Why are Trade Agreements Mostly Regional? A Welfare Analysis by Transportation Costs

Abstract:     
Why are trade agreements mostly regional? By making a welfare analysis, we show that the existence of transportation costs may be a possible reason. In particular, we set up a model of two countries by considering the effects of transportation costs on the welfare of each country. We also consider the relative size of the countries in our analysis together with naming them as small and large countries. We first show that the optimal (Nash) tariff rates are decreasing in transportation costs; i.e., closer countries tend to have lower tariff rates between each other, which lead to higher trade volume across them. Moreover, while the small country definitely sets a lower optimal tariff rate when it makes an agreement with a larger country, the large country does not necessarily set a higher optimal tariff rate when it makes an agreement with a smaller country. After that, we make a welfare analysis by using a stationary dynamic tariff game approach and show that it is harder to make an agreement for both countries if the transportation cost is higher; i.e., countries tend to make regional agreements to maximize their welfare. Finally, we show that it is easier to make an agreement for each country if the share of the transportation income received by the country is higher.

Keywords: Regional Trade Agreements, Transportation Cost, Repeated Game

JEL Classifications: C72, C73, D60, F15

Accepted Paper Series