The last twenty years has seen an unparalleled flurry of new preferential trading arrangements across the world: about two thirds of all PTAs notified by December 2006 were notified during the WTO years. Several countries have negotiated PTAs in sequence: so the EU, Mexico and Singapore are now hubs in a complex network of agreements. About 92% of PTAs notified as of December 2006 were free trade areas; but some of the most significant PTAs in share of trade (the EU and MERCOSUR) are customs unions.
This paper uses a three-country bargaining model to explore whether global free trade can be reached immediately or via a sequence of PTAs; and, in the latter case, whether customs unions or free trade areas form on the path to global free trade. These questions are related because of WTO rules which define the two sorts of PTA: customs union insiders must harmonize tariffs, so they can only participate in a new PTA if they leave the customs union or if all fellow insiders also join the PTA; whereas free trade area insiders set their tariffs independently, and may therefore form another PTA without consulting their fellow insiders.
I highlight two motives for countries to form a bilateral PTA en route to global free trade. Both motives rely on insiders being relative beneficiaries, in the sense that they earn more than the outsider while the PTA is in force:
If countries are patient enough and if PTA insiders immediately negotiate a trilateral PTA then insiders earn more of the global free trade pie than if they had agreed to a trilateral PTA at the outset. PTA formation then strategically manipulates the status quo: a motive which I call `strategic positioning'. It is only pertinent if insiders are the relative beneficiaries of the PTA (else the outsider would earn more of the eventual pie); and if countries are patient enough to care about the long-term consequences of PTA formation.
Strategic positioning also relies on insiders immediately negotiating a trilateral PTA. Indeed, the advantages of strategic positioning are dissipated if an insider subsequently agrees a PTA with the outsider: for patient enough countries would then split the global free trade pie approximately equally. Patient countries may therefore agree to a customs union which strategically positions insiders precisely because free trade area insiders would propose a hub and spoke pattern.
Impatient countries may of course form a PTA when insiders are the relative beneficiaries. More strikingly, even patient enough countries may reach a hub and spoke pattern for such short-term considerations if they are the relative beneficiaries of a free trade area but not of a customs union.
My results on strategic positioning formalize the familiar claims that EU and MERCOSUR formation were respectively motivated by insiders' improved bargaining position relative to the US in subsequent GATT and NAFTA negotiations. I provide conditions for such strategic positioning, and for why both PTAs were customs unions.
I also contribute to the literature on noncooperative bargaining, which has divided into studies of coalition and of network formation: a distinction which corresponds to the difference between customs unions and free trade areas. I interpret network links as binding agreements which cannot be broken unilaterally, modelling link formation as a bargaining process which allows multilateral links to form; and I study the PTAs that form en route to the eventual position when countries are far-sighted.
Players decide whether their agreements allow some (but not all) insiders to reach further agreements with outsiders; so I can ask when bilateral links predominate and when the position is always partitional (no hub and spoke pattern forms). I show that transitions for patient enough players may depend on short-run considerations. I also demonstrate that permitting trilateral offers may be necessary for (efficient) free trade to be reached because spokes which can only offer bilaterals might not reach global free trade by forming another PTA.
I end the paper by using my approach to address a couple of issues of particular importance in trade negotiations:
According to conventional wisdom, international public goods have only been provided by a hegemon which is prepared to incur an undue burden: a theory which can allegedly explain why progress in post-war trade negotiations was typically achieved via GATT rounds before the mid-'80s, and via bilateral agreements thereafter: the trigger for regime change being the US's willingness to negotiate bilaterally, as of 1982. However, it is unclear why a US commitment to multilateral negotiations deterred other countries from forming PTAs. I use a variant of my model to answer this question. If all countries are prepared to negotiate bilaterally and PTA insiders are the relative beneficiaries then it is unprofitable to make a multilateral proposal, as every country must then be compensated for not exercising its outside option of forming a PTA. By contrast, only two countries need be compensated if one country is committed to multilateral agreements; and it is then profitable to make multilateral proposals. While this argument addresses the critique of conventional wisdom, it is inconsistent with the tenor of the related literature: for I show that the hegemonic role can be undertaken by any of the symmetric countries.
WTO rules allow countries to form closed or open access PTAs: entrants must secure the assent of existing insiders to join a closed access PTA, but can choose unilaterally whether to join an open access PTA. According to the literature, mandating open access would promote global free trade. By contrast, I use a variant on our model to explain why no countries have formed an open access PTA under existing rules: open access bilateral PTAs are dominated by closed access bilateral PTAs if they result in strategic positioning; and are otherwise dominated by a trilateral PTA.
My approach could be adapted to address some related questions. Bagwell and Staiger (2005) argue that MFN and reciprocity protect outsiders when a PTA forms. Countries can then form an FTA without worrying that their partners will reach further agreements with outsiders. Such provisions may have the opposite effect in (an extension of) this model: measures which protect outsiders reduce the strategic advantage of forming exclusive PTAs, inducing countries to negotiate multilaterally rather bilaterally.
Bagwell, K., Staiger, R. (2005),“Multilateral trade negotiations, bilateral opportunism and the rules of GATT/WTO”, Journal of International Economics, 67, 268–294.
Seidmann, D. J. (2009), “Preferential trading arrangements as strategic positioning”, Journal of International Economics, 79, 143-159.
Dan Seidmann is Professor of Economic Theory at the University of Nottingham. He holds a PhD from L.S.E. His research area is game theory, with particular interests in bargaining and in strategic communication.