Offshoring and the Value of Trade Agreements

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Abstract:

We study the trade policy choices of governments in an environment in which some of the trade ‡flows being taxed or subsidized involve the exchange of customized inputs, and the contracts governing these transactions are incomplete. We show that the second-best policies that emerge in this environment entail free trade in fi…nal goods but not in intermediate inputs, since import or export subsidies targeted to inputs can alleviate the international hold-up problem. We next show that the Nash equilibrium policy choices of governments do not coincide with internationally efficient choices, and that the Nash policies imply an inefficiently low level of intermediate input trade across countries. The reason is that in our environment trade policy choices serve a dual role: they can enhance investment by suppliers but, because of ex-post bargaining over prices, they can also be used to redistribute pro…ts across countries. The inefficiencies inherent in the Nash policy choices of governments not only result in suboptimal input subsidies, but also in positive distortions in fi…nal-good prices, even when countries cannot affect world (untaxed) prices in those goods. As a result, an international trade agreement that brings countries to the efficiency frontier will necessarily increase trade in inputs, but it may require a reduction in …final-goods trade. When governments are not motivated by the impact of their policies on ex-post negotiated international input prices, the resulting policy choices are efficient, and hence a modifi…ed terms-of-trade interpretation of the purpose of trade agreements can be offered, but only when governments maximize real national income. If governments preferences are sensitive to political economy (distributional) concerns, the purpose of a trade agreement becomes more complex, and cannot be reduced to solving a simple terms-of-trade problem.

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