Abstract

We examine the implications of a customs union (CU) on the pattern of tariffs, welfare and the prospects for free trade when the nonmember firm has an incentive to engage in foreign direct investment (FDI). First we show that upon the formation of a bilateral CU, the non-member firm has greater incentives to engage in FDI. However, when FDI becomes a feasible entry option for the nonmember firm under a CU, member countries have incentives to strategically induce export over FDI by lowering their joint external tariff. When fixed set-up cost of FDI is sufficiently low, this tariff falls below Kemp-Wan tariff and CU leads to a Pareto improvement relative to no agreement. Moreover, using an infinite repetition of the one-shot tariff game under a CU, we show that FDI incentive of the nonmember firm makes the member countries (nonmember country) more (less) willing to cooperate multilaterally over free trade.<div><br></div><div>Keywords: Customs Union, Foreign Direct Investment, Multilateral Tariff Cooperation</div>

Highlights

  • Over the last few decades, the proliferation of preferential trade agreements (PTAs) has been the visible trend in the international trading system

  • The present paper examines the case where the formation of a customs union (CU) gives a nonmember ...rm an incentive to engage in foreign direct investment (FDI) in member countries’markets while this incentive does not exist under no agreement.[3]

  • When ...xed set-up cost of FDI is su¢ ciently low, this tari¤ falls below Kemp-Wan tari¤ (1976) and CU leads to a Pareto improvement relative to no agreement

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Summary

Introduction

Over the last few decades, the proliferation of preferential trade agreements (PTAs) has been the visible trend in the international trading system. PTAs, by eliminating tari¤s among members, lead to an expanded market and increase the incentives of nonmember countries’...rms to penetrate into the integrated area via FDI by building a plant in one of the member countries and producing output that will be sold in all member countries’markets.[2] Based upon this observation, the present paper examines the case where the formation of a customs union (CU) gives a nonmember ...rm an incentive to engage in FDI in member countries’markets while this incentive does not exist under no agreement.[3]. On the other hand, when the non-member country’s ...rm has an incentive to engage in FDI and multilateral cooperation breaks down, member countries internalize the potential FDI threat and lower their external tari¤s on nonmember’s export forever We argue that the non-member ...rm’s FDI incentives make the member countries (nonmember country) more (less) willing to cooperate multilaterally over free trade

Basic Model
No Agreement hf gi
Customs Union (CU) hfijgi
No FDI Incentives: F F u
FDI Incentives under a CU: F u > F F
Multilateral Cooperation under a CU
FDI Incentives: F u > F F
Conclusion
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