Farsightedly Stable FTA Structures∗
Noritsugu NAKANISHI†
Graduate School of Economics, Kobe University
Rokkodai-cho 2-1, Nada-ku, Kobe 657-8501
JAPANThis version compiled: July 20, 2011‡

Abstract
Taking account of the farsightedness of the countries and adopting the
von Neumann-Morgenstern (vNM) stable set as the solution concept, we
examine an FTA network formation game. FTA networks are represented
by undirected graphs with their vertex sets being identified with the set ofthe countries. Each country’s welfare depends upon the shape of the graphand its location in that graph. We examine two extreme cases: one in which
the pre-agreement tariffs are very high and the other in which they are sufficiently low. In the former, the farsighted vNM stable set only supports global
free trade, implying that bilateral FTAs are building blocks for achieving
global free trade. In the latter, the farsighted vNM stable set does not support global free trade, instead it supports some inefficient FTA networks,
implying that bilateral FTAs are stumbling blocks against achieving global
free trade.

∗

An earlier version of this paper (“Stable FTA Structure—An Application of the von NeumannMorgenstern Stable Set to International Trade”) was presented at the 6th Pan-Pacific Conference
on Game Theory, Tokyo Institute of Technology (February 28–March 2, 2011). The author is
grateful to Professors Eric Bond, Ngo Van Long, Yasukazu Ichino, and Toru Kikuchi for theirvaluable comments and suggestions. He also acknowledges the financial support of the Japan
Society for the Promotion of Science [Grant-in-Aid for Scientific Research (A), No. 22243024].
†
Address for correspondence: Noritsugu Nakanishi, Graduate School of Economics, Kobe
University, Rokkodai-cho 2-1, Nada-ku, Kobe 657-8501, JAPAN. Tel: +78-803-6837 (Office Direct). Fax: +78-803-7293 (Department Office). E-mail: nakanishi@econ.kobe-u.ac.jp‡
The first version: October 10, 2010; the second version: February 4, 2011.

1

1

Introduction

Since the late 1980s, preferential (or regional) trade agreements such as customs
unions (CUs) and free trade agreements (FTAs) have been growing rapidly innumber and becoming prevalent move in the international trade scene. Wellknown examples include the European Union (EU), the North American Free
Trade Agreement (NAFTA), the South American Common Markets (MERCOSUR), and the Association of South-East Asian Nations (ASEAN). Even Japan,
who had long been advocating for a multilateral approach to trade liberalization
under the GATT/WTO regime, has recently concluded some bilateral FTAs, which
are sometimes referred to as the Economic Partnership Agreements (EPAs), with
Singapore, Mexico, Malaysia, Philippine, Chile, and other countries.1
Bhagwati (1991, 1993) has argued that this trend of regionalism/bilateralism
is harmful to the accomplishment of global free trade under the auspices of the
GATT/WTO regime, which has been traditionally considered to be efficient and/or
welfare-enhancing from the point of view of the world as a whole. Further, he
has raised questions as to whether preferential trading blocs (CUs and/or FTAs)
reduce or increase the world welfare and whether the prevalence of bilateralism/regionalism can eventually lead to the situation where in the world welfare is
maximized. In other words, he raises a question as to whether preferential trading
blocs can be a “building block” for or a “stumbling block” against the achievingof global free trade. The former can be traced back to Viner (1950)’s questionthat preferential trading blocs can be trade-creating or trade-diverting. The latter
is now known as the “dynamic time-path” question.2
To answer these questions raised by Bhagwati (1991, 1993), a considerable
number of theoretical as well as empirical literature has emerged. Recent theoretical studies (on the “dynamic time-path” question) can be split into two interesting
approaches: one is based on the coalition/network formation games and the other1

WTO has reported in its website (as of October 15, 2010) that “The surge in RTAs has continued unabated since the early 1990s. As of 31 July 2010, some 474 RTAs, counting goods andservices notifications separately, have been notified to the GATT/WTO. Of these, 351 RTAs were
notified under Article XXIV of the GATT 1947 or GATT 1994; 31 under the Enabling Clause; and92 under Article V of the GATS. At that same date, 283 agreements were in force.”2
In this paper, we mainly focus on the latter dynamic time-path question.

2

is based on some “dynamic” games.3
For example, Yi (1996, 2000), Das and Ghosh (2006), and Saggi and Yildiz(2010) have followed the line of coalition formation game approach. Yi (1996)
has constructed a model with ex ante symmetric countries, in which countries intend to form CUs of certain sizes. In his model, global free trade is efficient (in thesense that the world welfare is maximized), formation of CUs exhibits negative
externalities on the welfare of the outsider countries, and international income
transfers are not allowed. He has shown that global free trade is the unique Nashequilibrium outcome of the simultaneous move, open regionalism game. He has
also shown that although global free trade is the only symmetric outcome of thesubgame perfect Nash equilibrium (SPNE) of the sequential move, open regionalism game, a typical SPNE outcome is asymmetric such that it contains the largest
customs union that is unique as well as some other smaller CUs.4 Das and Ghosh(2006) have considered a four-country model of coalition formation. They haveassumed asymmetry among countries in terms of income levels generated by thedifference in human capital content: two of them are high-income North countries
and the other two are low-income South countries. Adopting the coalition-proof
Nash equilibrium (CPNE) as the solution concept, they have shown that if themarket size difference (the difference in income levels) is sufficiently high, only
the North-North pair and the South-South pair form FTAs (i.e., polarization), but
no North-South pair is realized in the CPNE; otherwise, global free trade is realized in the CPNE. Saggi and Yildiz (2010) have constructed a three-country
model, and investigated both bilateralism and multilateralism games. Assuming
ex ante symmetry among countries, they have shown that global free trade is the
only CPNE outcome in both games.
On the other hand, Furusawa and Konishi (2005, 2007) and Goyal and Joshi(2006) have formulated the situation within the framework of network formation
games as developed by Jackson and Wolinsky (1996). They have examined the in3

Because there is a vast amount of literature concerning the dynamic time-path question, weonly consider those studies that are the most relevant to the current paper.
4
Yi (2000) has considered a similar model in which regional trade agreements take the form of
FTAs instead of CUs. There is an important difference between the cases of CUs and FTAs in his
model: formation of CUs exhibits “negative” externalities on the welfare of the outsider countries,
while that of FTAs exhibits “positive” externalities.

3

centives of countries to form or dissolve bilateral FTAs. Then, adopting the notionof pairwise stability as the solution concept, they have shown (simultaneously, but
independently) that the complete network of FTAs, which corresponds to efficient
global free trade, is pairwise stable; at the same time, they have also shown thatsome other inefficient configurations of FTA networks, in which one country isisolated and all the other form as many bilateral FTAs as possible, can be pairwise
stable.
In their coalition/network formation approach, we find two common featuresembedded in their models. One is concerned with the myopia of the countries. In
the coalition formation models, countries are considered to play the Nash equilibrium strategies in one-shot games. Although the concepts of SPNE and CPNE
take account of the farsightedness on the side of the countries to some extent, they
are myopic concepts and fail to capture the farsightedness of the countries satisfactorily. As for the network formation models, the pairwise stability requires fora particular network to be pairwise stable such that each country has no incentive
to abandon an existing FTA and any pair of countries with no FTA between themhas no incentive to form a new FTA. In the definition of pairwise stability, countries are supposed to only consider the immediate consequence of their actions offorming an FTA or abandoning an existing FTA, but ignore possible subsequent
reactions by other countries. The notion of pairwise stability fails to deal with thefarsightedness of the countries, too.
The other common feature is concerned with the ability of the models to predict the realization of the equilibrium outcomes. The solution concepts adopted
in the coalition/network formation approach only tell us that once an equilibrium
FTA structure has been reached, then no country wants to change it. These solution concepts together with the construction of the models, however, are totallysilent about whether and how an equilibrium FTA structure can be reached from
non-equilibrium FTA structures. In particular, these models, at the very outset, ignore the possibility that some interim FTAs might be formed en route to the final
outcome.
The models based on the “dynamic” game approach have taken explicit account of the possibility of forming interim FTAs. Aghion, Antràs, and Helpman(2007) have considered a transferable utility, extensive form, bargaining game4

among three countries. In their model, one country is assumed to be the agendasetter and others are assumed to be followers. The agenda-setter decides whether
to consider sequential bilateral bargaining with other countries or to consider simultaneous multilateral bargaining with all countries at once, and also decides
endogenously how much income transfers should be made. They have shown that
if global free trade is efficient—if the grand-coalition superadditivity in the terminology of Aghion et al. (2007) is satisfied—and if the formation of bilateral FTAs
imposes negative externalities on the outsider countries, then the agenda-setter
prefers sequential bargaining and the grand coalition forms; in other words, someinterim FTA between the agenda-setter and a follower country is formed on the
SPNE path, and eventually, global free trade is reached.
Macho-Stadler and Xue (2007) have considered a transferable utility, partition
function form, infinite horizon game among three countries. In their model, unlike
in Aghion et al. (2007), countries are assumed to be ex ante symmetric and they
move successively according to a predetermined order. Further, they assume thatthe surplus accruing from the formation of a trading bloc (CU) is divided throughincome transfers among the concerned countries according to a fixed sharing rule.
Similar to Aghion et al. (2007), their model exhibits the grand-coalition superadditivity and the negative externality on the outsider countries. Then, they haveshown that in the Markov Perfect Equilibrium (MPE) of the game, first, some trading bloc is formed, and eventually, a worldwide trading bloc is formed. Seidmann(2009) has, in a sense, extended the model of Macho-Stadler and Xue (2007) byallowing countries to form not only CUs but also FTAs. He has shed new light ona motive for forming a trading bloc, which he called the “strategic positioning”:
countries form a trading bloc in order to shift the status quo in a direction that ismore favorable for member countries than the initial position.
In the models of Aghion et al. (2007) and Macho-Stadler and Xue (2007), thegrand-coalition superadditivity and the negative externality due to the formation of
trading blocs imposed on the outsider countries play important roles in achieving
global free trade. The intuition behind this is explained as follows. If two or morecountries form a trading bloc, the outsider countries become worse-off by thenegative externalities; this gives the outsider countries higher incentives to form
new trading blocs or to join the existing ones. Furthermore, the grand-coalition5

superadditivity guarantees (or, at least, makes it possible) that every country will
be made better-off after global free trade is achieved. This explanation, however,relies on the fact that the existing trading blocs will never be dissolved as assumed(implicitly or explicitly) in Aghion et al. (2007), Macho-Stadler and Xue (2007),and Seidmann (2009). If countries can dissolve some of the existing trading blocs,
even the “positive” externality can serve as a device that enhances the incentivesof the countries to move toward global free trade. The point is not whether theexternality is positive or negative, but that countries can change their positions
strategically, and thereby, alter the incentive structure of the countries involved as
pointed out by Seidmann (2009).
In this paper, as in Furusawa and Konishi (2005, 2007) and Goyal and Joshi(2006), we address the “dynamic time-path” question within the framework of the
network formation games. Our approach, however, is different from theirs in that
we take full account of the farsightedness on the side of the countries (players)
and that we adopt the von Neumann-Morgenstern (vNM) stable set—the set ofoutcomes that satisfies both internal and external stabilities—as the solution concept.5 With the notion of the vNM stable set, we can incorporate the farsightedness of the countries appropriately into the model. Further, the vNM stability (inparticular, external stability) consistently explains whether and how some stablenetworks can be realized through the behavior of the farsighted players from otherunstable networks; in other words, it takes account of the possibility of forminginterim trading blocs as in Aghion et al. (2007), Macho-Stadler and Xue (2007),and Seidmann (2009). To highlight the roles of farsightedness and the notion ofvNM stability, we also consider cases where countries are myopic and compare
the vNM stable set with another well-known solution concept, that is, the core.
To make the model tractable, we adopt the same background trade model as
Goyal and Joshi (2006) and Macho-Stadler and Xue (2007). We assume that there
are ex ante symmetric countries; each country has one oligopolistic firm who sells
a homogeneous good in both the domestic market and the foreign markets. Firms
compete in the Cournot fashion. The markets are separated. Our model exhibits
5

The notion of the vNM stable set was originally introduced by von Neumann and Morgenstern(1944) as a solution concept for games in characteristic function form. Greenberg (1990)’s theoryof social situations has paved the way for its application to the games in other forms.

6the grand-coalition superadditivity and the negative externality. Further, unlike
Aghion et al. (2007), Macho-Stadler and Xue (2007), and Seidmann (2009), we
assume away international income transfers (even within the member countries ofa trading bloc).
Trading blocs in our model take the form of an FTA rather than that of aCU. That is, when a pair of countries form a bilateral FTA, they eliminate tariffs
on mutual trade, but they do not coordinate the tariff rates on the imports fromoutsider countries. A pair of countries can form a new FTA without consent fromthe member countries of the existing FTAs; in addition, each single country canunilaterally annul the existing FTAs as many as it wants.
We assume that the pre-agreement tariff rates are given exogenously.6 Then,
we consider two extreme cases: one in which the pre-agreement tariffs are very
(prohibitively) high and the other in which they are very low (almost zero). Whenthe pre-agreement tariffs are very high, we show that (i) if the countries are myopic, there exists a unique nonempty myopic core consisting not only of the complete FTA network, which corresponds to global free trade, but also of FTA networks in each of which all countries except for one form a complete FTA network(i.e., a free-trade club) and the remaining one country is isolated—the myopic
core in this case coincides with the set of all pairwise stable FTA networks; andthat (ii) if the countries are farsighted, there exists a unique farsighted vNM stable
set consisting only of the complete FTA network, which coincides with the farsighted core. On the other hand, when the pre-agreement tariffs are very low, weshow that (iii) if the countries are myopic, there exists a unique nonempty myopic
core consisting only of the complete FTA network; and that (iv) if the countries
are farsighted, the farsighted core is empty, but (v) there exists a unique farsighted
vNM stable set consisting of FTA networks in each of which all countries except
for one form a free-trade club.
In the case of high pre-agreement tariffs, the farsighted vNM stable set, refining the myopic core and the set of pairwise stable networks, supports only global
free trade. The external stability of the farsighted vNM stable set explains whether
and how global free trade is achieved from other situations through the successive
6This assumption conforms Article XXIV of the GATT, which requires members of a preferential trade agreement (FTA in this case) to not raise tariffs on nonmembers.

7formation (and/or dissolution) of bilateral FTAs. In this case, we can say that bilateral FTAs can be building blocks toward global free trade. On the other hand, inthe case of low pre-agreement tariffs, the farsighted vNM stable set predicts that
global free trade cannot be achieved; instead, it supports some other inefficient
FTA networks. In this case, bilateral FTAs can be said to be stumbling blocks
against global free trade.
Based on the same background trade model of Goyal and Joshi (2006) as thecurrent paper, Xue and Zhang (2009) have examined an FTA network formation
game incorporating the farsightedness of the countries. To capture the farsightedness, they have adopted the notion of pairwise farsightedly stable set developed by
Herings, Mauleon, and Vannetelbosch (2009), which is closely related to (but, different from) our farsighted vNM stable set. The farsighted vNM stability requires
both internal and external stabilities. On the other hand, the pairwise farsighted
stability requires deterrence of external deviations, minimality, and external stability. Xue and Zhang (2009) have assumed, unlike our model, that the countries
impose optimal tariffs on non-FTA countries. Their model admits a multiplicityof the pairwise farsightedly stable sets: one of them supports global free tradeas a stable outcome, while the others do not. In contrast to this, the farsighted
vNM stable set in our model is determined uniquely. The differences between
their results and ours are attributable to the differences in the solution concepts.7
The rest of the paper is organized as follows. In Section 2, we introduce thebackground trade model and show how to represent FTA network configurations
by using some graph-theoretical concepts. In Section 3, we explicitly formulate
the FTA network formation game and introduce the solution concepts of the vNM
stable set and the core. In Sections 4 and 5, we examine the high pre-agreement
tariff case and the low pre-agreement tariff case, respectively, and show our main
results. Section 6 contains some remarks.
To facilitate the discussion, all the proofs of the Lemmas and Theorems are relegated to the Appendices. Although we describe the model and state the lemmas
and theorems based on the general n-country model as far as possible, some of thelemmas and theorems (in particular, Theorem 2 and Theorem 5) can be proved
7

We will discuss this point later.

8

rigorously only in the benchmark model with four countries. If the restriction on
the number of the countries is necessary, we state it explicitly.

2

Basic modelIn each country, there is one oligopolistic firm, which can sell in the domestic
market and the foreign markets. The markets are separated. If two countries haveagreed on a bilateral FTA, then each country allows the other country’s firm toenter its own market without imposing an import tariff. Otherwise, each country
imposes a nonzero tariff on the imports from the other. For a firm of country k (i.e.,
firm k), the competitiveness and/or the profitability in country j’s market depends
not only on whether country k has established an FTA with country j but also on
whether country j has established FTAs with other countries. This implies that thewelfare of a country (which is the sum of the consumers’ surplus, the profit of its
firm, and the tariff revenue) depends on the whole structure of FTA configurations.

2.1

Demand, production, and welfare

Let N = {1, 2, . . . , n} be the set of symmetric countries. (As mentioned in the
Introduction, we describe the model and state the lemmas and theorems in termsof the general n-country model as far as possible. When we intend to be more
specific, we make use of the benchmark model with four countries.) In country j, there is a single firm (firm j) producing a homogeneous good with constantmarginal cost technology; we assume that the marginal costs are zero. Let Qkj be
the output of firm k in country j. Then, the total output supplied to country j’sPmarket is Q j ≡ k∈N Qkj . Let p j be the price of the good in country j. The inverse
demand function of country j is given by p j = α − Q j , where α > 0.
The unit tariff rate faced by firm k in country j is denoted by tkj . The profit offirm k obtained from operating in country j is


X



j
πkj ≡ α −Qij − t  Qkj .
k

(1)

i∈N

Of course, the total profit of firm k isPkj∈N π j . Firms compete in a Cournot fashionin each market. Because we assumed zero marginal costs, we can consider each9

country’s market separately. The first-order condition for profit maximization offirm k in country j isα−X

Qij − tkj − Qkj = 0.

(2)

i∈N

By symmetry, we obtain the following result:P
α − (n + 1)tkj + i∈N tij
.
(3)
n+1
Then, the profit of firm k obtained from operating in country j can be expressedQkj =as follows:2P α − (n + 1)tkj + i∈N tij 
 .
n+1


πkj ≡ (4)

On the other hand, the consumers’ surplus CSk of country k depends on the total
supply in country k:

P"#2
1 nα − i∈N tik
CS =
.
(5)
2
n+1
The tariff revenue Rkj that country k can collect from firm j operating in country k’skmarket is
Rkj = tkj Qkj = 2 P
αtkj − (n + 1) tkj + i∈N tik tkj

.
(6)
n+1
Let Nk be the set of country k itself and the countries with which country k
has FTAs; let nk be the number of those countries, that is, nk ≡ |Nk |. If country k
and country j form an FTA, then they eliminate their mutual tariffs: tkj = tkj = 0.
On the other hand, if country k has no FTA with country j, it sets its tariff rate
at tkj > 0. Further, we assume that country k’s tariff rates imposed on the imports
from non-FTA countries are the same: tkj = tk > 0 for all j ∈ N \ Nk . This reflects
the Most-Favored Nations principle in the GATT/WTO.
The social welfare W k of country k is measured by the sum of the consumers’
surplus, the total tariff revenue, and the total profit of firm k:
XX
W k = CSk +
Rkj +
πkj
j∈N

"

=

j∈N

#
k 2

n
o
tk (n − nk ) α − (1 + nk )tk

1 nα − (n − nk )t
+
2
n+1
n+1
X " α + (n − n j )t j #2
X " α − (1 + n j )t j #2
+
+
.
n+1
n+1
j∈N
j∈N\N
k

k

10

(7)

In general, the welfare of country k depends upon (i) the tariff rates of all countries(i.e., t1 , t2 , . . . , tn ); (ii) the number of FTAs that country k forms (i.e., nk ); (iii) the
number of FTAs that country k’s partners have (i.e., n j for j ∈ Nk ); and (iv) the
number of FTAs that non-partners have (i.e., n j for j ∈ N \ Nk ).
As is easily seen from Eq. (7), an increase in the tariff rate of a partner countryj(t for j ∈ Nk ) raises the welfare of country k, while an increase in the tariff rate ofa non-partner country (t j for j ∈ N \ Nk ) reduces the welfare of country k. Further,
if a partner country or a non-partner country forms a new FTA, which increases
the number of FTAs (n j for j , k), then the welfare of country k deteriorates. In
this sense, formation of an FTA in our model imposes “negative externalities” on
the outsider countries.

2.2

Some graph-theoretical concepts

To describe FTA networks in a formal way, we need to introduce some graphtheoretical concepts.8 Let V be a set of vertices. An unordered pair of distinct
vertices is called an edge. Let E be a subset of the set of all edges. Then, the pairof sets (V, E) is called a graph.9 For a graph G, we write V(G) and E(G) for its
vertex set and edge set, respectively: that is, G = (V(G), E(G)). The order of agraph G is the number of vertices and the size of G is the number of edges. We
denote the size of G as e(G) ≡ |E(G)|. An edge (v, w) is said to join the vertices v
and w, and is simply denoted as vw. By definition, vw and wv represent the sameedge. If vw ∈ E, then v and w are the end-vertices of vw and said to be adjacent
to each other. If the context is clear, we simply write v ∈ G and vw ∈ G insteadof writing v ∈ V(G) and vw ∈ E(G). The degree of a vertex v in G, denoted bydG (v), is the number of vertices adjacent to v in G. A vertex of degree zero is said
to be isolated. An empty graph is a graph such that every vertex is isolated. A
complete graph is a graph such that for every pair {v, w} of distinct vertices, there

8

Most of the definitions of the graph-theoretical concepts introduced here are borrowed from
Bollobás (1979).
9
The vertex set V is assumed to be nonempty, but the edge set E may be empty.

11

is an edge joining them.10 The following fact is well-known and easy to prove:11
for any graph G,X

dG (v) = 2e(G).

(8)

v∈V(G)

A walk from v0 to v` (i.e., a v0 -v` walk) in a graph G is an alternating sequenceof vertices and edges W = v0 , v0 v1 , v1 , v1 v2 , . . . , v`−1 v` , v` , where vk−1 vk ∈ E(G) fork = 1, 2, . . . , `. The length of a v0 -v` walk is `. A v0 -v` walk is called an `-cycle if` = 3, v0 = v` , and the vertices vk (0 5 k < `) are all distinct. A path is a walk with
distinct vertices. A graph is connected if for every pair {v, w} of distinct vertices,
there is a v-w path.
A graph (V1 , E1 ) is a subgraph of another graph (V2 , E2 ) if V1 ⊂ V2 andE1 ⊂ E2 . A maximal connected subgraph of a graph G is a component of G.12 Agraph G can be divided into some components. Two graphs (V1 , E1 ) and (V2 , E2 )are isomorphic if there exists a bijection ϕ : V1 → V2 such that vw ∈ E1 if andonly if ϕ(v)ϕ(w) ∈ E1 . Intuitively speaking, two isomorphic graphs are of thesame shape.
Given a graph G = (V(G), E(G)), we can obtain new graphs from G by deleting or adding some edges. If (v, w) ∈ E(G), then G − (v, w), or more simply,
G − vw denotes the graph obtained by deleting the edge (v, w) from G, that is,
G − vw = (V(G), E(G) \ {(v, w)}). Similarly, if (v, w) < E(G), then G + (v, w)
or G + vw denotes the graph obtained by adding the edge (v, w) to G, that is,
G + vw = (V(G), E(G) ∪ {(v, w)}).

2.3

Representation of FTA networks

An FTA network is a description of how the countries form bilateral FTAs withother countries. An FTA network is represented by a graph G such that V(G) = N
and (i, j) ∈ E(G) if and only if country i and country j have a bilateral FTA
between them. Let Γ be the set of all graphs with their vertex sets being identified
10

Note that some authors adopt a slightly different definition of a graph, in which two or more
distinct edges that join v and w (i.e., parallels) as well as an edge that joins a vertex to itself (i.e.,a loop) are allowed. In our definition, no parallels and loops are allowed.
11
Each edge has exactly two end-vertices. Then, if we add the degree over all vertices, a particular edge is counted exactly twice. This proves Eq. (8).
12Here, “maximal” is taken with respect to the set inclusion.

12with the set N of all countries. Then, Γ represents all possible FTA networks. The
empty graph, denoted by G∅ , corresponds to the situation where there is no FTA
in the world. On the other hand, the complete graph, denoted by G∗ , corresponds
to the situation where every pair of countries forms a bilateral FTA—global free
trade.
Let Nk (G) ≡ {k} ∪ { j ∈ N| (k, j) ∈ E(G)} be the set of country k itself andall countries with whom country k has FTAs in the FTA network G. Further, let
nk (G) ≡ |Nk (G)| be the cardinality of Nk (G). By definition, we have nk (G) =dG (k) + 1 = 1 for all k ∈ N and for all G ∈ Γ. By substituting nk (G) and n j (G) into
Eq. (7), we can write the welfare of country k as a function of G, that is, W k (G)for all G ∈ Γ.
Examples of FTA networks in the benchmark model with four countries areillustrated in Figure 1. Small circles (i.e., a, b, c, and d) represent possible “addresses” at which countries are located (one address for one country) in a graph.
The numbers in small circles represent the countries located at the corresponding
addresses. A bold solid line between a pair of addresses means that a bilateral
FTA is formed by the countries located at these addresses. On the other hand, athin broken line between a pair of addresses means that there is no FTA between
the countries located there.
Let G and H be the graphs that correspond to panel (i) and panel (ii) of Figure 1, respectively. Both G and H represent a situation where countries 1, 2, and 3
form a “hub-and-spoke” system of FTAs and the remaining country 4 is excluded
from the hub-and-spoke system. Although the same three countries participate in
the hub-and-spoke systems in both G and H, the welfare of each country obtainedin G can be different from that in H. Take country 1 for example. Country 1 isa spoke in G, but it is the hub in H. We have n1 (G) = 2, n2 (G) = 3, n3 (G) = 2,
and n4 (G) = 1 for G, while we have n1 (H) = 3, n2 (H) = 2, n3 (H) = 3, andn4 (H) = 1 for H. By substituting these results into Eq. (7), we can verify that
W 1 (G) < W 1 (H).13 In general, the welfare of a country depends upon the current
graph; more specifically, it depends both on the shape of the current graph (i.e.,
the isomorphic class to which the graph belongs) and on the address at which the13See, also, Table 1.

13

country is located in the graph.
In the benchmark model with four countries, we have eleven different shapesof graphs. In other words, the set Γ of all possible graphs is partitioned into
eleven isomorphic classes: Γ1 , Γ2 , Γ3 , Γ4 , Γ5 , Γ6 , Γ7 , Γ8 , Γ9 , Γ10 , and Γ11 such thatS
Γ = 11r=1 Γr and Γr ∩ Γ s = ∅ if r , s. The shape of a (representative) graph in eachisomorphic class Γr is illustrated in panel (r) of Figure 2 (r = 1, 2, . . . , 11).
Let us examine some of the isomorphic classes. The isomorphic class Γ1 contains only one graph, that is, the empty graph G∅ . The empty graph G∅ meansthat there is no FTA in the world. The isomorphic class Γ3 , which contains six
graphs, corresponds to a situation where the world is divided into two small trading blocs of equal size. For example, let us consider a graph G ∈ Γ3 such that
E(G) = {(1, 2), (3, 4)} (i.e., a = 1, b = 2, c = 3, d = 4). This describes the situation where countries 1 and 2 form a bilateral FTA and countries 3 and 4 form
another bilateral FTA and there are no other bilateral FTAs. The isomorphic classΓ4 corresponds to a three-country hub-and-spoke system (exclusive of one isolated country). The isomorphic class Γ5 contains four graphs. Let us consider agraph G0 ∈ Γ5 such that E(G0 ) = {(1, 2), (2, 3), (3, 1)}. This describes the situation
where three countries 1, 2, and 3 form a free-trade club among them, but theyexclude country 4 from the club. FTAs among countries 1, 2, and 3 constitutea complete component of G0 (a 3-cycle graph). The isomorphic class Γ7 , whichcontains four graphs, corresponds to a worldwide hub-and-spoke system with one
country being the hub and the other countries being spokes. Last, let us consider
the isomorphic class Γ11 . This is a singleton consisting only of the complete graphG∗ , which corresponds to global free trade.

3

Formation and stability of FTA networks

In the last section, we have considered how to describe the structure of FTA networks and their welfare implications. Here, we consider how an FTA network isformed and/or dissolved.

14

3.1

Inducement correspondence

Let G be a current FTA network. First, let us consider what a single country cando. A single country, of course, cannot form an FTA by itself, but it can annul
the existing FTAs unilaterally. Suppose that country k has an FTA with country j( j ∈ Nk (G) \ {k}) in the current FTA network G. If country k annuls the existing
FTA with country j, the current FTA network G changes to G − k j. Further,country k can choose some (possibly all) partner countries in G and cancel the
FTAs with those countries simultaneously. Technically, from the current FTA
P
network G, country k can induce another FTA network H = G − j∈T k j for someT ⊂ Nk (G) \ {k}.14 When a single country k can induce H from G in this way, we{k}kwrite G −−→ H or G →− H.
Next, let S = {k, j} be a coalition of two countries k and j and let us consider
what S can do. If countries k and j have no FTA between them in G (i.e., k j < G)
and if they negotiate and agree on a bilateral FTA, then a new FTA k j is added tothe current network G, and accordingly, a new FTA network G + k j is established.
More generally, when countries k and j form a new FTA, country k, at the sametime, can annul some of its FTAs with other countries unilaterally; the same istrue for country j. In this case, from the current G, a two-country coalition S can
P
P
induce H = G+k j− i∈Tk ki− i∈T j ji for some T k ⊂ Nk (G)\{k} and T j ⊂ N j (G)\{ j}.
If countries k and j have a bilateral FTA in G (i.e., k j ∈ G), countries k and j canannul some of the existing FTAs (possibly, including the FTA k j itself) at thePPsame time. Therefore, in this case, S can induce H = G − i∈Tk ki − i∈T j ji forsome T k ⊂ Nk (G) \ {k} and T j ⊂ N j (G) \ { j}. In this way, any coalition S of two
countries can induce a new FTA network H from a current FTA network G. Whena coalition S = {k, j} of two countries k and j can induce H from G, we writeS{k, j}G→− H or G −−−→ H.15
When there is a single country or a pair of countries that can induce H fromG, we simply write G → H. Following the terminology of the theory of social situations (Greenberg, 1990), we call the binary relation {→} defined on the set Γ of
all graphs as the inducement correspondence. The inducement correspondence
P
When T = { j1 , j2 , . . . , jR }, the expression G − j∈T k j means G − k j1 − k j2 − · · · − k jR .
15
A similar argument can also be applied to any nonempty coalition with an arbitrary numberof countries.
14

15

only describes how countries can change the current FTA network to another net{k, j}{k}work. It should be noted that neither G −−−→ H nor G −−→ H implies that H isbetter than G for the countries concerned.

3.2

Domination relations

Let G be a current FTA network and consider a coalition S = {k, j} of two counS

tries. Suppose that G →− H. That is, the coalition S has some power to change thecurrent FTA network G to another network H. However, whether the coalition S
actually exercises this power depends on the welfare consequence and also on theperspectives of the countries in S as to how the other countries react to their initialactions. If the countries anticipate that exercising the power to induce H from G
eventually leads to a situation in which they are made worse-off than the current
situation, then they will not do so. On the other hand, if the countries anticipate
that exercising the power eventually leads to a situation in which they are madebetter-off, then they do exercise their power.16
Taking different levels of the countries’ perspectives into account, we define
two domination relations on the set Γ of all possible FTA networks. The first one
reflects the myopia of the countries.
Definition 1 (Direct domination relation). For two FTA networks G and H, if
S

there exists a nonempty coalition S of countries with 1 5 |S | 5 2 such that G →− Hand W i (G) < W i (H) for all i ∈ S , then we say that “H directly dominates G
through S ” and we write G ≺S H. Further, when G ≺S H for some nonempty
S ⊂ N, we simply say that “H directly dominates G” and write G ≺ H.
S

Consider a coalition S that can induce H from G (i.e., G →− H). If all thecountries in S believe that they will be made better-off in H than in G and also
believe that H will remain in the status quo after being induced (i.e, S believes
that the other countries do not react in H at all), the countries actually exercise
their power to induce H from G. Thus, the direct domination relation G ≺S H isrealized if the countries in S ignore the possibility that H will be replaced withanother network H 0 through subsequent (re)actions by other countries. In this16

The same explanation also applies to a single country.

16

sense, the direct domination relation reflects the myopia of the countries in S .
When G ≺S H, we say that the countries in S have myopic incentives to movefrom G to H.
The indirect domination relation defined below reflects the farsightedness ofthe countries.
Definition 2 (Indirect domination relation). For two FTA networks G and H, if
there exist a sequence of FTA networks {Gr }Rr=0 and a corresponding sequence ofcoalitions of countries {S r }Rr=1 that satisfy the following conditions:(i) G0 = G and GR = H,Sr(ii) Gr−1 −→ Gr and 1 5 |S r | 5 2 for all r = 1, 2, . . . , R, and(iii) W i (Gr−1 ) < W i (H) for all i ∈ S r and for all r = 1, 2, . . . , R,
then we say that “H indirectly dominates G” and we write G  H.
The second requirement that the number of deviating countries in each stepof the indirect domination should not exceed two reflects the bilateralism in ourmodel. If we relax this requirement and allow the simultaneous deviation by morethan three (possibly, by all) countries, we can define another indirect domination
relation that reflects the multilateralism. After showing our main results, we will
discuss how the multilateralism works in our model.
Let us consider a coalition S r that appears in the definition of the indirect
domination relation. When S r induces Gr from Gr−1 , country k in S r compares
the current welfare level W k (Gr−1 ) with the welfare level W k (H) that can be obtained in the “final” FTA network H, but not with the welfare level W k (Gr ) thatcan be obtained in the “immediate” FTA network Gr after Gr−1 . Therefore, it may
be that S r does exercise the power to change Gr−1 to Gr even if some countries in
S r are made worse-off in Gr immediately after Gr−1 , anticipating that subsequent
inducements by other countries will eventually lead to H in which all the countries in S r are made better-off than in Gr−1 . In this sense, the indirect domination
relation reflects the farsightedness of the countries.1717Note that G ≺ H implies G  H.

17The definition of indirect domination relation is akin to that of a farsighted
improving path introduced by Herings et al. (2009) in order to define their solution concept of the pairwise farsightedly stable set. In each step of a farsighted
improving path, only one link (edge) can be formed or severed. On the other hand,in each step of a sequence realizing indirect domination, only one link (edge) can
be formed, but, at the same time, some of the existing links can be severed (if acountry or a pair of countries concerned wants to do so). In a sense, the indirect
domination relation allows the countries a higher degree of freedom to deviate
from a current FTA network than the farsighted improving path. This fact plays
an important role in establishing our main results.18

3.3

Solution concepts

In general, an abstract system is a pair (X, ∠) of a nonempty set X and a domination relation ∠ defined on X: for x, y ∈ X, we say that y dominates x if x∠y. Basedon the domination relations defined in the previous subsection, we have two particular abstract systems (Γ, ≺) and (Γ, ), which we call the myopic system andthe farsighted system, respectively. Let us define the solution concepts for (X, ∠).
Definition 3 (Core). The core of an abstract system (X, ∠), denoted by C(X, ∠), isa subset of X consisting of all outcomes that are not dominated. That is,C(X, ∠) ≡ {x ∈ X| there is no y ∈ X such that x∠y} .

(9)The core of (X, ∠) always exists and is unique, but it can be an empty set. Oncean outcome in the core has been reached, it will never be replaced with any otheroutcome according to the domination relation ∠. Therefore, we can say that in asense, outcomes in the core are “stable.” The concept of the core, however, fails to
explain whether and how outcomes in it can be reached from (unstable) outcomesoutside of the core.
Definition 4 (von Neumann-Morgenstern stable set). The vNM stable set is asubset K of X that satisfies the following conditions:18

The proof of Theorem 5, for example, heavily relies upon the fact that a pair of two countries
can form an FTA between them and, at the same time, abondon some of the existing FTAs. See
the discussion after Theorem 5.

18

(i) for all x ∈ K, there does not exist y ∈ K such that x∠y (internal stability);(ii) for all x ∈ X \ K, there exists y ∈ K such that x∠y (external stability).
The set of all vNM stable sets for (X, ∠) is denoted by K(X, ∠).
Let K be a vNM stable set for (X, ∠). Internal stability means that any stableoutcome, in the sense that it is included in K, will not be replaced with any otherstable outcome according to ∠. On the other hand, external stability means thatany unstable outcome, in the sense that it is excluded from K, will be replacedwith some stable outcome according to ∠. In this manner, the concept of thevNM stable set (in particular, its external stability) consistently explains what theconcept of the core fails to do.
We call the core and a vNM stable set for the myopic system (Γ, ≺) as the
myopic core and a myopic vNM stable set, respectively; similarly, we call thosefor the farsighted system (Γ, ) as the farsighted core and a farsighted vNM
stable set, respectively. Although the definitions are slightly different, the myopic
core in our model coincides with the set of all pairwise stable networks as definedby Jackson and Wolinsky (1996).
Based on the notion of farsighted improving path, Herings et al. (2009) havedefined the von Neumann-Morgenstern (vNM) pairwise farsightedly stable set andexamined its relation to the pairwise farsightedly stable set. They have shown, inparticular, that a vNM pairwise farsightedly stable set is a pairwise farsightedly
stable set. The difference in the definitions of the farsighed improving path andthe indirect domination relation renders our farsighted vNM stable set different
from the vNM pairwise farsightedly stable set. The farsighted vNM stable set is
not necessarily a pairwise farsightedly stable set; therefore, the predictions by thefarsighted vNM stable set and by the vNM pairwise farsightedly stable set can bedifferent.

4High pre-agreement tariff caseWe first consider the case in which the pre-agreement tariff rates are very high.
More specifically, we assume, as in Goyal and Joshi (2006), that each country
19levies prohibitive tariffs on the imports from countries with whom the country
does not have bilateral FTAs. In this case, international trade occurs only between
those countries who have bilateral FTAs; isolated countries (in a graph-theoreticalsense) actually adopt isolationist policies (i.e., they are in autarky). Therefore, nocountry earns tariff revenue. Then, the welfare of country k in an FTA network G
can be expressed as the sum of the consumers’ surplus and the profits obtained in
the markets of country k’s partners. Accordingly, Eq. (7) is reduced to
"
#2
#2
X "
1 αnk (G)α+.
W (G) =
2 nk (G) + 1
n j (G) + 1
j∈N (G)k(10)k

Note that the negative externality on the welfare of country k in this case only
comes from an increase in the number of FTAs that country k’s partners have (i.e.,
the number of partners’ partners). The reason is quite simple. If country k’s partner (say, country j) forms a new FTA with a third country (say, country i), thenthe market in country j becomes more competitive due to the entry of firm i after
the formation of the FTA ( j, i). Because firm k has no access to country i’s market,
it only suffers from a decrease in its profit obtained in country j’s market. This
makes country k worse-off. On the other hand, even if countries separated fromcountry k and its partners form some new FTAs, the markets in which firm k isoperating are not affected by the formation of these new FTAs. Firm k experiences no loss (gain) in its profit, and therefore, the welfare of country k is kept
unchanged.
Because Eq. (10) contains only one exogenous parameter (i.e., α), we caneasily calculate the value of W k (G) for every G ∈ Γ. As mentioned before, country k’s welfare depends both on the isomorphic class to which G belongs and on
the address at which country k is located in G. Table 1 summarizes the values ofW k (G) in our benchmark model with four countries. The table also shows world
welfare, which is defined as the sum of the welfare of all countries. As can be seenfrom Table 1, a single country can attain the highest welfare when it becomes the
hub of a worldwide hub-and-spoke system (i.e., when it is located at b in a graphG ∈ Γ7 ), while world welfare is maximized when global free trade is achieved(i.e., G∗ ∈ Γ11 ). In our model, the complete network G∗ is efficient, and therefore,20

satisfies the grand-coalition superadditivity.19
Concerning the incentives of a country to form FTAs, Goyal and Joshi (2006)
have shown the following results.
Observation 1 (Goyal and Joshi, 2006).
(i) If a country is involved in one or more FTAs, it has an incentive to form an
additional FTA.
(ii) If n = 4, in an FTA network in which one country is isolated and the othern − 1 countries constitute a complete component FTA network, the isolated
country has no incentive to form an additional FTA.
Based on the above observations, Goyal and Joshi (2006) have shown that (i)the complete network (i.e., global free trade) is pairwise stable, (ii) if n = 4, an
FTA in which one country is isolated and the other n − 1 countries constitute acomplete component FTA network (i.e., a free-trade club with n − 1 countries) ispairwise stable, and (iii) there is no other type of pairwise stable networks. In ourbenchmark model with four countries, we can rephrase their results as follows:
Theorem 1. In the case of high pre-agreement tariffs with four countries, themyopic core C(Γ, ≺) is nonempty and is characterized byC(Γ, ≺) = Γ5 ∪ Γ11 .

(11)

The formal proof is omitted; instead, we give an illustration. Bold black arrows in Figure 3 represent the direct domination relation when the pre-agreement
tariffs are high.20 For example, the arrow from panel (2) to panel (3) means thatfor any FTA network G ∈ Γ2 , there exists an FTA network H ∈ Γ3 that directly
dominates G. Other bold black arrows in the figure carry similar information
about the direct domination relation. It should be noted that any FTA network insome isomorphic class cannot directly dominate other FTA networks in the same
19

The fact that the complete network G∗ is efficient in a general n-country model has been
proved by Goyal and Joshi (2006).
20
For the moment, ignore other symbols such as thin arrows with white heads, double circles,
and asterisks.

21isomorphic class. As illustrated in Figure 3, there is no bold black arrow that begins from panel (5) or from panel (11), meaning that any FTA network in Γ5 orΓ11 cannot be directly dominated by other FTA networks. This proves Theorem 1.
When the countries are myopic and the pre-agreement tariffs are very high,global free trade is not the only stable outcome. Once a free-trade club with n − 1
countries (exclusive of one country) has been formed, the world is trapped in an
inefficient situation. Although each member of the free-trade club has an incentive
to form a new FTA with the isolated country, the isolated country has no myopic
incentive to do so.
Let us consider, in the benchmark model, an FTA network G ∈ Γ5 where
there exist a three-country free-trade club and an isolated country. Suppose thatcountries 1, 2, and 3 form a free-trade club and country 4 is isolated in G. Because
country 4 is located at d in G, it receives W 4 (G) = 3α2 /8 in G. On the other
hand, a member of the free-trade club (say, country 3) receives W 3 (G) = 15α2 /32
in G. If global free trade G∗ is achieved, both countries 3 and 4 will receive
W 3 (G∗ ) = W 4 (G∗ ) = 12α2 /25 (no matter where they are located in G∗ ), which ishigher than W 3 (G) and W 4 (G). Therefore, if all countries are farsighted enoughto understand the consequences of not only the immediate outcome of their own
action but the final outcome that will be realized through the chain reactions ofother countries, then, anticipating that global free trade will be realized eventually,
countries 3 and 4 may form a new FTA between them (even though country 4
becomes worse-off in the immediate FTA network). In the following, we showthat this is indeed the case.
Lemma 1. In the case of high pre-agreement tariffs with four countries,(i) no FTA network can indirectly dominate the complete network G∗ ;(ii) the complete network G∗ indirectly dominates any other FTA network.
With the above results, we can establish the following theorem.
Theorem 2. In the case of high pre-agreement tariffs with four countries, there
exists a unique farsighted stable set KH that is characterized by
KH = Γ11 ≡ {G∗ }.
22

(12)

Further, KH coincides with the farsighted core C(Γ, ) of the farsighted system.21
Comparing Theorem 1 and Theorem 2, we find that FTA networks in the isomorphic class Γ5 , which are included in the myopic core, fail to be stable when
the countries are farsighted. To see how FTA networks in Γ5 are “destabilized”
through the behavior of farsighted countries, let us consider the following example. Take an FTA network G ∈ Γ5 such that E(G) = {(1, 2), (2, 3), (3, 1)} andcountry 4 is isolated. Consider the coalitions {1, 4}, {2, 4}, {3, 4} ⊂ N; correspondingly, let us define the networks such that G1 = G + (1, 4), G2 = G1 + (2, 4), andG3 = G2 + (3, 4). By definition and from Table 1, we obtain the following results:{1,4}

G −−−→ G1 ∈ Γ8{2,4}

G1 −−−→ G2 ∈ Γ10{3,4}

G2 −−−→ G3 = G∗ ∈ Γ11
{1,4}

and

W i (G) < W i (G∗ )fori = 1, 4,and

W i (G1 ) < W i (G∗ )fori = 2, 4,and

W i (G2 ) < W i (G∗ )fori = 3, 4.

{2,4}

{3,4}

Therefore, the sequence G −−−→ G1 −−−→ G2 −−−→ G3 = G∗ realizes G  G∗ .
The key is the behavior of country 4 in the first step in this sequence: country 4
together with country 1 induces G1 from G. In the first step, country 4 itself
becomes worse-off. At the same time, due to the negative externality, countries 2
and 3 become worse-off; therefore, they have higher incentives to move from G1
toward global free trade G∗ . This makes it possible to realize global free trade.
Theorem 2 implies that if the pre-agreement tariffs are very high, global free
trade is the only final outcome that emerges from the chains of bilateral FTA
negotiations among the countries. Even under the prevalence of bilateralism (asembedded in the definition of our inducement correspondence), global free trade
can be achieved through the formation of bilateral FTAs by farsighted countries.
In this case, we can say that bilateral FTAs are building blocks toward global free
trade.
21

Applying the notion of the (myopic) vNM stable set to Krugman (1993)’s monopolisticallycompetitive FTA formation model, Oladi and Beladi (2008) have shown that there exist a unique
myopic vNM stable set supporting global free trade. Although it can be easily shown that there
exists a unique myopic vNM stable set for our model, it contains not only global free trade but
also some other inefficient FTA networks. We omit the proof of existence and the characterizationof the myopic vNM stable set for our model, because it is of less analytical interest.

23

5

Low pre-agreement tariff caseIn this section, we consider the case where the pre-agreement tariff rates are very
low. In this case, even an isolated country (in a graph-theoretical sense) engages
in international trade with all other countries. In other words, even if country kdoes not have FTAs with some (possibly, all) countries in the current situation,
firm k is operating in the markets of those countries. The welfare of country k
is represented by Eq. (7), which contains many exogenous parameters such as tk ,t j , and α. To compare the welfare levels at different addresses in different graphs
effectively, we assume that tk = t j = t for all k, j ∈ N in Eq. (7) and that t ispositive but sufficiently close to zero.
The following lemma characterizes the differences in the welfare of a single
country and in world welfare across different FTA networks.
Lemma 2. In the case of low pre-agreement tariffs, we have for all k ∈ N and for
all H, G ∈ Γ,(i) W k (H) > W k (G) if and only if∆ ≡ nk (H) − nk (G) −
(ii)

P

4
{e(H) − e(G)} > 0
2n + 1

and

(13)

P
k
k
k∈N W (G) if and only ifk∈N W (H) >e(H) − e(G) > 0.

(14)

The difference in the welfare of a single country (say, country k) in different
FTA networks depends both on the number of FTAs that country k has and on thenumber of existing FTAs in the world. On the other hand, the difference in world
welfare in different FTA networks depends only on the number of existing FTAs
in the world. As the number of FTAs increases, world welfare increases. The
following results are immediate from Lemma 2.
Observation 2.
(i) If FTAs not involving country k are formed, the welfare of country k decreases.
24

(ii) If FTAs involving country k and no other FTAs are formed, the welfare ofcountry k increases.
(iii) Global free trade is efficient.
Observation 2-(i) implies the negative externality due to the formation of FTAs.
In the high pre-agreement tariff case, the negative externality on country k only
comes from the formation of FTAs by the countries with whom country k alreadyhas formed FTAs. In the low pre-agreement tariff case on the other hand, even theformation of FTAs by the countries that are separated from country k in the current
situation can negatively affect the welfare of country k. In this sense, we can saythat the negative externality is stronger in the low pre-agreement tariff case thanin the high pre-agreement tariff case.
Observation 2-(ii) contrasts with Observation 1-(ii). In the low pre-agreement
tariff case, every country always has a myopic incentive to form as many new
FTAs as possible. This observation leads us to the following result.
Theorem 3. In the case of low pre-agreement tariffs, the myopic core C(Γ, ≺) isnonempty and it is characterized byC(Γ, ≺) = {G∗ }.

(15)

Note that the complete graph constitutes the myopic core in a general ncountry model and that the complete graph is the only pairwise stable FTA network in this case. In Figure 3, the direct domination relation in our benchmark
model is illustrated by thin arrows with white heads. For example, the arrow pointing from Γ5 to Γ8 implies that for any G ∈ Γ5 , there exists an FTA network in Γ8
that directly dominates G. As illustrated in the figure, Γ11 is the only isomorphic
class that has no originating arrow.22
If the countries are myopic and the pre-agreement tariffs are sufficiently low,
global free trade G∗ is the only stable outcome in the sense that it is included in
the myopic core. From a single country’s viewpoint, because global free tradecontains as many FTAs as possible, the negative externality is maximized in G∗ .
22

Differences between the direct domination relation in the low pre-agreement tariff case andthat in the high pre-agreement tariff case only appear in the relations between Γ4 and Γ7 andbetween Γ5 and Γ7 .

25

Therefore, if the countries are farsighted, some of them may want to abandon
some existing FTAs, anticipating the eventual realization of an FTA network inwhich they can be made better-off. The following lemma clearly shows this point.
Lemma 3. In the case of low pre-agreement tariffs with four countries, global
free trade G∗ is indirectly dominated by an FTA network in Γ5 .
The proof is omitted; see the discussion after Theorem 5. This lemma together
with Observation 2-(ii) implies the following results.
Theorem 4. In the case of low pre-agreement tariffs with four countries, the farsighted core C(Γ, ) is empty.
The proof is omitted; this follows directly from Theorem 3 and Lemma 3.
When the countries are farsighted and the pre-agreement tariffs are sufficiently
low, the notion of the core predicts nothing.
Myopic countries, only taking account of the immediate effects of their own
FTA formation, do not want to leave global free trade. On the other hand, inorder to avoid strong negative externalities, farsighted countries have incentives
to leave global free trade and to induce other FTA configurations with less FTAs
in the world. The tension between the incentives of a country to enlarge FTAs
(Observation 2-(ii)) and to avoid the negative externality due to the formation of
FTAs by other countries determines the stability of FTA networks.
Theorem 5. In the case of low pre-agreement tariffs with four countries, there
exists a unique farsighted stable set KL that is characterized by
K L = Γ5 .

(16)

To show how global free trade G∗ is “destabilized” and how an FTA network
H in KL is realized, we give an example of a sequence that realizes the indirect26

domination G∗  H. Let us consider the following set of FTA networks:G1 ∈ Γ10 : E(G1 ) = {(1, 2), (1, 3), (2, 3), (2, 4), (3, 4)},e(G1 ) = 5,G2 ∈ Γ8 : E(G2 ) = {(1, 2), (2, 3), (2, 4), (3, 4)},e(G2 ) = 4,G3 ∈ Γ6 : E(G3 ) = {(1, 2), (2, 4), (3, 4)},e(G3 ) = 3,G4 ∈ Γ9 : E(G4 ) = {(1, 2), (1, 3), (2, 4), (3, 4)},e(G4 ) = 4,

H ∈ Γ5 : E(H) = {(1, 2), (1, 3), (2, 3)},e(H) = 3.

In H, countries 1, 2, and 3 form a free-trade club, but country 4 is excluded. As
compared to global free trade G∗ , each member of the free-trade club loses only
one FTA in H, while the number of FTAs in the world is reduced by three. Eachmember experiences less negative externalities in H than in G∗ . Country 1 can
induce G1 from G∗ unilaterally by abandoning the FTA with country 4. Further,because n1 (H) − n1 (G∗ ) = −1 and e(H) − e(G∗ ) = −3, we have W 1 (H) > W 1 (G∗ )by Lemma 2. That is,{1}G∗ −−→ G1

and W 1 (G∗ ) < W 1 (H).

Similarly, we can show that{1}

G1 −−→ G2{3}

G2 −−→ G3{1,3}

G3 −−−→ G4{2,3}

G4 −−−→ HandW 1 (G1 ) < W 1 (H),andW 3 (G2 ) < W 3 (H),andW i (G3 ) < W i (H)for

i = 1, 2,and

W i (G4 ) < W i (H)for

i = 2, 3.

In the second step, country 1 cancels the FTA with country 3 unilaterally. (We cancompress the first and second steps by assuming that country 1 annuls the FTAs
with countries 3 and 4 simultaneously.) Then, country 2 comes to occupy a hublike position in G2 . In the third step, country 3 cancels the FTA with country 2.
Then, countries 1 and 3 form an FTA in the fourth step. In the last step, countries
2 and 3 form an FTA between them, and at the same time, abandon the FTAs withcountry 4 simultaneously. We obtain G∗  H.23
23

This proves Lemma 3.

27

It is worth noting that in the above sequence realizing G∗  H, the FTA
between countries 1 and 3 is abandoned once (by country 1 unilaterally) and isreorganized by them bilaterally. Similar argument also applies to the FTA between
countries 2 and 3. In this way, by forming and dissolving FTAs, countries canchange their relative addresses in FTA networks strategically. This can be seen asa reflection of the strategic positioning as indicated by Seidmann (2009).
Our Theorem 5 is in sharp contrast to the results obtained by Aghion et al.
(2007) and Macho-Stadler and Xue (2007). Although their models and our model
share important properties such as the grand-coalition superadditivity, negative
externality, and farsightedness of the countries, their models predict the realizationof global free trade, while our model predicts the realization of other inefficient
FTA structures. The possibility of dissolving the existing FTAs and the strengthof the negative externality are the differences between their models and ours. In
their models, it is assumed that if FTAs have been formed, they will never bedissolved. On the other hand, in our model, it is assumed that countries can form
and/or dissolve FTAs; as such, countries can make the most of their strategic
positioning to avoid the strong negative externality accruing from the formationof FTAs by other countries. If we assume away the possibility of dissolving theexisting FTAs from our model, we can realize global free trade, but we cannot
exclude the inefficient FTA networks from the farsighted vNM stable set.24
Thus far, we have assumed that only a single country or a pair of two countries can induce one FTA network from another FTA network; in other words, wehave only considered the role of bilateralism. Here, let us briefly discuss the roleof multilateralism. By dropping the requirement of |S r | 5 2 in the definition of
the indirect domination relation , we can define a new indirect domination relation under multilateralism. Is global free trade secured by the farsighted vNM
stable set under the new indirect domination relation? Unfortunately, the answer
is no. Even though the grand-coalition superadditivity is satisfied in our benchmark model, a coalition with three countries has a strong incentive to deviate from
24

The inducement correspondence can be modified easily to not allow the possibility of dissolving the existing FTAs. Further, it is easy to show the existence of the farsighted vNM stable set,
which includes global free trade and other inefficient FTA networks, under the modified inducement correspondence.

28

global free trade G∗ to an FTA network in the isomorphic class Γ5 , and actually,
it can do so in only one step. Global free trade is “destabilized” much easily
under multilateralism than under bilateralism when the pre-agreement tariffs are
sufficiently close to zero.25

6Remarks

We have shown that when the pre-agreement tariffs are very high, the farsighted
vNM stable set only supports global free trade, and that when the pre-agreement
tariffs are sufficiently low, the farsighted vNM stable set does not support global
free trade and instead supports some inefficient FTA networks. In the former case,
we can say that bilateral FTAs are the building blocks for achieving global free
trade, and in the latter case, to the contrary, they are the stumbling blocks against
achieving global free trade. These results make a somewhat ironic impression:
the closer the world economy is to global free trade (in the sense that the preagreement tariffs are very low), the harder it is to realizing the same.
Of course, our results depend upon the details and strong assumptions of ourmodel. In particular, we have assumed that the tariff rates on non-FTA countries
are exogenously determined. As Yi (2000) and Bond et al. (2004) have reported,
if the tariff rates on non-FTA countries are determined endogenously to maximize
the social welfare of each country, the tariff rates after the formation of an FTA
decrease.26 This tariff-complementarity effect makes non-FTA countries betteroff, and thereby, generates positive externalities on them.27 Then, the mechanisms
supporting our results and the roles of bilateralism and multilateralism can bereversed. Hence, it may be the case that global free trade is supported by thefarsighted vNM stable set. To investigate this possibility is a subject of future
research.
25

This conclusion depends upon the non-availability of international transfers in our model. If
we allow international transfers and coalitional moves by more than three countries, the isolated
country in a stable FTA network in Γ5 becomes able to bribe all the other countries to move toward
global free trade G∗ . In this case, it may be possible (though not proved) that Γ5 is destabilized andglobal free trade is established as the stable outcome through the behavior of farsighted countries.
26
The fact that the optimal tariff rate after the formation of an FTA is lower than before has beenreported by several other authors.
27
The term “tariff-complementarity” is attributable to Bagwell and Staiger (1998).

29

A

Appendix: Proofs

A.1

Proof of Lemma 1

Part (i)Suppose, in negation, that there exists H that indirectly dominates G∗ and that thefollowing sequence of FTA networks {Gr }Rr=1 and corresponding coalitions {S r }Rr=1
realizes G∗  H:
S1

S2

S3

SR

G∗ −−→ G1 −−→ G2 −−→ · · · −−→ GR = H.

(17)

Note that because no pair of two countries can form a new FTA in G∗ , the firstcoalition S 1 must dissolve one or some of the existing FTAs in G∗ . Because
the situation in G∗ is symmetric for all countries, we can assume S 1 = {1} orS 1 = {1, 2}. Further, without loss of generality, we can concentrate on the welfare
of country 1. If G∗ were to be indirectly dominated by H, we must have W 1 (G∗ ) <W 1 (H). From Table 1, we can show that W 1 (G∗ ) < W 1 (H) holds true only in thefollowing five cases: (i) H ∈ Γ4 and country 1 is located at b; (ii) H ∈ Γ6 andcountry 1 is located at b or at c; (iii) H ∈ Γ7 and country 1 is located at b; (iv)H ∈ Γ8 and country 1 is located at b; and (v) H ∈ Γ10 and country 1 is located atb or at d. Figure 3 illustrates the situation: vertices with asterisks (∗) mean thatcountries located at these addresses receive higher welfare than when they are inG∗ .
We prove only case (i), because essentially the same proof applies to the othercases as well. Because country 1 has three FTAs in G∗ , it can annul one or two or
three FTAs unilaterally. Therefore, we have three subcases: (i-1) G1 ∈ Γ5 (whencountry 1 annuls all three FTAs), (i-2) G1 ∈ Γ8 (when country 1 annuls two of thethree FTAs), and (i-3) G1 ∈ Γ10 (when country 1 annuls one of its FTAs).
Let us consider subcase (i-1). In H, because country 1 is located at b, eachof the other three countries must be located at a or c or d. Then, from Table 1,
we have W i (H) = 19α2 /48 or W i (H) = 3α2 /8 for i = 2, 3, 4 in H. In G1 , on
the other hand, country 1 is isolated and the other three countries form a 3-cycle
network. From Table 1, we have W i (G1 ) = 15α2 /32 for i = 2, 3, 4. Hence, wehave W i (G1 ) > W i (H) for i = 2, 3, 4. This implies that countries 2, 3, and 430

will not be members of S 2 in sequence (17). Therefore, S 2 must be a singletonconsisting only of country 1. Because country 1 is isolated in G1 , it cannot induce
any other FTA network from G1 unilaterally—a contradiction. Hence, subcase (i1) is not possible.
Next, let us consider subcase (i-2). Country 1 is located at a and the othercountries are located at b, c, or d in G1 . Similar to subcase (i-1), we have W i (G1 ) >W i (H) for i = 2, 3, 4. Then, countries 2, 3, and 4 will not be members of S 2 . The
only possibility is S 2 = {1} and G2 must be in Γ5 . Once an FTA network in Γ5 has
been reached, the same argument as subcase (i-1) applies. Hence, subcase (i-2) is
not possible either.
Last, let us consider subcase (i-3). Country 1 is located at a or c in G1 . Similar
to subcases (i-1) and (i-2), we must have S 2 = {1} and G2 ∈ Γ5 ∪ Γ8 . Once an
FTA network in either Γ5 or Γ8 has been reached, the situation becomes parallel tosubcases (i-1) or (i-2). Hence, subcase (i-3) is not possible either. This completes
the proof of part (i).
Part (ii)
Take the empty graph G∅ ∈ Γ1 . We now show that G∅ is indirectly dominatedby the complete network G∗ . By definition, we have E(G∅ ) = ∅ and E(G∗ ) ={(1, 2), (2, 3), (3, 4), (4, 1), (2, 4), (1, 3)}. To be specific, let us consider a sequenceof FTA networks {Gr }5r=1 whose edge sets are given as follows:E(G1 ) = {(1, 2)},E(G2 ) = {(1, 2), (3, 4)},E(G3 ) = {(1, 2), (2, 3), (3, 4)},E(G4 ) = {(1, 2), (2, 3), (3, 4), (4, 1)},
E(G5 ) = {(1, 2), (2, 3), (3, 4), (4, 1), (2, 4)}.
By construction and from Table 1, we have
{1,2}G∅ −−−→ G1 ∈ Γ2
{3,4}

G1 −−−→ G2 ∈ Γ3
{2,3}

G2 −−−→ G3 ∈ Γ6

and

W i (G∅ ) < W i (G∗ )fori = 1, 2,and

W i (G1 ) < W i (G∗ )fori = 3, 4,and

W i (G2 ) < W i (G∗ )fori = 2, 3,31{4,1}and W i (G3 ) < W i (G∗ ) fori = 1, 4,{2,4}

and W i (G4 ) < W i (G∗ ) for

i = 2, 4,{1,3}

and W i (G5 ) < W i (G∗ ) fori = 1, 3.

G3 −−−→ G4 ∈ Γ9
G4 −−−→ G5 ∈ Γ10
G5 −−−→ G∗ ∈ Γ11

Hence, G∅  G∗ . Similarly, for all G ∈ Γ1 ∪ Γ2 ∪ Γ3 ∪ Γ6 ∪ Γ9 ∪ Γ10 , we can showthat G  G∗ .
Next, take an FTA network H0 ∈ Γ7 . Again, we show that H0 is indirectly
dominated by G∗ . To be specific, let us consider a sequence of FTA networks{Hr }4r=0 whose edge sets are given as follows:
E(H0 ) = {(1, 2), (2, 3), (2, 4)},
E(H1 ) = {(2, 3), (2, 4)},
E(H2 ) = {(2, 3), (3, 4), (4, 2)},
E(H3 ) = {(1, 2), (2, 3), (3, 4), (4, 2)},
E(H4 ) = {(1, 2), (2, 3), (3, 4), (4, 2), (1, 4)}.
By construction and from Table 1, we have{1}and W 1 (H0 ) < W 1 (G∗ ),{3,4}

and W i (H1 ) < W i (G∗ )fori = 3, 4,{1,2}

and W i (H2 ) < W i (G∗ )fori = 1, 2,{1,4}

and W i (H3 ) < W i (G∗ )fori = 1, 4,{1,3}

and W i (H4 ) < W i (G∗ )fori = 1, 3.

H0 −−→ H1 ∈ Γ4
H1 −−−→ H2 ∈ Γ5
H2 −−−→ H3 ∈ Γ8
H3 −−−→ H4 ∈ Γ10
H4 −−−→ G∗ ∈ Γ11

Hence, H0  G∗ . Similarly, for all H ∈ Γ4 ∪ Γ5 ∪ Γ7 ∪ Γ8 , we can show thatH  G∗ . This completes the proof of part (ii).

A.2



Proof of Theorem 2First, we show that KH coincides with the farsighted core. Lemma 1 implies
that the complete network is included in the farsighted core. On the other hand,
Lemma 1 implies that no FTA network other than G∗ can be included in the farsighted core. Thus, {G∗ } is the farsighted core.
32

Next, we show that {G∗ } is a farsighted vNM stable set. Because KH is asingleton, its internal stability is trivial. External stability directly follows from
Lemma 1. Thus, KH is a farsighted vNM stable set. Uniqueness directly follows
from the coincidence of the farsighted core and the farsighted vNM stable set.

A.3



Proof of Lemma 2

Before proceeding, we show some elementary facts. First, we have ni (J) = d J (i) +1 for any graph J ∈ Γ and for any i ∈ N. Then, Eq. (8) can be rewritten as follows:
for any graph J ∈ Γ,X

ni (J) = n + 2e(J).

(18)

i∈N

Next, given an arbitrary country (say, country k) and arbitrary graphs H, G ∈ Γ,
let us define the following subsets A, B, C, D of N.
A ≡ Nk (H) ∩ Nk (G): the subset of countries that have FTAs with country k inboth H and G.
B ≡ N \ [Nk (H) ∪ Nk (G)]: the subset of countries that do not have FTAs withcountry k in both H and G.
C ≡ Nk (H) ∩ [N \ Nk (G)]: the subset of countries that have FTAs in H, but do
not in G.
D ≡ Nk (G) ∩ [N \ Nk (H)]: the subset of countries that have FTAs in G, but do
not in G.
Because nk (H) = |A ∪ C| = |A| + |C| and nk (G) = |A ∪ D| = |A| + |D|, then we
have nk (H) − nk (G) = |C| − |D|. We make use of the above facts in the following
calculation.
Country k’s welfare depends not only on the graph, but also on the common
pre-agreement tariff rate t. Then, the difference W k (H) − W k (G) multiplied bya positive constant (n + 1)2 can be considered a function of the common pre-33

agreement tariff rate t. Using Eq. (7), we obtain the following expression:hif (t) ≡ (n + 1)2 W k (H) − W k (G)11= [nα − (n − nk (H))t]2 − [nα − (n − nk (G))t]222+ (n + 1)(n − nk (H)) [α − (1 + nk (H))t] t− (n + 1)(n − nk (G)) [α − (1 + nk (G))t] tXhi+{α + (n − ni (H))t}2 − {α + (n − ni (G))t}2
+
+
+

i∈A
X
h
i∈B
X
h
i∈C
X
h

{α − (1 + ni (H))t}2 − {α − (1 + ni (G))t}2{α + (n − ni (H))t}2 − {α − (1 + ni (G))t}2iii{α − (1 + ni (H))t}2 − {α + (n − ni (G))t}2 .

i∈D

It is easy to verify that f (0) = 0. Therefore, by making use of the Taylor expansionof f around zero (up to the first order), we obtain f (t) + f 0 (0) × t. Consequently,
for a sufficiently small positive t, we have f (t) > 0 if and only if f 0 (0) > 0. Simply
calculating f 0 (t), we obtainf 0 (t)= − {n − nk (H)} [nα − {n − nk (H)} t] + {n − nk (G)} [nα − {n − nk (G)} t]+ (n + 1) {n − nk (H)} [α − {1 + nk (H)} t] − (n + 1) {n − nk (H)} {1 + nk (H)} t− (n + 1) {n − nk (G)} [α − {1 + nk (G)} t] + (n + 1) {n − nk (G)} {1 + nk (G)} t
X+2h{n − ni (H)} [α − {n − ni (H)} t] − {n − ni (G)} [α + {n − ni (G)} t]i
+2
+2

i∈A
X
i∈B
X

h− {1 + ni (H)} [α − {1 + ni (H)} t] + {1 + ni (G)} [α − {1 + ni (G)} t]ih{n − ni (H)} [α + {n − ni (H)} t] + {1 + ni (G)} [α − {1 + ni (G)} t]i

i∈C

+2

X

h− {1 + ni (H)} [α − {1 + ni (H)} t] − {n − ni (G)} [α + {n − ni (G)} t]i .

i∈D

By substituting t = 0 into f 0 (t), we obtainf 0 (0)34

= − {n − nk (H)} nα + {n − nk (G)} nα+ {n − nk (H)} (n + 1)α − {n − nk (G)} (n + 1)αXX+ 2α{−1 − ni (H) + 1 + ni (G)}{n − ni (H) − n + ni (G)} + 2α
+ 2α

i∈A
X

{n − ni (H) + 1 + ni (G)} + 2α

i∈C

i∈B
X

{−1 − ni (H) − n + ni (G)}i∈D

= α {n − nk (H)} (−n + n + 1) + α {n − nk (G)} (n − n − 1)XX
+ 2α{ni (H) − ni (G)} + 2α
{ni (G) − ni (H)}
+ 2α

i∈A
X

i∈B

{n + 1 + ni (G) − ni (H)} + 2αi∈CX{ni (G) − ni (H) − (n + 1)}i∈D= α {n − nk (H)} − α {n − nk (G)}
X
X
X
 X


ni (G) −ni (H) +ni (G) −ni (H) 


i∈A X
i∈B X
i∈B
 i∈AX + (n + 1) +

n
(G)
−
n
(H)
i
i
+ 2α 

 X

i∈C
i∈C
i∈C
X
X
 − (n + 1) +ni (G) −ni (H)


i∈D
i∈D
i∈D


X
X

= α {nk (G) − nk (H)} + 2α  ni (G) −ni (H) + (n + 1) {|C| − |D|}
i∈N

i∈N



X
X

= −α {nk (H) − nk (G)} + 2α  ni (G) −ni (H) + (n + 1) {nk (H) − nk (G)}
i∈N

i∈N





X


X

= α {2(n + 1) − 1} {nk (H) − nk (G)} + 2α 
n
(G)
−
n
(H)

i
i




i∈N
i∈N




X


X

= α(2n + 1) {nk (H) − nk (G)} + 2α 
n
(G)
−
n
(H)

i
i




i∈N

i∈N

= α(2n + 1) {nk (H) − nk (G)} + 2α {n + 2e(G) − n − 2e(H)}= α(2n + 1) {nk (H) − nk (G)} − 4α {e(H) − e(G)}"#4= α(2n + 1) nk (H) − nk (G) −{e(H) − e(G)}2n + 1= α(2n + 1)∆.
Therefore, we have f 0 (0) > 0 if and only if ∆ > 0. This proves Lemma 2-(i).
PPTo prove Lemma 2-(ii), it suffices to show that k∈N W k (H) − k∈N W k (G) > 035

if and only ifPk∈N ∆ > 0.

#
4∆={nk (H) − nk (G)} −{e(H) − e(G)}2n + 1
k∈N
k∈N
X
X
X 4
=
nk (H) −nk (G) −{e(H) − e(G)}2n + 1
k∈N
k∈N
k∈N

X

X"

= {n + 2e(H)} − {n + 2e(G)} −4n{e(H) − e(G)}2n + 14n= 2 {e(H) − e(G)} −{e(H) − e(G)}
2n
+
1
!
4n
= 2−
{e(H) − e(G)}2n + 12={e(H) − e(G)} .
2n + 1This completes the proof.

A.4



Proof of Observation 2

Part (i)If country k forms new FTAs and if no other FTAs are formed, we have nk (H) −nk (G) = e(H) − e(G) > 0. By substituting this into Eq. (13), we obtain!
42n − 3∆= 1−{nk (H) − nk (G)} ={nk (H) − nk (G)} .
2n + 12n + 1(19)

Because n = 2, we have ∆ > 0.
Part (ii)
If the number of FTAs not involving country k increases, we have nk (H) − nk (G) =0 and e(H) − e(G) > 0. By substituting this into Eq. (13), we obtain∆=−4{e(H) − e(G)} < 0.
2n + 1(20)

Part (iii)
For any G other than the complete network G∗ , we have e(G∗ ) > e(G). Then,P
P
Lemma 2 implies k∈N W k (G∗ ) > k∈N W k (G).

36

A.5

Proof of Theorem 3

Let G be a current network in which a pair of countries do not have a bilateral
FTA between them. Then, by Observation 2-(ii), they have myopic incentives toform a new FTA between them. In other words, G can be directly dominated byanother graph.
Let us consider the complete network G∗ . Then, no pair of countries can form
a bilateral FTA; moreover, by Observation 2 again, no country has an incentive toabandon the existing FTAs. The complete network is not directly dominated.

A.6



Proof of Theorem 5

As mentioned in the text, any graph cannot indirectly dominate other graphs inthe same isomorphic class. Therefore, internal stability is achieved.
Let us turn to external stability. As shown in the proof of Lemma 3, any graphG ∈ Γ6 ∪ Γ8 ∪ Γ9 ∪ Γ10 ∪ Γ11 is indirectly dominated by a graph in KL = Γ5 . It
remains to be shown that for any G ∈ Γ1 ∪ Γ2 ∪ Γ3 ∪ Γ4 ∪ Γ7 , there exists a graphH ∈ KL that indirectly dominates G.
Take the empty graph G∅ ∈ Γ1 and consider the following sequence of graphs:
G1 ∈ Γ2 : E(G1 ) = {(1, 2)},e(G1 ) = 1,G2 ∈ Γ4 : E(G2 ) = {(1, 2), (2, 3)},e(G2 ) = 2,

H ∈ Γ5 : E(H) = {(1, 2), (1, 3), (2, 3)},e(H) = 3.

Similar to the proof of Lemma 3, we can show thatG∅ −−−→ G1{1,2}

and W i (G∅ ) < W i (H)for

i = 1, 2,{2,3}

G1 −−−→ G2

and W i (G1 ) < W i (H)for

i = 2, 3,{1,3}

and W i (G2 ) < W i (H)for

i = 1, 3.

G2 −−−→ H

Hence, G∅ is indirectly dominated by H ∈ KL . The above argument can be modified to show that any graph in G ∈ Γ1 ∪ Γ2 ∪ Γ4 is indirectly dominated by a graphin KL .

37

Next, let us consider J0 ∈ Γ7 and a sequence of graphs such that
J0 ∈ Γ7 : E(J0 ) = {(1, 3), (2, 3), (4, 3)},e(J0 ) = 3,

J1 ∈ Γ3 : E(J1 ) = {(1, 2), (3, 4)},e(J1 ) = 2,J2 ∈ Γ4 : E(J2 ) = {(1, 2), (2, 3)},e(J2 ) = 2,

H ∈ Γ5 : E(H) = {(1, 2), (1, 3), (2, 3)},e(H) = 3.

Again, similar to the proof of Lemma 3, we can show that
J0 −−−→ J1{1,2}

and W i (J0 ) < W i (H)for

i = 1, 2,

J1 −−−→ J2{2,3}

and W i (J1 ) < W i (H)for

i = 2, 3,{1,3}

and W i (J2 ) < W i (H)for

i = 1, 3.

J2 −−−→ H

Hence, J0 is indirectly dominated by H ∈ KL . The above argument also implies
that any graph in Γ3 ∪ Γ7 is indirectly dominated by a graph in KL . Consequently,
any graph not in Γ5 is indirectly dominated by a graph in Γ5 . External stability isachieved.



38

References
Aghion, P., P. Antràs, and E. Helpman, 2007, Negotiating free trade, Journal ofInternational Economics 73: 1–30.
Bagwell, K. and R.W. Staiger, 1998, Regionalism and multilateral tariff cooperation, in: J. Piggott and A. Woodland (eds.), International Trade Policy and thePacific Rim, Macmillan, London.
Bhagwati, J.N., 1991, The World Trading System at Risk, Princeton University
Press, Princeton.
Bhagwati, J.N., 1993, Regionalism and multilateralism: an overview, in: J. de
Melo and A. Panagariya (eds.), New Dimensions in Regional Integration, Cambridge University Press, Cambridge, UK.
Bollobás, B., 1979, Graph Theory: An Introductory Course, Springer-Verlag,
Berlin.
Bond, E., R. Riezman, and C. Syropoulos, 2004, A strategic and welfare theoretic
analysis of free trade areas, Journal of International Economics 64: 1–27.
Das, S.P. and S. Ghosh, 2006, Endogenous trading bloc formation in a NorthSouth global economy, Canadian Journal of Economics 39: 809–830.
Furusawa, T. and H. Konishi, 2005, Free trade networks with transfers, Japanese
Economic Review 56: 144–164.
Furusawa, T. and H. Konishi, 2007, Free trade networks, Journal of International
Economics 72: 310–335.
Goyal, S. and S. Joshi, 2006, Bilateralism and free trade, International Economic
Review 47: 749–778.
Greenberg, J., 1990, The Theory of Social Situations—An Alternative GameTheoretic Approach, Cambridge University Press, Cambridge, UK.
Herings, P.J-J, A. Mauleon, and V. Vannetelbosch, 2009, Farsightedly stable networks, Games and Economic Behavior 67: 526–541.
39

Jackson, M. and A. Wolinsky, 1996, A strategic model of social and economic
networks, Journal of Economic Theory 71: 44–74.
Krugman, P., 1993, Regionalism versus multilateralism: analytical notes, in: J.
de Melo and A. Panagariya (eds.), New Dimensions in Regional Integration,
Cambridge University Press, Cambridge, UK.
Macho-Stadler, I. and L. Xue, 2007, Winners and losers from the gradual formation of trading blocs, Economica 74: 664–681.
Oladi, R. and H. Beladi, 2008, Is regionalism viable? A case for global free trade,
Review of International Economics 16: 293–300.
Seidmann, D.J., 2009, Preferential trading arrangements as strategic positioning,
Journal of International Economics 79: 143–159.
Saggi, K., 2006, Preferential trade agreements and multilateral tariff cooperation,
International Economic Review 47: 29–57.
Saggi, K. and H.M. Yildiz, 2010, Bilateralism, multilateralism, and the quest for
global free trade, Journal of International Economics 81: 26–37.
Viner, J., 1950, The Customs Union Issue, Carnegie Endowment for International
Peace, New York.
von Neumann, J. and O. Morgenstern, 1944, Theory of Games and Economic
Behavior (2nd edition: 1947, 3rd edition: 1953), Princeton University Press,
Princeton.
WTO, 2010, http://www.wto.org/english/tratop_e/region_e/region_e.htm (asof October 15, 2010).
Xue, L. and J. Zhang, 2009, Farsighted free trade network, unpublishedmanuscript.
Yi, S-S, 1996, Endogenous formation of customs unions under imperfect competition: open regionalism is good, Journal of International Economics 41:
153–177.
40

Yi, S-S, 2000, Free-trade areas and welfare: an equilibrium analysis, Review ofInternational Economics 8: 336–347.

41

Figure 1: Examples of FTA networks

42Figure 2: Possible shapes (isomorphic classes) of FTA networks

43

Figure 3: Direct domination relation among FTA networks. Note: (i) Bold blackarrows indicate the direct domination relation when the pre-agreement tariffs are high; (ii) Thin
arrows with white heads indicate the direct domination relation when the pre-agreement tariffs arelow; (iii) Asterisks mean that the welfare of countries located at these addresses is higher thanunder global free trade in the case of high pre-agreement tariffs; (iv) Double circles mean that thewelfare of countries located at these addresses is higher than under global free trade in the case of
low pre-agreement tariffs.

44aAddresses in each isomorphic classbcdWorld welfare

Γ1

3/8(0.375)

3/8(0.375)

3/8(0.375)

3/8(0.375)

3/2
(1.5)

Γ2

4/9
(0.444)4/9(0.444)

3/8(0.375)

3/8(0.375)59/36(1.638)Γ3

4/9(0.444)4/9(0.444)4/9(0.444)4/9(0.444)

16/9(1.777)

Γ4

19/48(0.395)∗163/288(∗0.565)

19/48(0.395)

3/8(0.375)499/288(1.732)

Γ5

15/32(0.468)15/32(0.468)15/32(0.468)3/8(0.375)57/32(1.781)

Γ6

19/48(0.395)∗149/288(∗0.517)∗149/288(∗0.517)

19/48(0.395)263/144(1.826)

Γ7

28/75(0.373)∗52/75(∗0.693)28/75(0.373)28/75(0.373)

136/75(1.813)Γ8

28/75(0.373)∗1073/1800(∗0.596)357/800(0.446)357/800(0.446)6703/3600(1.861)Γ9

15/32(0.468)15/32(0.468)15/32(0.468)15/32(0.468)15/8(1.875)Γ10

21/40(0.423)∗339/800(∗0.525)

21/40(0.423)∗339/800(∗0.525)

759/400(1.8975)

Γ11

12/25
(0.480)12/25(0.480)12/25(0.480)12/25(0.480)48/25(1.920)

Table 1: Welfare levels when the pre-agreement tariffs are high. Note: (i) The fractions are the exact numbers, while the decimals in parentheses are approximate numbers; (ii) To
obtain W k (G), the values in the table must be multiplied by α2 ; (iii) The values with an asterisk(∗) are higher than the corresponding values obtained in the complete graph; (iv) World welfare is
the sum of the welfare of four countries.

45