Industrial Policy and Regional Trade Agreements

Abstract

This study examines whether regional trade agreements (RTAs), such as free trade agreements (FTAs) and customs unions (CUs), facilitate or hinder the achievement of multilateral trade liberalization when governments implement industrial policies. We develop a symmetric three-country model of international oligopoly with endogenously determined tariffs and production subsidies and consider not only RTAs, where member countries independently determine their production subsidies, but also deep RTAs, where member countries harmonize production subsidies. We show that forming an FTA or CU, with or without harmonizing production subsidies, improves the welfare of all member and non-member countries. More importantly, FTAs, regardless of whether production subsidies are harmonized among member countries, will prevent multilateral trade liberalization. Furthermore, if member countries harmonize production subsidies, CUs act as building blocks for multilateral free trade; otherwise, they serve as stumbling blocks. This is in sharp contrast to the results of traditional models with tariffs alone, where given three symmetric countries, both FTAs and CUs tend to facilitate multilateral free trade.

Appendices

Appendix 1. Equilibrium outputs and consumption levels for each regime

• (i) Pre-RTA regime ($i, j=X, Y, Z$, $i\ne j$)

  ${q}_{ii}^{*}$	${q}_{ij}^{*}$	${Q}_{i}^{*}$
  $0.43105\left(\alpha -c\right)$	$0.16721\left(\alpha -c\right)$	$0.76547\left(\alpha -c\right)$

• (ii) FTA ($i, j=X, Y$, $i\ne j$)

  ${q}_{ii}^{F}={q}_{ij}^{F}$	${q}_{iZ}^{F}$	${Q}_{i}^{F}$
  $0.37025\left(\alpha -c\right)$	$0.1982\left(\alpha -c\right)$	$0.93871\left(\alpha -c\right)$

  Non-member country Z

  ${q}_{ZZ}^{F}$	${q}_{Zi}^{F}$	${Q}_{Z}^{F}$
  $0.38798\left(\alpha -c\right)$	$0.21311\left(\alpha -c\right)$	$0.8142\left(\alpha -c\right)$

• (iii) Deep FTA ($i, j=X, Y$, $i\ne j$)

  Member country $i$

  ${q}_{ii}^{DF}={q}_{ij}^{DF}$	${q}_{iZ}^{DF}$	${Q}_{i}^{DF}$
  $0.35974\left(\alpha -c\right)$	$0.19517\left(\alpha -c\right)$	$0.91466\left(\alpha -c\right)$

  Non-member country Z

  ${q}_{ZZ}^{DF}$	${q}_{Zi}^{DF}$	${Q}_{Z}^{DF}$
  $0.40849\left(\alpha -c\right)$	$0.19215\left(\alpha -c\right)$	$0.79279\left(\alpha -c\right)$

• (iv) CU ($i, j=X, Y$, $i\ne j$)

  Member country $i$

  ${q}_{ii}^{C}={q}_{ij}^{C}$	${q}_{iZ}^{C}$	${Q}_{i}^{C}$
  $0.3974\left(\alpha -c\right)$	$0.12345\left(\alpha -c\right)$	$0.91824\left(\alpha -c\right)$

  Non-member country Z

  ${q}_{ZZ}^{C}$	${q}_{Zi}^{C}$	${Q}_{Z}^{C}$
  $0.35438\left(\alpha -c\right)$	$0.22556\left(\alpha -c\right)$	$0.80549\left(\alpha -c\right)$

• (v) Deep CU ($i, j=X, Y$, $i\ne j$)

  Member country $i$

  ${q}_{ii}^{DC}={q}_{ij}^{DC}$	${q}_{iZ}^{DC}$	${Q}_{i}^{DC}$
  $0.3669\left(\alpha -c\right)$	$0.12356\left(\alpha -c\right)$	$0.85736\left(\alpha -c\right)$

  Non-member country Z

  ${q}_{ZZ}^{DC}$	${q}_{Zi}^{DC}$	${Q}_{Z}^{DC}$
  $0.40608\left(\alpha -c\right)$	$0.17666\left(\alpha -c\right)$	$0.75941\left(\alpha -c\right)$

• (vi) MTA and deep MTA ($i, j, k=X, Y, Z,$ $i\ne j\ne k$)

  ${q}_{ii}^{M}= {q}_{ij}^{M}={q}_{ik}^{M}$	${Q}_{i}^{M}$
  $\left(\alpha -c\right)/3$	$\alpha -c$

  The equilibrium outputs and consumption levels for a deep MTA are the same as those for an MTA.

Appendix 2. Case without industrial policy

Suppose that the three governments do not provide production subsidies, ${s}_{i}=0$ ($i=X, Y, Z$).

In the absence of an industrial policy, under the pre-RTA regime, country $i$’s first-order condition for welfare maximization is given by

$$\frac{\partial {W}_{i}}{\partial {t}_{i}}=\frac{3\left(\alpha -c\right)-10{t}_{i}}{8}=0, i=X, Y, Z.$$

(38)

Equation (38) shows that a country’s first-order condition depends only on its tariff, indicating the strategic independence of countries’ policies. From Equation (38), the pre-RTA tariff of country $i$ is

$${\widetilde{t}}_{i}^{*}=\frac{3}{10}\left(\alpha -c\right), i=X, Y, Z.$$

(39)

The pre-RTA welfare level is

$${\widetilde{W}}_{i}^{*}=0.42{\left(\alpha -c\right)}^{2}, i=X, Y, Z.$$

(40)

Under an FTA between countries X and Y, the member countries eliminate tariffs on each other. The FTA member $i$’s first-order condition for welfare maximization is given by

$$\frac{\partial {W}_{i}}{\partial {t}_{iZ}}=\frac{3\left(\alpha -c-7{t}_{iZ}\right)}{16}=0, i=X, Y$$

(41)

From Equation (41), FTA member $i$’s external tariff is

$${\widetilde{t}}_{iZ}^{F}=\frac{1}{7}\left(\alpha -c\right), i=X, Y.$$

(42)

From Equations (39) and (42), ${\widetilde{t}}_{iZ}^{F}<{\widetilde{t}}_{i}^{*}$ ($i=X, Y$). Because of the strategic independence, the welfare maximization problem of non-member Z in the FTA regime remains the same as that in the pre-RTA regime; thus, non-member Z’s tariff is the same before and after the FTA.

The FTA welfare levels of member and non-member countries are

$${\widetilde{W}}_{i}^{F}=0.44878{\left(\alpha -c\right)}^{2}, {\widetilde{W}}_{Z}^{F}=0.44082{\left(\alpha -c\right)}^{2}, i=X, Y.$$

(43)

From Equations (40) and (43), ${\widetilde{W}}_{i}^{F}>{\widetilde{W}}_{i}^{*}$ ($i=X, Y$), and ${\widetilde{W}}_{Z}^{F}>{\widetilde{W}}_{Z}^{*}$. In addition, ${\widetilde{W}}_{i}^{F}>{\widetilde{W}}_{Z}^{F}$ ($i=X, Y$).

Under an MTA, the three countries remove tariffs. Their MTA welfare levels are

$${\widetilde{W}}_{i}^{M}=0.46875{\left(\alpha -c\right)}^{2}, i=X, Y, Z.$$

(44)

From Equations (43) and (44), ${\widetilde{W}}_{i}^{M}>{\widetilde{W}}_{i}^{F}$ ($i=X, Y$) and ${\widetilde{W}}_{Z}^{M}>{\widetilde{W}}_{Z}^{F}$.

Consider three trade regimes: (a) MFN tariffs (the pre-RTA regime); (b) an FTA between countries X and Y; and (c) an MTA. Using Equations (40), (43), and (44), we find that only an MTA is in the core because it is the best regime for all three countries (${\widetilde{W}}_{i}^{*}<{\widetilde{W}}_{i}^{F}<{\widetilde{W}}_{i}^{M}$, for $i=X, Y, Z$).

We summarize the results as follows.

Proposition A1

• (i) ${\widetilde{W}}_{X}^{F}={\widetilde{W}}_{Y}^{F}>{\widetilde{W}}_{X}^{*}={\widetilde{W}}_{Y}^{*}$ and ${\widetilde{W}}_{Z}^{F}>{\widetilde{W}}_{Z}^{*}$.

• (ii) ${\widetilde{W}}_{X}^{M}={\widetilde{W}}_{Y}^{M}>{\widetilde{W}}_{X}^{F}={\widetilde{W}}_{Y}^{F}$ and ${\widetilde{W}}_{Z}^{M}>{\widetilde{W}}_{Z}^{F}$.

• (iii) In the absence of industrial policy, only an MTA is in the core in the case of FTA

Under a CU between countries X and Y, the tariffs between member countries are eliminated. The first-order condition for joint-welfare maximization by the CU members is given by

$$\frac{\partial \left({W}_{X}+{W}_{Y}\right)}{\partial {t}_{C}}=\frac{5\left(\alpha -c\right)-19{t}_{C}}{8}=0.$$

(45)

From Equation (45), CU members’ common external tariff is

$${\widetilde{t}}_{C}=\frac{5}{19}\left(\alpha -c\right).$$

(46)

From Equations (39), (42), and (46), ${\widetilde{t}}_{iZ}^{F}<{\widetilde{t}}_{C}<{\widetilde{t}}_{i}^{*}$ ($i=X, Y$). Non-member Z’s tariff is the same before and after the CU because of the strategic independence.

The CU welfare levels of member and non-member countries are

$${\widetilde{W}}_{i}^{C}=0.45737{\left(\alpha -c\right)}^{2}, {\widetilde{W}}_{Z}^{C}=0.40554{\left(\alpha -c\right)}^{2}, i=X, Y.$$

(47)

 

From Equations (40) and (47), ${\widetilde{W}}_{i}^{C}>{\widetilde{W}}_{i}^{*}$ ($i=X, Y$) and ${\widetilde{W}}_{Z}^{C}<{\widetilde{W}}_{Z}^{*}$. Moreover, from Equations (44) and (47), ${\widetilde{W}}_{i}^{M}>{\widetilde{W}}_{i}^{C}$ ($i=X, Y$) and ${\widetilde{W}}_{Z}^{M}>{\widetilde{W}}_{Z}^{C}$.

Consider three trade regimes: (a) MFN tariffs (pre-RTA regime); (b) a CU between countries X and Y; and (c) an MTA. From Equations (40), (44), and (47), only an MTA is in the core because it is the best regime for all countries (${\widetilde{W}}_{i}^{*}<{\widetilde{W}}_{i}^{C}<{\widetilde{W}}_{i}^{M}$, for $i=X, Y$, and ${\widetilde{W}}_{Z}^{C}<{\widetilde{W}}_{Z}^{*}<{\widetilde{W}}_{Z}^{M}$).

These results are summarized below.

Proposition A2

• (i) ${\widetilde{W}}_{X}^{C}={\widetilde{W}}_{Y}^{C}>{\widetilde{W}}_{X}^{*}={\widetilde{W}}_{Y}^{*}$ and ${\widetilde{W}}_{Z}^{C}<{\widetilde{W}}_{Z}^{*}$.

• (ii) ${\widetilde{W}}_{X}^{M}={\widetilde{W}}_{Y}^{M}>{\widetilde{W}}_{X}^{C}={\widetilde{W}}_{Y}^{C}$ and ${\widetilde{W}}_{Z}^{M}>{\widetilde{W}}_{Z}^{C}$.

• (iii) In the absence of industrial policy, only an MTA is in the core in the case of CU.

The above results imply that, given three symmetric countries, RTAs, whether FTAs or CUs, facilitate multilateral trade liberalization in the absence of industrial policy.

Appendix 3. Timing of policy decisions

• (I) Simultaneous determination of tariffs and production subsidies

  In an FTA, we obtain the following results on the welfare rankings for FTA member and non-member countries: ${\widehat{W}}_{i}^{M}=0.5{\left(\alpha -c\right)}^{2}>{\widehat{W}}_{i}^{F}=0.47794{\left(\alpha -c\right)}^{2}>{\widehat{W}}_{i}^{*}=0.46875{\left(\alpha -c\right)}^{2}$ for member country $i$ ($i=X, Y$), and ${\widehat{W}}_{Z}^{F}=0.51897{\left(\alpha -c\right)}^{2}>{\widehat{W}}_{Z}^{M}=0.5{\left(\alpha -c\right)}^{2}>{\widehat{W}}_{Z}^{*}=0.46875{\left(\alpha -c\right)}^{2}$ for non-member Z. This implies that Propositions 2, 3, and 4 hold, even in the case of simultaneous policy decisions.

  In a deep FTA, we find the following welfare rankings: ${\widehat{W}}_{i}^{DM}=0.5{\left(\alpha -c\right)}^{2}>{\widehat{W}}_{i}^{DF}=0.48203{\left(\alpha -c\right)}^{2}>{\widehat{W}}_{i}^{*}$ for member country $i$ ($i=X, Y$), and ${\widehat{W}}_{Z}^{DF}=0.50511{\left(\alpha -c\right)}^{2}>{\widehat{W}}_{Z}^{DM}=0.5{\left(\alpha -c\right)}^{2}>{\widehat{W}}_{Z}^{*}$ for non-member Z. Therefore, Proposition 5 holds.

  In a CU, the following welfare rankings are obtained: ${\widehat{W}}_{i}^{M}>{\widehat{W}}_{i}^{C}=0.4775{\left(\alpha -c\right)}^{2}>{\widehat{W}}_{i}^{*}$ for member country $i$ ($i=X, Y$), and ${\widehat{W}}_{Z}^{C}=0.5107{\left(\alpha -c\right)}^{2}>{\widehat{W}}_{Z}^{M}>{\widehat{W}}_{Z}^{*}$ for non-member Z. Thus, Propositions 6 and 7 remain valid.

  In a deep CU, we get the following: ${\widehat{W}}_{i}^{DM}>{\widehat{W}}_{i}^{DC}=0.48557{\left(\alpha -c\right)}^{2}>{\widehat{W}}_{i}^{*}$ for member country $i$ ($i=X, Y$), and ${\widehat{W}}_{Z}^{DM}>{\widehat{W}}_{Z}^{DC}=0.4715{\left(\alpha -c\right)}^{2}>{\widehat{W}}_{Z}^{*}$ for non-member Z. Hence, Proposition 8 remains valid.

• (II) Determination of production subsidies in stage 1 and tariffs in stage 2

  In an FTA, we find the following welfare rankings:${\check{W}}_{i}^{M}=0.5{\left(\alpha -c\right)}^{2}>{\check{W}}_{i}^{F}=0.47164{\left(\alpha -c\right)}^{2}>{\check{W}}_{i}^{*}=0.46713{\left(\alpha -c\right)}^{2}$  for member country $i$ ($i=X, Y$), and${\check{W}}_{Z}^{F}=0.51841{\left(\alpha -c\right)}^{2}>{\check{W}}_{Z}^{M}=0.5{\left(\alpha -c\right)}^{2}>{\check{W}}_{Z}^{*}=0.46713{\left(\alpha -c\right)}^{2}$ for non-member Z. Consequently, Propositions 2, 3 and 4 hold, even if the timing of policy decisions is reversed.

  In a deep FTA, we obtain the following welfare rankings:${\check{W}}_{i}^{DM}=0.5{\left(\alpha -c\right)}^{2}>{\check{W}}_{i}^{DF}=0.47556{\left(\alpha -c\right)}^{2}>{\check{W}}_{i}^{*}$ for member country $i$ ($i=X, Y$), and${\check{W}}_{Z}^{DM}=0.5{\left(\alpha -c\right)}^{2}>{\check{W}}_{Z}^{DF}=0.49129{\left(\alpha -c\right)}^{2}>{\check{W}}_{Z}^{*}$ for non-member Z. From this result, a deep MTA makes FTA member and non-member countries better off relative to a deep FTA, and only a deep MTA is in the core. This is in sharp contrast with Proposition 5 (ii) and (iii).

  In a CU, the following welfare rankings are obtained:${\check{W}}_{i}^{M}>{\check{W}}_{i}^{C}=0.47668{\left(\alpha -c\right)}^{2}>{\check{W}}_{i}^{*}$  for member country $i$ ($i=X, Y$), and${\check{W}}_{Z}^{C}=0.51025{\left(\alpha -c\right)}^{2}>{\check{W}}_{Z}^{M}>{\check{W}}_{Z}^{*}$  for non-member Z. Therefore, Propositions 6 and 7 remain valid.

  In a deep CU, we get the following: ${\check{W}}_{i}^{DM}>{\check{W}}_{i}^{DC}=0.48373{\left(\alpha -c\right)}^{2}>{\check{W}}_{i}^{*}$  for member country $i$ ($i=X, Y$), and ${\check{W}}_{Z}^{DM}>{\check{W}}_{Z}^{DC}=0.46794{\left(\alpha -c\right)}^{2}>{\check{W}}_{Z}^{*}$  for non-member Z. Thus, Proposition 8 remains valid.