Wednesday, December 14, 2016

Bilateral versus Multilateral Free Trade Agreements: A Welfare Analysis

Bilateral versus Multilateral Free Trade Agreements: A Welfare Analysis


One sentence summary: International development policies conducted for the removal of obstacles such as transportation costs and differences in comparative advantages should be the main goal toward achieving a multilateral FTA, which is shown to be the first-best solution to the maximization problem of global welfare.

The corresponding paper by Demet Yilmazkuday and HakanYilmazkuday has been published at Review of International Economics.

 
Abstract
Why do we observe proliferation of bilateral free trade agreements (FTAs) between certain types of countries instead of having progress in attaining global free trade through a multilateral FTA? We answer this question by exploring the enforceability of different types of FTAs through comparing minimum discount factors that are necessary to sustain them in an infinitely repeated game framework. We also search for the globally welfare maximizing trade agreements that are sustainable under different conditions. The results depict that transportation costs, differences in country sizes and comparative advantages are all obstacles for having a multilateral FTA. Accordingly, international development policies conducted for the removal of such obstacles should be the main goal toward achieving a multilateral FTA, which we show to be the first-best solution to the maximization problem of global welfare.


Non-technical Summary
The lack of a forcing authority in trade relations of world countries makes it difficult to achieve a multilateral free trade agreement (FTA) that increases world welfare. This creates a structural problem of rules in trade agreements that will self-enforce the trading countries to achieve more liberal trade.

In this paper, we study these self-enforcing rules with asymmetric countries from the perspective of bilateral and multilateral FTAs. In particular, we attempt to find an answer to the question of "Why are FTAs bilateral/regional/preferential rather than multilateral?" Before we can answer this question, since many trade models find a multilateral FTA to be the first-best solution, we need to know why bilateral FTAs exist in the first place. To better understand the characteristics of bilateral FTAs, consider Baier and Bergstrand (2004) who empirically find that the potential welfare gains and likelihood of a bilateral FTA are economically and significantly higher: (i) the closer in distance are two trading partners; (ii) the more remote a natural pair is from the rest of the world (ROW); (iii) the larger and more similar economically (i.e. real GDPs) are two trading partners; (iv) the greater the difference in comparative advantages; and (v) the less is the difference in comparative advantages of the member countries relative to that of the ROW.

The empirical findings of Baier and Bergstrand (2004) above are consistent with 85% of the 286 bilateral FTAs existing in 1996 among 1431 pairs of countries and 97% of the remaining 1145 pairs with no bilateral FTAs. Hence, to have credible results, any trade model investigating bilateral FTAs should be consistent with these empirical findings. We present such an N-country-N-good partial equilibrium trade model by generalizing the 2-good-2-country model in Bond and Park (2002) through considering possible interactions between country sizes, comparative advantage, and transportation costs.

For simplicity, we assume that the downward-sloped demand curve and upward-sloped supply curve of each good in each country are linear in price of the good. We show that international trade between any two countries is achieved through differences in supply and demand structures of the countries. It follows that the equilibrium autarky price (for each good) in any country depends on the individual country specific demand and supply structure, while the equilibrium price (for each good) under international trade depends on the demand and supply structures of all countries together with country-specific tariff rates and transportation costs. We let each country to receive all the tariff income for the good that the country imports.

Accordingly, the national welfare is defined as the weighted sum of consumer surplus, producer surplus and tariff incomes. Using this definition in a welfare analysis, we estimate the policy weights (assigned to consumer surplus, producer surplus, and tariff income across countries) that are consistent with the empirical findings of Baier and Bergstrand (2004) regarding bilateral FTAs. The estimation results suggest that the policy weight on producer surplus is much higher than the others. Specifically, the estimates of policy weights on producer surplus range between 0.71 and 0.77, policy weights on consumer surplus range between 0.01 and 0.07, and policy weights on tariff income are about 0.22. Using the estimated policy weights, we investigate for the economic conditions of our model under which bilateral versus multilateral FTAs may exist with self-enforcing rules.

In order to incorporate self-enforcement agreements into the model, we allow countries to get involved in a stationary dynamic tariff game, i.e., countries play an infinitely repeated game for tariff rates. In this game, each country is able to compare future payoffs out of a possible collusion (cooperation) with future payoffs out of a possible deviation from the agreement. In order to sustain collusion in a trade agreement, the trade-off between the gains from deviating from an agreed-upon tariff policy and the discounted expected future gains from collusion must be balanced in a way that the latter should keep away countries from deviating.

Within this picture, we ask the more-detailed question of this paper as "Why do we observe proliferation of bilateral FTAs between certain types of countries instead of having progress in attaining global free trade through a multilateral FTA?" We answer this question first by exploring the enforceability of different types of FTAs through comparing the minimum discount factor that is necessary to sustain them. After having such a minimum-discount-factor analysis, we go one step further by searching for globally-sustainable-Pareto-optimal trade agreements defined as the globally welfare maximizing trade agreements that are sustainable under different conditions. 

Our results suggest that transportation costs, differences in country sizes and comparative advantages are all obstacles for having a multilateral FTA, which we show to be the globally first-best solution for several different cases of our model. Therefore, removal of such obstacles should be the main goal toward achieving a multilateral FTA. Accordingly, international development policies conducted for countries to converge to each other (e.g., increasing internal and international stability, reducing poverty, investing in transportation technology, and international diffusion of production technology) should be the main tools.





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