Cross-country Productivity Heterogeneity, Trade Agreement, and the Quest to Free Trade

Abstract

In the first essay, I study the role played by cross-country productivity heterogeneity in affecting the formation of global free trade. My model extends the three-country endowment model of Bagwell and Staiger (1999) by introducing production and productivity heterogeneity across countries. There are two main findings: (i) global free trade is the only equilibrium in the case of symmetric productivity; (ii) the bilateral free trade between two similarly-productive countries can be in equilibrium in the case of asymmetric productivity. I study two special trading cases of productivity asymmetry: (i) one highly-productive country and two low-productive countries and (ii) two highly-productive countries and one low-productive country. I find that in both cases when the degree of productivity asymmetry is too large, in equilibrium, only the two similarly-productive countries will form a bilateral free trade agreement. In the second essay, I study the role played by bilateralism (i.e. discriminatory tariff policy) under a condition of asymmetric productivity across countries in affecting the formation of global free trade. I show that global free trade is the only equilibrium in the case of symmetric productivity no matter if bilateralism is prohibited, or not. However, in the case of asymmetric productivity, the consent of bilateralism will either help or hinder the formation of global free trade. I study two special cases: (i) one highly-productive country and two low-productive countries and (ii) two highly-productive countries and one low-productive country. I find that in the case of two highly-productive countries and one low-productive country, the consent of bilateralism can help the formation of global free trade; but in the case of one highly-productive country and two low-productive countries, the consent of bilateralism can prevent the formation of global free trade. In the third essay, I study the role played by custom unions under a condition of asymmetric productivity across countries in affecting the formation of global free trade. I find that the consent of custom unions can always help achieve the global free trade. I also study the case of that custom unions and bilateral free trade agreement are both available. Bilateral free trade are always preferred to custom unions. The role of productivity asymmetry in the case of custom unions is same with that in the case of bilateral free trade: as the productivity asymmetry level is too large, only the custom union formed between two similarly-productive countries is the stable equilibrium.