Profit Shifting and Trade Agreements in Imperfectly Competitive Markets

Abstract

Governments have a reason to form a trade agreement when an international externality is associated with their trade-policy choices. When countries are large, if a government raises its import tariff, the world (offshore) price of the imported good is reduced. The importing country then enjoys an improvement in its terms of trade, and the exporting country suffers a negative terms-of-tradeexternality.AsJohnson(1954)argues,whengovernmentsmaximizerealnational income and markets are perfectly competitive, the associated noncooperative equilibrium is inefficient, and governments can achieve greater welfare by forming an appropriately designed trade agreement. Bagwell and Staiger (1999) and Grossman and Helpman (1995) extend the modeling framework to allow that governments have political‐economic preferences. Allowing for a wide range of possible political‐economic motivations, Bagwell and Staiger (1999) show that the noncooperative equilibrium is inefficient if and only if governments are motivated by the terms-of-trade consequences of their trade policies. Building from this finding, they then characterize the form that an efficiency-enhancing trade agreement might take. They show that the principles of reciprocity and nondiscrimination (the latter embodied in the most-favorednation [MFN] obligation) play a useful role in guiding governments toward efficient policies. In this article, we move beyond the competitive-markets paradigm and expand the analysis to markets with imperfect competition, thereby introducing the realistic possibility that firms have market power. A firm with market power is itself “large” in the sense that it does not regard the market price as fixed; instead, such a firm recognizes that its decisions may influence the price at which its output sells. The terms-of-trade externality is still present in markets with imperfectcompetition,butthewell-known“profit-shifting”rolefortradepoliciesinimperfectly competitive markets suggests that other international externalities might also be present. For a sequence of workhorse models with imperfectly competitive markets, we examine the rationale foratradeagreementandconsidertheformthatanefficiency-enhancingtradeagreementmight take.