Domestic Policies in Self-Enforcing Trade Agreements
30 Pages Posted: 3 May 2012 Last revised: 24 Sep 2012
Date Written: May 2, 2012
If all cross-country externalities travel through the terms-of-trade, efficient trade agreements target the terms-of-trade but ignore domestic policies. This argument has been advanced by prominent studies on trade agreements. The present paper shows that its logic fails if production possibilities are intertemporally linked -- for example, under dynamic factor accumulation. In this case, past policies shape current production possibilities and thus affect defection temptations. Therefore, self-enforcing trade agreements that leave the choice of domestic policies to individual countries risk that countries abandon the zone of voluntarily cooperation while optimizing their policies. Consequently, trade agreements that target only the terms-of-trade suffer inefficiencies that are absent in trade agreements that target policies directly. The losses are strictly positive except for knife-edge cases, which existing studies have focussed on.
Keywords: self-enforcement constraint, state variable
JEL Classification: F10, F13
Suggested Citation: Suggested Citation