this game. The possibility of choosing different preferential agreements may lead to an equilibrium that is not politically efficient. To deal with this issue, let us first define the following concept: Definition 1 A preferential trade agreement is politically viable if the median voter prefers it over the status quo. Political viability of preferential agreements is measured using the median voter s indirect utility function, v t, γ m. We continue using the example of country A to study the equilibrium of the game. A similar analysis applies to country B. Using external tariffs described by expressions 11, 17, and 25, and applying the equilibrium price and quantity described in expressions 5, allow us to obtain the following measures: 19

21 v H c γ m 16γ m2 t CU, γ m A = 11 4γ m 2 + γ m π 1 A,F 28 v H c γ m 32γ m2 t F T A, γ m A = + γ m π γ m A,F v H c γ m 2γ m2 t MF N, γ m A = + γ m π γ m A,F Would a politically viable preferential agreement that is not the most preferred choice from the median voters perspective become an equilibrium in a game with representative democracy? The following Proposition shows that this can not happen in this model. Proposition 3 In a model with representative democracy, the formation of a customs union is not politically viable. Proof. Using expressions 28 it can be shown that v t MF N, γ m A v t CU, γ m A for any γ m ɛ 0, 1. What is the intuition behind this result? We can write the change in the median voter s indirect utility pertaining to moving from the status quo to the formation of a preferential agreement in the following manner: where represents the change in variables from the status quo to a preferential agreement. v t, γ m A = v t, γ A }{{} Social welfare 1 γ m A π 1 }{{} A t }{{} Inequality Pr ofits Equation 29 indicates that the median voter s indirect utility is positively correlated to changes in social welfare and negatively correlated to changes in the product of profits and inequality. Expression 29 makes clear that increases in profits relative to the status quo situation are not as important on political grounds as they are on welfare grounds since the median voter receives a share of profits lower than the average In the comparison

22 between the status quo and a customs union, we know that the common external tariffs see expressions 25 are higher than the MFN tariffs see expressions 11. Then, profits increase when moving from the status quo to a customs union, and, consequently, the second term on the right-hand-side of expression 29 is negative. Consumer surplus and tariff revenue changes aside, the decrease in the importance of profit increases makes customs unions politically unattractive. The value of the median voter s indirect utility function then increases when moving from the status quo to a customs union if social welfare increases sufficiently to compensate for the negative effect created by the variation in profits. Proposition 2 shows that the latter happens if the level of inequality is sufficiently high, i.e. 0 < γ m < However, the second term on the right-hand-side of expression 29 also depends on the level of inequality, and it can be shown that it may increase or decrease with changes in the level of inequality see Appendix. The net effect is that the absolute value of the second term on the righthand-side exceeds the absolute value of the first term on the right-hand-side. This explains the result described in Proposition 3. Using Proposition 3, we can conclude that only the formation of an FTA is an alternative to the status quo policies in our game with representative democracy. The next proposition indicates the conditions under which the political process will lead to the formation of an FTA. Proposition 4 In a model of representative democracy, the formation of a free trade area will emerge as an equilibrium if the share of profits received by the median voter is sufficiently close to the share of profits received by the average voter. Proof. Comparing expressions 28 it can be shown that the difference between v t F T A, γ m A and v t MF N, γ m A equals H c 2 135γ m 44. This implies that v t F T A, γ m 1936 A > v t MF N, γ m A if < γ m < 1. Proposition 4 says that an FTA is the outcome of the electoral process if the level of inequality is sufficiently small. We can again use expression 29 to understand the result 21

23 described in Proposition 4. Proposition 2 indicates that an FTA raises social welfare relative to the status quo. This implies that the first term on the right-hand-side of expression 29 is positive. We also know from the previous sections that an FTA raises profits relative to the status quo. If the degree of inequality is sufficiently large i.e., 0 < γ m < then the absolute value of the second term in the right-hand-side of 29 exceeds the value of the first term. Notice that the decrease in importance of profit increases on political grounds relative to welfare grounds, drives again the result described in Proposition 4. On a positive note, the results indicate that only welfare-enhancing FTAs are politically viable. Thus, politics and welfare concerns may be strongly related when it comes to the formation of preferential trade agreements. 5 Extensions In this section, we extend the model used to obtain Propositions 1-4 in order to check the robustness of our results. We investigate two main extensions. First, we consider the case where the number of firms in country F is greater than one. Second, we consider the case where the income distribution in country A differs from the income distribution in country B. We retain all other assumptions of the model. Note that in both cases, equations 1, 3, and 4 do not change. Equation 2 has to be adjusted in accordance with the number of firms in each country and with differences in income distribution when needed. 5.1 Number of firms in country F Assume that we have n F >1 firms in country F producing goods 1 and 2, while we maintain the assumption that one firm produces good 1 in country A and one firm produces good 2 in country B. The other assumptions of the model remain the same. This implies that country A country B does not produce good 2 good 1. Taking into account the number of firms in country F allows us to replace expressions 5 in the fourth stage of the model by the following: 22

24 x 1 A,A = x 1 F,A = p 1 A = H + nf t 1 F,A c n F + 2 H 2t 1 F,A c n F + 2 H + nf t 1 F,A + n F + 1 c n F + 2 x 2 B,A = x 2 F,A = p 2 A = H + nf t 2 F,A n F + 1 t 2 B,A c n F + 2 H + nf t 2 B,A n F + 1 t 2 F,A c n F + 2 H + n 2 F t 2 F,A n2 F n F + 1 t 2 B,A + n F + 1 c n F where we assume that H > c. Similar expressions apply to country B where the differences reside in the fact that country B does not produce good 1. The solutions of the second and third stages of the model follow the same steps of the previous sections. The difference in this section resides in having a number of firms in country F greater than one. Taking this into account, we find that the representative of each country corresponds to the median voter in the status quo and FTA equilibria, γ = γ m. Thus, the median voter does not delegate power in these two cases. Moreover, we find the same level of strategic delegation in the formation of customs unions, γ = 2γ m. This indicates that the level of strategic delegation does not vary with the number of firms in country F. In this case, the equilibrium tariffs in the three possible scenarios are given by: MF N,1 ta = H c 1 + 2γm 3n F 2n F γ m + 8 MF N,2 ta = H c n F

25 t F T A,1 A = H c 1 + 2γm 3n F 2n F γ m + 8 t F T A,2 A = H c 3n F t CU,1 A = t CU,2 A = H c 1 + 4γm 3n F 4n F γ m Notice that MFN and FTA tariffs are negatively related to the number of firms in country F. Thus, tariffs decrease when the number of firms in country F increases in the status quo and FTA situations. In the case of customs unions, tariffs may increase or decrease with the number of firms in country F. If the level of inequality is relatively low 0.75 < γ m < 1, then tariffs increase when the number of firms in country F increases. Otherwise, tariffs decrease when the number of firms in country F increases. We continue measuring the welfare in member countries using the average voter s indirect utility function, v t, γ. Using external tariffs described by expressions 32 and 33, and applying equilibrium price and quantity described in expressions 30, allows us to calculate welfare measures that can be used to obtain the following result. Proposition 5 In the context of a representative democracy, free trade areas raise member countries welfare relative to customs unions as long as the fraction of profits received by the median voter γ m is sufficiently close to the fraction of profits received by the average voter γ = 1. As the number of firms in country F increases, the lower is the fraction of profits received by the median voter γ m necessary for free trade areas to raise member countries welfare relative to customs unions. The proof of Proposition 5 requires that we find the fraction of profits received by the median voter as a function of the number of firms in country F that sets v t CU, γ A equal to v t F T A, γ A. Three solutions emerge from this process but only one provides an answer compatible with 0 < γ m < 1. We can view the relationship between γ m and n F in figure 24

26 γ m v F T A > v CU 0.59 γ m n F n F v F T A < v CU Figure 1: Increasing the number of firms in the rest of the world 1 where the vertical axis represents γ m and the horizontal axis represents n F. The graph shows that as the number of firms in country F grows larger, values of γ m > 0.59 imply that FTAs raise welfare relative to customs unions. If we merge the information contained in Propositions 1 and 5, we find out that the cut off fraction of profits received by the median voter needed to ensure that an FTA raises welfare relative to customs union satisfies 0.59 < γ m < The message conveyed in Proposition 5 reinforces the findings of Proposition 1; welfarecaring governments may favor FTAs over customs unions if the degree of inequality is relatively low. 9 It is also important to understand the changes in welfare when moving from a situation where MFN tariffs are applied status quo situation to a situation where a preferential trade agreement between A and B is in place. Following the same strategy adopted in the previous section, we can use external tariffs described by expressions 31 and can use the equilibrium 9 I am not sure whether we should include the following: When n F > 1 the comparison between the summation of consumer surplus and profits in FTAs and customs unions yields ambigous results. For relatively high levels of inequality, the summation is greater in FTAs than in customs unions. For relatively low levels, the contrary occurs. The reverse occurs with the tariff revenue term. Since for relatively low levels of inequality, the tariff revenue is much lower in customs unions than in FTAs, then the welfare in FTAs is greater than in customs unions. 25

27 price and quantity described in expressions 30, to obtain the level of welfare in the status quo, v t MF N, γ A. The comparison between the welfare levels under different tariff regimes, allows us to obtain the following result. Proposition 6 In a model of representative democracy, free trade areas raise member countries welfare relative to the status quo situation regardless of the fraction of profits received by the median voter γ m. However, if the share of profits received by the median voter is sufficiently close to the share received by the average voter then a customs union decreases member countries welfare relative to the status quo situation. As the number of firms in country F increases, the lower the fraction of profits received by the median voter γ m needed so that a customs union decreases member countries welfare relative to the status quo situation. The proof of Proposition 6 follows the same steps as the proof for Proposition 4. We can show that the difference between v t F T A, γ A and v t MF N, γ A is positive for 0 < γ m 1. Thus, it is not dependent on the distribution of income. The difference between v t CU, γ A and v t MF N, γ A yields a complex expression but simulations 10 indicate that as we increase the number of firms in country F, the minimum share of profits received by the median voter so that v t CU, γ A equals v t MF N, γ A decreases. This exercise also indicates that as nf grows larger the minimum cutoff for γ m converges to In general, Propositions 5 and 6 indicate that as the number of firms in country F grows so does the parameter space that guarantees that FTAs and the status quo situation are preferred on welfare grounds to the formation of a customs union. Learning about the welfare effects of the formation of preferential agreements is desirable but the implementation of preferential agreements depends on their political viability. In this section, we study the political viability of preferential agreements using the same assumptions applied in Section 3, with the exception of the number of firms in country F. Thus, given the status quo situation MFN tariffs, each member country holds a referendum to decide 10 Simulation focuses on varying n F to calculate γ m 0, 1] such that v t CU, γ A = v t MF N, γ A. 26

28 whether an FTA or a customs union will replace the status quo trade policy. If countries A and B decide to form a preferential agreement, then voters choose the representative that will decide trade tariffs as described in the previous section. Otherwise, the status quo trade policy remains in place. In this set-up, the median voter is pivotal in the referendum process. Then, political viability of preferential agreements continues to be measured using the median voter s indirect utility function, v t, γ m. We continue using the example of country A to study the equilibrium of the game. A similar analysis applies to country B. Using external tariffs described by expressions 31, 32, and 33, and applying the equilibrium price and quantity described in expressions 30, allow us to obtain the following Proposition which combines and extends the results in Propositions 3 and 4. Proposition 7 In a model with representative democracy, the formation of a customs union is not politically viable. On the other hand, the formation of a free trade area will emerge as an equilibrium if the share of profits received by the median voter is sufficiently close to the share of profits received by the average voter. As the number of firms in country F increases, the higher is the fraction of profits received by the median voter γ m needed so that a free trade area will emerge as an equilibrium. The proof of Proposition 7 follows the same steps of the proof of Propositions 3 and 4. Comparing the expressions for v t CU, γ m A and v t MF N, γ m A, simulations 11 indicate that there is no γ m ɛ 0, 1] such that v t CU, γ m A > v t MF N, γ m A. The difference between v t F T A, γ m A and v t MF N, γ m A yields the expression 24 17n 3n 2 F +γ m A 80+48n F +7n F. We can then set v t F T A, γ m A equal to v t MF N, γ m A to find γ m A = 24+17n F +3n 2 F. The latter 80+48n F +7n 2 F expression can be used to show that as the number of firms in country F increases, the higher the fraction of profits received by the median voter γ m needed so that a free trade area will emerge as an equilibrium. In general, Propositions 5-8 extend the results from previous 11 Simulation focuses on varying n F to calculate γ m such that v t CU, γ m A = v t MF N, γ m A. In this case, we could not find γ m ɛ {0, 1] that satisfies that equality. 27