The Free Rider Effect and Market Power in Trade Agreements

Regional trade agreements have proliferated in the past two decades while multilateral trade negotiations have stalled. Both these agreements are governed by the WTO and have to abide by the non-discriminatory (Most-Favored Nation, MFN) clause to varying degrees-regional agreements to a lesser extent than multilateral agreements. This paper investigates the free rider effect that can stem from the MFN clause and how it impacts country incentives towards these agreements. Free-riding occurs because countries cannot be excluded from the benefits of other countries’ liberalizations and thus have less incentive to contribute to the cost of liberalization by signing trade agreements and offering their own market access. I extend the equilibrium model of endogenous trade liberalization via trade agreements developed by Saggi and Yildiz (2010) to better capture the effects of MFN. Within multilateral agreements, I show that the free rider effect eliminates global free trade as an equilibrium even when countries have symmetric market power. Within regional agreements, smaller countries are excluded more under the equilibrium with MFN compared to without.