The Self-Enforceability of Trade Agreements in the Presence of Trade Costs

This paper sets up a two-country model of oligopoly to analyze the relationship between trade costs and trade policy cooperation. Acting non-cooperatively, the two countries are caught in a prisoner’s dilemma in which import tariffs are used to improve one country’s terms of trade and to shift profits towards its domestic market at the expense of the other. The incentive to do this is higher when trade costs are lower. Cooperative trade policy, on the other hand, is concerned with minimizing losses in transit, such that internationally efficient tariffs are lower when trade costs fall. Hence, there is a conflict of interest between unilateral and cooperative trade policy in response to reductions in trade costs. I then analyze trade policy cooperation which must be sustained by a reputation mechanism. I first demonstrate that, provided the two countries care sufficiently about the future, lower import tariffs are more self-enforceable when trade costs are lower. I also find that global free trade can be supported for a larger range of discount factors in response to falling trade costs, provided firms interact strategically.