## _wp0865

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### Introduction and research question
- Some 380 regional trade agreements had been notified to the GATT/WTO through July 2007.
- Research objective: political economy analysis of a country's incentives to enter a regional trade agreement (RTA) when a multilateral free trade agreement (FTA) is available, and implications for incentives to pursue multilateral trade liberalization.
- Framework: political-economy model à la Grossman-Helpman (1994) where the policymaker trades off aggregate social welfare and political contributions from an organized industrial interest group.
- Core contributions:
  - Formalize the role of "politics" in preferring an RTA to multilateral free trade.
  - Show that entering an RTA can render politically feasible multilateral liberalization infeasible thereafter.

### Model structure and assumptions
- World: three symmetric countries X, Y, Z.
- Sectors per country: manufacturing (differentiated products, increasing returns, imperfect competition) and agriculture (homogeneous, constant returns, perfect competition).
- Agent types: laborers and firm owners with utility forms given in equations (1) and (2); parameters λ and φ with 10≤≤λ and 10≤≤φ, and φ set to zero in parts of analysis.
- Manufacturing technology: unit labor requirement li = α + β xi with α fixed cost; number of manufacturing firms per country = k (fixed, no entry).
- Trade costs: iceberg costs for manufactured varieties with 1>τ; agriculture trade costless.
- Labor numeraire and normalization: wages equalized and labor force normalized to unity; labor income and firm-owner income expressions (3) and (4).
- Demand and pricing: isoelastic demands with elasticity of substitution σ (1>σ); producer mark-up leads to unitary producer price under chosen normalization; consumers pay unit price domestically and τ for imports when trade costs apply.

### Initial symmetric equilibrium (status quo)
- Manufactured composite price in symmetric autarky-like setup: PZ = PX = PY = [. 2 1 1 1000 σ σ τ − − ⋅+===kkPPP ZXY] (equation (6) as presented).
- Aggregate demands for manufactured good: MY = MX = MZ = 0,0,0 as per equation (7) (notation preserved).
- Aggregate agricultural demands and firm profits: expressions in equations (8) and (9) with profits 0 Π for any manufacturing firm.

### Policy options: Regional versus Multilateral agreements
- Two choices for policymaker in country Y:
  - Enter RTA with X: eliminate trade costs between Y and X only; trade costs with Z remain (section IV.A).
  - Enter multilateral FTA with X and Z: eliminate all trade costs among X, Y, Z (section IV.B).
- Policymaker objective (equation (10)): GY = aY ⋅ DY + (1 − aY) ⋅ WY where aY measures political distortions with (11≤<−YY aa) (preserved notation/inequality).
- Lobby: all manufacturing firms in Y form a single organized interest group offering a truthful contingent contribution schedule {RYD, FTYD}, maximizing members' net welfare net of contributions; contributions are non-negative and voluntary participation of policymaker pins contribution level.

### Socially optimal choice (no political contributions)
- Aggregate social welfare under RTA and FTA:
  - WR~Y = ( ) ( ) ( ) ,1 R Y R Y k P W Π + ⋅ − ⋅ = − − λ λ λ λ λ (equation (29), notation preserved).
  - WFT~Y analogous (equation (30)).
- Proposition 1: "The aggregate social welfare reached in country Y would be greater under the multilateral free trade agreement than under the regional trade agreement."
  - Welfare differential is zero at τ = 1 and increasing in τ under stated parameter condition.

### Lobbying as a pro-regionalism force
- Proposition 2: "Manufacturing firms located in country Y would earn higher profits under the regional trade agreement than under the multilateral free trade agreement."
  - Intuition: RTA raises relative price of Z varieties (τ) in Y and X markets, boosting demand and profits there; profit loss in Z market is outweighed by gains in Y and X.
- Corollary 1: The organized interest group is a pro-regionalism force.
- Contribution schedule mechanics:
  - Truthful schedule: DY = max{VFY − B, 0} with B chosen to maximize group net welfare subject to policymaker participation (Bernheim-Whinston truthful contract).
  - Interest group will offer positive contribution toward RTA if its net welfare under RTA is at least equal to welfare under social optimum; otherwise contribution is nil.

### Political equilibrium and the regionalism condition
- Policymaker chooses policy to maximize political support GY, comparing GR and GFT.
- Proposition 3 (regionalism condition): policymaker chooses RTA if and only if
  - ()()()() λλ λ λ λλ −− − −⋅−⋅⋅−≥Π−Π⋅ RYFTYY FT Y R YY PP akka , , 1 11
  - (Equation (31) preserved in form and symbols as presented.)
- Interpretation:
  - LHS: maximum political contribution organized interest group would pay (profit gain under RTA vs FTA adjusted by political weight).
  - RHS: loss in aggregate social welfare from choosing RTA times policymaker weight.
- Equilibrium implications:
  - If condition holds: contribution schedule yields positive DY and policymaker picks RTA.
  - If not: DY = DFTY = 0 and policymaker picks multilateral FTA.
- Proposition 4: If political distortions are strong enough (aY > aY*), a threshold trade cost level τ* exists such that for any τ ≤ τ* the policymaker will prefer RTA to FTA.
  - Explanation: increasing political distortions lower required contribution; maximum contribution (an inverse U-shape in τ) and welfare loss (increasing in τ) determine τ* (Figure 1 described).

### Effect of RTA on subsequent multilateralism
- Proposition 5: "Regionalism crucially affects the incentives for multilateralism: multilateral trade liberalization that would have been otherwise feasible is rendered infeasible by a politically supported regional trade agreement."
  - Mechanism:
    - Before RTA: multilateral liberalization is socially optimal and feasible; manufacturing firms are indifferent so no lobbying; policymaker would choose FTA.
    - After RTA: firms gain preferential access to partner market (X), earn higher profits under RTA; moving to multilateral FTA reduces their profits overall; organized interest group will contribute to preserve RTA; policymaker thus lacks incentive to move to multilateral FTA.
  - Conclusion: politically supported RTA generates anti-multilateralism lobbying that blocks multilateral liberalization that was previously feasible.

### Quantitative simulations and parameter sensitivity (Table 1)
- Simulation parameter choices:
  - Baseline σ = 5, also experiment with σ = 4 and σ = 10.
  - Baseline λ = 0.4, also consider λ = 0.3 and λ = 0.6.
- Baseline simulation results (preserved cells and numeric thresholds):
  - Baseline: σ 5 λ 0.4 α* τ* a* Policymaker's choice
    - Baseline 5 0.4 0.78 1.06
    - Regionalism if τ lower or equal to 1.06
    - Multilateralism otherwise
  - Lower σ 4 0.4 0.82 1.09
    - Regionalism if τ lower or equal to 1.09
    - Multilateralism otherwise
  - Higher σ 10 0.4 0.69 1.01
    - Regionalism if τ lower or equal to 1.01
    - Multilateralism otherwise
  - Lower λ 5 0.3 0.76 1.03
    - Regionalism if τ lower or equal to 1.03
    - Multilateralism otherwise
  - Higher λ 5 0.6 0.82 1.02
    - Regionalism if τ lower or equal to 1.02
    - Multilateralism otherwise
- Key simulation finding (baseline): if political distortions strong enough (78.0 *=> aa) and trade costs low enough (06.1 *=≤ τ τ), policymaker chooses RTA; otherwise chooses multilateral FTA. (Numeric inequalities and thresholds preserved exactly as in source.)

### Conclusions
- Policymaker faces a trade-off between industrial lobbying (pro-RTA) and aggregate welfare (pro-FTA).
- Formal condition derived for when RTA is preferred to multilateral FTA: depends on political distortions aY, lobbying gains (profit differential), and trade costs τ.
- If distortions are sufficiently strong and trade barriers against non-members sufficiently low, RTA may be chosen even though FTA yields higher aggregate welfare.
- Entering a politically supported RTA creates incentives (via industrial lobbying) that block subsequent multilateral liberalization that would otherwise have been politically feasible.

_Italic: Source — _wp0865 - References.............................................................................................................._

### References..............................................................................................................

### _wp0865 - References..............................................................................................................

### Introduction and research question
- Regional trade agreements proliferated: "some 380 regional trade agreements had been notified to the GATT/WTO through July 2007."
- Research objective: political economy analysis of a country's incentives to enter a regional trade agreement (RTA) when a multilateral free trade agreement (FTA) is available, and implications for incentives to pursue multilateral trade liberalization.
- Framework: political-economy model à la Grossman-Helpman (1994) where the policymaker trades off aggregate social welfare and political contributions from an organized industrial interest group.
- Core contributions:
  - Formalize the role of "politics" in preferring an RTA to multilateral free trade.
  - Show that entering an RTA can render politically feasible multilateral liberalization infeasible thereafter.

### Model structure and assumptions
- World: three symmetric countries X, Y, Z.
- Sectors per country: manufacturing (differentiated products, increasing returns, imperfect competition) and agriculture (homogeneous, constant returns, perfect competition).
- Agent types: laborers and firm owners with utility forms given in equations (1) and (2); parameters λ and φ with 10≤≤λ and 10≤≤φ, and φ set to zero in parts of analysis.
- Manufacturing technology: unit labor requirement li = α + β xi with α fixed cost; number of manufacturing firms per country = k (fixed, no entry).
- Trade costs: iceberg costs for manufactured varieties with 1>τ; agriculture trade costless.
- Labor numeraire and normalization: wages equalized and labor force normalized to unity; labor income and firm-owner income expressions (3) and (4).
- Demand and pricing: isoelastic demands with elasticity of substitution σ (1>σ); producer mark-up leads to unitary producer price under chosen normalization; consumers pay unit price domestically and τ for imports when trade costs apply.

### Initial symmetric equilibrium (status quo)
- Manufactured composite price in symmetric autarky-like setup: PZ = PX = PY = [. 2 1 1 1000 σ σ τ − − ⋅+===kkPPP ZXY] (equation (6) as presented).
- Aggregate demands for manufactured good: MY = MX = MZ = 0,0,0 as per equation (7) (notation preserved from source).
- Aggregate agricultural demands and firm profits: expressions in equations (8) and (9) with profits 0 Π for any manufacturing firm.

### Policy options: Regional versus Multilateral agreements
- Two choices for policymaker in country Y:
  - Enter RTA with X: eliminate trade costs between Y and X only; trade costs with Z remain (section IV.A).
  - Enter multilateral FTA with X and Z: eliminate all trade costs among X, Y, Z (section IV.B).
- Policymaker objective (equation (10)): GY = aY ⋅ DY + (1 − aY) ⋅ WY where aY measures political distortions with (11≤<−YY aa) (preserved notation/inequality as in source).
- Lobby: all manufacturing firms in Y form a single organized interest group offering a truthful contingent contribution schedule {RYD, FTYD}, maximizing members' net welfare net of contributions; contributions are non-negative and voluntary participation of policymaker pins contribution level.

### Socially optimal choice (no political contributions)
- Aggregate social welfare under RTA and FTA:
  - WR~Y = ( ) ( ) ( ) ,1 R Y R Y k P W Π + ⋅ − ⋅ = − − λ λ λ λ λ (equation (29), notation preserved).
  - WFT~Y analogous (equation (30)).
- Proposition 1: "The aggregate social welfare reached in country Y would be greater under the multilateral free trade agreement than under the regional trade agreement."
  - Proof in Mathematical Appendix; welfare differential is zero at τ = 1 and increasing in τ under stated parameter condition.

### Lobbying as a pro-regionalism force
- Proposition 2: "Manufacturing firms located in country Y would earn higher profits under the regional trade agreement than under the multilateral free trade agreement."
  - Intuition: RTA raises relative price of Z varieties (τ) in Y and X markets, boosting demand and profits there; profit loss in Z market is outweighed by gains in Y and X.
- Corollary 1: The organized interest group is a pro-regionalism force.
- Contribution schedule mechanics:
  - Truthful schedule: DY = max{VFY − B, 0} with B chosen to maximize group net welfare subject to policymaker participation (Bernheim-Whinston truthful contract).
  - Interest group will offer positive contribution toward RTA if its net welfare under RTA is at least equal to welfare under social optimum; otherwise contribution is nil.

### Political equilibrium and the regionalism condition
- Policymaker chooses policy to maximize political support GY, comparing GR and GFT.
- Proposition 3 (regionalism condition): policymaker chooses RTA if and only if
  - ()()()() λλ λ λ λλ −− − −⋅−⋅⋅−≥Π−Π⋅ RYFTYY FT Y R YY PP akka , , 1 11
  - (Equation (31) preserved in form and symbols as presented.)
- Interpretation:
  - LHS: maximum political contribution organized interest group would pay (profit gain under RTA vs FTA adjusted by political weight).
  - RHS: loss in aggregate social welfare from choosing RTA times policymaker weight.
- If condition holds: contribution schedule yields positive DY and policymaker picks RTA; if not, DY = DFTY = 0 and policymaker picks multilateral FTA.
- Proposition 4: If political distortions are strong enough (aY > aY*), a threshold trade cost level τ* exists such that for any τ ≤ τ* the policymaker will prefer RTA to FTA.
  - Explanation preserved: increasing political distortions lower required contribution; maximum contribution (an inverse U-shape in τ) and welfare loss (increasing in τ) determine τ* (Figure 1 described).

### Effect of RTA on subsequent multilateralism
- Proposition 5: "Regionalism crucially affects the incentives for multilateralism: multilateral trade liberalization that would have been otherwise feasible is rendered infeasible by a politically supported regional trade agreement."
  - Mechanism:
    - Before RTA: multilateral liberalization is socially optimal and feasible; manufacturing firms are indifferent so no lobbying; policymaker would choose FTA.
    - After RTA: firms gain preferential access to partner market (X), earn higher profits under RTA; moving to multilateral FTA reduces their profits overall; organized interest group will contribute to preserve RTA; policymaker thus lacks incentive to move to multilateral FTA.
  - Conclusion: politically supported RTA generates anti-multilateralism lobbying that blocks multilateral liberalization that was previously feasible.

### Quantitative simulations and parameter sensitivity (Table 1)
- Simulation parameter choices and interpretations:
  - Baseline σ = 5 (middle of empirical range), also experiment with σ = 4 and σ = 10.
  - Baseline λ = 0.4 (manufactured share), also consider λ = 0.3 and λ = 0.6.
- Baseline simulation results (summary from Table 1; preserved cells and numeric thresholds):
  - Baseline: σ 5 λ 0.4 α* τ* a* Policymaker's choice
    - Baseline 5 0.4 0.78 1.06
    - Regionalism if τ lower or equal to 1.06
    - Multilateralism otherwise
  - Lower σ 4 0.4 0.82 1.09
    - Regionalism if τ lower or equal to 1.09
    - Multilateralism otherwise
  - Higher σ 10 0.4 0.69 1.01
    - Regionalism if τ lower or equal to 1.01
    - Multilateralism otherwise
  - Lower λ 5 0.3 0.76 1.03
    - Regionalism if τ lower or equal to 1.03
    - Multilateralism otherwise
  - Higher λ 5 0.6 0.82 1.02
    - Regionalism if τ lower or equal to 1.02
    - Multilateralism otherwise
- Key simulation finding (baseline): if political distortions strong enough (78.0 *=> aa) and trade costs low enough (06.1 *=≤ τ τ), policymaker chooses RTA; otherwise chooses multilateral FTA. (Numeric inequalities and thresholds preserved exactly as in source.)

### Conclusions (concise)
- Policymaker faces a trade-off between industrial lobbying (pro-RTA) and aggregate welfare (pro-FTA).
- Formal condition derived for when RTA is preferred to multilateral FTA: depends on political distortions aY, lobbying gains (profit differential), and trade costs τ.
- If distortions are sufficiently strong and trade barriers against non-members sufficiently low, RTA may be chosen even though FTA yields higher aggregate welfare.
- Entering a politically supported RTA creates incentives (via industrial lobbying) that block subsequent multilateral liberalization that would otherwise have been politically feasible.

*Italic: Source — _wp0865 - References..............................................................................................................*

### REFERENCES

### REFERENCES

### Cited works

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- Bernheim, B., and M. Whinston, 1986, “Menu Auctions, Resource Allocation and Economic Influence,” Quarterly Journal of Economics, Vol. 101, pp. 1–31.  
- Bagwell, K. and R. Staiger, 1997a, “Multilateral Tariff Cooperation during the Formation of Free Trade Areas,” International Economic Review, Vol. 38, pp. 291-319.  
- ______, 1997b, “Multilateral Tariff Cooperation during the Formation of Custom Unions,” Journal of International Economics, Vol. 42, pp. 91-123.  
- Baldwin, R. E., and A. Venables, 1997, “International Economic Integration” in Handbook of International Economics, ed. by G. Grossman and K. Rogoff, Vol. 3 (Amsterdam: North Holland).  
- Bond, E., and C. Syropoulos, 1996, “The Size of Trading Blocs, Market Power and World Welfare Effects,” Journal of International Economics,Vol. 40, pp. 411–37.  
- Bond, E., Syropoulos, C. and L. Winters, 2001, “Deepening of Regional Integration and Multilateral Trade Agreements”, Journal of International Economics, Vol. 53, 2, pp. 335–61.  
- Broda C. and D. Weinstein, 2004, “Globalization and the Gains from Varieties,” NBER Working Paper 10314 (Cambridge, MA: NBER).  
- Dixit, A., and J. Stiglitz, 1977, “Monopolistic Competition and Optimal Product Diversity,” American Economic Review, Vol. 67 (June), pp. 297–308.  
- Cadot, O., J. de Melo and M. Olarreaga, 1997, “Lobbying and the Structure of Protection,” CEPR, Discussion Paper 1574 (London: CEPR).  
- ______, 1999, “Regional Integration and Lobbying for Tariff Against Non-Members,” International Economic Review, Vol. 40, 3, pp. 635-56.  
- Desrouelle, D., and M. Richardson, 1997, “Fortress Europe: Jericho or Chateau d'If?,” Review of International Economics, Vol. 5, pp. 41–57.  
- Findlay R., and A. Panagarya, 1996, “A Political Economy Analysis of Free Trade Areas and Customs Unions,” in “The Political Economy of Trade Policy: Papers in Honor of Jagdish Bhagwhati” ed. by R. Feenstra, G. Grossman and D. Irwin, (Cambridge, MA: MIT Press).  
- Fujta M., P. Krugman, and A. Venables, 1999, The Spatial Economy: Cities, Regions and International Trade, (Cambridge, MA: MIT Press).  
- Grossman, G., and E. Helpman, 1994, “Protection for Sale,” The American Economic Review, Vol. 84 (September), pp. 833–50.  
- ______, 1995, “The Politics of Free Trade Agreements,” The American Economic Review, Vol. 85 (September), pp. 667–90.  
- Krishna, P., 1998, “Regionalism and Multilateralism: a Political Economy Approach,” The Quarterly Journal of Economics, Vol. 113, 1, pp. 227-51.  
- Krugman P., 1991, “Is Bilateralism Bad?,” ed. by E. Helpman and A. Razin, International Trade and Trade Policy (Cambridge, MA and London, England: MIT Press).  
- Head K. and T. Mayer, 2004, “The Empirics of Agglomeration and Trade,” in Handbook of Regional and Urban Economics, ed. by J. Henderson and J. Thisse, Vol. 4 (Amsterdam: Elsevier).  
- Levy P., 1997, “A Political-Economic Analysis of Free Trade Agreements”, American Economic Review, Vol. 87, pp. 506-19.  
- Mayer, W., 1984, “Endogenous Tariff Formation,” The American Economic Review, Vol. 74, No 5, pp. 970-85.  
- Martin P. and H. Rey, 2005, “Globalization and Emerging Markets: With or Without Crash?,” CEPR Discussion Paper 5165 (London: CEPR).  
- Ornelas E., 2005a, “Endogenous Free Trade Agreements and the Multilateral Trading System,” Journal of International Economics, Vol. 67, pp. 471-97.  
- ______, 2005b, “Rent Destruction and the Political Viability of Free Trade Agreements,” The Quarterly Journal of Economics, November, pp. 1475-1506.  
- ______, 2005c, “Trade Creating Free Trade Areas and the Undermining of Multilateralism,” European Economic Review, Vol. 49, pp. 1717-35.  
- Richardson, M., 1993, “Endogenous Protection and Trade Diversion,” Journal of International Economics, Vol. 34, pp. 309-24.  
- Winters, A., 1996, “Regionalism versus Multilateralism,” CEPR Discussion Paper 1525 (London: CEPR).

*Source: _wp0865 - REFERENCES (IMF PDF).*

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