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&Blackwell Publishers Ltd 2002. Published by Blackwell Publishers, 108 Cowley Road,Oxford OX4 1JF, UK and 350 Main Street, Malden MA 02148, USA. 259
HARMONIZING EXTERNAL QUOTAS IN AN FTA:A STEP BACKWARD?
OLIVIER CADOT, JAIME DE MELO, AND MARCELO OLARREAGA*
This paper explores how political-economy forces shape quantitativebarriers against the rest of the world in an FTA. We show that whereasthe dilution of lobbying power in an FTA typically leads to a relaxation ofexternal quotas, this result is likely to be overturned as integration deepens.In particular, we show that cooperation among member countries on thelevel of their external quotas, cross-border lobbying by import-competinginterests in the free-trade area, and the consolidation of national externalquotas into a single one, all lead to stiffer restrictions against imports fromthe rest of the world. We also show that, unlike tariffs, endogenous quotasare not crucially affected by the presence of rules of origin.
1. INTRODUCTION
IN SPITE of the failure to launch a new round of trade negotiations in Seattle in
December 1999, the multilateral trading system remains very strong – perhaps
stronger than ever – in its capacity to prevent discriminatory treatment, to settle
disputes, and to promote gradual trade liberalization. At the same time,
regionalism is also thriving: the European Union is – so far successfully –
managing unprecedented ‘‘deepening’’ and enlargement, while Mercosur and
other regional agreements are faring better than earlier South–South agree-
ments. Is the second of these trends (regionalism)1 reinforcing or sapping the
first (multilateralism)? A voluminous and growing literature has so far provided
an ambiguous answer (see the recent surveys by Winters, 1996; Frankel, 1997;
Panagariya, 1999, 2000; see also the edited volumes by de Melo and Panagariya,
1993; Anderson and Blackhurst, 1993; Bhagwati and Panagariya, 1996a; and
Bhagwati et al., 1999). Over time, concerns expressed in the literature have
ECONOMICS AND POLITICS 0954-1985
Volume 14 November 2002 No. 3
*We are grateful to Rupa Duttagupta, Aaditya Mattoo, Maurice Schiff, participants at seminars atthe WTO and the World Bank, two anonymous referees, and the editors for very helpful comments.An earlier version of this paper was written while Cadot was at INSEAD and was financed undergrant 2010-5308 R. The views expressed are those of the authors and do not necessarily reflect those ofthe institutions to which they are affiliated. Contact addresses: Olivier Cadot, HEC, University ofLausanne, 1015 Dorigny, Switzerland, CERDi and CEPR. E-mail: olivier.cadot@hec.unil.ch.Jaime de Melo, University of Geneva, 102 bd Carl Vogt, 1211 Geneva 4, Switzerland, CERDi andCEPR. E-mail: jaime.demelo@ecopo.unige.ch. Marcelo Olarreaga, The World Bank, 1818 H Street,NW, Washington, DC 20433, USA, and CEPR. E-mail: molarreaga@worldbank.org.
1Although we use here the term ‘‘regionalism’’, the expression ‘‘preferential trade agreements’’ is abetter characterization of the type of arrangements we are dealing with in this paper, as some of them,like the US–Israel FTA, have little ‘‘regional’’ dimension. We are grateful to J. Bhagwati forattracting our attention to this point.
shifted from what Bhagwati and Panagariya (1996b) called the static Vinerian
analysis of trade diversion to other issues. First, a growing number of
overlapping preferential trading agreements (PTA) and the resulting criss-
crossing rules of origin have generated what Jagdish Bhagwati aptly called a
‘‘spaghetti’’ problem. Second, a number of authors have analyzed ‘‘dynamic
time-path’’ issues (the expression is from Bhagwati et al., 1999) including
whether PTAs will tend to expand by opening up to new members (on this, see
inter alia Baldwin, 1996; Levy, 1997; or Krishna, 1998). Third, how PTAs affect
the incentives of member countries in setting external trade barriers against non-
members has been explored in a number of papers (see e.g. Richardson, 1993,
1994, 1995; Grossman and Helpman, 1995; Panagariya and Findlay, 1996; or
Cadot et al., 1999, 2001). The present paper is a further contribution to this third
strand of the literature. If a wealth of theoretical arguments suggest potential
sources of conflict between regionalism and multilateralism, sources of
complementarity have also been identified, and both the empirical and historical
evidence are somewhat ambiguous.2 As long as the debate is not finally settled
one way or another – and it may never be: in Frankel’s words (1997, p. 226),
‘‘trading blocs have both building-block attributes and stumbling-block
attributes’’ – further work is needed on particular aspects of the interaction
between preferential trade liberalization and the incentives to seek protection
against non-members. In this perspective, the present paper examines the effect
of harmonizing quantitative restrictions (QR) within a trading bloc on the
endogenous level of the bloc’s external QRs.
How important are quantitative restrictions? There is little doubt that one of
the Uruguay Round’s successes was to contribute to a general reduction in their
use as a trade policy instrument, in particular by industrial countries. However,
in spite of efforts toward the ‘‘tariffication’’ of agricultural QRs and the planned
phasing out of Multi-Fiber Agreement (MFA) quotas in textile and clothing,
they are still widespread. Tariff-quotas are still important in agriculture
(Hathaway and Ingco, 1996). In textiles and clothing, although industrial
countries are formally on schedule in meeting their obligations under the
Uruguay Round, the selective elimination of QRs on categories that account for
a small share of textile trade means that, of the 35 percent elimination of QR
incidence that should logically have been completed by January 1998 under the
planned phasing-out of the MFA, only 1 percent had actually been achieved in
the US at that date (see Finger and Schuknecht, 1999, for details). Also, many of
the special actions allowed under the General Agreement on Tariffs and Trade
(GATT) authorize the use of QRs (e.g., safeguards and balance of payments
measures).3 Voluntary Export Restraint (VER) agreements, a form of QR, have
260 CADOT, DE MELO, AND OLARREAGA
2On the empirical evidence, see Frankel (1997) and references therein; on the historical evidence,see Irwin (1993).
3Many of the restrictions allowed in the General Agreement on Trade in Services (GATS) can alsobe seen as quantitative restrictions; for example, quotas for foreign maritime transport or for foreigncultural products (see Mattoo, 2000).
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also been negotiated under the threat of antidumping measures, as was the case
in March 1999 between the US and Brazil. Thus, notwithstanding commendable
efforts to get rid of QRs, their prevalence simply cannot be overlooked.
When QRs are in use, their harmonization can be a significant step in the
deepening of regional integration. In Europe, for instance, progressive QR
harmonization was undertaken as part of the 1992 Single Market program and
involved the dismantling of national QRs that member countries had hitherto
maintained under the umbrella of Article 115 of the Treaty of Rome (see
Schuknecht, 1992). In the automobile sector, drastic harmonization led the
European Commission to negotiate with Japan the complete phase-out by 1999
of a web of bilateral quotas and VERs, including the extremely restrictive Italian
and French ones. In the much-publicized case of bananas, by contrast,
harmonization took a more protectionist turn, as Germany was unable to
retain the free-trade regime that it had secured under the special ‘‘banana
protocol’’ of the Treaty of Rome. The European banana regulation led to a
series of complaints, first at the GATT, then at the WTO, which the European
Union lost (see, e.g., Schohe, 1997, or Cadot and Webber, 2002). The
automobile and bananas examples show just how diverse the outcomes of QR
harmonization can be. The question of this paper is whether, in general, the
harmonization of national QRs in a trading bloc and their ultimate
consolidation into a single area-wide external QR should be expected to
reinforce or weaken the political pressure for protection against non-members.4
In the case of tariffs, whether internal free trade, in the form of a Free Trade
Area (FTA) or Customs Union (CU), would reduce or enhance political
pressure for external protection was first explored formally by Richardson
(1993, 1995). Both papers argued that FTAs are more likely to bring external
tariff reductions and highlighted the importance of tariff revenue considerations
behind this result. In Richardson (1993), he argued that the importing country in
an FTA would tend to reduce its external tariff if competition within the FTA
reduced the domestic price, thus making a high external tariff redundant. By
lowering its external tariff, the importing country would raise revenue from rest-
of-the-world imports instead of transferring the rent to exporters in the FTA
partner. In Richardson (1995), he also highlighted the role of competition for
tariff revenue within an FTA as a force that could lead to the complete
elimination of external tariff barriers. By lowering its tariff below the partner’s
level in an FTA a country could raise tariff revenue not only on its imports, but
also on (part of ) its partner’s deflected imports. In equilibrium these incentives
could lead to the complete elimination of external tariffs by both countries. We
proposed a generalization of Richardson’s analysis in Cadot et al. (1999), where
we assessed the different political-economy forces released by preferential trade
HARMONIZING QUOTAS 261
4The mirror question is whether the existence of QRs rather than tariffs makes regional integrationmore feasible. This is explored in Panagariya and Duttagupta (2000) within a political-economysetting.
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liberalization under FTAs and CUs. But as tariff-revenue competition is unlikely
to play a crucial role in actual policy-making – at least in industrial countries –
its importance in the game-theoretic analysis of tariff equilibria is a somewhat
unappealing feature. QRs are more well-behaved in this regard as they do not
create the kind of discontinuity in payoffs which are encountered with tariffs.
That is, whereas a country reducing its external tariff to just below that of its
FTA partner will see its imports (and consequently tariff revenue) jump up by a
discrete amount, the same does not apply to QRs, as the point of equality of
external QRs has no special significance. Thus, the analysis of QRs is both
empirically relevant and analytically better suited to the understanding of
strategic interaction between FTA partners.
We tackle this question using the Grossman–Helpman (1994) model of
influence activities, in which lobbies representing owners of specific factors in a
Ricardo–Viner economy face the government with contribution schedules
conditioned on the vector of trade-policy instruments (here, the vector of quotas
in import-competing sectors). Under Bernheim and Whinston’s (1986)
‘‘truthfulness’’ restriction, the derivative of a lobby’s contribution function is
the derivative of the industry’s profit function; thus, the political equilibrium is
directly related to some of the economy’s fundamentals (e.g. import-demand
elasticities, levels of domestic output, or the fraction of quota rents retained by
the importing country).5 Unlike Syropoulos (1999), who considers strategic
interaction between a trading bloc and the rest of the world, we focus our
analysis on what happens inside the bloc. Internal trade liberalization in the bloc
induces a reallocation of real resources. This reallocation also redistributes the
cards politically: winning sectors are better able to lobby for external protection,
losing sectors less so. If the winning sectors happen to be those that compete
with the rest of the world, external protection will go up.
We consider first the pure effect of the elimination of internal trade barriers in
an FTA on the external quotas of member countries. That is, we suppose at this
stage that member countries keep independent external quotas and set them
non-cooperatively (the import-competing good’s domestic price is common to
the free-trade area, though, because barriers to internal trade have been
removed). In this context, we show that member countries endogenously choose
to relax their external quotas compared to their pre-FTA levels. The reason is
that in an FTA, the effect of a given change in a member country’s external
quota on the import-competing good’s domestic producer prices is less than
before the FTA’s formation, because the domestic price is determined in a larger
area after the FTA’s formation. This cuts the marginal benefit of the quota
change for the import-competing lobby, thereby reducing the incentive to lobby.
However, as integration deepens, taking the form of a cooperative determination
262 CADOT, DE MELO, AND OLARREAGA
5Given that lobbying here only implies an income transfer from the firm to the government, anddoes not imply any use of productive resources, there is no possibility for lobbying to paradoxicallylead to higher levels of welfare as it draws away resources from the import-competing sector (seeBhagwati and Srinivasan, 1980, 1982).
&Blackwell Publishers Ltd 2002.
of external quotas, and ultimately of their consolidation into a single one, we
show that this pro-free-trade effect is reversed. The reason is that cooperation
and deeper integration enable lobbies to internalize a ‘‘protection spillover’’
(namely, when member country i tightens its external quota under pressure from
its domestic import-competing lobby, the price rises in the whole area, benefiting
import-competing lobbies in other member countries as well), leading to tighter
external quotas.
The paper is organized as follows. Section 2 sets up the model; section 3
derives basic results that hold in the context of symmetric countries. Section 4
extends the model to asymmetric countries and explores the role of rules of
origin. Section 5 concludes.
2. THE MODEL
Three countries, A, B, and C, produce and consume three tradable goods,
labeled respectively one, two and three, and a non-tradable, labeled zero, which
serves as numeraire. Each country is the least-cost producer – and hence the
exporter – of one of the three tradables: A of one, B of two, and C of three, so
that international trade follows the ‘‘Meade pattern’’ (Meade, 1955); however,
none is specialized in either production or consumption. All tradable-good
sectors use specific capital and intersectorally mobile labor, while the non-
tradable-good sector uses only labor under constant return to scale; thus, the
wage rate is fixed at the level of its productivity in the non-tradable sector.
Consumers in all countries have identical preferences represented by the quasi-
linear and additive function
U ¼ c0 þX3
k¼1
uðckÞ, ð1Þ
where the function u satisfies the usual properties.
To avoid the complexities arising when terms of trade are endogenous (see,
e.g., Grossman and Helpman, 1995), we assume that all countries are small;6
moreover, the rest of the world, which we call ‘‘C’’, is itself an aggregate of small
countries; thus, strategic interaction is limited to A and B, in which trade policy
is determined a la Grossman–Helpman (1994). That is, lobbies representing the
residual claimants of import-competing sectors (there are two of them in each
country) simultaneously face their government with ‘‘truthful’’ (Bernheim and
Whinston, 1986) political contribution schedules conditioned on the vector of
HARMONIZING QUOTAS 263
6As shown by Syropoulos (1999), the introduction of terms-of-trade effects as determinants ofprotection may introduce some ambiguity in our results regarding the relative levels of protectionbetween CU and the pre-FTA situation. On one hand, a CU will internalize terms-of-tradeexternalities, and that will induce it to adopt a more aggressive external trade policy. On the otherhand, trade diversion generated by the CU’s internal trade liberalization raises the price elasticity ofthe ROW demand for its exports. This second effect may more than compensate the first and result ina CU with a lower level of protection.
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trade-policy instruments.7 The government, acting as the lobbies’ common
agent, chooses its trade policy in order to maximize a weighted average of
political contributions and aggregate welfare. Trade policy consists of non-
discriminatory quotas on import goods (goods two and three in A, and goods
one and three in B); by ‘‘non-discriminatory,’’ we mean that import licenses do
not restrict the origin of imported goods subject to quotas. Export taxes and
subsidies are ruled out.
In this setup, each lobby is concerned exclusively with the protection it can
obtain for itself, regardless of the protection simultaneously sought by other
sectors, so that the common agency problem degenerates into a simpler
collection of separate principal–agent relationships.8 All world prices are
assumed to be unity. Let pi ¼ ðpi0, : : :, pi3Þ be the vector of domestic prices in
country i; as each country exports one tradable good, two of the elements of pi
must be unity: namely, pA0 and pA1 in A, and pB0 and pB2 in B. Let qi be the two-
dimensional vector of i ’s import quotas: thus, qA ¼ ðqA2 , qA3 Þ and qB ¼ ðqB1 , q
B3 Þ;
let also Ki be the set of i ’s import goods. We assume that a uniform fraction
b 2 ð0, 1Þ of quota rents is retained by importing countries and redistributed
lump-sum to domestic residents. That quota rents be retained, at least in part, by
the importing country is crucial to the calculus, as it is a necessary condition for
the government’s optimization problem to have an interior solution in any QR
setting. However, by virtue of our ‘‘double-smallness’’ assumption (namely, that
owners of specific capital in import-competing industries, i.e. lobbies, are small
in the population, and that countries A and B, whose trade policy we are
interested in, are small compared to the collection of countries aggregated in
‘‘C’’), we do not have to worry about the effect of retained quota rents on the
incentive to lobby, nor about the effect of unretained quota rents on ROW
welfare. In practice, arrangements on the sharing of rents generated by QRs
differ. In VERs, the rents are retained by exporters; indeed, it is often argued
that those rents are what ‘‘buys’’ the consent of the exporting parties in such
arrangements. By contrast, when import licenses are auctioned out, the rents are
retained by the importing government.
Because preferences are additive and quasi-linear and the wage rate is fixed,
unconstrained expenditure and revenue functions can be used, with the
understanding that the domestic price of good k is a function of the import
quota. For country i, these two functions are respectively Eiðpi, WiÞ and
Riðpi, liÞ, where Wi is i ’s welfare and li its labor endowment. Finally, mikðpikÞ is
country i ’s import-demand function in sector k. The government’s problem is:
264 CADOT, DE MELO, AND OLARREAGA
7We assume that specific-factor ownership is sufficiently concentrated to ensure that lobbiesdisregard the effect of trade barriers on the price index; moreover, labor is not represented in thelobbying process. See Cadot et al. (1997) for a discussion and extensions.
8 For models with lobby interaction and second-best policy formulation, see Grossman andHelpman (1994) and Cadot et al. (1997). For the problem at hand, such issues are peripheral.
&Blackwell Publishers Ltd 2002.
maxqiV i �
Xk2Ki
CikðqikÞ þ aW
i ð2Þ
subject to
Eiðpi, WiÞ ¼ Riðpi, liÞ þ bXk2Ki
ðpik � 1Þqik, ð3Þ
mikðpikÞ ¼ q
ik 8k 2 Ki, ð4Þ
where a is a constant assumed common to all countries. Along (4), dq ik ¼
ðmikÞ0dpik, whereas, along (3), dWi ¼ ½ðb� 1Þqik=ðm
ikÞ
0þ bðpik � 1Þ�dq ik. (The last
expression makes use of the fact that @Ei=@Wi ¼ 1 under quasi-linear
preferences and of the fact that the price of the good entering the utility
function additively is taken as the numeraire.) Substituting these, using the fact
that mik ¼ qik, and applying Bernheim and Whinston’s (1986) ‘‘truthfulness’’
property whereby @Cik=@qik ¼ @pik=@q
ik, we obtain the first-order condition
corresponding to problem (2)–(4):
@Vi
@qik�
@pik@qik
þ a@Wi
@qik¼yik � að1� bÞq
ik
ðmikÞ
0 þ abðpik � 1Þ ¼ 0, ð5Þ
where yik is the output of sector k in country i. As abðpik � 1Þ > 0, it follows that,
at the optimum,
ffik � ½yik � að1� bÞqik�=ðm
ikÞ
0 < 0. ð6Þ
Expression ffik will be useful later on when comparing quota levels before and
after an FTA. The second-order condition is ½ðyikÞ0=ðmikÞ
0þ að2b� 1Þ � ffikðm
ikÞ
00�=
ðmikÞ0 < 0; it is verified provided that the fraction of quota rents retained by the
importing country, b, is at least one-half and that a is sufficiently large. For
instance, with linear demand and supply functions ½ðmikÞ
00¼ 0�, if b ¼ 1 then the
second-order condition boils down to a > jðyikÞ0=ðmikÞ
0j > 0: We assume from
now on that the second-order condition is satisfied.
Let qq ik be the solution to (5). Its comparative-statics properties are
straightforward. Given that the second-order condition holds, @qqik=@a has the
sign of the cross-partial derivative
@2Vi
@qik@a¼ �
ð1� bÞqikðmikÞ
0 þ bðpik � 1Þ > 0.
In accordance with intuition (since A and B, being small countries, have nothing
to gain, in aggregate, from trade protection) a higher value of the weight on
welfare in the government’s objective function leads to a relaxation of the
optimum quota. Conversely, a parametric increase in the level of good k’s
domestic output yik would lead to a tightening of the quota on good k: this is
because an increase in the domestic output of good k raises sector k’s incentive
to lobby for a higher domestic price – or, equivalently, for a tighter quota.
HARMONIZING QUOTAS 265
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3. EXTERNAL QUOTAS IN AN FTA
Supposenow thatA andB formanFTAwherebyA eliminates its quota on imports
of good two from B, while B eliminates its quota on imports of good one from A.
Meanwhile, both determine their external quotas on imports of good three fromC
independently, at a new level which reflects the change in trade flows triggered by
the FTA. Two questions arise: First, if A and B determine their quotas non-
cooperatively, how does the presence of regional free trade affect the optimal
level of their quotas on the area’s import good (good three)? Second, would
cooperation in the determination of A and B’s national quotas – a step forward
in regional integration – make them more or less protectionist vis-a-vis the rest
of the world? These two questions are tackled in the following two sections.
As far as external quotas are concerned, the action is confined to sector three,
which competes in A and B with imports from the rest of the world. Therefore,
the game played after the formation of an FTA has only four players: the lobbies
representing sector three in A and B respectively, and the two governments. In
the first stage, the lobbies set their contribution schedules; in the second stage,
the two governments set external quotas that are best responses vis-a-vis each
other given their domestic lobby’s contribution schedule. In the game’s simplest
form, the import-competing lobby of each member country takes the other
member’s policy decision as given. Therefore, q j enters as a parameter in the
contribution function of i ’s lobby, but i ’s lobby does not attempt to influence it.
As integration deepens, each country’s lobby may carry out influence activities
in the partner country or, alternatively, members may cooperate to harmonize
their external quotas. Ultimately, economic integration may lead to a complete
harmonization of external trade barriers, with lobbies in both countries merged
into one big lobby spanning the entire area. Each of these possibilities is
considered in the following subsections.
3.1 Non-cooperative FTA
When two countries form an FTA, their ability to keep external trade barriers at
unequal levels creates opportunities for arbitrage, as goods originating from the
rest of the world can be imported into the low-protection country and then re-
exported to its more protectionist partner, undermining the effectiveness of the
latter’s external protection. Because of this, FTAs are generally riddled with
rules of origin preventing the transshipment of imported goods through the
area’s internal borders. When external protection takes the form of tariffs, such
rules of origin are crucial because, in their absence, unlimited quantities of
imports could be brought in from the rest of the world for arbitrage purposes
(see Krueger, 1993, and Cadot et al., 1999). By contrast, when external protection
takes the form of quantitative restrictions, rules of origin are less crucial,
because the quantities of foreign goods available for arbitrage are, in any case,
limited. Because such rules introduce significant complications into the analysis
without modifying the main results, we relegate their analysis to the Appendix.
266 CADOT, DE MELO, AND OLARREAGA
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Once A and B liberalize trade in sectors one and two, the only remaining trade-
policy issue is the determination of external quotas (affecting imports from C) in
sector three. In that sector, the optimization problem faced by the government of
each member country is somewhat similar to what it was before the FTA, except
that good three has now a single price p3 in the whole free-trade area, so that
constraint (4) must be suitably modified. Without general-equilibrium interaction
in either welfare or political contributions, the government’s maximization
problem involves only variables pertaining to the area’s import-competing sector
(sector three). This enables us to eliminate sector subscripts, keeping only
country superscripts. Accordingly, country i ’s government (i ¼ A, B) solves
maxqiV i � CiðqiÞ þ aWi ð7Þ
subject to
Eiðpi, Wi Þ ¼ Riðpi, liÞ þ bðp� 1Þqi, ð8Þ
mAðpÞ þmBðpÞ ¼ qA þ qB. ð9Þ
The first-order condition for problem (7)–(9) implicitly defines country i ’s
reaction function in ðqi, q j Þ space:
@Vi
@qi¼yi � aðmi � bqi Þ
ðmAÞ0 þ ðmBÞ0þ abðp� 1Þ ¼ 0. ð10Þ
Let �qqiðq jÞ be the solution to (10). Note that all strategic interaction betweenA and
B takes place through the adjustment of the area’s common price p.9 Condition
(10) differs from (5) in two (related) ways. First,mi can be in excess of qi in (10) if i
also imports from its FTApartner, or less than qi if i re-exports to its FTApartner.
Second, because (4) has been replaced, in (7), by the aggregate relation (9), the first
term’s denominator is now the price derivative of the aggregate import-demand
function. Let us call this first term �ffi, by analogy with (6).
We can now tackle the first question, namely how the FTA affects quota
policy towards the rest of the world. Suppose that A and B are symmetric in the
import-competing sector (we maintain this simplifying assumption throughout
this section, and relax it in subsection 4.2). Under the second-order condition,
the two objective functions VA and VB are globally strictly concave in own
strategies (i.e. in qA and qB respectively); therefore, (10) characterizes the game’s
unique pure-strategy equilibrium.10 Moreover, this unique equilibrium is
HARMONIZING QUOTAS 267
9 It is shown in the Appendix that qA and qB are strategic complements whenever a > 1; however,the results below do not hinge on whether they are strategic complements or substitutes.
10 See Friedman (1986, p. 43). Strictly speaking, (10) characterizes only the equilibrium of thesecond-stage subgame whose strategic variables are the external quotas; a full characterization of thegame’s equilibrium would also involve the contribution schedules. However, ‘‘truthfulness’’ pinsdown the contribution schedules up to a constant (whose role is to determine how the economic rentsgenerated by the quotas are shared between the government and the lobbies). As the policy outcome isunaffected by the rent-sharing issue, we will not provide here a complete characterization of thecontribution schedules (see Grossman and Helpman, 1994; or Cadot et al., 1997).
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symmetric, so after the FTA’s formation, A and B have identical imports and
domestic prices, and (10) simplifies to
@Vi
@qi¼yi � að1� bÞqi
ðmAÞ0 þ ðmBÞ0þ abðp� 1Þ ¼ 0, ð11Þ
which can be readily compared to (5). We will show that the equilibrium
characterized by (11) entails larger (looser) quota levels than before the FTA. To
see this, let bars denote variables evaluated at their post-FTA values, and
suppose that qqi ¼ �qqi. Then qqA þ qqB ¼ �qqA þ �qqB, so ppA ¼ ppB ¼ �pp, and the only
difference between (5) and (11) is that, for any value of qi, ffiðqi Þ < �ffiðqi Þ(because the latter’s denominator is larger in absolute value and both are
negative numbers); but this implies that qqi < �qqi, a contradiction. Thus, qqi 6¼ �qqi;
moreover, as @2Vi=@ðqi Þ2 < 0 at qqi, it follows that qqi < �qqi. Therefore, we have:
Proposition 1. If A and B are symmetric in the area’s import-competing sector,
the formation of an FTA without rules of origin leads them to relax their
external quotas.
Proposition 1 shows that regional trade liberalization creates a force working to
reduce the level of the area’s trade barriers against the rest of the world. The
reason is as follows. A tighter quota benefits the import-competing lobby only
inasmuch as it leads to a higher domestic price. Prior to the formation of an
FTA, the link between the national quota and the domestic price in sector three
was described by (4), along which, omitting again industry subscripts,
dpi ¼ dqi=ðmiÞ0. After the FTA’s formation, the relationship between quota
and domestic price (the domestic price is now common to the entire area) is
described by (9), along which dp ¼ dqi=½ðmAÞ0 þ ðmBÞ0�. Clearly, the marginal
benefit of a tighter quota is reduced in an FTA, because the common domestic
price, being determined in a larger area, is less sensitive to changes in a member
country’s individual quota. This reduces the optimal level of the quota.
This result can be related to earlier ones by Richardson (1994) and Panagariya
and Findlay (1996). Both papers argue that the power of domestic lobbies is
diluted more effectively in a CU than in an FTA because in the former, lobbies
need to capture a larger political constituency in order to influence policy
decisions. Here, the power of the import-competing lobby is diluted even in an
FTA, but the source of the dilution is economic rather than political.
Proposition 1 is also in accordance with the results of Richardson (1995) and
Cadot et al. (1999). Both papers showed that, in the absence of rules of origin,
tariff-revenue competition in an FTA would give rise to a sort of ‘‘Bertrand
paradox’’ in which the only non-cooperative tariff equilibrium would be the
outright elimination of external tariffs by both member countries. Whereas the
real-life importance of tariff-revenue competition can be debated, we show here
that a weaker version of the result – namely, that an FTA without rules of origin
weakens lobbying pressure – still holds true in a setting where member countries
268 CADOT, DE MELO, AND OLARREAGA
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have only quotas and have accordingly no revenue-driven incentive to undercut
each others’ trade barriers.11
3.2 Quota Harmonization and Integration
Consider first the possibility of cross-country influence activities within the area.
If j ’s import-competing lobby can undertake influence activities in i, the political
equilibrium in i is determined by
@ ~VVi
@qi¼
@pi
@qiþ@p j
@qiþ a
@Wi
@qi¼ 0. ð12Þ
Let ~qqi solve (12); as @p j=@qi ¼ y j=½ðmAÞ0 þ ðmBÞ0� < 0 whenever y j > 0, (12)
implies that ~qqi must be lower than �qqi whenever y j > 0. Moreover, under
symmetry and with a common price in the area, we have yA ¼ yB, cA ¼ cB,
whence mA ¼ mB and ðmAÞ0 ¼ ðmBÞ0. Let respectively y, c, m, and m0 denote these
common values. Writing (12) in full, we have
@ eVVi
@qi¼
2y� að1� bÞqi
2m0þ abð p� 1Þ ¼ 0. ð13Þ
In order to compare (13) with (5), let us evaluate (13) at qqi, the solution to (5).
Putting hats on variables evaluated at qqi and taking the difference between the
two first-order conditions, we have�@ eVVi
@qi�@Vi
@qi
�����qqi¼
2yy� að1� bÞqqi
2 bmm0 �yy� að1� bÞqqibmm0
¼ ~ff j � ff j ¼að1� bÞqqi
2mm0< 0,
which implies that ~qqi < qqi: Thus, under symmetry, an FTA with cross-border
lobbying is characterized by an external quota that is not only tighter than that
of an FTA without cross-border lobbying, but also tighter than the pre-FTA
non-discriminatory quota. Intuitively, cross-border lobbying cancels out the
price dilution effect of the FTA formation on firm’s profits. In other words, after
the FTA formation, for a given quota increase, price falls are smaller, which
implies less lobbying by domestic firms. However, once we allow for cross-
border lobbying this effect vanishes. On the other hand, as price changes are
smaller, it also becomes less socially costly to tighten the quota in an FTA. This
effect is not canceled out by cross-border lobbying and therefore leads to a
tighter quota compared to the pre-FTA situation.
Summing up, we have:
HARMONIZING QUOTAS 269
11 Technically, the quota game of this paper has continuous payoff functions and is in this sensemore akin to a Cournot game, whereas tariff games have, like Bertrand games, discontinuous payoffs.
&Blackwell Publishers Ltd 2002.
Proposition 2. Under symmetry, cross-country influence activities within the
FTA lead member countries to tighten their external quotas compared to their
Nash equilibrium value and compared to their pre-FTA value.
We turn now to inter-governmental cooperation, an arguably deeper degree of
integration. The cooperative solution for i’s external quota is defined by
@ðVi þ V jÞ
@qi¼
@Vi
@qiþ@Vj
@qi¼ 0 for i ¼ A, B. ð14Þ
The question is again whether cooperation leads member governments to relax
or tighten their external quotas compared to their Nash equilibrium values. The
answer to this question hinges on the cross-partial derivative of the function V j
with respect to qi, which measures the externality exerted by i ’s quota (through
its influence on the area’s common price for the import-competing good) on j ’s
objective function. If it is positive at the Nash equilibrium, cooperation would
lead i to relax its quota; if it is negative, it would lead i to tighten its quota. This
cross-partial derivative is equal to
@V j
@qi¼dV j
dp
@p
@qi¼y j � að1� bÞq j
ðmAÞ0 þ ðmBÞ0� �ff j,
which is negative at ð �qqi, �qq j Þ; thus,
@ðVi þ V jÞ
@qi
�����qqi, �qq j
¼ �ffi þ �ff j þ abðp� 1Þ < �ffi þ abð p� 1Þ ¼ 0, ð15Þ
implying that the cooperative level of i ’s quota should be lower (i.e. stricter)
than its Nash equilibrium level. Moreover, performing an exercise similar to the
previous one, we get�@ðVi þ VjÞ
@qi�@Vi
@qi
�����qqi¼ ffi > 0,
so the external quota is now less tight than the pre-FTA quota. Summing up, we
have:
Proposition 3. Cooperation on the FTA’s external quotas leads member
countries to tighten them compared to their Nash equilibrium value, albeit by
less than cross-border lobbying alone does. Under symmetry, the cooperative
FTA’s external quota is also less tight than the pre-FTA quota.
Intuitively, an increase in i ’s external quota has four distinct effects, three of
which apply both domestically and across the border, and one of which applies
only domestically. First, an increase in qi reduces the domestic output and hence
the political contribution of sector three in both countries. Second, it also raises
consumer surplus in both countries. Third, it reduces the wedge between good
three’s domestic price in the area and its world price, thereby reducing quota
270 CADOT, DE MELO, AND OLARREAGA
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rents in both countries. In addition (this is the fourth effect), an increase in qi
raises the import quantities over which the diminished quota rents are collected;
unlike the previous three ones, this effect is purely domestic. At country i ’s
optimum, because the last effect is positive, the domestic component of the
previous three ones, taken together, must be negative; but as they apply equally
to i and j, if they are negative for i, so are they for j. Hence, the externality
exerted by an increased qi on V j is negative at the optimum, and cooperation
leads to a tightening of quotas, as stated in Proposition 3.
Finally, note that if the two economies merge completely and consolidate their
external quotas into a single one, the post-merge quota will be twice the size of
the pre-merge quota. To see this, observe that if they do, the ‘‘consolidated’’ or
harmonized quota is determined by the usual first-order condition, but with
aggregate variables replacing national ones. Because A and B are symmetric and
expression (5) is linear in country-specific variables (yi and qi ), aggregation
leaves it unaffected. (This invariance holds irrespective of the bargaining rule
used to share the rents of the common external quota.)12
4. EXTENSIONS
We explore here the robustness of our results by considering two extensions of
the model: the introduction of general-equilibrium effects and a different trade
pattern. The analysis of the FTA’s political feasibility, if it was to form
endogenously, is relegated to the Appendix.
4.1 General-Equilibrium Effects
The model developed in this paper is essentially a partial-equilibrium one. On
the supply side, general-equilibrium effects are frozen by the assumption that the
numeraire good is produced with labor only and under constant returns to scale.
On the demand side, they are eliminated by the assumption of a quasi-linear and
additive utility function: the quasi-linearity on the numeraire good suppresses
income effects on goods one, two, and three, and additivity implies that goods
are neither substitutes nor complements for consumption purposes.
Allowing for general-equilibrium effects would lead to cross-industry
lobbying, which would alter some of the qualitative results of the previous
sections. General-equilibrium effects on the labor market (i.e. a wage rate that
reacts to tariff changes through implied changes in labor demand in a full-
fledged specific-factor model) would imply that producers of good one are
adversely affected by the level of protection in sector two through their wage bill.
In such a model, internal trade liberalization would reduce employment by
sectors competing with intra-bloc imports; this would put downward pressure
on the equilibrium wage rate, which would be beneficial to the sector competing
HARMONIZING QUOTAS 271
12 This result also holds for endogenous tariffs when countries are symmetric but not when they areasymmetric; see Cadot et al. (1999).
&Blackwell Publishers Ltd 2002.
with ROW exports. That sector would consequently expand output, and this
output expansion, through the familiar working of the common-agency model,
would encourage it to lobby more aggressively for protection. Thus, the level of
external protection would, ceteris paribus, rise with internal trade liberalization
because of the inter-sectoral reallocation of productive resources within the
liberalizing economies.
The effects of substitutability in demand in our political-economy model
would be ambiguous. On one hand, were goods one, two, and three to be
substitutes in demand, internal QR liberalization would trigger an effect
identified by Syropoulos (1999). Namely, after internal trade liberalization, trade
diversion due to external protection would not generate quota rents on intra-
bloc trade flows anymore. Ceteris paribus, this would reduce the marginal
welfare benefit of external protection to any member country. But in a political-
economy model such as ours, this effect, which would undoubtedly be present,
would not be the end of the story. Internal trade liberalization, leading to lower
internal prices for the goods traded within the bloc, would also, through
substitutability, reduce the demand for the good imported from the rest of the
world. In a QR regime (in contrast to a tariff regime where this effect would be
irrelevant), the equilibrium domestic price and output of the good competing
with ROW imports would go down, thus reducing the sector’s incentive to seek
protection. The endogenous level of the quota would thus, ceteris paribus, tend
to be enlarged. Which of the two effects (supply side or demand side) of
substitutability dominates would be an empirical question.
4.2 An Alternative Trade Pattern
The interest of the Meade trade pattern assumed so far is that FTA partners
import the same good from the rest of the world, so that interesting coordination
issues arise. We explore here what would happen under a different trade pattern.
Suppose, following Syropoulos (1999), that A imports good one and exports the
other two goods, B imports good two and exports the other two, and C imports
good three and exports the other two. Then A and B import different goods from
the rest of the world, and no direct coordination issue arises, although indirect
issues will arise. Consider what happens on market one in A after the formation
of an FTA. In this section, we relax the symmetry assumption of the previous
sections as it could not hold under the present trading pattern. In order to avoid
a taxonomy of cases, we will assume that A’s consumption of good one is
sufficient to absorb B’s output and the quota on imports from C at the free-trade
price. Good one is imported into A freely from B and subject to an external
quota from C. In B, producers of good one, having free access to A’s market, are
not concerned by its domestic price at home and consequently do not lobby for
external protection. Given this and the fact that A’s domestic price is above its
world price, all of B’s output of good one is sold in A, and B’s own consumption
of that good is now covered by imports from C. Thus, the FTA alters the trade
272 CADOT, DE MELO, AND OLARREAGA
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pattern, generating intra-industry trade in good one since B is now both an
exporter (to A) and an importer (from C).
After the FTA has been formed, both A and B import good one from the rest
of the world. But only A’s external trade policy raises an issue in sector one,
since B maintains free trade in the absence of domestic lobbying for protection.
The interesting question is then, is A induced to tighten or to relax its quota on
good one from C compared to its pre-FTA quota? In order to answer this
question, we need to go back to the original policy problem. Note that A’s
imports are now given by
mA1 ¼ qA1 þ yB1 , ð16Þ
whereas mB1 ¼ cB1 : Clearly, for A to maintain protection in sector one while
having selective free trade with B which has itself no protection, there has to be a
rule of origin. We leave the full treatment of rules of origin to the Appendix, but
here such a rule plays a very clear-cut role, simply preventing the unlimited
arbitrage of domestic-price differences within the free-trade bloc. The problem
solved by the government of country A is:
maxqA1
VA � CA1 ðqA1 Þ þ aW
A ð17Þ
subject to
EAðpA, WAÞ ¼ RAðpA, lAÞ þ bðpA1 � 1ÞqA1 , ð18Þ
mAðpA1 Þ ¼ qA1 þ yBðpA1 Þ. ð19Þ
Using (16), the FOC is
@VA
@qA1¼yA1 � a½yB1 þ ð1� bÞqA1 �
ðmA1 Þ0� ðyB1 Þ
0 þ abðpA1 � 1Þ ¼ 0. ð20Þ
Formula (20) is not directly comparable to (5). However, suppose that yA1 , the
level of good one’s output, was the same in both expressions. Compared to (5),
the first term’s numerator would have gone down in absolute value whereas its
denominator would have gone up, also in absolute value. Recall that when the
FOC is satisfied, its first term must be negative since its second one is positive.
As the negative first term has gone down in absolute value, the curve plotting
@VA=@qA1 as a function of qA1 has shifted up, whence the optimal value of qA1 lies
now to the right of its previous location. In other words, country A’s quota on
imports of good one from C is relaxed compared to its pre-FTA value. But then,
if the quota is enlarged, the domestic price goes down, which implies a
contraction in domestic output. Thus, yA1 is smaller in (20) than in (5), which
reinforces the conclusion.
However, note that the comparison is somewhat misleading, since we are
comparing a non-discriminatory quota (pre-FTA) with an external quota (post-
FTA). In order to assess the effect of the FTA on the bloc’s total imports, we must
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now aggregate imports of good one by A and B after the pattern of trade has
changed. It turns out that those total imports are up. To see this, observe that,
prior to the FTA, C’s exports of good one to the area, xC1 , are given by
xC1 ¼ qA1 � xB1 ð1Þ
¼ qA1 � ½yB1 ð1Þ � cB1 ð1Þ�,
where xB1 ð1Þ, yB1 ð1Þ, and cB1 ð1Þ are respectively B’s exports, output, and
consumption of good one at free trade (prior to the FTA, B does not protect
good one since it is an exporter of the good). After the FTA’s formation, as
already noted, all of B’s consumption of good one is covered by imports, so
xC1 ¼ �qqA1 þ cB1 ð1Þ,
where �qqA1 denotes A’s post-FTA external quota on good one. But if �qqA1 > qA1 , it is
clear that C’s total exports (the area’s total imports) of good one are up.
This means that the quota-relaxation effect identified in section 2 is robust to
the change in trade pattern considered here. The reason is as follows. Recall that
the quota-relaxation effect was previously due to the fact that the area’s
common domestic price was less sensitive to an arbitrary tightening of national
external quotas than ‘‘national’’ domestic prices before the FTA, thus reducing,
at the margin, the incentive to lobby for tighter quotas. Here, two distinct effects
play in the same direction. First, any tightening of A’s quota would raise imports
from trading partner B along the latter’s supply curve, thus mitigating the price-
raising effect (what the lobby is ultimately interested in). This obviously is a
dilution effect that is fairly similar (although not identical) to what we had
before. But there is a second effect, namely the fact that the equilibrium output
of good one in A has shrunk under the effect of intra-bloc trade liberalization,
contributing to discourage lobbying. In sum, trade diversion plays here the
useful role of reducing the return to lobbying.
Again, cross-border lobbying would anihilate this liberalizing effect, as
producers of good one in B would now enter the game, having an interest of
their own in seeing protection in market A rise. As the logic is similar to that of
the previous section and the intuition is clear, we will not develop the argument
formally here.
5. CONCLUDING REMARKS
From a political-economy perspective, it has been often argued that deep forms
of regional integration are a lesser evil for the multilateral trading system (e.g.
Richardson, 1994; Panagariya and Findlay, 1994; and Bhagwati and Panagar-
iya, 1996). When special interests from different countries must coordinate their
lobbying efforts to influence policies set at a supra-national level, Olson-type
collective-action problems are less likely to be overcome, and lobbying pressures
for trade protection tend to be diluted.
274 CADOT, DE MELO, AND OLARREAGA
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By contrast, we suggested in an earlier paper (Cadot et al., 1999) that,
notwithstanding possibly serious collective-action problems, deep integration
might enable special interests to internalize cross-border externalities in their
lobbying activities, leading to increased external protection. However, our
results were derived in an endogenous-tariff model in which (as in Richardson,
1995) competition for tariff revenue played a significant role, although its role in
actual policy-making is of debatable relevance, at least in rich countries. In this
paper, we extended our analysis to the highly relevant case of quantitative
barriers, where quota rents, even if they are captured by the importing countries,
do not generate competition and therefore do not affect the strategic interaction
between the regional bloc’s member states.
The new results contain both good and bad news for the multilateral trading
system. The good news is that shallow, non-cooperative regionalism (which
eliminates intra-bloc barriers but does not involve the coordination of external
barriers) helps keep import-competing interests in check because of an economic
dilution mechanism that is different from the collective-action problem
previously stressed in the literature. The bad news is that those favorable effects
are likely to reverse themselves as regional integration deepens through the
coordination and harmonization of external barriers, enabling special interest to
internalize cross-border externalities (as in the tariff case, although the nature of
the externalities is different). Thus, the new results confirm qualitatively the
intuition of the tariff-case results, although the equilibria are all interior and
feature more plausible outcomes under quantitative barriers than under tariffs.
In a richer model with general-equilibrium interaction on factor markets,
additional considerations would also come into play. As sectors competing with
imports from within the area (sectors two in A and one in B) shrink under the
effect of regional trade liberalization, the sector competing with the rest of the
world (sector three) enjoys reduced rivalry on factor markets and can therefore
expand. In the logic of the present model, sector three’s ability to gain economic
power translates into enhanced political clout as well, leading to renewed
protectionist pressure against the rest of the world. In sum, it seems that, for a
variety of reasons, our pessimistic conclusions on the effect of ‘‘deep
regionalism’’ on outward protectionism are likely to hold irrespective of the
type of trade-policy instruments available to member countries.
APPENDIX
Rules of Origin
This section extends the characterization of the non-cooperative external-quota
equilibrium of section 3 to FTAs with rules of origin. In an FTA with
endogenous external tariffs, if goods imported from the rest of the world could
transit through a member country with a low external tariff into one with a
higher external tariff, the latter would see its protection flounder. Because
transshipment brings tariff revenue, each country in such a setting has an
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incentive to undercut the external tariff of its partners, creating a sort of
prisoners’ dilemma leading to the complete elimination of external tariffs by all
member countries. While being efficient from a welfare point of view, this
outcome is, of course, not the one preferred by import-competing lobbies. Rules
of origin, which prevent the transshipment of goods through the area’s internal
borders, prevent this type of arbitrage, and therefore play a crucial role in the
political equilibrium (see Cadot et al., 1999). We show here that rules of origin
play no such role in an FTA with endogenous quantitative restrictions, as the
unique symmetric equilibrium of Proposition 1 retains its properties when rules
of origin are imposed.
Although the equilibrium is symmetric, a full characterization of payoff
functions requires asymmetric quota pairs (with unequal prices) to be
considered. Ceteris paribus, consumer price differentials can arise in an FTA
with rules of origin only if national external quotas are set at sufficiently unequal
levels. To see this, suppose that pA > pB, and let ciðpiÞ be country i’s
consumption of the import-competing good and yiðpiÞ its domestic output. As
the functions ci and y i are identical in A and B, we will omit superscripts on
them. When pA > pB, B’s producers ship their entire output yðpAÞ to A, but rules
of origin prevent goods imported from C into B from being transshipped to A.
Thus, A’s domestic price pA must satisfy the market-clearing equation
qA ¼ cðpAÞ � 2yðpAÞ. ðA1Þ
Note that a necessary condition for the existence of a positive quota qA satisfying
(A1) is that cð1Þ > 2yð1Þ, i.e. that the import-penetration ratio mð1Þ=cð1Þ be in
excess of one-half at free trade. As B’s consumption is met entirely through
imports from C, B’s domestic price pB is determined by
qB ¼ cðpBÞ. ðA2Þ
Let cAðqBÞ ¼ supfqA : pAðqAÞ > pBðqBÞg; i.e. cA defines an upper bound on the
range of qA compatible with pA > pB given qB. Using (21) and (22),
cAðqBÞ ¼ cðpBÞ � 2yðpBÞ
¼ cðc�1ðqBÞÞ � 2yðc�1ðqBÞÞ
¼ qB � 2yðc�1ðqBÞÞ, ðA3Þ
where c�1ð�Þ is the inverse demand for the import good. Because c and c�1 are
decreasing functions whereas y is an increasing one, cA is an increasing function;
moreover, it is readily seen from (23) that its slope ½cA�0 ¼ 1� 2y0 � ½c�1�0 is more
than one (the second derivative of cA is positive with a linear demand and
indeterminate otherwise). Define qB0 by cðqB0 Þ ¼ 0; using (23), qB0 must satisfy
qB0 ¼ 2y½c�1ðqB0 Þ�; that is, qB0 is a fixed point, if any, of the function 2y½c�1ðxÞ�. We
claim that this fixed point exists, is positive, and is unique. Let pB0 ¼ c�1ð0Þ
whenever c�1ð0Þ is well-defined (otherwise we say that pB0 ¼ 1); pB0 is the ‘‘choke
276 CADOT, DE MELO, AND OLARREAGA
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point’’ (vertical intercept) of B’s inverse demand function, when it has one.
Clearly, 2y½c�1ð0Þ� ¼ 2yðpB0 Þ > 0; hence, if it exists, qB0 must be strictly greater
than zero. Moreover, at qB ¼ cð1Þ (B’s free-trade level of consumption, at which
its external quota ceases to be binding), c�1ðqBÞ ¼ 1, so 2y½c�1½cð1Þ�� ¼ 2yð1Þ,
which is, by (21), less than cð1Þ; therefore, at qB ¼ cð1Þ, 2y½c�1ðqBÞ� < qB. It
follows that the function 2y½c�1ðxÞ� has at least one fixed point strictly between
x ¼ 0 and x ¼ cð1Þ; moreover, because it is monotone decreasing, this fixed
point is unique. Having established the existence of qB0 > 0 completes the
characterization of the function cAðqBÞ. A similar function cBðqAÞ can be
constructed on the assumption that pB > pA, leading to a partition of the space
ðqA, qBÞ into three regions: a central band with price equalization, and two
lateral regions with price differentials of opposite signs.
We can now map quota pairs ðqA, qBÞ into pairs of domestic prices ðpA, pBÞ in
order to construct payoff functions VA and VB. Consider the following three
functions: for all x, z in Rþ,
z ¼ fðxÞ , x ¼ cðzÞ � 2yðzÞ,
z ¼ gðxÞ , x ¼ 2½cðzÞ � yðzÞ�,
z ¼ hðxÞ , x ¼ cðzÞ.
Using (A1), it can be seen that f gives pi as a function of qi when qi is such that
pi > p j [i.e. when qi < ciðq jÞ]; similarly, g gives pi as a function of qA þ qB when
pi ¼ p j [i.e. when ciðq j Þ4 qi4 ðc j Þ�1ðq j Þ]; while h gives pi as a function of qi
when pi < p j [i.e. when ðc j Þ�1ðq jÞ < qi]. A few more pieces of notation are
needed to construct payoff functions. Let sðpi Þ stand for consumer surplus in i,
and define the following three continuously differentiable functions:
VV iðqi Þ ¼ Ci½ fðqiÞ� þ afp½ fðqiÞ� þ s½ fðqiÞ� þ b½ fðqiÞ � 1�qig,
�VViðqi, q jÞ ¼ Ci½gðqi þ q jÞ� þ afp½gðqi þ q jÞ� þ s½gðqi þ q jÞ� þ b½gðqi þ q jÞ � 1�qig,
�VViðqi, q jÞ ¼ afp½ fðqjÞ� þ s½hðqiÞ� þ b½hðqiÞ � 1�qig.
Recalling from section 2 that Ci is sector three’s contribution function in i and
noting that the terms in curly brackets are welfare terms, VV i is i ’s ‘‘payoff ’’
(contributions plus appropriately-weighted welfare) when qi < c iðq jÞ; similarly
for �VVi when c iðq jÞ4 qi4 ðc jÞ�1ðq jÞ; and for �VVi when ðc jÞ
�1ðq jÞ < qi. The
function �VVi differs from the other two in that i’s import-competing lobby does
not contribute because it sells its output in j; for the same reason, the producer
price relevant for the calculation of producer surplus p is fðq j Þ instead of the
domestic price hðqiÞ. Using these, i’s payoff function is
V i ¼
VVi if qi < c iðq jÞ
�VVi if c iðq jÞ4 qi4 ½c j��1ðq jÞ
�VVi otherwise.
8>><>>: ðA4Þ
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Equation (A4) shows that Vi may be, in general, neither differentiable nor
continuous. As ViVi and �VVi are identical at qi ¼ ciðq jÞ, but ½VVi �0 > ½ �VVi �0, Vi has a
point of non-differentiability at qi ¼ ciðq j Þ. Moreover, as �VVi is strictly greater
than �VVi at qi ¼ ½c j ��1ðq j Þ, it also has a point of discontinuity (a jump down) at
that point; by construction of the functions ci and cj, this jump must lie to the
right of the point where qi ¼ q j. To the right of its jump, Vi rises monotonically
along �VVi up to the point where qi is no longer binding. In addition, because
sector three is, in each country, the only lobby actively trying to influence the
government, its contribution schedule Ci is adjusted so as to leave the
government just indifferent between adopting �qqi � argmax �VVi and free trade.
The last remaining analytical step consists of characterizing the Nash
equilibrium in ðqA, qBÞ. Because all relevant functions and parameters are
identical in A and B, �qqA ¼ �qqB; hence, any equilibrium must be symmetric.
Maximizing the function �VVi given �qq j yields the first-order condition
@ �VVi
@qi¼
@p@qi
þ a
�@p@qi
þ@s
@qiþ b½gðqi þ qjÞ � 1� þ qig 0ðqi þ q j Þ
�¼ yþ aðy� cþ bqi Þg 0 þ abðg� 1Þ
¼y� að1� bÞqi
2m0þ abðp� 1Þ ¼ 0. ðA5Þ
Note that the last transformation comes from the fact that, by implicit
differentiation, g 0 ¼ 1=2m0 where m ¼ c� y, and that, when pA ¼ pB, no intra-
bloc trade takes place so mi ¼ qi. It is apparent by comparison of (A5) with (11)
that the value of qi which maximizes i ’s payoff is the same whether or not rules
of origin are imposed.
Strategic Complementarity
The second cross-partial derivative of the function Vi is:
@ðVi Þ2
@qi@qj¼
ðyi Þ0 � aðmiÞ0 þ �ffiðmi Þ00þ ab
ðmi Þ0 . ðA6Þ
Let ci be i ’s domestic consumption of the import good. After slight
rearrangement and substitution of the first-order condition, (A6) can be
rewritten as
@ðVi Þ2
@qi@q j¼
ð1� aÞðyi Þ0 þ aðciÞ0 þ ab½1� ðp� 1ÞðmiÞ00�
ðmiÞ0.
Provided that a > 1, the numerator of this expression is negative, so qi and q j
are strategic complements (numerical simulations in Cadot et al., 1997,
suggest that plausible policy outcomes require values of a largely in excess of
unity).
278 CADOT, DE MELO, AND OLARREAGA
&Blackwell Publishers Ltd 2002.
A.1 Political Feasibility of FTA
We consider here the political feasibility of an FTA (i.e. its acceptability for
sector-specific lobbies) by looking at the change it involves in the income of the
lobbies net of political contributions. Clearly, the issue arises only if the pre-
FTA (‘‘MFN’’) equilibrium involves positive protection of sector two or three,
since otherwise there would be no loss of protection and hence no political
feasibility issue to start with. We consider country A, which imports goods two
(from its FTA partner B) and three (from the rest of the world). Let us write
aggregate welfare as a function of the quotas in sectors two and three, i.e.
W ¼Wðq2, q3Þ.
Similarly, let CkðqkÞ be sector k’s political contribution, pkðqkÞ its profits, and
vk ¼ pkðqkÞ � CkðqkÞ its income net of contribution. We will use the notation
qk ¼ 1 to denote the elimination of the quota on good k.
The first task is to calculate sector three’s equilibrium contribution in the FTA.
The government’s objective function V, evaluated at the FTA equilibrium, is
�VV ¼ C2ð1Þ þ C3ð �qq3Þ þ aWð1, �qq3Þ.
Were sector three to get out of the lobbying game, keeping sector two’s contri-
bution unchanged, the government’s objective function V would then become
C2ð1Þ þ aWð1, 1Þ.
Equating these two expressions and lettingW* stand forWð1, 1Þ (the value of
welfare at free trade) and �WW for Wð1, �qq3Þ (the value of welfare in the FTA
equilibrium) gives the indifference condition that pins down sector three’s
contribution; namely,
�CC3 ¼ aðW*� �WWÞ.
In words, the lobby representing sector three transfers to the government the
monetary equivalent (given a, the government’s marginal rate of substitution
between money from contributions and welfare) of the distortion created by
protection in sector three. Lobby three’s income net of its political contribution
is thus
�vv3 ¼ �pp3 ��CC3 ¼ �pp3 þ að �WW�W*Þ.
Similar calculations for lobby three’s net income in the pre-FTA (‘‘MFN’’)
regime in which variables are designated by hats give
vv3 ¼ pp3 � CC3 ¼ pp3 þ a½WW�Wðqq2, 1Þ�.
Thus, the variation in lobby three’s net income attributable to the formation of
the FTA is
Dv3 ¼ �vv3 � vv3 ¼ �pp3 � pp3 þ a½ �WW�W*� WWþWðqq2, 1Þ�.
HARMONIZING QUOTAS 279
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Similar calculations for sector two give
Dv2 ¼ �vv2 � vv2 ¼ �pp2 � pp2 þ a½Wð1, qq3Þ � WW�.
We now derive a necessary condition for the change in the aggregate income of
lobbies, Dv2 þ Dv3, to be positive. Adding up the last two expressions, we have
Dv¼ �pp2 � pp2 þ �pp3 � pp3 þ a½ �WW�W*� WWþWðqq2, 1ÞþWð1, qq3Þ � WW �.
But note that, by construction, positive protection of sector two in the pre-FTA
equilibrium implies vv2 > v*2, or, after slight rearrangement,
a½Wð1, qq3Þ � WW� < pp2 � p*2.
Substituting this in the expression for Dv above and simpifying gives
Dv < �pp3 � pp3 þ a½ �WW�W*þWðqq2, 1Þ � WW�.
By the same reasoning, vv3 > v*3 implies
a½Wðqq2, 1Þ � WW � < pp3 � p*3;
again substituting this in the previous expression gives
Dv < �pp3 � p*3 þ að �WW�W*Þ,
which implies that, for Dv to be positive, it must be the case that the rent from
protection of sector three at its FTA-equilibrium level ( �pp3 � p*3Þ exceeds the
monetary equivalent of its distortionary cost að �WW�W*Þ. This simply says that the
FTA equilibrium involves positive protection of sector three. Thus, provided that
the FTA equilibrium is an interior one, the necessary condition is always verified.
Next, we derive a sufficient condition for the change from MFN to FTA
regime to be politically feasible. It is easily seen that the change in lobby two’s
net income is negative if the MFN regime involves positive protection of sector
two. Thus, the change in sector three’s net income must be positive and
sufficiently large to ensure that Dv is positive. But Dv3 > 0 requires
pp3 � �pp3 < afð �WW� WWÞ þ ½Wðqq2, 1Þ �W*�g.
The term on the LHS is the loss of protection rent for sector three attributable
to the FTA’s formation. The first term on the RHS (in parentheses) is the
efficiency gain attributable to the FTA compared to the MFN regime, which is
necessary for political feasibility given that lobbies are residual claimants. But
the second term on the RHS (in square brackets) is negative. Given that the term
in parentheses, scaled by a, cannot by itself be larger than the LHS since
otherwise the MFN regime would not be an equilibrium, this condition simply
cannot be met. Thus, under the assumptions of strong separability, fixed wage
rate and Meade trade pattern, the FTA is not politically feasible. However, this
result breaks downundermore general assumptions including general-equilibrium
280 CADOT, DE MELO, AND OLARREAGA
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interaction on either the demand or supply side or an alternative trade pattern
with more than one good imported from the rest of the world. Moreover, other
non-economic objectives may be behind the creation of a preferential agreement
(e.g. national security). Finally, note that it can also be shown that the move
from an FTA to quota harmonization within a CU is politically feasible. The
issue of political feasibility is analyzed in detail in Cadot et al. (2001).
OLIVIER CADOT JAIME DE MELO
University of Lausanne, CERDI University of Geneva, CERDI
and CEPR and CEPR
MARCELO OLARREAGA
The World Bank, and CEPR
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