Do Regional Trade Agreements Hinder Global Welfare Maximization

8/4/2019 Do Regional Trade Agreements Hinder Global Welfare Maximization

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320.000 SE Internationale konomik SS 2008

Univ.- Prof. Dr. Karl Farmer

Do Regional Trade Agreements hinder Global Welfare

Maximization?

Andreas Birnstingl

MatNr.: 9913099

Seminararbeit


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Do Regional Trade Agreements hinder Global WelfareMaximization?

Andreas Birnstingl

Abstract

In a model by Krugman (1991a) it is argued that three main trading blocks is theworst scenario for the world economy. It deals with special cases of differing

transport costs arguing that trade will just occur inside continents. In my

paper I follow the increase of regional trade agreements and look at the

theoretical background of potential Pareto efficient equilibriums resulting from

international trade. I will use a model set up by Feenstra (2007) showing that

such an equilibrium is indeed possible. Because this model is general kept I will

then turn to a more specific model by Ludema (1998) based on Krugman andHelpman (1985) including the trade off between transportation cost and

increasing returns to scale in production, firms are facing.

Keywords: Increasing Returns to Scale, Transportation Costs, Regional Trade

Agreements, Multinational Production

RTA Regional Trade Agreements

FTA Free Trade Agreements

PTA Preferential Trade Agreements


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Table of contents

1) INTRODUCTION ........................................................................................................................... 3

2) IMPERFECT COMPETITION AND INCREASING RETURNS TO SCALE .......................... 4

2.1)TRADE OFF WITH POLITICS.................................................................................................................... 7

3) MULTINATIONALS AND DECISION MAKING ...................................................................... 8

3.1)THE MODEL .............................................................................................................................................. 8

3.1.1) Trade costs and market clearing: .............................................................................................. 9

3.1.2) Plant Location................................................................................................................................... 10

3.2)TRIANGULAR MODEL ........................................................................................................................... 10

3.2.1) Equilibriums based on Most Favoured Nation Agreements: ....................................... 12

3.2.2) Equilibriums based on Exclusive Bilateral Agreements: ............................................... 14

3.2.3) Equilibriums based on Hub-and-Spoke Agreements: ..................................................... 15

4) IMPLICATIONS ...........................................................................................................................16

5) CONCLUSIONS ............................................................................................................................19

6) BIBLIOGRAPHY ..........................................................................................................................21


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1) Introduction

In the late 1990s there has been a remarkable spread of Regional TradeAgreements. While in 1990 more or less 40 agreements have been in force, this

rose with 250% to 102 agreements by late 1998. Explanations for these enforcedimplementations include theoretical inputs as well as political ones. In the 1990sa lot of new states emerged because the former soviet block collapsed starting toset up new agreements in search for economies of scale (or maintain it).Interestingly Alesina, Spolaore and Wacziarg (1999) trace this search back topolitical processes. They argue that economies are in need for economies ofscale. If it is possible to attain it with international trade there is no need for acountry to form a political union with other countries. One aspect of these newlyformed regional trade agreements is their increasing size. APEC as the economiccooperation of the Pacific rim countries includes 40% of the worlds population

and the FTAA or EU are each inhabitated by more than 500 million people. Thesize of trade agreements rise the question of transport costs as these are a maincomponent of decisions concerning the delivery of a good to a market, usuallyfollowing the principle that those costs are lower the closer markets are. Frankel(2000) offers some estimates that trade (measured in quantities) falls between0,7% and 1% as the distance between markets rise by 1%.

Krugman (1991a) offered an extreme example stressing the differences of costsof transportation of intra-continental and inter-continental trade. By assumingthat costs for the first case are zero whereas for the latter very high, it followsthat an inter-continental trade would not offer any benefit while an intra-

continental PTA would augment the welfare of the continent. Using theterminology of Frankel (1997) the continent is said to be a natural trading bloc.

However, facing the existence of many PTA across continents, an explanationrelying just on transportation costs seems to be too short sighted. On one handthis might result from political links and/or linguistic advantages e.g. Francestrade with its remaining over sea-departments is still three times higher thantrade with comparable countries or from competition for Foreign DirectInvestments and exclusive access to markets as well as Bandwagon-effects(Baghwati 1993) or Domino-effects (Baldwin 1995, 1997) when countries followdeviating countries which implement GATT Article XXIV quite improperly.1 An

additional assumption will be that governments enter into trade agreements thatgive the highest welfare to their country. According to the theory this willhappen if there is global free trade. So why do governments bother with RTAs?

Alan Winters has argued that RTAs are like street gangs: "you may not like them, but

if they are in your neighborhood, it is safer to be in one".2

However, Winters (1996)

argues that, on the basis of various models, it is not yet possible to determine

1Baghwati (1993) states: (that) the main driving force for regionalism today is the conversionof the United States of America, hitherto an abstaining party to Article XXIV, p.29

2Statement at Seminar on Regional Trade Agreements, WTO, Geneva, Wednesday 30 June 1999.


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whether regionalism encourages or discourages evolution towards globally freer

trade, and Winters (1998) says that there is no reason to expect a single, simple

answer.

A dilemma expressed also by Baghwati (1991) when he speaks of tradingblocks and tumbling blocks.

In Krugmans example with exorbitant high transportation costs for inter-continental trade no country will benefit from a unilaterally imposed tariff.Within intra-continental trade however, a large country might benefit byintroducing a small tariff (Feenstra 2007, chapter 7). So there are greaterpotential benefits out from intra-continental cooperation but there is also agreater incentive to deviate from this agreed cooperation. Hence it cannot beanticipated that neighbouring countries will agree on lower tariffs than distantones, as long as we remain in a conventional constant returns/perfectcompetition framework.

Thus we regard a model set up by Feenstra (2007) based on the analyses ofGrinols (1991) showing that an equilibrium with the case of increasing returnsto scale and/or imperfect competition in international trade is indeed possible.Because this model is general kept I will then turn to a more specific model byLudema (1998) based on Krugman and Helpman (1985) including the trade offbetween transportation cost and increasing returns to scale in production firmsare facing.

2) Imperfect Competition and Increasing Returns to Scale

In industries with monopolistic pricing there is always a gap between prices andmarginal costs. As prices are the same as marginal costs and marginal returns,consumers would be better off if the industry increases its output (of course inthe absence of any price discrimination).

Monopolies often exist due to cost functions with increasing returns to scaleforming a so-called natural monopoly. The main issue is if such monopolies stillwill prevail when their home markets are opened to international trade. Ethier(1982a) argues that small countries will suffer losses due to the contraction oftheir increasing returns to scale industries, whereas Markusen (1981) states thatthe large countrys monopolistic firms will also face contractions, thus thecountrys welfare will lose.

In the presence of increasing returns to scale we have to be more specific aboutthe structure of industry output and its costs. Lets follow a model introduced byFeenstra (2007, ch. 6) where we denote industry is output with yi and the totalminimum costs by Ci (yi, w). We allow for constant or increasing returns to scale

and also for zero or positive profits in each industry.


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ACi(yi, w) Ci(yi, w) / yi are average costs. With increasing returns to scaleACfallsas output rises.

The autarky budget constraint for the consumer h can be put as:

pa

cha

wa

vha

+ h

(pa

ya

wa

va

) (1)with total profits of firms in the autarkypaya wava and with h, being the profitshare of consumer h.

By opening the economy and dealing with the international price p andintroducing additional lump-sum transfers, the budget constraint of consumerswill become:

pchwvh + Rh + h(py wv) (2)

with the lump sum transfers:

Rh = (p pa)cha (w wa)vha + h(paya wava) h(py wv) (3)

As always theres the question if the state can afford the lump sum transfers of

this policy? By summing the transfers and reversing the sign we get:

=

H

h

hR1

= (pa p)=

H

h

hac1

(wa w)=

H

h

hav1

[(paya wava) (py wv)]

= (pa p) ya (wa w) va (paya wava) + (py wv)]

= (p y p ya) + (4)

= (p y p ya) ,

whereby we use the expressions: c ha

h=1

H

= y a ,

and

wv= Cii=1

N

(y i,w),


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to get: > 0.

Under the condition that the term on the left side is positive, Pareto efficiencycan be achieved. In the case of industries with constant returns to scale this is

quite obvious to hold. However for proving that this is also true in the case ofincreasing returns to scale, we use a theorem stated by Grinols (1991):

A sufficient condition to obtain Pareto gains from trade is that a weightedaverage of the outputs of industries (subject to increasing returns to scale orimperfect competition) expands, or that the weights i satisfy 0 i1, with

, foryiyia. (5)

Under the assumption of constant returns to scale the weightI= (pi ACi) / pi ,which shows the mark up over average costs. Under perfect competition Itherefore will be zero. With increasing returns to scale we can argue that costswill not increase with free trade, therefore the bracketed term of (5) is positiveor zero, yielding i1. Expression (5) can be rewritten as

, withyi> .

AC are falling with an increase in output (due to international trade) thereforethe total costs will be smaller than the average costs:

and inserting this expression into (5)yields

. (6)

This result shows that no country with sectors of increasing returns to scales will

be worse off by starting international trade than if staying in autarky.

The question we are now concerned with is, if output increases in one countryswitching from autarky to free trade, will this cause a decrease of output in othercountries, thus violating the principle of a Pareto efficient equilibrium? Sufficientconditions to avoid this for all countries have been analysed by Helpman andKrugman (1985) stating that Pareto efficient equilibriums for a single countryare achieved when:

Output of a single firm does not contract

Output of the countrys whole industry does not fall The set of goods available to consumers is not reduced


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2.1) Trade off with politics

Like always there is a trade off between economic theory and its practicalimplementation. The model of Feenstra above shows the possibility of a Pareto

efficient equilibrium but its welfare maximization is based only on outputchoices of domestic firms of a country and it does not include the impact ofForeign Direct Investments on an economy. It has to be stressed that in modelsof this kind transportation costs are neglected. But they should be includedbecause each firm sells more in home markets on account of transportationcosts. Hence, a tariff imposed by one country indicates firms to enter thatcountry. This has the effect of expanding domestic production to the benefit ofdomestic consumers this effect is referred to by Helpman and Krugman (1985)as the home-market effect.

These two economists introduce a more complex model to combine elements of

increasing returns, potential imperfect competition and transport costs. Theexample depends on a number of simplifying assumptions.

Ludema (1998) uses the set up of this model and combines it with a model ofmultinational firms to deal with trade-offs between proximity of markets andconcentration of production. In other words, such a model deals with horizontal(tariff jumping) Foreign Direct Investment. Ludema argues that an importingcountry may induce multinational firms to engage in local production byrestricting trade (e.g. by introducing tariffs), so that domestic consumers willbenefit from lower prices. This incentive may increase with higher transportcosts. In this case we have a threshold of transport costs, below which global free

trade (including Preferential Trade Agreements) will be attainable, above not.

The model of Ludema follows game theory, arguing that in repeated games acountrys one time incentive to deviate from an agreement must be less than thediscounted benefit of future cooperation. It concentrates also on a three-countrytriangular model, in which two countries are geographically close to each otherwhereas the third country is remote. To underline the argument, I denote thiscountry with Nmeaning the rest of the world. I chose this notation and departfrom Ludemas "remote country C" because according to data from the WTO

(1998)3 97% of its members are part of other both notified and non-notifiedregional trade agreements.

As mentioned above the explanation presented here is based on increasingreturns to scale or considerable multinational production, so it is best applied toNorth-North trade relations.

3Source: Crawford, Jo- Ann, Laird, Sam: Regional Trade Agreements and the WTO (2000), p.2


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3) Multinationals and Decision Making

3.1) The model

The set up of the model by Ludema based on Helpman and Krugman (1985) isthe following:

m 2 countries, 2 sectorsXand Y, n firms

In the home country firms can produce with 0 fixed costs, whereas a plant in theforeign country will cause fixed costs of the amount F. The marginal costs ofproduction are constantc for all plants.

There is only trade with goods of the X-sector (none with goods of the Y-sector)

whereas this trade is subject to iceberg-type transportation costs meaning thefurther away a good is shipped the more it will lose value. Putting itmathematically it means that the survival rate of goods shipped betweencountry i and countryjunderlies rij1.

rij= 1 Survival rate between a plant and its home market

rij1, (7)

with Ci being consumption of a variety of goodXand Ybeing consumption of thehomogeneous numeraire good Y. With the budget constraint

I=CiPi +YPY,

where Idenotes total income, the demand function is obtained by differentiatingwith respect to Ci:

U

Ci= /

1

/C

i

1

= Pi


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=Ci

1

= Pi

=Ci = Pi

1

,

resulting in:

with a consumer price Piand the elasticity of demand / ( 1) .

3.1.1) Trade costs and market clearing

A firm facing a survival rate rmust produce a quantity 1 / rtimes the quantity

demanded in the market to compensate losses due to transportation. Becausethere are tariffs, the consumer price must be (1 + t) / rtimes the producer price.Therefore a firm produces:

(8)

with as measure for transportation costs and p0 the producer pricewhich is defined as

p0 = c (9)

due to the fact that elasticity of demand is not affected by trade costs.

The operating profit , however, is subject to transportation costs and

tariffs

(s,t) = (p0 c)X(s,t)

= (p0 c)(1+ t)p

0

(1 s)

= (c c)(1 t)(c c)(1 s)

= c(1)(c c)

(1 t)

(1 s)= c

1(1)(1 t)(1 s)

=(1+ t)(1 s)

(10)

with , showing that profit is also decreasing in marginal costs c

and elasticity of demand .

The sum of consumer surplus and tariff revenue from imports is obtained byusing expressions (7), (8) and (9):

, (11)

which is decreasing in s, t, c and .


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It should be stressed again that the producer price is NOT affected by trade costs,therefore tariffs will not result in a term-of-trade improvement for the importingcountry. In this model the only benefit a country will have by imposing tariffs isto induce foreign firms to engage in multinational production and to eliminatetransportation costs s.

3.1.2) Plant Location

A firm faces a trade-off between trade costs and fixed costs. Production in thehome country is subject to increasing returns to scale, whereas a new plant inthe foreign country will cause F costs but avoids trade costs associated withexporting goods to that country. There are two assumptions about plantlocation:

1. If all countries choose zero tariffs, then all firms prefer single plantproduction,

2. >F means that it is profitable for the firm to operate foreign plants,implying that there exists a high enough tariff t*such that if any countryimposes a tarifftt*then all firms would locate a plant in that countryand thereby all countries maximize their consumer surplus (regardless ofpolicies other countries apply).

3.2) Triangular model

In the following model with three countries, A, B and N, where A and B areneighbours and N the (distant) rest of the world we have transport cost sbetweenA and B and betweenA and B respectively and Nofs>s. Concerning thenotation it must be stressed that the model concentrates on economicgeography, regardless of the size of the countries but assume that all three areidentical by size. The central question of the model is whether a PTA betweenneighbours is more likely than between remote ones.

There are three preliminary remarks in order:

1. In a three-country world firms must choose whether to operate one, twoor three plants and further where to locate them for exporting either fromhome or from a foreign plant. Also, if a firm is headquartered outside of abilateral FTA and decides to locate a plant within the FTA, it still raisesthe question in which of the two countries of the FTA it will invest. Thischoice matters because it affects the distribution of consumer surplus


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within the FTA. Generally, the country receiving less consumer surplus ismore likely to deviate from the FTA.4

2. In a two-country case there is according to theory always a Paretoimprovement going from autarky to free trade and thus causing an

efficient equilibrium. On a higher level this is harder to achieve because itmay be the case that there are many asymmetric equilibriums that aredifficult to rule out on grounds of Pareto efficiency. Take for example thecase when a country imposes a tariff while all other countries have zerotariffs. Assuming that a punishment equilibrium (regarded as a discountfactor of future outcomes) is low enough, the outcome for the countryimposing a tariff is going to be better relative to a world without tariffs.Therefore it is assumed that there is a mild form of reciprocity, sayingthat a country will only reduce its tariffs if its trade partner will do thesame.

3. Third, we assume that every tariff in a Pareto equilibrium must be eitherzero or prohibitive. Remember that with a tariff t higher than the highenough tarifft*every firm will decide to locate its additional plants in theforeign market. t* is determined by , which is where thetotal profit of a firm facing a foreign tariff of t is minimized. Figure 1demonstrates that total profit as a function oftfor two different levels ofs


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t* t*

Figure 1: Trade-off between transportation costs and tariffSource: Ludema R. D. (1998):Why are trade agreements regional, p.12

In the three-country case we face the following lemma: In any Pareto

efficient equilibrium, iftij>0, then exports ofXfrom countryjto country imust be zero (for all i, j = A, B, N). With this lemma (which doesnt dependon reciprocity) the model restricts to equilibriums involving only twotariffs: zero and the high-enough t*.

Under these assumptions we get six possible cases of outcome concerning the setup of trade agreements:

3.2.1) Equilibria based on Most Favoured Nation Agreements

1. The One-Shot Nash Equilibrium:By imposing a tariff t*, determined by , a countrymaximizes its consumer surplus because this is the smallest tariff e.g.country A would need to impose to attract firms from country B tooperate inA (independently what the rest of the world Nis doing). This isso because all goods will be produced locally in country A. Country B willdo the same and firms in Nwill be even more inclined to start operating

in countryA because of higher transport costs s


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Under assumption of just a one-shot strategy this is going to be thedominant strategy for all countries meaning that every country willimpose a tarifft*due to a prison-dilemma situation and this will cause anequilibrium with a payoff of:

and (12)

for all countries, where being the surplus from consuming 3n goods(under assumption thats = s = 0) and being the profit of a countrys nfirms, each operating three plants. Hence + is the lowest welfareequilibrium any country can experience in this one shot game, forming asub-game perfect equilibrium.

2. Global Free Trade (FT)On the other extreme with no tariffs at all, all firms will have single plantproduction with exporting everything from their home plant. With asingle plant at home they enjoy increasing returns to scale production. Afirm in country A or in country B will yield a total profit of

5, whereas a firm located in the rest ofthe world will yield a profit of . Summing theseprofits with the corresponding consumer surpluses gives the payoffs:

and (13)

and (14)

Obviously, both consumers and producers in countries A and B are betteroff (because ofs


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(16)

Under assumption of free trade to be globally efficient, the left hand sideof the bottom of equation (16) must be less than 1, otherwise firms wouldnot find it profitable to open a second plant. Notice the presence of thediscount factor on the right hand side which increases this part of theequation. It follows that larger fixed costs, higher discount factors orlower transport costs sall favour free trade agreements.

Under assumption of high transport costs to the rest of the world, theresult above shows that there wont be global trade if the rest of the worldis too far away fromA and B even if it is Pareto efficient.

3.2.2) Equilibria based on Exclusive Bilateral Agreements

3. Free Trade Agreements between neighbouring countries (AB)If there is a FTA agreement between country A and country B and withtariffs t*for N, a firm headquartered in A or B will open a second plant inNand supply the market of the FTA partner country from its home plant.For Nwe will have the same outcome because a firm from Nwill operate aplant either in country A or country B but because of the FTA it doesntmatter where it will receive the same profit as do firms from A and B.Under assumption that the rest of the world Nshares its plants Solomonic

between members of the FTA we get:


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and AAB

=BAB

= n(3 s) F (17)

VN

AB=V and N

AB= n(3 s) F (18)

Actually the rest of the world N is even better off due to the fact thatN

suffers no transport costs on its imports but benefits from the low tradecosts betweenA and B on its exports.

Substituting (17) and (18) the same way like the evolution of equation(16) we can show that RTAs betweenA and B are equilibria if and only if:

F

s

3

2

+1

, (19)

meaning a RTA being possible if the transport costs between these twocountries are small enough.

4. Free Trade Agreements between distant countries (AN)Here we have the same situation like the former, only with the differencethat the relevant transport costs now are s instead of s. But this alsomeans that the success of this agreement will depend on thetransportation costs slike in a global FTA. Hence, if global free trade failsto be an equilibrium than also does the FTA between remote countries.

The payoff for this kind of trade agreement can be written as:

F

s'

3

2

+1

, (20)

showing the dependence on transport cost between distant countries s.

3.2.3) Equilibria based on Hub-and-Spoke Agreements:

5. CountryA as the hub (AH)The next cases look at the possibilities for members of bilateralagreements to have different external tariffs such that a member of anFTA signs a second FTA without including its partner from the first. Thisis known as hub-and-spoke agreements, with the member of bothagreements being the hub and the two other partners being the spoke.

If country A is the hub (later on referred to with the index AH), his firmshave tariff-free access to country B and N, therefore having the same

profits as under global free trade. Firms headquartered in country Blocate a plant in Nto serve that market but export to A from their home


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plants in B. therefore their profits will be like under an AB agreement. Afirm headquartered in Nlocates a plant in either A or B and exports fromthere, getting also a profit like with an AB agreement. Thus, payoffs looklike:

and , (21)

and , (22)

and . (23)

Relative to an AB agreement country A now looks better, the rest of theworld and B worse. Country A saves its direct investments in N at theexpense of consumers there. Which country B or the rest of the world N is going to deviate from an agreement like that depends once again ontransport cost. Ifsis high, consumer surplus in Nwill be low and by thatcausing deviation. Otherwise it will be country B because since B receivesthe same payoff withAHas withAB, the existence condition is the same asforAB,

. (24)

6. The rest of the world as the hub (NH)If the rest of the world (as one block) has bilateral free trade agreementswithA and B, firms headquartered in Nobviously receive the same profitsas under global free trade. Firms located in B operate a plant in eithercountry A or in Nand export from there, generating the same profits asunder anANagreement. The same will happen with firms headquarteredin countryA. So we have payoffs like to that of anANagreement:

and , (25)

and . (26)

Here we have the same existence condition as for AC. Thus, we see againthat this kind of agreement will fail to be an equilibrium just as global freetrade also fails on that.

4) Implications

With certain assumption being made we have seen that in a triangular model sixdifferent existence conditions are achieved. By comparing them it clearly shows


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that below a threshold of transport costs s, an exclusive bilateral tradeagreement betweenA and B is the only equilibrium to survive a high enough s.

This is the central result, showing that if two countries have low transport costsbetween them and high transport costs in relation to the rest of the world, then

these two countries must have an exclusive bilateral trade agreement. This resultshows the strong incentive for RTAs. The threshold for thisAB trade agreementis shown in equation (19) which can be drawn as a horizontal line as done inFigure 26. However, ifs is above this threshold, then either with low s(the arealeft of the vertical line denoted with (16)) a FT agreement is possible or withhigh sno cooperation will take place at all.

s

45

FT NONE

(19)

FT

ALL AB AB

s

(20) (16)

Figure 2: Trade agreements for different combinations ofs and s.Source: Ludema R. D. (1998):Why are trade agreements regional, p.26

Hence, for the setup of a global free trade agreement, equations (16) and (19)must be fulfilled, implying:

FTandAHare Pareto efficient equilibria6To simplify the model, I concentrate on cases of free trade and bilateral agreements betweenneighbouring countries and exclude the cases of hub-and-spoke agreements. This is possiblebecause the model presented until now, assumes that defection from equilibrium would result inworldwide trade war. This is the case because as a response to unilaterally imposed unfairtariffs by a defecting country, other countries would raise their own tariffs on a general base,attacking not only the defecting country but all.

If, on the other hand, non-defecting countries target their tariff increases instead, applying t*onlyto imports from the defecting country and maintaining tariffs towards each other at pre-

defection levels, equilibrium might be maintained. With this assumption hub-and-spokeagreements can be ruled out.


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AB is a Pareto efficient equilibrium iff

Proof: Comparing (13) and (17) we have > iff > . But

because of (19) we have > > , thus >

whenever (19) is satisfies. Country A ranks its payoffs as follows:

> > >WAAN=W

A

NH

We know that = and = therefore we can also rank thepayoffs for country B:

> = >WANH

We see by these two rankings that FT and AH cannot be Paretodominated. Additionally, only FT is better than AB for both A and B. Thus,AB is Pareto dominated iffW

N

FT>WN

AB . Subtracting (18) from (14) we get:

WNFTWN

AB

= (VNFT

+NFT

) (VNAB

+NAB

) with VNAB

=V

= n(3 2s')+ n(3 2s') 3n+ n(3 s) F[ ]

= /3 /n // 2ns'+/3 /n / 2ns'/3 /n // /3 /n /+ ns+ F 0

= ns 2ns'(+1) F

= s 2(+1)s'F

n

= s 2(+1)s'F

.

(27)

Note thatn becomes 1 because we are just interested in the decision making ofone single firm. Also, s must be at least as low as the term on the right hand sideto guarantee a Pareto efficient equilibrium for AB.

Equation (27) shows the possibility to rule out an AB agreement on grounds ofPareto efficiency whenever Nprefers FTtoAB. If the cost of shipping goods fromN is low relative to the fixed costs F of setting up a new plant, then Ns firmsbenefit from global free trade by more than Ns consumers benefit from havingforeign goods locally produced. Hence, low s relative to s and F will promoteglobal free trade.


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5) Conclusions

In this paper I mainly presented a model by Ludema (1998) who applies gametheory onto international trade and decision-making processes of firms and

governments. The model of multinational firms used in this paper featurestransport cost, increasing returns to scale and imperfect competition.

However, the results we got from this model only assure what is alreadyintuitively assumed, namely that global free trade will only take place iftransport cost between distant countries are relatively low to cost betweenneighbouring countries. Thus, concerning the triangular model above, it can beargued that there indeed exists a strong bias to create RTAs. It was shown,however, that with relatively low transport cost between distant countries, these

regional agreements can be ruled out on account of Pareto optimality. Butregarding rising prices of oil and fuel nowadays, causing an increase in transportcost, it even seems more likely that RTAs will prevail in near future.

For example, the cost of sending a 40-foot container from Shanghai, China to SanDiego, USA has soared by 150%, to US-$ 5,500, since 2000. CIBC World Markets,a financial-services firm located in Toronto, Canada, assumes that if oil hits US-$200 a barrel, this shipping cost could even reach US-$ 10,000. Another exampleconcerns Japans steel industry, which heavily depends on imported iron ore andcoal to create metal for Japanese car producers in the USA (especially Toyota). In2003 it cost US-$ 15 to ship a ton of iron ore from Brazil to Japan. By last spring

shipping cost had risen to US-$ 90. Transport of raw materials now accounts for13% of the price of rolled steel (although the price for raw materials alsoincreased, but this was far lower compared to the rise in transport cost). Thefinished steel must then be sent to factories in the USA, pumping up the priceeven further7. The latter example implies that within the framework of the modelpresented above it might even become profitable for Japanese car producers toset up steel rolling plants in the USA as these construction costs Ffall relative totransport costs.

Hence, to explain the pattern of RTAs, it will be necessary to include the role ofhome market effects as well as the role of competition. Firms do not only decideon issues of setting up new plants by solely regarding the trade off betweentransport cost and tariffs, but also on factor cost like wage rates and also onstrategic targets like their future share of new markets. Also, the presentedmodel unfortunately is not sufficient as results might differ when we includemore countries than just three.

Additionally, as most countries are members of the WTO, it will also beinteresting to include the role of trade agreements set up under the WTO,especially when regarding occasional trade wars. Instead of using general

7Figures and examples extracted from: Engardio, Pete: Can the U.S. bring Jobs back fromChina? (2008). BusinessWeek (June 30, 2008): p. 38


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tariffs, countries usually impose targeted tariffs onto defecting countries asmentioned in footnote 6 above. However, it might render difficult for non-defecting countries to impose such targeted tariffs due to the rules and thedifficult structure of the decision making body of the WTO which generallydecides within its panel reports. In an interesting paper by Chang (2002) it is

argued that because of the need of consensual adoptions of panel reports itindeed might be beneficiary for a country to defect from the global free tradeagreement.

Regarding the results of this paper, the future of a global market does not lookbright. Facing political influences and its implications for global free tradeagreements, it does not seem that a theoretical based Pareto optimal point forglobal welfare maximization will be reached soon. On account of the presentedmodel with differences between regional and distant transport cost (s and srespectively) being the clue for the set up of a global free trade agreement, thedevelopment of oil prices especially indicates to be a great obstacle.

5) Bibliography


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Baghwati, Jagdish: The causes of Regionalism(1997).

Crawford, Jo-Ann; Laird, Sam: Regional Trade Agreements and the WTO(2000).

Chang, Pao-Li: The Evolution and Utilization of the GATT/WTO DisputeSettlement Mechanism (2002).

Ethier, Wilfried J.: Regionalism in a Multilateral World (1998). Journal ofPolitical Economy, Volume 106 (6): p. 1214-45

Feenstra, Robert C.: International Economics (2007), Ch. 6

Frankel, Jeffrey: Globalisation of the Economy (2000).

Helpman, Ethaniel; Krugman, Paul R.: Market Structure and Foreign trade(1985), Ch. 10

Ludema, Rodney E.: Why are Trade Agreements Regional? (1998, 2002).Journal of International Economics (2002), Volume 56 (2): p. 329-358

Parthapratim, Pal: Regional Trade Agreements in a Multilateral Trade Regime:An Overview (2003).

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Do Regional Trade Agreements Hinder Global Welfare Maximization

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