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How Does Uncertainty Affect the Choice of Trade Agreements?

  • Appelbaum, Elie
  • Melatos, Mark

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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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
Contact details of provider: Postal: Sydney, NSW 2006
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Web page: http://sydney.edu.au/arts/economics
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  1. Carlo Perroni & John Whalley, 2000. "The new regionalism: trade liberalization or insurance?," Canadian Journal of Economics, Canadian Economics Association, vol. 33(1), pages 1-24, February.
  2. Caroline Freund & Emanuel Ornelas, 2010. "Regional Trade Agreements," Annual Review of Economics, Annual Reviews, vol. 2(1), pages 139-166, 09.
  3. Horn, Henrik & Maggi, Giovanni & Staiger, Robert, 2007. "Trade Agreements as Endogenously Incomplete Contracts," CEPR Discussion Papers 6037, C.E.P.R. Discussion Papers.
  4. Martin, Alberto & Vergote, Wouter, 2008. "On the role of retaliation in trade agreements," Journal of International Economics, Elsevier, vol. 76(1), pages 61-77, September.
  5. Riezman, Raymond, 1985. "Customs unions and the core," Journal of International Economics, Elsevier, vol. 19(3-4), pages 355-365, November.
  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, vol. 38(1), pages 187-203, February.
  7. Dasgupta, Partha & Stiglitz, Joseph E, 1977. "Tariffs vs . Quotas as Revenue Raising Devices under Uncertainty," American Economic Review, American Economic Association, vol. 67(5), pages 975-81, December.
  8. Wilfred J. Ethier, 2002. "Unilateralism in a Multilateral World," Economic Journal, Royal Economic Society, vol. 112(479), pages 266-292, April.
  9. Caroline Freund & Emanuel Ornelas, 2010. "Regional trade agreements: blessing or burden?," CentrePiece - The Magazine for Economic Performance 313, Centre for Economic Performance, LSE.
  10. Caroline Freund, 2010. "Third‐country Effects of Regional Trade Agreements," The World Economy, Wiley Blackwell, vol. 33(11), pages 1589-1605, November.
  11. Jennifer Pédussel Wu, 2005. "Trade Agreements as Self-Protection," Review of International Economics, Wiley Blackwell, vol. 13(3), pages 472-484, 08.
  12. Giovanni Maggi, 1999. "The Role of Multilateral Institutions in International Trade Cooperation," American Economic Review, American Economic Association, vol. 89(1), pages 190-214, March.
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