Hub and spoke trade agreements under oligopoly with asymmetric costs

Abstract

Using an oligopoly model of trade with asymmetric costs, we study the individual and world welfare implications of a hub and spoke trade agreement where the hub country is more efficient than spoke countries. Under a hub and spoke trade regime, the hub country can benefit at the expense of the spokes relative to free trade. Furthermore, if the hub is sufficiently efficient compared to the spokes, such a regime can yield higher global welfare than free trade. Preferential treatment of the efficient hub country in its export markets improves world welfare because it helps allocate a larger share of the world’s output to a low cost location.

Keywords:

• oligopoly
• hub and spoke trade agreements
• global free trade

JEL Classifications:

• F12
• F13

Notes

1. In the extensive literature on FTAs, welfare effects of FTAs are generally discussed in the form of tariff complementarity effects these agreements yield. See Bagwell and Staiger (1997, 1998), Yi (2000), and Ornelas (2005) for further details. See Richardson (1995) on the incentives for member countries of FTAs to reduce their external tariffs. See Bhagwati, Panagariya, and Krishna (1999) and Kowalczyk (1999) for a collection of many important articles in the PTA literature.

2. If a PTA is a CU, due to joint determination of external tariffs, expansion can only take the form of new membership. When the PTA is a free trade area, however, each member can negotiate individually with outside countries. Using a network formation game, Furusawa and Konishi (2007) point out this important difference in a model of endogenous formation of PTAs.

3. Studies by Goyal and Joshi (2006), Furusawa and Konishi (2006), Mukunoki and Tachi (2006), Saggi and Yildiz (2010, 2011), and Saggi, Woodland and Yildiz (2012) examine PTAs as a network formation game.

4. Similar result arises in Goyal and Joshi (2006) that endogenizes the FTA formation with exogenous tariffs and Mukonoki and Tachi (2006) in a setting of sequential negotiations of bilateral free trade agreements. Unlike the present article, both of these papers assume symmetry across countries.

5. Similarly, in Puga and Venables (1997), due to agglomeration effects, the formation of a hub and spoke arrangement benefits the hub whereas it can hurt the spoke nations by making location in the hub more attractive to firms. For further discussion see Wonnacott (1996).

6. Collie (1993) and Lahiri and Ono (1997) apply the similar argument in an international trade context.

7. It is immediate under global free trade that the two stage game is reduced to a one stage game and the tariffs we use in the below discussion disappear.

8. It is important to note from the literature on trade policy under imperfect competition that results are highly sensitive to the choice and functional form of policy instruments. For example, as shown by Brander and Spencer (1984), and further discussed by Jørgensen and Schröder (2005), whether the policy is ad-valorem or specific could matter even for the sign of welfare improving intervention.

9. If we replace the local strategic substitutability with its global counterpart, then many of the assumptions about the demand function can be consolidated under this new assumption. See Lahiri and Ono (2004) for further details. We would like to thank the referee pointing out this possibility.

10. Under symmetry, it is clear that .