Academic journal article Yale Economic Review

Are Free Trade Agreements Contagious!

Academic journal article Yale Economic Review

Are Free Trade Agreements Contagious!

Article excerpt

Free trade agreements (FTAs) dominate today's global economy more than ever before, in recent years spreading like wildfire. But why the sharp rise? In their June 2010 paper entitled "Are Free Trade Agreements Contagious?" international economics professor Richard Baldwin and post-graduate student D any Jaimovich of The Graduate Institute, Geneva, analyze this trend through a model of a political economy in which firms face high sunk costs - meaning they can enter markets quickly but can only exit slowly - and influence government decisions directly. Baldwin and Jaimovich hypothesize that existent FTAs themselves contribute to the establishment of future FTAs, and are thus "contagious."

Suppose there are only three countries in the world, and they trade with each other on an equal and non-discriminatory basis (Most Favored Nation [MFN] trade). That is, no FTAs exist. By itself, this would be a stable situation. If countries 1 and 2 do sign an agreement, their mutual trade would no doubt increase, meaning that their firms would face a higher overall demand for their goods and thus earn above-normal profits. All seems well so far.

But here's the caveat. Ab ove -normal profits would attract more firms in countries 1 and 2 to rapidly enter the market. Total supply would consequently rise, and prices for the goods would fall once again, bringing the firms in countries 1 and 2 back to pre-FTA profit levels. Therefore, with little prospect of increased profits, countries 1 and 2 don't have much incentive to "be the first" in signing an FTA, especially since such a move may have political ramifications.

Now suppose the world already has an FTA, say between countries 2 and 3. …

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