The “New” Economics of Trade Agreements: From Trade Liberalization to Regulatory Convergence?

Econometrica, vol. 89, Issue 1 (January 2021), p. 215-249
https://doi.org/10.3982/ECTA17536

Negotiations at the multilateral, regional and bilateral levels have been remarkably successful at reducing traditional barriers to international trade in the post-war period. With this success, the trade community has shifted its attention to various non-tariff barriers (NTB’s) that leave world markets still far from integrated. Among the NTB’s that receive the most scrutiny are impediments to trade that arise from differences in domestic regulations, or what Alan Sykes (1999a, 1999b) has termed “regulatory heterogeneity.”

The trade community has long recognized that governments can use their regulatory authority to pursue mercantilist objectives. Moreover, if governments do not cooperate in setting their national policies, and if they neglect the interests of consumers and firms that are not part of their constituencies, then the resulting externalities can cause global inefficiencies even in the absence of protectionist intent.

The Changing Landscape for Trade Negotiations
Pascal Lamy, former Director General of the World Trade Organization, has highlighted a particular form of international externality arising from regulatory heterogeneity. When firms must satisfy different regulations for each of their destination markets, they may end up paying a high cost In terms of foregone economies of scale. This creates a new challenge for the world trading system. As the precautionary motive for trade regulation designed to protect consumers’ health, safety and values displaces the protectionist motive to insulate producers from competition, the levelling of the trade playing field will become less about eliminating protective barriers and more about reducing differences between policies that have legitimate aims. Lamy views the current period as a watershed moment for trade agreements. Future trade negotiations may emphasize harmonization, or at least convergence, in regulatory measures ,as Lamy suggests. Yet, as Sykes (1999a, 1999b, 2000) argues, international differences in incomes, cultures, risk preferences and tastes generally justify regulatory heterogeneity, even with the extra cost of satisfying a multitude of different rules. So, what is the appropriate trade-off in international trade agreements between heterogeneous tastes across international borders and the cost burdens imposed by disparate regulations?

Different Countries, Different Values
To address this question, the paper by Gene Grossman, Philip McCalman and Robert Staiger recently published in Econometrica considers an environment in which individuals residing in different countries hold dissimilar valuations of the characteristics of goods and services, reflecting idiosyncratic local conditions, histories and cultures, or what Lamy (2016) refers to as “collective preferences.” The authors extend the Venables (1987) model of intra-industry trade. Whereas Venables considered a single dimension of product differentiation that generates a “love of variety,” Grossman et al. add a second dimension of differentiation along which the residents of different countries have different ideals. If the potential versions of a brand are horizontally differentiated along the second dimension, then the representative consumer in each country has an ideal specification for each brand, but with favorite versions that differ internationally, perhaps due to different geographic conditions or cultural proclivities. Alternatively, if the potential versions of a brand are vertically differentiated, individuals worldwide recognize a hierarchy among them, but consumers in one country have a greater willingness-to-pay for quality than those in the other. In the model, firms are free to tailor variants of their brands to suit local tastes or to satisfy local regulations, but they face a (fixed) cost of product adaptation that increases with the distance in characteristic space between their offerings. The authors consider both horizontal and vertical differentiation.  Moreover, to broaden the scope for efficiency-enhancing product regulation, the authors entertain the possibility that consumption externalities arise from product choices.  The model incorporates shipping costs that generate home-market effects. As a consequence, firms sell relatively more in their local market than in their export market. This affects their optimal design decisions, as profit-maximizing firms cater especially to local tastes due to the relative importance of this market to their bottom line. And given the extra costs of designing second products that differ from the core products sold domestically, it is both profitable and efficient for firms to sell products in their export market that are further from the offshore ideal than the products offered there by local firms. While local governments may not care about the profits of foreign producers, they do care about the prices and variety of goods available to their constituents. Accordingly, the model features an economic rationale for regulatory heterogeneity and even for “discriminatory” treatment of goods from different origins; we thus capture Sykes’ concerns about the inefficiencies of complete harmonization.

Trade Agreements: New or Old?
The authors study the optimal design of trade agreements in an environment with regulatory policy.  They characterize a “new trade agreement” (NTA) that achieves global efficiency by stipulating not only the cooperative trade taxes that formed the heart of an “old trade agreement” (OTA), but also how governments should optimally set their standards. Net trade taxes should be set to zero (as usual) and consumption subsidies are needed to offset market power (as is standard). However, provided that consumption subsidies are subject to national treatment (similar subsidies for local and imported goods), there is no need to stipulate the levels of such subsidies in a trade agreement; under national treatment, governments unilaterally set the subsidy needed to offset market power. Additionally, a consummate NTA could detail the characteristics of goods from all sources in all markets. But in the absence of consumption externalities, the products that firms would design and sell to maximize profits in a world without regulation have exactly the characteristics that are globally efficient. Therefore, when consumption externalities from product choice are not an issue, an NTA need not formalize detailed rules for product standards, it is enough that it stipulates that governments refrain from regulation. Is an NTA needed to achieve global efficiency? Or can an OTA be modified to do the trick, perhaps with what Sykes (1999a) terms “policed decentralization”; i.e., provisions such as national treatment that constrain broad aspects of governments’ regulatory choices?  As a benchmark, Grossman et al. consider a free-trade agreement (FTA) that constrains tariffs to zero and that requires national treatment for consumption subsidies but otherwise leaves governments completely free to choose their domestic policies. They find that such a setting indeed creates a strong incentive for “regulatory protectionism”; each government leaves its local firms free from regulation but imposes onerous burdens on import goods in an attempt to “delocate” firms from the foreign to the domestic market. This confirms Sykes’ (1999b) intuition that regulatory cooperation may be needed when governments are constrained in the use of their preferred protectionist instruments.  The delocation that motivates onerous standards suggests that discrimination may be the primary cause of the inefficiencies associated with OTAs. Might the requirement for national treatment of standards be a simple solution? When each government sets a single standard, the outcome can never be first best. Moreover, allowing governments to set multiple standards subject to a national treatment requirement also fails to secure the globally efficient outcome; governments have no incentive to offer a standard that is efficient for foreign firms. The resulting Nash equilibrium of an FTA with multiple standards set according to national treatment provides an example of Sykes’ (1999b) “facially neutral regulatory protectionism.” An alternative to negotiating rules about regulatory cooperation might be a provision for mutual recognition, namely each government agrees to respect the set of standards allowed by other governments. When each government sets a single standard and commits to mutual recognition, the outcome again is not first best. However, when governments can designate multiple standards, an OTA that includes a provision for mutual recognition can achieve efficiency. In equilibrium, each government announces (at least) two standards, one that maximizes profits for its firms in their local sales and the other that maximizes profits for its firms in their export sales. When the importing government is bound to accept goods with these characteristics, the outcome is the same as emerges with no regulation whatsoever, which Grossman et al. argue is first-best in a Venables world without consumption externalities.  An implication is that, in an environment where consumption externalities are absent but tastes are heterogeneous across international borders and disparate regulations impose cost burdens on firms, an OTA can perform as well as an NTA provided that the OTA includes a mutual recognition clause for standards and a national treatment requirement for fiscal (i.e., tax/subsidy) measures. Interestingly, an OTA with only a national treatment requirement for both fiscal and regulatory measures (along the lines of the World Trade Organization) cannot achieve this level of performance, suggesting that in this environment mutual recognition may be preferred to national treatment as a method for “policed decentralization” of governments’ regulatory choices.

Consumption Externalities
When (negative) consumption externalities are considered, the optimal NTA has positive net tariffs, and a consumption subsidy that offsets both the externality and monopoly distortions. Additionally, optimal standards are no longer the same as those that profit-maximizing firms would design on their own. Without regulation, firms in both countries have insufficient incentive to differentiate the local and export versions of their brands. The optimal NTA calls for standards that induce all firms to design products closer to the ideal in the destination markets compared to what they would choose if unconstrained to maximize profits. Interestingly, the efficient standards are more lenient for imports than for local products, reflecting the differential costs that the different firms face in meeting strict regulations. Moreover, an OTA with mutual recognition no longer replicates the efficient outcome of an NTA. Therefore, even if consumption externalities are entirely local in geographic scope, where such externalities are important an NTA with detailed rules about countries’ national regulations can outperform an OTA that relies either on a national treatment requirement or a mutual recognition clause to police the regulatory choices of its member governments.  Taking together, the findings for the cases without and without consumption externalities offers practical guidance for future trade negotiators. Countries could negotiate selectively over product standards where externality problems are sufficiently severe, but rely on mutual recognition to achieve efficient policies when externalities are not a particular concern.

References

Lamy, Pascal, 2015, “The New World of Trade,” Jan Tumlir Lecture, https://pascallamy.eu/2015/03/09/colloque-le-bien-commun-futur-paradigme-de-la-gouvernance-de-mers/.

Lamy, Pascal, 2016, “The Changing Landscape of International Trade,” The Frank D. Graham Lecture, https://pascallamyeu.files.wordpress.com/2017/02/2016-04-07-lamy-princeton-graham-lecture-final.pdf.

Sykes, Alan O., 1999a, “The (Limited) Role of Regulatory Harmonization in International Goods and Services Markets,” Journal of International Economic Law 2, 49-70.

Sykes, Alan O., 1999b, “Regulatory Protectionism and the Law of International Trade,” The University of Chicago Law Review 66, 1-46.

Sykes, Alan O., 2000, “Regulatory Competition or Regulatory Harmonization? A Silly Question?,” Journal of International Economic Law 3, 257-264.

Venables, Anthony, 1987, “Trade and Trade Policy with Differentiated Products: A Chamberlinian-Ricardian Model,” Economic Journal 97, 700-717.