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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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References

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  1. Wilfred J. Ethier, 2002. "Unilateralism in a Multilateral World," Economic Journal, Royal Economic Society, Royal Economic Society, vol. 112(479), pages 266-292, April.
  2. Giovanni Maggi, 1999. "The Role of Multilateral Institutions in International Trade Cooperation," American Economic Review, American Economic Association, American Economic Association, vol. 89(1), pages 190-214, March.
  3. Horn, Henrik & Maggi, Giovanni & Staiger, Rikard W., 2007. "Trade Agreements as Endogenously Incomplete Contracts," Working Paper Series, Research Institute of Industrial Economics 689, Research Institute of Industrial Economics.
  4. Caroline Freund & Emanuel Ornelas, 2009. "Regional Trade Agreements," CEP Discussion Papers dp0961, Centre for Economic Performance, LSE.
  5. Alberto Martin & Wouter Vergote, 2005. "On the role of retaliation in trade agreements," Economics Working Papers 914, Department of Economics and Business, Universitat Pompeu Fabra, revised Apr 2008.
  6. Grant, Simon & Quiggin, John, 1997. "Strategic Trade Policy under Uncertainty: Sufficient Conditions for the Optimality of Ad Valorem, Specific and Quadratic Trade Taxes," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 38(1), pages 187-203, February.
  7. Riezman, Raymond, 1985. "Customs unions and the core," Journal of International Economics, Elsevier, Elsevier, vol. 19(3-4), pages 355-365, November.
  8. Jennifer Pédussel Wu, 2005. "Trade Agreements as Self-Protection," Review of International Economics, Wiley Blackwell, vol. 13(3), pages 472-484, 08.
  9. Caroline Freund, 2010. "Third‐country Effects of Regional Trade Agreements," The World Economy, Wiley Blackwell, vol. 33(11), pages 1589-1605, November.
  10. Caroline Freund & Emanuel Ornelas, 2010. "Regional trade agreements: blessing or burden?," CentrePiece - The Magazine for Economic Performance, Centre for Economic Performance, LSE 313, Centre for Economic Performance, LSE.
  11. Dasgupta, Partha & Stiglitz, Joseph E, 1977. "Tariffs vs . Quotas as Revenue Raising Devices under Uncertainty," American Economic Review, American Economic Association, American Economic Association, vol. 67(5), pages 975-81, December.
  12. Carlo Perroni & John Whalley, 1994. "The New Regionalism: Trade Liberalization or Insurance?," NBER Working Papers 4626, National Bureau of Economic Research, Inc.
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Cited by:
  1. James Lake & Halis M. Yildiz, 2014. "On the different geographic characteristics of Free Trade Agreements and Customs Unions," Departmental Working Papers, Southern Methodist University, Department of Economics 1403, Southern Methodist University, Department of Economics.

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