Equilibrium coalition structures in the presence of foreign direct investment

Abstract

This paper incorporates foreign direct investment (FDI) into the examination of trading bloc formation with endogenously determined coalition structures. In so doing, we build a three-country model, in which firms serve foreign markets either by exporting or undertaking FDI, and consider a coalition formation game with the Coalition Proof Nash Equilibrium as an equilibrium concept. We find that the equilibrium coalition structure varies upon firms characterization before and after the formation of a trading bloc. As in the literature, when all firms are exporters in the pre- and post-formation, bilateralism can be an equilibrium outcome. However, when trade barriers are not so high as to be trade-prohibitive and the environment is favorable to multinational activities in the pre- or post-formation, only global free trade will prevail as an equilibrium coalition structure.