A Model of Endogenous Trading-Bloc Formation

I study a dynamic process of trading-bloc formation in an n-country international trade model of imperfect competition. Countries differ in their industrialization levels and market sizes. In this model, both the formation of trading-blocs and countries’ external tariffs are endogenously determined. The impacts of free trade areas (FTAs) and customs unions (CUs) on trade liberalization are evaluated and compared. I demonstrate that global free trade is always achieved in equilibrium either sequentially or simultaneously when politically motivated protection (e.g., protection induced by lobbying) is absent. Moreover, I demonstrate in a three-country model that the equilibrium path towards global free trade depends on the type of regional trade agreements, the characteristic terms of each country, and the common discount factor, which is in contrast to Aghion et al. (2007) where equilibrium path is determined by the sign of externalities. Sufficient conditions under which a country prefers bilateralism or multilateralism are identified. In addition, when a country prefers bilateralism, it always tends to firstly approach either a less developed country or a country with a relatively small market size. This finding is consistent with Japan’s recent FTA strategies and the United States’ strategies in the formation of NAFTA. ∗I would like to thank Professor Licun Xue, Professor Ngo Van Long, and Professor William Watson for helpful discussions and suggestions and Social Science and Humanities Research Council of Canada (SSHRC) and Fonds québécois de la recherche sur la société et la culture (FQRSC) for financial support. †Department of Economics, McGill University, 855 Sherbrooke Street West, Montreal, Quebec, Canada H3A 2T7; [email protected]