Networks of free trade agreements among heterogeneous countries

The paper examines the formation of free trade agreements as a network formation game. We consider a three-country model in which international trade occurs between economies with imperfectly competitive product markets. Labor markets can be unionized and non-unionized in each country. We show that if all countries are of the same type (all of them are either unionized or non-unionized), the global free trade network is both the unique pairwise stable network and the unique efficient network. If some countries are unionized while others are non-unionized, other networks apart from the global free trade network are likely to be pairwise stable. However, the efficient network is always the global free trade network. Thus, a conflict between stability and efficiency may occur. Moreover, starting from the network in which no country has signed a free trade agreement, all sequences of networks due to continuously profitable deviations do not lead (in most cases) to the global free trade network, even when global free trade is stable.