The role of side payment requirements in free trade negotiations under asymmetric information

Abstract

Recent free trade agreements (FTAs) have two outstanding features: they have been drawn among countries with different market size, and relatively small market-sized countries have offered implicit side payments (i.e. concessions pertaining to non-trade aspects). The present study examines FTA negotiations between two asymmetric market-sized countries (one large and the other small) in which the former is unaware of the latter's demand and is allowed to require the latter to transfer side payments. The analysis clarifies that the side payments required by the large country depend on its beliefs about the small country's demand. If the large country expects that the small country's demand is sufficiently high, the FTAs derived from the former's requirement for moderate side payments could be either building blocks or stumbling blocks to global free trade, depending not only on each country's relative market size but also on the required side payments. Otherwise, the large country's requirement for huge side payments leads to or prevents FTAs that serve as stumbling blocks to global free trade, depending on the small country's actual demand.

Keywords:

• Free trade agreement
• side payments
• incomplete information
• screening game
• building block
• stumbling block

JEL Classifications:

• F15
• C72

Acknowledgments

A preliminary version of this article was presented under the title ‘FTA Negotiations with Side Payments: Asymmetric Countries and Asymmetric Information’ at the CCES & SSEM Joint International Conference on Institutions, Economic Growth and International Trade at Fudan University, China and at the ETSG (European Trade Study Group) 2014 Annual Conference at the University of Munich, Germany. The author would like to express my gratitude to the participants at these events for their comments and suggestions.

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1 Representative studies on the implications of information asymmetry in the context of strategic trade policy are Qiu (1994), Brainard and Martimort (1996), Maggi (1999), and Creane and Miyagiwa (2008). These previous studies dealt with uncertainty about market demand or production costs between firms and governments, whereas the present study considers the existence of information asymmetry between two governments making a trade regime decision; that is, one country's government has private information about its own market size, while the other does not have access to this information.

2 Empirical studies based on PTAs established either by the United States or by the European Union have indicated that some have resulted in stumbling blocks to multilateral trade liberalization, which is especially pronounced in agreements between the United States and relatively small countries (Limão 2006; Karacaovali and Limão 2008).

3 To avoid the conclusion of discriminatory bilateral trade liberalization that would harm external countries, Article XXIV of the GATT prohibits FTA members from raising import tariff levels for non-members. In the present study, the FTA members' optimal tariffs are consistent with this constraint.

4 From Lemma 2.1, I can easily confirm that $\mathrm{\Delta }{\underset{\_}{W}}^{A\ast }>\mathrm{\Delta }{\overline{W}}^{A\ast }$ for any $a_A^H,a_A^L,a_B$. That is, country $\underset{\_}{A}$ has an incentive to join an FTA at the expense of more side payments than does country $\overline{A}$.

Additional information

Funding

This work was supported by MEXT (Ministry of Education, Culture, Sports, Science, and Technology)-Supported Program for the Strategic Research Foundation at Private Universities [S1203005].