RESEARCH AND ANALYSIS

On the Relationship between Preferential and Multilateral Trade Liberalization: The Case of Customs Unions

Kamal Saggi (Vanderbilt University)
Halis M. Yildiz (Ryerson University)
Alan Woodland (University of New South Wales)

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Article XXIV of the General Agreement on Tariffs and Trade (GATT) permits member countries of the World Trade Organization (WTO) to form preferential trade agreements (PTAs) such as free trade agreements (FTAs) and customs unions (CUs) under which PTA members can grant tariff reductions to each other that they do not extend to other WTO members. Empirical evidence indicates that WTO members have made rather liberal use of Article XXIV: as per the WTO's official web-site, as of Feb 2010, the WTO had received notification of 462 such arrangements, of which 345 were notified under Article XXIV.1

While FTAs constitute an overwhelming majority of PTAs, the existing CUs involve some of the major economies of the world: for example, the Latin American CU MERCOSUR counts Argentina, Brazil, Paraguay, and Uruguay as its members while the EC (27) — a CU that extends across both goods and services — comprises of most major European economies. As a result, it is important to obtain a better understanding of the factors that give rise to CUs and the effect CUs have on the multilateral trading system.

The sanctioning of discriminatory trade agreements by GATT Article XXIV and the complicated web of global tariffs that has resulted from their pursuit by WTO member countries raises some uncomfortable questions about the very structure of GATT. Indeed, Article XXIV appears to be in direct conflict with the first and the most fundamental Article of GATT — i.e., the most favored nation (MFN) clause that forbids WTO members from pursuing discriminatory trade liberalization. Bhagwati (1991) has argued quite forcefully that PTAs are fundamentally incompatible with the WTO's stated goal of multilateral trade liberalization and many observers have wondered whether the multilateral trading system would function more effectively if the exception to non-discriminatory trade liberalization provided by Article XXIV were simply absent from GATT.

While Article XXIV sanctions PTAs, it does so only under certain conditions. In particular, Article XXIV requires that (1) a PTA should cover “substantially all trade” between members; (2) a PTA should result in significant trade liberalization among members almost to the point that it leads to free trade amongst them; and (3) that PTA members not raise tariffs on non-members — a condition that appears to be an attempt to safeguard the interests of those left outside such discriminatory trade agreements. Of course, these conditions do not necessarily imply that Article XXIV is successful in protecting the interests of non-members or that PTAs satisfying the requirements of Article XXIV are consistent with multilateral trade liberalization.

In two related papers, we have attempted to isolate the consequences of Article XXIV for the process of multilateral trade liberalization. The first paper focuses on FTAs while the second studies CUs. In what follows, we limit our discussion to the second paper.2 In our three-country competing exporter’s model (that is common to both papers), each country imports a unique good from the other two countries so that there is a terms of trade incentive to impose tariffs on one’s trading partners. As might be expected, an outcome where each country imposes its optimal MFN tariff on its trading partners is inefficient from a global welfare perspective. To study whether and how countries can achieve outcomes that are preferable from an aggregate welfare perspective, we derive and compare the stable (or coalition proof) Nash equilibria of two games of trade liberalization called Bilateralism and Multilateralism.

Under Bilateralism, countries are free to liberalize trade bilaterally, multilaterally, or not at all. The bilateral option takes the form of a CU under which members eliminate tariffs on each other while imposing common external tariffs on the non-member. Under Multilateralism, countries must either liberalize multilaterally or not at all. This restricted game is an attempt to capture a world where the exception to MFN liberalization provided by Article XXIV does not exist. It is important to note that non-discriminatory trade liberalization is an option under both games; it is just that the Multilateralism game rules out a trade agreement that discriminates against the non-member country.

By comparing equilibrium outcomes under Bilateralism with those under Multilateralism, we attempt to isolate the consequences of the exception to non-discriminatory trade liberalization provided by GATT Article XXIV. The most attractive feature of our approach is that both the nature and the degree of trade liberalization are endogenously determined in our model — something that has been done rather infrequently in the rather vast literature on PTAs.

Consistent with actual trade negotiations and the WTO's MFN principle, under our Multilateralism game a pair of countries undertaking reciprocal trade liberalization are required to extend their respective tariff reductions to the third country. We denote such an MFN-consistent trade agreement between countries i and j by <ij>m. By contrast, under the discriminatory CU <ij> members i and j impose their jointly optimal external tariffs on the non-member country. In our model, the tariff implemented by a country as a participant in the MFN-consistent agreement <ij>m is lower than its optimal external tariff as a member of the CU <ij>. As a result, the non-participating country (i.e., country k) is worse off under the CU <ij> relative to the MFN-consistent agreement <ij>m due to two separate reasons. First, it faces discriminatory tariffs in both export markets under <ij> whereas such discrimination is absent under the MFN-consistent agreement <ij>m. Second, the external tariffs of member countries i and j under <ij> are higher than those under the MFN consistent agreement <ij>m.

When countries are fully symmetric with respect to their endowments, we find that multilateral free trade emerges as the unique stable equilibrium under both Bilateralism and Multilateralism.3 In other words, under symmetry, global free trade obtains and the option to discriminate provided by Article XXIV is simply not exercised by countries. This result suggests that heterogeneity across countries is likely to be a crucial determinant of why WTO members sometimes end up preferring discriminatory trading arrangements to non-discriminatory ones. Indeed, we show that when endowments are asymmetric across countries, the option to form CUs has important and somewhat surprising ramifications for the types of agreements that emerge in equilibrium. Furthermore, the nature of underlying asymmetry plays a rather subtle role in determining the relationship between bilateral and multilateral trade liberalization.

We first examine a scenario where one country has a relatively smaller endowment than the other two.4 Under such a pattern of asymmetry, we find that the option to form CUs can actually increase the likelihood of achieving global free trade. The intuition for this result is as follows: opting out of global free trade is relatively costlier for a country when it faces a discriminatory CU between the other two countries — as it does under Bilateralism — than when it faces an MFN-consistent agreement between them — as it does under Multilateralism. As a result, absent the threat of a discriminatory CU, the smaller country is less willing to liberalize multilaterally. However, if endowments are sufficiently asymmetric across countries, global free trade fails to arise under both Bilateralism and Multilateralism. If so, the equilibrium agreement reached under Multilateralism is welfare-superior to Bilateralism due to its non-discriminatory nature. An important practical implication of this result is that if global free trade is truly infeasible (i.e., cannot be reached under either Bilateralism or Multilateralism) then a purely multilateral approach to trade liberalization is preferable since it delivers a superior outcome.

When we consider a pattern of asymmetry where one country is relatively bigger than the other two, the argument in favor of Multilateralism becomes even stronger. First, as under the former pattern of asymmetry, Multilateralism yields a superior trade agreement when free trade is infeasible under both games. Perhaps more interesting is the fact that, under this alternative pattern of asymmetry, global free trade arises over a larger parameter space under Multilateralism (i.e., when countries cannot form bilateral CUs). The intuition is that under Bilateralism each of the smaller countries has a joint incentive to exclude the larger country and to impose optimal external tariffs on its relatively large volume of exports. This result lends support to the view that discriminatory trade agreements can end up supplanting multilateral liberalization.  

An important difference between FTAs and CUs is that an FTA member is free to sign another FTA with an existing non-member without needing consent of an existing FTA partner whereas a CU member cannot do so. Naturally, this suggests that the potential adverse impact of a CU on non-members might be larger. This fear finds some support in the existing literature: in many models, the tariff complementarity effect — i.e., the tendency of PTA members to lower their tariffs on non-members — is generally weaker for a CU relative to an FTA. An important implication of this finding is that one of the key conditions of Article XXIV — i.e., PTA members should not raise tariffs on non-members — is more likely to bind for a CU relative to an FTA. In our model, there exist circumstances where this indeed happens. To shed light on the potential effects of Article XXIV's constraint on the external tariffs of CU members, we also derive equilibrium trade agreements under the assumption that the maximum tariff a CU member can charge equals its optimal MFN tariff (i.e. the tariff it charged prior to the formation of the CU). Our main finding here is that while such a tariff restriction on CU members yields a constrained CU that is preferable from an aggregate welfare perspective, it does not make the attainment of multilateral free trade any more likely.

Notes
1. About 271 such agreements are already in force with the number expected to reach 400 during 2010. Mongolia is the only WTO member that does not participate in any PTA and most WTO members belong to multiple PTAs. Indeed, one even observes major PTAs in discussion with each other regarding mutual liberalization.
2. The complete citation for the paper on FTAs is: Kamal Saggi and Halis M. Yildiz, 2010. “Bilateralism, Multilateralism, and the Quest for Global Free Trade,” Journal of International Economics 81, 26-37 and for the paper on CUs is: Kamal Saggi, Halis M. Yildiz, and Alan Woodland, 2010.  “On the Relationship between Preferential and Multilateral Trade Liberalization: The Case of Customs Unions” mimeo.
3. Incidentally, this is true even in our paper on FTAs.
4. It is worth clarifying that in our model no country is ‘small’ in the traditional sense (where a country is considered to be small if it lacks the ability to manipulate its terms of trade). As noted earlier, all countries possess market power in our model and can affect their terms of trade. A small country in our model is simply one that has a lower volume of exports relative to others. Indeed, this why we use the word ‘smaller’ rather than ‘small’.

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Dr. Kamal Saggi is the Director of the Graduate Program in Economic Development and Professor of Economics at Vanderbilt University. He is an Associate Editor of the Journal of International Economics and an Associate Fellow of CIREQ, a joint research center housed in McGill University, Concordia University, and the University of Montreal. Dr. Saggi holds a Ph.D. in Economics from the University of Pennsylvania and has done extensive research in the theory of international trade and investment, international technology transfer, economic development, and on many other issues of fundamental importance to the multilateral trading system. His research has been published in leading economics journals and he has consulted for a variety of organization in the area of development and trade.

Alan Woodland is currently Scientia Professor of Economics and ARC Australian Professorial Fellow in the School of Economics within the Australian School of Business at the University of New South Wales. He was previously Professor of Econometrics at the University of Sydney and Professor of Economics at the University of British Columbia, Canada. He completed his Ph.D. at the University of New England in Australia. Woodland's primary research interests and publications are in the areas of international trade theory, applied econometrics and population ageing.

Dr. Halis Murat Yildiz is an Associate Professor of Economics at Ryerson University, Toronto. Dr. Yildiz holds a Ph.D. in Economics from the Southern Methodist University has done extensive research in the theory of international trade and investment, industrial organization, environmental economics and on issues related to the multilateral trading system. He is an Associate Editor of the Journal of Business Strategies and he was awarded a Standard SSHRC (Social Sciences and Humanities Research Council of Canada) grant as a solo investigator. His research has been published in leading field journals in international economics and environmental economics.

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