Agreements to liberalise trade between groups of countries will boost wages in the partner countries but harm third countries excluded from the agreement. That is the central finding of research by Pascal Mossay and Takatoshi Tabuchi, published in the December 2015 issue of the Economic Journal.
Their study notes that in a globalised economy, countries and thus trade flows are interdependent. What this means is that trade cost and labour shocks that affect some countries will ultimately affect all other countries either directly or indirectly. These indirect effects come from the interdependence of countries via international trade and result from the propagation of shocks across economies.
Past research addressing this issue typically relies on the unrealistic assumption of ''factor price equalisation''. This implies that wages are equalised across all countries, therefore excluding the possibility of any ''terms-of-trade effects'' – changes in the relative prices of exports and imports.
The new study allows for such terms-of-trade effects while also using the standard ingredients of ''new trade theory'', such as consumers'' love for product variety and increasing returns to scale.
Unsurprisingly, market size and market access play an important role in explaining the network effects of international trade and how shocks transmit across the world economy. A positive labour shock in some country increases the wage in that country but also that in a small and nearby country, while that in a large and distant country falls.
This result illustrates how the market size effect (first explored by Nobel laureate Paul Krugman) propagates across countries: the market potential is larger in a neighbouring country than in a distant one. In term of welfare, all countries gain from the increase in size of some country as world production and therefore world consumption end up increasing.
The main finding of the new study is about how trade cost shocks affect interdependent countries. When some countries engage in a preferential trade agreement, market integration induces wages to increase and the terms-of-trade to improve in the integrated area.
While the preferential trade agreement improves the welfare of partner countries, it is always detrimental to third countries, which experience a negative terms-of-trade effect as they have to import goods produced at higher costs of production in the integrating area.
''Preferential Trade Agreements Harm Third Countries'' by Pascal Mossay and Takatoshi Tabuchi is published in the December 2015 issue of the Economic Journal.
