Preferential trade liberalization with endogenous cartel discipline: Implications for trade and welfare

Abstract

We consider an international cartel whose members interact repeatedly in their own as well as in third-country markets. Cartel discipline—an inverse measure of the degree of competition between firms—is endogenously determined by the cartel's incentive compatibility constraint, which strategically links markets that are otherwise independent. This linkage implies that trade cost reductions induce cartel members to adjust their sales, not only because of direct but also because of spillover effects. We apply these ideas to preferential trade agreements and show that the indirect effects can give rise to trade diversion. We also characterize the welfare effects of preferential tariff cuts for all countries and identify circumstances under which preferential trade liberalization is welfare-reducing.