American Economic Review: Papers & Proceedings 2012, 102(3): 470–476 http://dx.doi.org/10.1257/aer.102.3.470 Contents † Trade Agreements and the Nature of Price Trade Agreements and the Nature of Price Determination † 470 Determination By Pol Antràs and Robert W. Staiger* I. Perfect Competition 471 The terms-of-trade theory of trade agree- from subsequently manipulating their domes- ments holds that governments are attracted to tic policy choices to undercut the market access trade agreements as a means of escape from a implications of their tariff commitments, can II. Imperfect Competition 472 terms-of-trade–driven prisoner’s dilemma see bring governments to the efficiency frontier.1 Bagwell and Staiger 1999 . One of the terms-( In this paper, we show that the nature of inter- of-trade theory’s most striking) predictions is national price determination can have important III. Matching 474 about the treatment of behind-the-border pol- effects on this prediction of the terms-of-trade icy measures in trade agreements. According theory. In particular, while the terms-of-trade to this prediction, in the noncooperative Nash theory adopts the view that international prices REFERENCES 476 equilibrium from which countries would begin are fully disciplined by market clearing condi- in the absence of a trade agreement, tariffs are tions, we show here that support for shallow set inefficiently high but behind-the-border poli- integration is overturned, and instead a need for cies are set at efficient levels. Hence, even in the “deep” integration is suggested—wherein direct context of a complex policy environment there negotiations occur over both border and behind- is no need for member governments of a trade the-border policies—if international prices are agreement to negotiate directly over the lev- determined through bargaining. els of their behind-the-border policies. Rather, Our results are most closely related to those according to the terms-of-trade theory, the in Antràs and Staiger forthcoming , where we fundamental problem for a trade agreement to focus on the potential( for offshoring) of spe- solve is to prevent terms-of-trade manipulation cialized inputs to increase the prevalence of and to thereby reduce tariffs and raise trade vol- bargaining as a mechanism for international umes, without introducing distortions into the price determination, and where we argue that unilateral choices of domestic tax subsidy and as such the recent rise in offshoring may pres- regulatory policies as a result of the/ negotiated ent the World Trade Organization (WTO) with constraints on tariffs see Bagwell and Staiger a profound institutional challenge. Here we 2001 . Importantly, this( result holds for a wide abstract from the details of offshoring and con- variety) of government preferences and has also sider instead foreign producers and domestic been shown to hold in imperfectly competitive consumers of a final good that interact under environments. different market structures and under different The terms-of-trade theory of trade agreements mechanisms of price determination. Our main therefore provides strong support for “shallow” result is that when foreign producers and domes- integration as the most direct means to solve the tic consumers must match and bargain over the policy inefficiencies that would arise absent a terms of their exchange, and this bargaining is trade agreement. Simply put, according to the not fully disciplined by market clearing condi- terms-of-trade theory, negotiations over tariffs tions, shallow integration can no longer achieve alone, coupled with an effective “market access internationally efficient policies. Although the preservation rule” that prevents governments 1 At a conceptual level, this resonates with the approach * Antràs: Harvard University, Cambridge, MA e-mail: taken by the General Agreement on Tariffs and Trade (GATT) [email protected] ; Staiger: University of Wisconsin,( and, to a lesser extent, by the WTO to behind-the-border Madison, WI e-mail: [email protected]) . We thank Kyle policies,( wherein negotiations focus )on tariff reductions as Bagwell, Arnaud( Costinot, and Michele )Ruta for helpful a means to expand market access, and where various GATT comments. provisions such as GATT’s “nonviolation” clause are then † To view additional materials, visit the article page at meant to protect( the value of negotiated market access) agree- http://dx.doi.org/10.1257/aer.102.3.470. ments against erosion by behind-the-border policies. 470 VOL. 102 NO. 3 TRADE AGREEMENTS AND PRICE DETERMInatION 471 simple models we develop below are special Welfare levels are given by the sum of con- along several dimensions, in a longer version of sumer and producer surplus and net tax revenues this paper, Antràs and Staiger 2012 , we show in addition to labor income : ( ) ( Λ) that our main results apply in much more general _p ​ environments. We refer the reader to this longer W 1 2 D p dp D p 2; paper for the derivations of our main results. = Λ + ( / ) p ( ) + τ ( ​ )/ ∫ _p ​ I. Perfect Competition W * 1 2 D p dp * s* , p * = Λ + ( / ) p * ( ) + π ( ​​ ) We consider first a two-country Home/Foreign ∫ partial-equilibrium perfectly competitive trade * D p 2 s* L * s* , p * , + ​τ ( ​ )/ − ( ​​ ) model in which Foreign denoted with a “*” exports a single good to Home.( In particular, we) where we have suppressed the dependence of ​ p assume that there is a measure 1 2 of consumers and p * on s* and * to save space. at Home with demand D p , a /measure 1 2 of We consider (τfirst + τ ) the efficient policies, ( ) * / W * consumers in Foreign with demand D p , and which maximize W W W . Letting a measure 1 of firms in Foreign with( produc) - T * , it is straightforward = + to show that tion technology y* F L* , with F L* 0, W≡W is(τ only + τ a) function of the aggregate trade tax F L* 0, and Inada= ( conditions) ′( holding. ) > T and the labor subsidy s* . The efficient choice Finally,″( ) < there is a measure of workers in of these instruments must then satisfy the first- each country that are paid a wageΛ of 1 with a order conditions W W T 0 and W W s* numeraire good entering linearly into ( utility 0, which yield ∂ /∂ = ∂ /∂ and closing our partial equilibrium model in the = usual way . T e 0, s*e 0. We suppose) that the Home government has = = an import tariff , while the Foreign government That the efficient policies in this setting corre- has both an exportτ tax * and a labor subsidy s* spond to laissez-faire should come as no sur- applied only to the export ​τ sector . All policies prise, as there are no frictions in our competitive are( defined in specific terms. Markets) are inte- model. grated and so the wedge between foreign and The noncooperative Nash policies are deter- domestic prices satisfies p p* * for mined by the three first-order conditions nonprohibitive tariffs. Throughout, = + (weτ + assume τ ) W * * 0, W * s* 0, and W 0. that governments are social welfare maximizers, Manipulating∂ /∂ ​τ = the∂ first /∂ two = first-order∂ /conditions,∂ τ = but none of our results depend on this. which determine the Foreign best-response poli- The competitive production sector in Foreign cies to any Home tariff, yields hires labor to maximize profits and thus solves *R *R p M, s 0, * * * * * * ​τ = ​ / η = L arg max p F L 1 s L , = { π = ( ) − ( − ) } where M is the elasticity of Home import yielding the first-order condition p* F L * demandη defined positively and so *R is the 1 s* , and implying L * s* , p* , and hence′( ) Johnson optimal terms-of-trade–manipulatingτ y= * s* ,−p * F L * s* , p* . The( )international export tax defined for a specific tariff. Turning market ( clearing) ≡ ( condition( )) is then to the Home best-response tariff, the associated first-order condition can be manipulated to yield y * s* , p* D p* * 2 D p* 2, ( ) = ( + (τ + τ ))/ + ( )/ R * * p , E determining the market clearing foreign τ = ​​ / η ​ * * * * * * price p s , . We then have ​ p s , where E is the elasticity of foreign export sup- p * s* ,( τ +* τ ) * . Notice that( τthe + for τ )- ply andη so R is the Johnson optimal import tar- eign≡ ​​ (and τ domestic + τ ) + local(τ + prices τ ) are functions of iff defined τfor a specific tariff. * * N * * *N the sum of tariffs only, as are ​​ L and y . We will Nash policies are p E , p M, use this property shortly when we solve for the and s*N 0 where allτ prices = ​​ and/ η elasticitiesτ = ​ / ηare efficient tariffs. evaluated = at (the Nash policies . Notice that the ) 472 AEA PAPERS AND PROCEEDINGS MAY 2012 sum of the Nash tariffs is strictly positive, and market-access preservation constraint subse- so Nash tariffs are inefficiently high T N T e , quent to its tariff negotiations with Home, the ( > ) * * but the Foreign Nash subsidy is set at its efficient Foreign choices of and s will then satisfy the level s*N s*e . As a consequence, the funda- following first-orderτ condition: mental( inefficiency = ) for a trade agreement to correct in this setting is the unilateral incentive * * * d ​ p d s* d W W W ​ / 0, for each government to manipulate the terms of _d s* = ​ _∂ s* − ​ _∂ * _d ​ p d * = trade with its tariff choice. But Foreign could in ∂ ∂ τ / τ * * * principle use both and s to alter its terms of with W evaluated at 0. Straightforward trade. Why, then, isτ s * left undistorted from its manipulations establish τthat = this equation can internationally efficient level in the noncoopera- only hold if s*R 0. Hence, with 0, the tive Nash equilibrium? The simple reason is that market access constraint = will induceτ =Foreign * * the tariff is the first-best instrument for manipu- to select the combination 0 and s 0 to lating the terms of trade in this environment, and meet the market access constraintτ = and deliver= hence with the Foreign Nash tariff set to achieve the efficient trade volume, so that “shallow” this purpose, there is no need for Foreign to dis- negotiations designed in this way will achieve tort any other policy choices to engage in terms- the efficiency frontier.