Paths of efficient self-enforcing trade agreements

This paper characterizes the efficient payoff frontier in a three country model where countries face one time adjustment costs of forming trade agreements, and compares it with the constrained efficient frontier when agreements must be self-enforcing. The presence of self-enforcement constraints puts a limit on the magnitude of transfers that can be made between countries, and makes it more likely that bilateral agreements are observed on the constrained efficient frontier. The existence of adjustment costs leads to the possibility that payoffs under a two step agreement, in which an initial bilateral agreement is expanded to include the third country, may Pareto dominate the payoffs from immediate formation of an agreement among all three countries. However, the condition that a two step agreement be efficient in the absence of self-enforcing constraints is neither necessary nor sufficient for the gradual approach to have a lower minimum discount factor. This paper was prepared for the conference “New Directions in International Trade Theory” held at the University of Nottingham. I thank Andres Rodriguez-Clare, Rod Falvey, conference participants, and anonymous referees for helpful comments on an earlier draft.