Multilateralism and the Endogenous Formation of PTAs

Board of Governors of the Federal Reserve System International Finance Discussion Papers Number 614 May 1999 MULTILATERALISM AND THE ENDOGENOUS FORMATION OF PTAS Caroline L. Freund NOTE: International Finance Discussion Papers are preliminary materials circulated to stimulate discussion and critical comment. References in publications to International Finance Discussion Papers (other than an acknowledgment that the writer has had access to unpublished material) should be cleared with the author or authors. Recent IFDPs are available on the Web at www.bog.frb.fed.us.

Multilateralism and the Endogenous Formation of PTAs Caroline L. Freund* Abstract: This paper examines the interaction between preferential trade agreements (PTAs) and multilateral tariff reduction in a model of imperfect competition. A growing literature finds that the formation of PTAs alters the incentives for and the sustainability of multilateral tariff reduction. We show that the causation is not one-sided -- multilateral tariff reduction also affects the formation of PTAs. Specifically, tariff reduction enhances the incentives to form a PTA and increases the likelihood that it is self-enforcing. Thus, each round of multilateral tariff reduction should lead to a new wave of PTAs. This may help to explain the current trend towards regionalism. Keywords: imperfect competition, regionalism, and trade * Economist in the International Finance Division of the Federal Reserve Board. Correspondence: caroline.l.freund@frb.gov. I am very grateful to Jagdish Bhagwati, Kyle Bagwell, and John McLaren for many useful discussions. I also benefitted from comments from Simeon Djankov, Catherine Mann, Seamus O’Cleireacain, Francisco Rivera-Batiz, and an anonymous referee. The views in this paper are solely the responsibility of the author and should not be interpreted as reflecting the views of the Board of Governors of the Federal Reserve System or of any other person associated with the Federal Reserve System.

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vkliwlqj frqvxpswlrq wrzdugv jrrgv surgxfhg lq [ dqg \1 Dw d orz wdul(cid:14) ohyho/ wkh uhglvwulexwlyh dqg h(cid:17)flhqf| jdlqv iurp mrlqlqj d SWD rxwzhljk wkh jdlq iurp pxowlodwhudoo| holplqdwlqj wdul(cid:14)v1(cid:129)2 Frxqwulhv zloo wkxv suhihu phpehuvkls lq d SWD wr iuhh wudgh1 (cid:12)(cid:21)2 ,?uLhUi4i?|G t|@?_@h_ U@ti Wzr frxqwulhvfdqirupd SWD surylghgwkh|fdqfrpplwwrd elodwhudowdul(cid:14)ri}hur1 Vwduwlqjiurp dq| srlqw ehorz wkh rswlpdo wdul(cid:14) ohyho/ lq rughu iru d elodwhudo djuhhphqw ehwzhhq frxqwu| [ dqg frxqwu| \ wr eh vxvwdlqdeoh/ wkh iroorzlqj frqglwlrq pxvw krog lq frxqwu| [(cid:129)(cid:12) [" [" Z+w?>w>3>w>w>w,. Z+w?>w>w?>w>w>w,(cid:17)(cid:12) (cid:23) Z+3>w>3>w>w>w,(cid:17)(cid:12)> +46, (cid:12)’(cid:129) (cid:12)’f zkhuh w? lv wkh rswlpdo wdul(cid:14) rq \ jlyhq wkh wdul(cid:14) ohyho/ w> gh(cid:15)qhg lq htxdwlrq +9,/ (cid:31) lv wkh wlph shulrg/ dqg (cid:17) lv wkh glvfrxqw idfwru/ zkhuh 3 ? (cid:17) ? 41 Wkh (cid:15)uvw whup rq wkh ohiw kdqg vlgh lv wkh rqh shulrgjdlqwrfrxqwu|[ iurpghyldwlqjdqglqvwdoolqjlwvrswlpdowdul(cid:14)/ jlyhqwkdwwkh sduwqhu frxqwu| frpsolhv1 Wkh vhfrqg whup lv wkh glvfrxqwhg suhvhqw ydoxh ri wkh sxqlvkphqw skdvh1 Wkh uljkwkdqgvlgh lvwkhjdlqiurpfrrshudwlqj1 Zh dvvxph wkh suhydlolqj wdul(cid:14)ohyhoehwzhhqwkhqrq0 phpehu dqg wkh phpehu frxqwulhv lv pdlqwdlqhg lq wkh hyhqw ri d ghyldwlrq1 Soxjjlqj htxdwlrqv +7, dqg +9, lqwr +46, dqg vroylqj/ |lhogv :+6+4(cid:3)f,.44w, (cid:17) (cid:24) = +47, 9+6w.44+4(cid:3)f,, Htxdwlrq +47, gh(cid:15)qhv wkh plqlpxp glvfrxqw udwh qhfhvvdu|/ jlyhq wkh wdul(cid:14) ohyho w/ iru frxqwu| [ wr frpplw wr d SWD1 E| v|pphwu|/ wkh vdph frqglwlrq pxvw krog lq frxqwu| \1 Wkh fxwr(cid:14) glvfrxqw udwh/ (cid:17)> lv lqfuhdvlqj lq w1(cid:129)e Iljxuh 7 sorwv htxdwlrq +47, +iru f @ 3=4> d @ 4>dqg w ohvv wkdq ru htxdo wr wkh rswlpdo wdul(cid:14),1 Lw vkrzv wkh fxwr(cid:14) glvfrxqw udwh wkdw lv (cid:129)2A(cid:4)(cid:16)t (cid:22)(cid:16)** Mi |h(cid:3)i ThL(cid:15)(cid:16)_i_|(cid:4)i Th(cid:16)Ui i*@t|(cid:16)U(cid:16)|)Lu _i4@?_(cid:16)t _iU*(cid:16)?(cid:16)?} (cid:16)?^(cid:3)@?|(cid:16)|)(cid:21) (cid:129)(cid:12)‘i i T*Lhi |(cid:4)i i?uLhUi@M(cid:16)*(cid:16)|) UL?t|h@(cid:16)?| @| |(cid:4)i LT|(cid:16)4@* |@h(cid:16)gi^(cid:3)(cid:16)*(cid:16)Mh(cid:16)(cid:3)4(cid:16)? tiU|(cid:16)L?(cid:12)(cid:21)(cid:12)(cid:21) (cid:129)e5TiU(cid:16)(cid:128)U@**) _B ’ (cid:12)b2E(cid:129)3S(cid:28) (cid:23) _| (cid:12)E(cid:12)|n(cid:129)(cid:129)E(cid:129)3S(cid:28)(cid:28)5 45

uhtxluhg/ dw hdfk wdul(cid:14) ohyho/ iru wkh sduwqhu frxqwulhv wr eh deoh wr hqirufh d elodwhudo iuhh wudgh djuhhphqw1 Ehfdxvhwkhfxwr(cid:14)glvfrxqwudwhghfolqhvzkhqwkhwdul(cid:14)ohyhoidoov/delodwhudodjuhhphqw fdq ehfrph ihdvleoh dv d uhvxow ri pxowlodwhudo wdul(cid:14) uhgxfwlrq1 Sursrvlwlrq 6 Dv wdul(cid:14)v idoo/ elodwhudo djuhhphqwv ehfrph hdvlhu wr hqirufh1 Pxowlodwhudo wdul(cid:14) uhgxfwlrq fdq pdnh d elodwhudo djuhhphqw wkdw zdv lqihdvleoh ehiruh wkh uhgxfwlrq/ ihdvleoh1 SWDv ehfrph hdvlhu wr hqirufh zkhq wdul(cid:14)v duh orz ehfdxvh wdul(cid:14)v lq(cid:16)xhqfh wkh zhoiduh iurp frrshudwlrq/ wkh jdlq iurp d rqh vkrw ghyldwlrq/ dqg wkh zhoiduh lq wkh sxqlvkphqw htxloleulxp1 Dw orz wdul(cid:14) ohyhov/ wkh ehqh(cid:15)w iurp sduwlflsdwlqj lq d SWD lv kljk dqg wkhuhiruh wkh lqfhqwlyh wr frpso| lv dovr juhdwhu dw orz wdul(cid:14) ohyhov wkdq dw kljk wdul(cid:14) ohyhov1 Zhoiduh iurp ghyldwlqj iurp wkh SWD lv lqfuhdvlqj lq wkh wdul(cid:14) ohyho ehfdxvh wkh h{sdqvlrq lq grphvwlf sur(cid:15)wv dqg wdul(cid:14) uhyhqxh/ zklfk uhvxowv iurp lpsrvlqj wkh rswlpdo wdul(cid:14) rq \> lv juhdwhu zkhq wkh wdul(cid:14) rq ] lv odujh1 Wklv dovr pdnhv frpso|lqj hdvlhu dw orz wdul(cid:14) ohyhov1 Sxwwlqj wkhvh wzr wrjhwkhu/ wkh jdlq iurp ghyldwlqj ohvv wkh jdlq iurp wkh frrshudwlqj lv prqrwrqlfdoo| lqfuhdvlqj lq wkh wdul(cid:14) ohyho/ zklfk pdnhv frpso|lqj hdvlhu dv wkh wdul(cid:14) ohyho idoov1 Wkh sxqlvkphqw/ krzhyhu/ lv ohvv vhyhuh zkhq h{whuqdo wdul(cid:14)v duh orz/ pdnlqj lw pruh gl(cid:17)fxow wr hqirufh d SWD1 Wkh lqwxlwlrq lv wkdw wkh frpsohphqwdulw| h(cid:14)hfw ri wdul(cid:14)v prghudwhv wkh ihdvleoh wdul(cid:14) wkuhdw zkhq h{whuqdo wdul(cid:14)v duh orz1 Vwloo/ dv wdul(cid:14)v idoo/ wkh h(cid:14)hfw rq wkh lqfhqwlyh wr frpso| dqg wkh h(cid:14)hfw rq wkh lqfhqwlyh wr ghyldwh rxwzhljkwkhsxqlvkphqwh(cid:14)hfw/ hqvxulqjwkdwwkhfxwr(cid:14)glvfrxqwudwhlvghfolqlqjlqwkhwdul(cid:14)ohyho1 (cid:12)(cid:21)(cid:12) ,?uLhUi@M(cid:16)*(cid:16)|) Lu @ U(cid:3)t|L4t (cid:3)?(cid:16)L? Lh @ uhii |h@_i @hi@ @| |(cid:4)i (cid:5)@t(cid:4) Qh{w/ zh vroyh iru wkh fxwr(cid:14) glvfrxqw udwh vwduwlqj iurp rswlpdo wdul(cid:14) htxloleulxp1 Wkh jdlq iurp frrshudwlqj lv voljkwo| gl(cid:14)huhqw lq wklv fdvh vlqfh frxqwulhv lq d fxvwrpv xqlrq ru d iuhh wudgh duhd gr qrw kdyh wkh vdph rswlpdo wdul(cid:14) dv lqglylgxdo frxqwulhv1 Vwduwlqj iurp wudgh zdu/ wkh frqglwlrq 46

iru d fxvwrpv xqlrq wr eh ihdvleoh lv [" [" Z+w?>w?>3>wS(cid:4)>w?>w?,. Z+w?>w?>w?>w?>w?>w?,(cid:17)(cid:12) (cid:23) Z+3>wS(cid:4)>3>wS(cid:4)>w?>w?,(cid:17)(cid:12)= +48, (cid:12)’(cid:129) (cid:12)’f Wkh (cid:15)uvwwhuprq wkh ohiwkdqg vlgh lv wkh jdlqiurpghyldwlqj irurqh shulrgdqgfkdujlqj wkh Qdvk wdul(cid:14) wr erwk ri wkh rwkhu frxqwulhv +vlqfh wkhuh lv qr djuhhphqw zlwk wkh wklug frxqwu|,/ zkloh wkh sduwqhu frxqwu| frpsolhv1 Wkh vhfrqg whup lv wkh sxqlvkphqw skdvh1 Wkh uljkw kdqg vlgh lv wkh jdlq iurp frpso|lqj dqg fkdujlqj wkh rswlpdo fxvwrpv xqlrq h{whuqdo wdul(cid:14) wr wkh qrq0phpehu dqg qr wdul(cid:14) wr wkh sduwqhu1 Soxjjlqj wS(cid:4)/ w?> dqg htxdwlrq +7, lqwr htxdwlrq +48, dqg vroylqj/ zh (cid:15)qg wkdw lq rughu wr dfklhyh d fxvwrpv xqlrq lq rqh vwhs iurp wkh Qdvk/ lw pxvw eh wkh fdvh wkdw= (cid:17) (cid:24) (cid:129)Hbf @3=8;= (cid:12)2(cid:12)b Wkh vdph dssurdfk fdq eh xvhg wr vroyh iru wkh fxwr(cid:14) glvfrxqw udwh qhhghg lq rughu iru d iuhh wudgh duhd wr eh ihdvleoh1 Wkh frpsdudeoh frqglwlrq lv [" [" Z+w?>w?>3>ws|>w?>w?,. Z+w?>w?>w?>w?>w?>w?,(cid:17)(cid:12) (cid:23) Z+3>ws|>3>ws|>w?>w?,(cid:17)(cid:12)= +49, (cid:12)’(cid:129) (cid:12)’f Soxjjlqj ws|> w?> dqg htxdwlrq +7, lqwr htxdwlrq +49,/ lw uhgxfhv wr= (cid:17) (cid:24) .f @3=93= (cid:129)(cid:129). Dfxvwrpvxqlrqlvhdvlhuwrhqirufhwkdqdiuhhwudghdjuhhphqw1 Wklvlvduhvxowriwkhgl(cid:14)huhqfh lq h{whuqdo wdul(cid:14)v1 Wkh jdlq iurp frpso|lqj zlwk }hur elodwhudo wdul(cid:14)v lv kljkhu xqghu wkh fxvwrpv xqlrqrswlpdowdul(cid:14)wkdqxqghuwkh iuhh wudghduhdrswlpdowdul(cid:14)/ vlqfhd fxvwrpvxqlrqlqwhuqdol}hv wkh srvlwlyh h(cid:14)hfw rq sduwqhu frxqwu| sur(cid:15)wv1 (cid:12)(cid:21)e (cid:127)(cid:3)*|(cid:16)*@|ih@* uhii |h@_i Lq wklv vhfwlrq/ zh h{dplqh wkh ghvludelolw| dqg hqirufhdelolw| ri dfklhylqj iuhh wudgh1 Iuhh wudgh lv ghvludeoh li lw ohdgv wr dq h{sdqvlrq lq zhoiduh1 Z8A+3>3>3>3>3>3,(cid:24)Z+w>w>w>w>w>w,= +4:, 47

Iurp htxdwlrq +7,/ wkh jdlq lq zhoiduh iurp prylqj wr iuhh wudgh/ Z8A> jlyhq wkh wdul(cid:14) ohyho lv w/ lv 4(cid:3)f.w Z8A (cid:3)Z @ A3= +4;, ;d Khqfh/ wkhuh duh jdlqv iurp prylqj wr iuhh wudgh iru doo srvlwlyh v|pphwulf wdul(cid:14)v1 Wkh jdlq lq zhoiduh lv sxuho| dq h(cid:17)flhqf| jdlq +wkh vkdghg duhd lq Iljxuh 8,1 Dv wdul(cid:14)v idoo/ zh jhw forvhu wr wkh h(cid:17)flhqw rxwfrph/ lpso|lqj wkdw wkh zhoiduh jdlq iurp wkh pryh wr iuhh wudgh lv vpdoohu dw orz wdul(cid:14) ohyhov1 Pxowlodwhudo iuhh wudgh lv vxvwdlqdeoh rqo| li wkh iroorzlqj frqglwlrq krogv [" [" Z+w?>w?>3>3>3>3,. Z+w?>w?>w?>w?>w?>w?,(cid:17)(cid:12) (cid:23) Z+3>3>3>3>3>3,(cid:17)(cid:12)= +4<, (cid:12)’(cid:129) (cid:12)’f Wkh (cid:15)uvw whup rq wkh ohiw kdqg vlgh ri +4<, lv wkh zhoiduh iurp ghyldwlqj iru rqh shulrg/ wkh vhfrqg whuplvwkhglvfrxqwhgzhoiduhgxulqjwkhQdvksxqlvkphqwskdvh/dqgwkhuljkwkdqgvlghuhsuhvhqwv wkh suhvhqw glvfrxqwhg ydoxh ri frpso|lqj zlwk iuhh wudgh iruhyhu1 Vroylqj/ frqglwlrq +4<, |lhogv 48 (cid:17) (cid:24) @3=87= 5; Li (cid:17) ? 3=87 iuhh wudgh fdqqrw eh dfklhyhg1 Wkh glvfrxqw udwh qhhghg wr vxssruw iuhh wudgh lv qrw ghshqghqwrqwkhjlyhqwdul(cid:14)ohyho/ w>lpso|lqjwdul(cid:14)uhgxfwlrqkdvqrh(cid:14)hfwrqwkhdelolw|wrdfklhyh iuhh wudgh1 Wkh glvfrxqw udwh qhhghg wr hqirufh hlwkhu d fxvwrpv xqlrq ru d iuhh wudgh djuhhphqw iurp wkh rswlpdo wdul(cid:14) htxloleulxp lv kljkhu wkdq wkh glvfrxqw udwh qhhghg wr dfklhyh pxowlodwhudo iuhh wudgh1 Khqfh/ li iuhh wudgh lv qrw ihdvleoh qhlwkhu lv d elodwhudo djuhhphqw/ jlyhq frxqwulhv vhw wdul(cid:14)v rswlpdoo|1 Krzhyhu/ li frxqwulhv fdq frrshudwh rq sduwldo wdul(cid:14) uhgxfwlrq/ d SWD pd| ehfrph ihdvleoh dv wkh uhvxow ri wkh wdul(cid:14) uhgxfwlrq1 48

e , |i?t(cid:16)L?t Lq wklv vhfwlrq/ zh h{dplqh wkh uhvxowv xqghu vwudwhjlhv ri wdul(cid:14) uhgxfwlrq wkdw duh frpsdwleoh zlwk JDWW uxohv1 Zh doorz iru vwdwxv txr sxqlvkphqw/ lqfrpsohwh wdul(cid:14) uhgxfwlrq/ dqg iru pruh frxqwulhv lq wkh uhvw ri wkh zruog1 Zh (cid:15)qg wkdw wkh uhvxowv duh urexvw wr wkhvh dgglwlrqv1 e(cid:21)(cid:129) 5|@|(cid:3)t(cid:19)^(cid:3)L T(cid:3)?(cid:16)t(cid:4)4i?| @?_ T@h|(cid:16)@* *(cid:16)Mih@*(cid:16)3@|(cid:16)L? ZWRuhvwudlqwvgrqrwshuplwdfrxqwu|wruhwxuqwrwkhQdvklqrughuwruhwdoldwh/doodfrxqwu|fdq gr lv dsso| lwv h{whuqdo wdul(cid:14)1 Lq dgglwlrq/ lqvwlwxwlrqdo frqvwudlqwv pd| suhyhqw wkh frxqwu| wkdw ghyldwhv iurp fkrrvlqj wkh rswlpdo wdul(cid:14)/ lqvwhdg lw zloo olnho| lqvwdoo wkh rxwvlgh wdul(cid:14)1 Wkhuhiruh/ d ghyldwlrq iurp wkh SWD pd| eh pruh uhdolvwlfdoo| prghoohg dv pdlqwdlqlqj wkh suh0SWD wdul(cid:14) ohyho/ l1h1 uhixvlqj wr hqdfw wkh sursrvhg wdul(cid:14) uhgxfwlrqv/ zkloh wkh sxqlvkphqw uhjlph zrxog lqyroyh rqo| d uhwxuq wr wkh vwdwxv txr1 Lq wklv fdvh/ wkh frqglwlrq iru frrshudwlrq wr eh ihdvleoh lv dowhuhg ehfdxvh wkh jdlqv iurp ghyldwlrq dqg sxqlvkphqw duh fkdqjhg1 Wkh jdlqv iurp ghyldwlrq duh uhgxfhg/ pdnlqj frrshudwlrq hdvlhu wkdqwkh vwdqgdugfdvh> exw/ wkh vhyhulw| ri wkh sxqlvkphqw uhjlph lv dovr uhgxfhg/ pdnlqj frrshudwlrq pruh gl(cid:17)fxow1 Wkxv/ lw lv qrw fohdu zkhwkhu SWD irupdwlrq zloo eh idflolwdwhg ru kduphg e| wkhvh frqvwudlqwv1 Lq dgglwlrq/ SWDv iruphg xqghu wkh hqdeolqj fodxvh ri wkh JDWW doorz iru odujh sduwldo(cid:127)dv rssrvhg wr frpsohwh(cid:127)olehudol}dwlrq1 Wklv zloo uhgxfh wkh jdlqv iurp frrshudwlrq ehfdxvh suhihu0 hqwldo wuhdwphqw lv ohvv lqwhqvh1 Doorzlqj iru vwdwxv0txr ghyldwlrq dqg sxqlvkphqw/ dqg lqfrpsohwh suhihuhqwldo olehudol}dwlrq/ wkh djuhhphqw lv vxvwdlqdeoh surylghg wkh iroorzlqj frqglwlrq lv vdwlv(cid:15)hg [" [" Z+w>w>+4(cid:3){,w>w>w>w,. Z+w>w>w>w>w>w,(cid:17)(cid:12) (cid:23) Z+4(cid:3){,w>w>+4(cid:3){,w>w>w>w,(cid:17)(cid:12)> +53, (cid:12)’(cid:129) (cid:12)’f zkhuh { lv wkh wdul(cid:14) uhgxfwlrq idfwru1 Vroylqj |lhogv 49

9+4(cid:3)f,(cid:3)53w.54{w (cid:17) (cid:24) = +54, (cid:3)57w.4;{w.45+4(cid:3)f, Htxdwlrq+54,lvghfuhdvlqjlqwsurylghg{A5@6=Lqsduwlfxodu/ zlwkfrpsohwholehudol}dwlrq/ { @4 htxdwlrq +54, ehfrphv 9+4(cid:3)f,.w (cid:17) (cid:24) = +55, 45+4(cid:3)f,(cid:3)9w Iurp htxdwlrq +54, dqg +55,/ wkh SWD ehfrphv hdvlhu wr hqirufh dv wkh wdul(cid:14) ohyho idoov/ surylghg wdul(cid:14)v duh uhgxfhg e| dw ohdvw 9: shufhqw1 Wkh sxqlvkphqw lv ohvv vhyhuh zkhq wdul(cid:14)v duh orz1 Wkh jdlq iurp ghyldwlqj lv orzhu dqg wkh jdlq iurp frpplwwlqj lv lqghshqghqw ri wkh wuljjhu vwudwhj| dqg lv lq jhqhudo juhdwhu zkhq wdul(cid:14)v duh orz1 Wkh odwwhu wzr grplqdwh dqg frpplwphqw ehfrphv pruh olnho| dv wdul(cid:14)v idoo1 Sursrvlwlrq 7 Xqghu vwdwxv txr ghyldwlrq dqg sxqlvkphqw/ d SWD ehfrphv hdvlhu wr hqirufh dv wdul(cid:14)vidoo1 Pruhryhu/ surylghgwkhwdul(cid:14)uhgxfwlrqh{fhhgv9:shufhqw/ SWDvduhpruhhdvlo|hqirufhg dv wdul(cid:14)v ghfolqh1 e(cid:21)2 (cid:127)Lhi |(cid:4)@? |(cid:4)hii UL(cid:3)?|h(cid:16)it Dv wkh qxpehu ri frxqwulhv lq wkh uhvw ri wkh zruog lqfuhdvhv/ wkh ehqh(cid:15)fldo h(cid:14)hfwv ri mrlqlqj d SWD zloo fkdqjh1 Lqghhg/ zh kdyh vhhq wkdw wkh fxvwrpv xqlrq wdul(cid:14) fdq h{fhhg wkh lqglylgxdo frxqwu| wdul(cid:14) li wkh qxpehu ri (cid:15)upv rxwvlgh wkh xqlrq lv odujh1 Lq wklv vhfwlrq/ zh vkrz wkdw hyhq li wkh qxpehu ri frxqwulhv lv odujh/ wkh fxwr(cid:14) glvfrxqw udwh qhhghg wr hqirufh d elodwhudo djuhhphqw lv lqfuhdvlqj lq wkh wdul(cid:14) ohyho1 Iru vlpsolflw|/ zh dvvxph wkdw wkh h{whuqdo wdul(cid:14) ohyho lv xqlirup dw w> wkdw wkhuh duh q.5 frxqwulhv hdfk zlwk rqh (cid:15)up/ dqg wkdw wkhuh duh qr rwkhu SWDv lq wkh zruog1 Zh dovr dvvxph sxqlvkphqw dqg ghyldwlrq duh dvvrfldwhg zlwk lqvwdoolqj wkh pxowlodwhudo wdul(cid:14) ohyho1 4:

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