Disaggregating PTAs and the Role of International Division of Labor on PTA Formation

Hazel C. Parcon (1)

The world trading system has exhibited two important trends since the 1980s.

First is the proliferation of preferential trade agreements (PTAs). In 1980, there were only about 20 agreements in force. This number has grown over tenfold in three decades, increasing to 223 as of 2010 RTA Database. Related to this, the structure of PTAs has also changed throughout the years. Majority of earlier PTAs are among countries in the same level of development; that is, among developed or among developing countries, while more recent (late 1990s and onwards) ones are between developed and developing countries.

Second is the increase in importance of trade in intermediate goods, which can be mainly attributed to the rise in international production fragmentation (IPF). The production of many manufactured goods has taken the character of international division of labor as firms seek to find the lowest cost producers of different components of a final good across the globe. Aggregate indicators of IPF have shown its rapid growth since the early 1980s (UNCTAD 2006). From 1982 to 2005, gross product associated with international production and foreign affiliate sales worldwide increased faster than global GDP and global exports. Outward FDI stock, albeit an imperfect measure of international production, likewise increased.

We set two goals in this study.

First, we juxtapose aforementioned trends and investigate whether the latter can help explain the former. Blanchard (2005), Chase (2005), Cheng, Liu, and Yang (1998), Cantwell (1994), and Milner (1993) argued that trade policies of a country are influenced by the international economic activities of its firms, which essentially recognize that trade policy is endogenous. Traditional studies on endogenous trade policy focus on the political process of trade policy formation (see for instance Magee et al. 1989). Likewise, most domestic firms modeled are import-competing, where trade policy is motivated to protect them and extract rents from foreign competitors. More recent theoretical work on endogenous trade policy have shown that when countries have more firms involved in international production, there is more pressure for trade liberalization since trade barriers are additional trade costs.

Second, we consider that the impact of different economic and political factors on the formation of PTAs may be different across periods and countries in different levels of development, which most previous studies have assumed to be the same. Thus, we disaggregate PTAs into North-North, South-South, and North-South; and consider whether they were formed in the period 1981-1995 or 1996-2006. The fact that earlier PTAs (1981-1995) are North-North and South-South and the more recent ones (1996-2006) are North-South suggest that motivations of countries in joining PTAs may have changed.

We develop a simple model where trade policy is formed by governments or social planners in countries with firms involved in international division of labor through IPF. We apply the IPF models of Jones and Kierzkowski (1990) and Ethier (1982) in the context of PTAs. A North country is an exporter of a final manufactured good that is highly dependent on imported inputs from a South country. Even with transportation and other trade costs, firms prefer to import the inputs from a particular South country, which we refer to as original South, since the latter can produce the inputs at lower costs. To further lower the costs for its firms, the social planner in the North country can negotiate a PTA with original South. Meanwhile, given the possibility that firms in other South countries may try to compete, the social planner in original South has an incentive to enter into a PTA with the North country in order to secure its trading relationship with the North. Merely the threat of firms in other South countries stealing the market of the North will give the social planner in original South a motivation to initiate a PTA negotiation with the North to secure its position as the low-cost input provider of the latter. Consumers in both countries benefit due to the lower price of the final manufactured good. Thus, a PTA between countries involved in international division of labor maybe welfare-improving.

We use sequential probit and multinomial logit to predict the probability of countries forming North-North, South-South and North-South PTAs given a set of economic and political factors.
Empirical results of our study help explain the major changes in the world trading system.

First, most countries choose PTA partners with which they have a history of trading, but more recent trading relationship is more important. This suggests that PTAs are formed by countries in order to strengthen the already existing trading relationship and not necessarily to dramatically increase the volume of trade. This is most especially true of PTAs formed in more recent years.

Second, earlier PTAs formed among countries in the same level of development (North-North and South-South) have more political motivation than PTAs formed between developed and developing countries (North-South) and in more recent years (1996-2006). We find that in general, PTAs formed in more recent years have more economic motivation.

Finally, disaggregating trade of countries into inter- and intra-industry trade shows that while inter-industry trade is mostly statistically significant in the formation of PTAs, intra-industry trade has a positive and significant impact only for North-North and North-South PTAs. The significance of intra-industry trade in the formation of North-North PTAs is due to North-North trade in different varieties of the same good. The significance of intra-industry trade in the formation of North-South PTAs, meanwhile, can be attributed to North-South trade in intermediate goods. The latter result supports the proposition put forth that developments in international division of labor have contributed to the formation of North-South PTAs.

Our results suggest that disaggregating PTAs into North-North, South-South and North-South can give valuable insights as to the different motivations of countries when they formed PTAs with different countries in different periods. Whether PTAs formed in more recent years are more welfare-enhancing than earlier ones is an interesting area left for future research.

Blanchard, Emily (2005). “Foreign Direct Investment, Endogenous Tariffs, and Preferential Trade Agreements.” SSRN Working Paper 691469.

Cantwell, J. (1994). “The Relationship Between International Trade and International Production,” D. Greenaway and L.A. Winters, Surveys in International Trade. Oxford: Basil Blackwell.

Chase, Kerry A. (2005). Trading Blocs: States, Firms, and Regions in the World Economy. Ann Arbor: The University of Michigan Press.

Cheng, Wen Li, and Meng-chun Liu, and Xiaokai Yang (2000). “A Ricardian Model with Endogenous Comparative Advantage and Endogenous Trade Policy Regimes.” The Economic Society of Australia, 76, 172-82.

Ethier, Wilfred (1982). “National and International Returns to Scale in the Modern Theory of International Trade.” American Economic Review, 72(3), 389-405.

Jones, Ronald and Henryk Kierzkowski (1990). “The Role of Services in Production andInternational Trade: A Theoretical Framework,” in R.W. Jones and A.O. Krueger, eds., The Political Economy of International Trade. Oxford: Basil Blackwell.

Magee, Stephen P. and William A. Brock and Leslie Young (1989). Black hole tariffs and endogenous policy theory: Political economy in general equilibrium. Cambridge: Cambridge University Press.

Milner, Helen (1993). “Trading Places,” in J. S. Odell and T.D. Willet, eds., International Trade Policies: Gains from Exchange Between Economics and Political Science. Ann Arbor: The University of Michigan Press, 141-172.

Parcon, Hazel C. (2008). "Disaggregating PTAs and the Role of International Division of Labor on PTA Formation", University of Hawaii at Manoa, Department of Economics, Working Papers Series n. 200806.

UNCTAD (2006). World Investment Report 2006: FDI from Developing and Transition Economies: Implications for Development.

Associate Professor, School of Economics, De La Salle University, Manila, Philippines. back to text

Hazel C. Parcon is an Associate Professor at the School of Economics of the De La Salle University in Manila, Philippines. She is also a Research Fellow at the Anghelo King Institute of the university. She has written and taught subjects on international trade theory and policy, globalization, foreign direct investments, labor markets, and macroeconomics.

Ms. Parcon was a Post-Doctoral Research Fellow at the College of Tropical Agriculture and Human Resources, University of Hawaii. She earned her Ph.D in Economics from the University of Hawaii.

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