Country size, trade liberalization and transfers

In this paper, I develop a North-South pure exchange model to explain transfers between asymmetric countries. Two theories are investigated: firstly, I consider the theory of trade agreements; contrary to conventional wisdom, an efficient trade agreement (ETA) does not necessarily lead to free trade in the absence of internal political economy distortions. In fact, the ETA between asymmetric countries is such that the South sets a tariff higher than its Nash tariff and the North subsidizes its imports. When the difference in the endowment size is very large, the South's welfare gain is insufficient to compensate for the North's welfare loss. Interestingly enough, free trade always dominates the trade war equilibrium, regardless of countries' endowments. Secondly, I consider the theory of optimal tariffs and foreign aid. To encourage the South to liberalize trade, the North makes a transfer to the South - which increases with the countries' size asymmetry. To test this prediction, I use ACP-EU aid data and find that an increase in the recipient countries' relative size reduces foreign aid transfers. The present analysis provides a theoretical framework to understand the transition from the privileged market access to ACP-EU economic partnership agreements (EPAs) involving reciprocal trade concessions and the role of the adjustment transfers in this process.