The role of side payment requirements in free trade negotiations under asymmetric information

Abstract

Recent free trade agreements (FTAs) have two outstanding features: they have been drawn among countries with different market size, and relatively small market-sized countries have offered implicit side payments (i.e. concessions pertaining to non-trade aspects). The present study examines FTA negotiations between two asymmetric market-sized countries (one large and the other small) in which the former is unaware of the latter's demand and is allowed to require the latter to transfer side payments. The analysis clarifies that the side payments required by the large country depend on its beliefs about the small country's demand. If the large country expects that the small country's demand is sufficiently high, the FTAs derived from the former's requirement for moderate side payments could be either building blocks or stumbling blocks to global free trade, depending not only on each country's relative market size but also on the required side payments. Otherwise, the large country's requirement for huge side payments leads to or prevents FTAs that serve as stumbling blocks to global free trade, depending on the small country's actual demand.