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How Does Uncertainty Affect the Choice of Trade Agreements?

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  • Appelbaum, Elie
  • Melatos, Mark

Abstract

This paper analyzes how uncertainty and the timing of its resolution influence the formation and design of regional trade agreements. Two sources of uncertainty — in demand and costs — are considered. We compare the case in which uncertainty is resolved "early" (before tariffs are chosen), with the case in which uncertainty is resolved "late" (after tariffs are chosen). These cases are, in turn, compared with the benchmark case of no uncertainty. We demonstrate that, as long as some decisions are made after uncertainty is resolved, trade agreements have option values. These option values differ across agreements, reflecting members' different degrees of (trade policy) freedom to respond to changes in the trading environment. Moreover, these option values may be sufficiently large as to lead prospective members to opt for a more flexible trading arrangement (such as a free trade area) over a less flexible agreement (such as a customs union). Indeed, countries may even prefer to stand alone than join a free trade area under some circumstances. Finally, we show that the timing of the resolution of uncertainty can significantly impact the type of trade agreement that countries wish to form.

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File URL: http://hdl.handle.net/2123/8207
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Bibliographic Info

Paper provided by University of Sydney, School of Economics in its series Working Papers with number 2012-08.

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Date of creation: Apr 2012
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Handle: RePEc:syd:wpaper:2123/8207

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Keywords: Resolution of Uncertainty; Uncertainty; Customs Union; Free Trade Area; Trade Agreement;

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