Essays on Static and Dynamic Preferential Trade Agreement Formation: Role of Political Economy and Scale Economies

This dissertation focuses on the static and dynamic formation of preferential trade agreements (PTAs) and examines the implications of (i) political pressures from both exporting and import competing sectors and (ii) varying degree of (dis)economies of scale in production for the equilibrium trade agreements. We use a three country model under both perfectly and imperfectly competitive settings. We endogenize trade agreement formation in static and dynamic settings.

In the second and third chapters, governments are pressurized from exporting and import competing sectors. To this end, we propose a relatively flexible trade model where countries can be a sole exporter, a sole importer, a competing exporter in some sectors and a competing importer in other sectors. In chapter 2, using Coalition Proof Nash Equilibrium (CPNE) concept, we investigate the value of Article XXIV of the GATT in providing the option to form Free Trade Agreements (FTAs) for the prospect of global free trade. We examine whether the ability to form FTAs promotes global free trade relative to the pure multilateralism approach where discriminatory trade liberalization such as PTAs is not an option. We find that, when governments have weak political motivation to serve the interests of exporting and import competing sectors, FTAs act as strong building blocs towards free trade. On the other hand, when governments are sufficiently biased to serve the interests of exporting, and import competing sectors, FTA formation acts as strong stumbling blocs towards free trade. This is an important finding showing that the answer to the famous building vs. stumbling blocs question critically depends on the degree of political motivation.

In our third chapter, we endogenize the types of PTAs: FTA and Custom Union (CU) in a dynamic setting. We use Markov perfect equilibrium concept. Isolating for the effects of FTAs, the degree of political motivation to serve exporting and import competing sectors generates exclusion incentive of FTA members and free riding incentive of FTA nonmember that constrains expansion to global free trade. Focusing on the effects of CUs, only exclusion incentive of CU members constrains expansion to global free trade. Thereafter, the choice between FTA and CU generates tension between flexibility benefit of FTA and coordination benefit of CU. These tensions reveal that, when the degree of political motivation is low, the ability to choose FTA always serve as PTA building blocs towards free trade. On the contrary, the ability to choose CU may serve as PTA building blocs when countries are sufficiently myopic and degree of political motivation is high, but may serve as PTA stumbling blocs when countries are sufficiently myopic or sufficiently farsighted and the degree of political motivation is low.

Finally, we allow for economies of scale (diseconomies of scale) in an oligopoly model of trade when endogenizing the choice of FTAs and CUs. Our external tariff discussion complements the theoretical and empirical literature on the tariff complementarity effect in a crucial way since we show that it heavily depends upon the nature of the scale economies. As in chapter 3, we use Markov perfect equilibrium concept in determining equilibrium path of trade agreements in a dynamic setting. The following incentives are critical. Under FTA formation, myopic FTA nonmember holds free riding incentive that prevents free trade from emerging, whereas under CU formation, for sufficiently large diseconomies of scale, CU members hold exclusion incentive that prevents free trade from emerging.

Subsequently, the decision to form FTAs or CUs reveal that if countries are sufficiently myopic, then under economies of scale, constant returns to scale or sufficiently small diseconomies of scale, CUs serve as PTA building blocs towards free trade. Alternatively, if countries are sufficiently farsighted and diseconomies of scale is sufficiently large, FTAs serve as PTA building blocs or else CUs serve as PTA stumbling blocs.