On the Relationship between Preferential andMultilateral Trade Liberalization: The Case of
Customs Unions
Kamal Saggi, Alan Woodlandyand Halis Murat Yildizz
March 29, 2011

Abstract
This paper analyzes a game of trade policy (called Bilateralism) between three
countries in which each country chooses whether to liberalize trade preferentially inthe form of a Customs Union (CU), multilaterally, or not at all. We also analyze
a restricted version of this game (called Multilateralism) under which countries do
not have the option to form CUs. The analysis sheds light on the relationshipbetween multilateral and preferential trade liberalization as sanctioned by GATT
Article XXIV. We …nd that when countries have symmetric endowments, global
free trade can be achieved without permitting CUs. Allowing for asymmetry, we
isolate circumstances where Article XXIV helps further the cause of multilateralliberalization as well as when it does not. Furthermore, we show that Article XXIV’s
stipulation –that countries forming a CU not raise tari¤s on outsiders –fails to makemultilateral liberalization any more attractive to countries. However, such a tari¤
restriction does lower the adverse impact of a CU on the non-member.
Keywords: Customs Unions, preferential trade agreements, multilateral tradeliberalization, GATT, WTO. JEL Classi…cations: F13, F12.
Department of Economics, Vanderbilt University, Nashville, TN 37235-1828. Phone: 615-322-3237;
e-mail: kamal.saggi@vanderbilt.edu. Parts of this paper were written during my visit to the Stanford
Center for International Development (SCID), Stanford University, Palo Alto, CA. I am grateful to SCID
researchers and its administrative sta¤ for providing me with an excellent research environment.
ySchool of Economics, Australian School of Business, The University of New South Wales, NSW 2052,
Australia. Phone: (61)-2-9385-9707; e-mail: A.Woodland@unsw.edu.au.
zDepartment of Economics, Ryerson University, 350 Victoria Street, Toronto, ON, Canada M5B 2K3.
Phone: 416-979-5000 (ext 6689); e-mail: hyildiz@ryerson.ca.

11Introduction

Article XXIV of the General Agreement on Tari¤s and Trade (GATT) permits member
countries of the World Trade Organization (WTO) to form preferential trade agreements(PTAs) such as free trade agreements (FTAs) and customs unions (CUs) under which
PTA members can grant tari¤ reductions to each other that they do not extend to other
WTO members. Empirical evidence indicates that WTO members have made rather
liberal use of Article XXIV: as per the WTO’s o¢ cial web-site, as of Feb 2010, the WTO
had received noti…cation of 462 such arrangements, of which 345 were noti…ed under
Article XXIV.1 While FTAs constitute an overwhelming majority of PTAs, the existingCUs involve some of the major economies of the world: for example, the Latin American
CU MERCOSUR counts Argentina, Brazil, Paraguay, and Uruguay as its members while
the EC (27) – a CU that extends across both goods and services – comprises of mostmajor European economies. As a result, it is important to obtain a better understandingof the factors that give rise to CUs and the e¤ect CUs have on the multilateral trading
system.
The sanctioning of discriminatory trade agreements by GATT Article XXIV and thecomplicated web of global tari¤s that has resulted from their pursuit by WTO member
countries raises some uncomfortable questions about the very structure of GATT. Indeed,
Article XXIV appears to be in direct con‡ict with the …rst and the most fundamental
Article of GATT –i.e., the most favored nation (MFN) clause that forbids WTO members from pursuing discriminatory trade liberalization. Bhagwati (1991) has argued quite
forcefully that PTAs are fundamentally incompatible with the WTO’s stated goal of multilateral trade liberalization and many observers have wondered whether the multilateral
trading system would function more e¤ectively if the exception to non-discriminatory
1
About 271 such agreements are already in force with the number expected to reach 400 during 2010.
Mongolia is the only WTO member that does not participate in any PTA and most WTO members
belong to multiple PTAs. Indeed, one even observes major PTAs in discussion with each other regarding
mutual liberalization.

2

trade liberalization provided by Article XXIV were simply absent from GATT.
While Article XXIV sanctions PTAs, it does so only under certain conditions. In
particular, Article XXIV requires that (1) a PTA should cover "substantially all trade"
between members; (2) a PTA should result in signi…cant trade liberalization among members almost to the point that it leads to free trade amongst them; and (3) that PTA
members not raise tari¤s on non-members – a condition that appears to be an attempt
to safeguard the interests of those left outside such discriminatory trade agreements. Of
course, these conditions do not necessarily imply that Article XXIV is successful in protecting the interests of non-members or that PTAs satisfying the requirements of Article
XXIV are consistent with multilateral trade liberalization.
This paper attempts to isolate the consequences of Article XXIV for the process ofmultilateral trade liberalization. To accomplish this objective, we derive and compare thestable (or coalition proof) Nash equilibria of two games of trade liberalization between
three countries with potentially asymmetric endowments. Under the …rst game (called
Bilateralism), countries are free to liberalize trade bilaterally, multilaterally, or not at all.
The bilateral option takes the form of a CU under which members eliminate tari¤s oneach other while imposing common external tari¤s on the non-member. Under the second
game, countries must either liberalize multilaterally or not at all. This restricted game –called Multilateralism –is an attempt to capture a world without Article XXIV of GATT.
By comparing equilibrium outcomes under Bilateralism with those under Multilateralism,
we isolate the consequences of the exception to non-discriminatory trade liberalization
provided by GATT Article XXIV. The most attractive feature of our approach is that it
endogenizes both the nature and the degree of trade liberalization –something that has
been done rather infrequently in the rather vast literature on PTAs.2
Consistent with actual trade negotiations and the WTO’s MFN principle, under ourMultilateralism game a pair of countries undertaking reciprocal trade liberalization are
2

See Bhagwati et. al. (1999) for a collection of some of the key papers in the area.

3

required to extend their respective tari¤ reductions to the third country. We denote suchan MFN-consistent trade agreement between countries i and j by hijim . By contrast,
under a discriminatory CU hiji members i and j impose their optimal external tari¤son the non-member country. In our model, the tari¤ implemented by a country as aparticipant in the MFN-consistent agreement hijim is lower than its optimal externaltari¤ as a member of the CU hiji. As a result, the non-participating country (i.e., k)is worse o¤ under the CU hiji relative to the MFN-consistent agreement hijim due to
two separate reasons. First, it faces discriminatory tari¤s in both export markets underhiji whereas no such discrimination exists under hijim . Second, the external tari¤s ofcountries i and j under hiji are higher than those under hijim .
When countries are fully symmetric with respect to their endowments, we …nd thatmultilateral free trade emerges as the unique stable equilibrium under both Bilateralism
and Multilateralism. In other words, under symmetry, global free trade obtains anda CU simply does not arise in equilibrium and the option to discriminate provided by
Article XXIV is not exercised. This result suggests that heterogeneity across countries
is likely to be a crucial determinant of why WTO members sometimes end up preferring
discriminatory trading arrangements to non-discriminatory ones. Indeed, we show thatwhen endowments are asymmetric across countries, the option to form CUs has important
rami…cations for the types of agreements that emerge in equilibrium. Furthermore, thenature of underlying asymmetry plays a rather subtle role in determining the relationshipbetween bilateral and multilateral trade liberalization.
We …rst examine a scenario where one country (called country s) has a relatively
smaller endowment than the other two (called l and l0 ). Under such a pattern of asymmetry, we …nd that the option to form CUs can actually increase the likelihood of achieving
global free trade. The intuition for this result is as follows: opting out of global free trade
is relatively costlier for a country when it faces a discriminatory CU between the other two
countries –as it does under Bilateralism –than when it faces an MFN-consistent agree-4

ment between them –as it does under Multilateralism. As a result, absent the threat of adiscriminatory CU, the smaller country is less willing to liberalize multilaterally. However,
if endowments are not too symmetric across countries, global free trade fails to arise underboth Bilateralism and Multilateralism. If so, the equilibrium agreement reached under
Multilateralism is welfare-superior to Bilateralism due to its non-discriminatory nature.
An important practical implication of this result is that if global free trade is truly infeasible (i.e., cannot be reached under either Bilateralism or Multilateralism), then a purely
multilateral approach to trade liberalization is preferable since it delivers a superior trade
agreement.
When we consider a pattern of asymmetry where one country is relatively bigger(called l) than the other two (called s and s0 ), the argument in favor of Multilateralism
becomes even stronger. First, even under this type of asymmetry, Multilateralism yields
a superior trade agreement when free trade is infeasible under both games. Perhaps moreinteresting is the fact that, under this alternative pattern of asymmetry, global free tradearises over a larger parameter space under Multilateralism (i.e., when countries cannot
form bilateral CUs). The intuition is that under Bilateralism each of the smaller countries
has a joint incentive to exclude the larger country and to impose optimal external tari¤son its relatively large volume of exports. This result lends support to the view that
discriminatory trade agreements can end up supplanting multilateral liberalization.
In the existing literature on PTAs, perhaps the two most closely related papers to ours
are: Aghion et. al. (2007) and Saggi and Yildiz (2010).3 While Aghion et. al. (2007)
also provide a comparison of bilateral and multilateral liberalization, their approach isfundamentally di¤erent from ours. In particular, in their multilateral bargaining protocol
countries must choose between global free trade and no agreement, whereas in our ap3
In a recent paper, Seidmann (2009) develops a three-country bargaining model of trade negotiations
in which bilateral agreements arise only if members gain more than outsiders and this alters the status
quo in favor of PTA members during subsequent negotiations. Thus, PTAs can help improve the strategic
position of members during future negotiations. Such a strategic incentive for PTA formation does notarise in our simultaneous game. Another important di¤erence between his approach and ours is that, by
design, PTAs cannot be conducive to the cause of global free trade in his model.

5proach two countries can undertake reciprocal trade liberalization so long as each extends
its respective tari¤ reduction to the third country on an MFN basis. This implies thatin Aghion et al. (2007), by voting against free trade any country (say country k) canensure that the status quo continues to prevail under multilateral bargaining. Under ourapproach to multilateral negotiations, a country that does not wish to liberalize ends up
facing the MFN-consistent agreement hijim .4 Thus, unlike in their model, the relativee¤ects of the non-discriminatory agreement hijim and the discriminatory CU hiji play a
crucial role in our analysis.
Our analysis of CUs complements and builds on that of Saggi and Yildiz (2010) who
address related questions in the context of FTAs, the second major type of PTAs sanctioned by GATT Article XXIV.5 The two types of PTAs di¤er in an important way: while
FTA members impose individually optimal tari¤s on non-members, CUs coordinate theirexternal tari¤s.6 Naturally, this suggests that the potential adverse impact of a CU on
non-members might be larger. This fear …nds some support in the existing literature: inmany models, the tari¤ complementarity e¤ect – i.e., the tendency of PTA members tolower their tari¤s on non-members –is generally weaker for a CU relative to an FTA. An
important implication of this …nding is that one of the key conditions of Article XXIV –i.e., PTA members should not raise tari¤s on non-members –is more likely to bind for a
CU relative to an FTA. In the model we present below, there exist circumstances where
this indeed happens. To shed light on the potential e¤ects of Article XXIV’s constraint
4

Our approach di¤ers from Aghion et. al. (2007) in several other ways as well. First, they focus
on FTAs while we consider CUs. Second, in our model, all countries are free to propose and negotiateagreements whereas in their model the follower countries must choose whether or not to join an agreement
proposed by the leading country. Finally, unlike Aghion et. al. (2007), we do not allow transfers betweendi¤erent coalitions. This is important because they show that when transfers are possible and global free
trade maximizes aggregate welfare, it emerges as the equilibrium under both sequential and multilateralbargaining. This is not the case in our model since transfers are not permitted.
5
Several papers have considered the relationship between an endogenously determined FTA between
two countries and its impact on incentives for multilateral liberalization – see, for example, Krishna(1998), and Ornelas (2005a and 2005b). Our contribution is to provide an equilibrium theory in which
the choice between bilateral CUs and multilateral liberalization itself is endogenous.
6
An important consequence of this di¤erence between the two types of PTAs is that an FTA member
is free to sign another FTA with an existing non-member without needing consent of an existing FTA
partner whereas a CU member cannot do so.

6

on the external tari¤s of CU members, we also derive equilibrium trade agreements under
the assumption that the maximum tari¤ a CU member can charge equals its tari¤ prior
to the formation of the CU (i.e., its tari¤ under the status quo). Our main …nding hereis that while this tari¤ restriction on CU members does not make the attainment of multilateral free trade any more likely, it does yield a constrained CU that is preferable froman aggregate welfare perspective.7
We next brie‡y discuss three strands of existing literature that overlap to some degreewith our paper. The …rst related stream of literature comprises of models of repeatedinteraction that examine how the exogenous formation of a PTA a¤ects incentives for selfenforcing multilateral tari¤ cooperation on the part of members and non-members –seeBagwell and Staiger (1997a, 1997b, and 1998), Bond and Syropoulos (1996), Hadjiyiannis(2004), and Saggi (2006).8 A second closely related line of research examines the type of
trading blocs that emerge as stable equilibria when the number and the sizes of trading
blocs are endogenously determined –see Yi (1996), Goyal and Joshi (2006), and Furusawa
and Konishi (2007).9 Finally, the third related strand studies the endogenous formationof CUs using a cooperative game theory approach – see Riezman (1985), Kennan andRiezman (1990), Riezman (1999), and Melatos and Woodland (2007). While we departfrom these lines of research in several ways, perhaps the most important di¤erence is that
we evaluate the relative pros and cons of preferential and multilateral trade liberalization
in a model where the choice between the two types of liberalization is endogenous.
7

Mrazova et al. (2010) examine the implications of the constraint Article XXIV imposes on a CU’s
external tari¤ in the oligopoly model of trade with an arbitrary number of countries and …nd that while
this constraint makes CU formation less attractive, it can also lead to a reduction in world welfare when
free trade fails to obtain.
8
Unlike others, Bagwell and Staiger (1997a) also consider the period of transition during which a
CU arises and …nd that while the early stages of CU formation facilitates multilateral liberalization,
the harmony between CUs and multilateral trade liberalization is only temporary. Hadjiyiannis (2004)
extends the Bagwell Staiger (1998) competing exporters model of trade to allow for asymmetric discountfactors across countries. He examines a scenario where two countries are patient relative to the third
and …nds that the impact of a PTA depends on which countries form the PTA. Finally, Freund (2000)
takes the multilateral tari¤ as exogenous and asks how it a¤ects incentives for cooperation among PTA
members.
9
In a three country framework, Furusawa (2002) examines the choice between preferential arrangement
and open regionalism when countries form a trading bloc.

7

2

Trade model

To endogenize the formation of trade agreements among asymmetric countries, we makeuse of an adapted version of the competing exporters model of Bagwell and Staiger (1997band 1998). There are three countries: a; b; and c and three (non-numeraire) goods: A, B,
and C. Each country’s market is served by two competing exporters and I denotes thegood that corresponds to the upper case value of i. For example, if i = a then I = A.
Country i is endowed with zero units of good I and ei units of the other two goods.
The demand for good z in country i is as follows:10d(pzi ) =pzi where z = A; B; or C

(1)

Since each country possesses only two goods while it demands all three, country i must
import good I in order to consume it and it can import it from either trading partner.
For example, country a imports good A from both countries b and c while it exports good
B to country b and good C to country c.
Let tij be the tari¤ imposed by country i on its imports of good I from country j.
Ruling out prohibitive tari¤s yields the following no-arbitrage conditions for good I:

pIi = pIj + tij = pIk + tik(2)

where i; j; k = a; b; c; and i 6= j 6= k. Let mIi be country i’s imports of good I. Since
country i has no endowment of good I, we have

mIi = d(pIi ) =

pIi

(3)

Each country’s exports of a good must equal its endowment of that good minus its local
10

X As is well known, the above demand functions can be derived from a utility function of the formu(cz ) + w where u( ) is quadratic; cz denotes consumption of good z and z = A; B; or C; and w isz

the consumption of the numeraire good.

8

consumption:xIj = ej

pIj ]

[

(4)

Market clearing for good I requires that country i’s imports equal the total exports of
the other two countries:
X

mIi =

xIj

(5)

j6=i

Equations (2) through (5) imply that the equilibrium price of good I in country iequals:
pIi =

1
3

3

X

ej +

j6=i

X
j6=i

tij

!

(6)

Using these prices, the volume of trade is easily calculated. As is clear from equation (6),the price of good I in country i increases in its tari¤s and decreases in the endowment
levels of the other two countries. The e¤ect of a country’s tari¤ on its terms of tradeis evident from equation (6): only a third of a given increase in either of its tari¤s ispassed on to domestic consumers with exactly two third of the tari¤ increase falling on
the shoulders of foreign exporters.11
Country’s welfare is de…ned as the sum of consumer surplus, producer surplus, andtari¤ revenue over all such goods:

wi =

X

X

CSiz +z

P Siz + T Ri

(7)z

Using equations (2) through (6) welfare of country i as a function of endowment levels
and global tari¤s can easily be calculated. Let aggregate world welfare be de…ned as thesum of each country’s welfare

ww =

X

wi

(8)

i

11

By design the model examines country j’s trade protection towards only good J (i.e. the only
non-numeraire good that it imports).

9

We proceed as follows. First, we consider a three stage game of trade liberalization(which we refer to as Bilateralism) under which each country is free to pursue either(a) no trade liberalization or (b) bilateral trade liberalization or (c) multilateral tradeliberalization.12 After deriving Nash equilibria of this game and isolating those equilibria
that are stable (more on this below), we next ask how equilibrium outcomes are a¤ected
if countries can choose only between options (a) and (c). This restricted game is called
Multilateralism. Next, we compare the two games under the restriction that CU members
cannot raise their tari¤s on outsiders. These two experiments help shed light on theconsequences of the exception to MFN provided under GATT Article XXIV as well as on
the restriction imposed by it on the external tari¤s of CU members.

3

Equilibrium under Bilateralism

The Bilateralism game proceeds as follows. In the …rst stage, each country announces
the names of countries with whom it wants to form a customs union (CU). Country i’sannouncement is denoted byi and its strategy set

i consists of four possible announce-

ments:
i = ffg; fjg; fkg; fM gg(9)where the announcement f g by country i is in favor of the status quo (or no tradeliberalization); fjg is in favor of a CU with only country j; fkg is in favor of a CU with
only country k; and fM g is in favor of multilateral free trade. This announcement stage
determines the global policy regime. Next, given the policy regime, countries impose theiroptimal external tari¤s. Finally, given trade agreements and tari¤s, international tradeand consumption take place.
The Bilateralism game can yield the following policy regimes: (i) the status quo h i
12Note that all countries have market power in the competing exporters model of Bagwell and Staiger(1997b and 1998) that we utilize. As a result, allowing for unilateral liberalization is not necessary –no
country will choose to pursue it in this model.

10

prevails when no two announcements match or when everyone announces f g; (ii) theCU hiji is formed if countries i and j announce each other’s name(iii) free trade hF i obtains if

i = fjg and

j = fig;

i = fM g for all i; j; k = a; b; c.

One aspect of our Bilateralism game deserves comment. The CU habi obtains so longas country a and b call each other and neither of them calls country c, regardless ofthe nature of country c’s announcement. This means that if
the excluded country (i.e., c) is indi¤erent between

c = f

g,

a

= fbg andc = fag,b= fag,

c = fbg, or

c = fM g since the outcome under any of these announcements on its part is the CU

habi. We settle such indi¤erence on the part of the excluded country in favor of the mostparsimonious announcement among the three –i.e.,c = f

g. This is reasonable since a

proposal to form a CU is unlikely to be costless in the real world and a country facing no
proposals from others would be better o¤ not making any proposals of its own.
We next derive equilibrium trade agreements. Throughout the remainder of this section as well as in section 4, we maintain the following assumption:13
Assumption 1 (Symmetry):ei = e for all i = a; b; c:(symmetry)

Let country i’s welfare as a function of trade regime r be denoted by wi (r) wherer 2 fh i ; habi ; haci ; hbci ; or hF ig. Also, letwi (rv) denote the di¤erence between

country i’s welfare under trade regimes r and v:

wi (r

v)

wi (r)wi (v)(10)

In accordance with Article I of GATT, we assume that under the status quo, eachcountry imposes a non-discriminatory tari¤ on its trading partners: tij = tik = ti for all
13

Calculations supporting the results reported in the rest of the paper are contained in the appendix.

11

i; j; k = a; b; c. Country i’s optimal MFN tari¤ is easily calculated:ti

Arg max wi ( ) =

e
4

(11)

Under symmetry, ti = t for all i = a; b; c. If two countries form a CU, they remove tari¤s
on each other and impose jointly optimal external tari¤s (denoted by tui and tuj ) on the
non-member country.14 The tari¤ pair (tui ; tuj ) is chosen to solve:15

max
wi (ij) + wj (ij) subject to tij = tji = 0u uti ; tj(12)

Since each country is the unique importer of a good in our competing exporters model,
the "market power e¤ect" of a CU emphasized by Bagwell and Staiger (1997a) does notarise here since that e¤ect arises only when CU members "compete" for imports.16 As aresult, the coordination of tari¤s is bene…cial to CU members only because each member
internalizes the e¤ect of its tari¤ on the export surplus of the other member. Furthermore,note that the constraint of zero internal tari¤s does not bind for a CU since free internal
trade is actually optimal for members.
When countries are symmetric, we have tui = tuj = tu and the optimal external tari¤of each CU member is given by
tu =

e
5

(13)

Note that, under symmetry, the formation of a CU induces each member country to lower
14

Our simple formulation of a CU’s tari¤ choice problem is intuitively appealing and in line with muchof existing literature. However, Syropoulos (2003) has shown that the nature of the sharing rule of a CU
with respect to tari¤ revenue can a¤ect tari¤ preferences as well as the trade patterns of CU members inways that can prevent the implementation of jointly optimal tari¤s. An important insight of his analysis
is that CU members have an incentive to in‡uence their common tari¤s not just for external terms-oftrade reasons but also for internal distributional purposes. Given the focus of our paper, we abstractfrom such considerations.
15
The assumption that the CU maximizes the sum of national utilities is commonly employed in theliterature. Issues of the delegation of tari¤-setting authority and the choice of weights in the social welfare
function are discussed by Gatsios and Karp (1991) and Melatos and Woodland (2007).
16
In Bagwell and Staiger (1997a), countries forming a CU do not trade with each other at all and the
CU is attractive to them only because it allows them to pool their market power and extract a larger
terms of trade gain from non-members.

12

its tari¤ on the non-member relative to the status quo (i.e., the model exhibits tari¤complementarity): tu < t .17 Furthermore, since tari¤s are independent across countries,
the non-member continues to impose its optimal MFN tari¤ on the member countries of
the CU.
We are now ready to derive equilibrium trade agreements under Bilateralism. It is
straightforward that the status quo is a Nash equilibrium since no country has an incentive
to announce another’s name if the latter does not announce its name in return. Which of
the other two policy regimes –i.e., a CU hiji and global free trade –are Nash equilibria?
We address this next.
Denote the welfare of a country under a regime r with the relevant optimal tari¤s
substituted by w (r). For example, when each country’s tari¤ equals its optimal MFN
tari¤, the welfare of country i is given by wi ( ). Using calculations reported in the
appendix, it is easy to show that a CU member has no unilateral incentive to defect fromthe agreement:wi (ij)=wj (ij)>0(14)

so that a CU is a Nash equilibrium. It is worth clarifying here that our model di¤ers in
an important way from the usual one-stage model of trade agreements where countries
simply choose tari¤s. In our model, the tari¤s chosen by countries at the second stage
depend upon the agreements reached in the …rst stage. In particular, if two countries
agree to form a CU in the …rst stage, they essentially commit to choosing jointly optimal
tari¤s at the next stage. To see why this matters, suppose …rst stage announcements are
given bya = fbg,

b = fag andalters is announcement to

a = f

c = f

g. Then, if country a unilaterally deviates andg it does so with the understanding that at the tari¤setting stage all countries will impose their optimal MFN tari¤s on each other.
17

Unlike Yi (1996), in our model the CU tari¤ does not violate Article XXIV under symmetry. It
is noteworthy that tari¤ complementarity also arises in the general equilibrium model of Bond et. al.
(2004). For empirical evidence regarding tari¤ complementarity in the context of the Latin American CU
MERCOSUR, see Estevadeordal et. al. (2008).

13

It is noteworthy that the tari¤ complementarity e¤ect in our model is not large enoughto make the non-member better o¤ under a CU relative to the status quo:wk (ij)<0(15)

Free trade is also a Nash equilibrium since no country has an incentive to unilaterally
deviate from it:
wk (Fij) > 0(16)

To capture the process of CU formation in a more realistic fashion, we now re…ne theset of Nash equilibria by isolating those Nash equilibria that are stable or coalition proof– i.e., are immune to self-enforcing coalitional deviations as de…ned in Bernheim et. al.
(1987).18
Which, if any, of the Nash equilibrium agreements described above are stable? For
free trade to be stable, we need to rule out two joint deviations:(JF1): Deviation of i and j from hF i to hiji.
(JF2): Deviation of i and j from hF i to h i.
The …rst of these deviations - i.e., (JF1) –is easily dismissed sincewi (Fij) > 0(17)

Furthermore, it is immediate from (14) and (17) that joint deviation (JF2) will also
not occur. In fact, h i is not a stable equilibrium because inequality (14) implies that thejoint deviation of countries i and j from h i to hiji is self-enforcing: any further deviationfrom hiji on the part of either member reverts them back to h i under which both areworse-o¤. The CU hiji also fails to be stable since all three countries have an incentive
to jointly deviate from hiji to hF i and this joint deviation is self-enforcing since each18

In our three-country model, a coalitional deviation is credible or self-enforcing if, taking the nonmember’s announcement as given, no member of the deviating coalition has an incentive to further
deviate from its announcement as a part of the deviating coalition.

14

country’s welfare under hF i is higher than that under the CU hiji or the status quo.19
Thus, we have:

Proposition 1: Given symmetry, the status quo, a CU between two countries, andfree trade are all Nash equilibrium trade agreements under Bilateralism. However, free
trade is the only stable trade agreement.
An important point to note is that when countries are symmetric, a CU between two
countries is not a stable equilibrium. Under symmetry, the move from the status quoof optimal MFN tari¤s to global free trade confers equal gains on all countries. As aresult countries have an incentive to communicate with each other to attain the Pareto
optimal outcome of global free trade. When countries make unilateral decisions and such
communication is not possible, while free trade can arise as a Nash equilibrium, so can
the status quo and a CU – outcomes that are decidedly worse from a global welfare
perspective.
Proposition 1 raises the following question: can a bilateral CU arise as a stable equilibrium when countries are not symmetric in some respect? Before addressing this importantquestion, we analyze the Multilateralism game under symmetry.

4

Equilibria under Multilateralism

Under the Multilateralism game, the strategy set of country i is

i = ffg; fM gg, j 6=

k 6= i where fM g is an announcement in favor of multilateral liberalization and f g anannouncement against it. If all three countries announce in favor, they implement thejointly optimal set of tari¤s which, in our model, are all equal to zero – i.e., a threecountry agreement implies free trade. If only countries i and j announce in favor of
multilateral liberalization fM g, they form the MFN-consistent agreement hijim underwhich they jointly choose their optimal tari¤s subject to the constraint that they cannot
19

Note that under symmetry even the members of a CU are better o¤ under free trade.

15

discriminate against country k.
Formally, countries i and j sign the agreement hijim when individual country announcements are as follows:i= fM g,j= fM g,k= f g. Under the agreementmhijim , countries i and j choose the tari¤ pair (tmi , tj ) to solvemmax wi (ij m ) + wj (ij m ) subject to tij = tik = tmi and tji = tjk = tjm(tm
i ; tj )(18)

Finally, if two (or more) countries do not announce fM g, the status quo h i prevails
under which each country imposes its optimal MFN tari¤ on every other country.
As in the previous section, we maintain the assumption that countries are symmetric:mm
ei = e for all i = a; b; c. Under symmetry, we must have tm
and this jointly
i = tj = t

optimal MFN tari¤ is given by:tm =e
where tm < t
7(19)

Since tm < t , it is immediate that countries that sign the MFN-consistent agreement
hijim lower their tari¤s on each other as well as on the non-participating country (i.e., k).
One aspect of the MFN-consistent agreement hijim is noteworthy: since country k retains
its optimal Nash tari¤ t under hijim while countries i and j cut tari¤s on an MFN basis,
it bene…ts from the trade liberalization undertaken by countries i and j without having
to o¤er any liberalization in return.20
Next, note that tm < tu : i.e., country k faces higher tari¤s in export markets when
the other two countries implement a CU hiji relative to when they sign the multilateralagreement hijim . To make matters worse, country k is also subject to discriminatory
treatment in both its export markets under the CU hiji –while countries i and j face zero
20
In a competitive general equilibrium model, Raimondos-Møller and Woodland (2006) have shown that
if coordinated non-discriminatory tari¤ reforms by a subset of countries are accompanied by appropriate
income transfers between them, reforming members can make themselves strictly better o¤ without
having an adverse e¤ect on non-members. In our model, while there are no transfers, the MFN-consistentmagreement hiji makes all countries strictly better o¤ under symmetry. However, as we note below, themmore relevant question here is how the non-member fares under hiji relative to the CU hiji.

16tari¤s in each other’s market under hiji, country k faces the tari¤ tu . By contrast, suchdiscriminatory treatment is absent under the agreement hijim . Therefore, the welfare of
the non-member country (k) is strictly lower under the CU hiji compared to the agreement
hijim . Of course, as noted above, the ‡ip side of this is that countries i and j are strictly
better o¤ under the CU hiji relative to the multilateral agreement hijim since only under
the latter agreement do they have to abide by the non-discrimination constraint. These
results are formalized in Section 5 as Lemma 1.
We now derive equilibrium agreements under Multilateralism. As under Bilateralism,
the status quo h i is a Nash equilibrium under Multilateralism. In order to check whether
hijim is also Nash, we need to rule out two unilateral deviations:(UM1): Deviation of i from hijim to h i(UM2): Deviation of k from hijim to hF i.
A member country has no incentive to break the multilateral agreement hijim sincewi (ij m

)>0

(20)

whereas the outside country (k) bene…ts from joining the agreement hijim thereby converting it to hF i:
wk (Fij m ) > 0(21)

Thus, under symmetry the multilateral agreement hijim fails to be a Nash equilibrium
because the outside country has an incentive to alter its stance in favor of the agreement
thereby converting it to global free trade.21 This result is interesting because it says thatwhile the non-discriminatory trade liberalization that occurs under hijim makes country
k better o¤ relative to the status quo, the extent of such liberalization is not large enoughunder symmetry to make country k opt out of the agreement.
The only remaining question is whether free trade is a Nash equilibrium. The answer
21

We show later that such an agreement can indeed be a Nash equilibrium under asymmetry.

17

is in the a¢ rmative: the only possible unilateral deviation that can occur from free tradeis (UM2) and we have already argued that this deviation does not occur. Furthermore, it
is clear that the status quo h i is not stable since all three countries bene…t from deviatingfrom h i to hF i from which there are no further unilateral or coalitional deviations –seeinequalities (20) and (21). We thus have:

Proposition 2: Given symmetry, the status quo and free trade are both Nash equilibrium trade agreements under Multilateralism. However, free trade is the only stableagreement.
A comparison of Propositions 1 and 2 shows that when endowments are symmetricacross countries, a multilateral approach to trade liberalization is su¢ cient to reach global
free trade. One implication of this result is that if the gains from global trade liberalization
were spread equally across countries (something that necessarily happens when countries
have symmetric endowments), the freedom to pursue bilateral CUs is irrelevant for theultimate objective of achieving global free trade. Given this result, the natural question is:do there exist circumstances under which the freedom to pursue bilateral CUs matters?
We show next that such a possibility arises when endowments are su¢ ciently asymmetricacross countries.

5

Liberalization among asymmetric countries

From hereon we drop Assumption 1 and begin by deriving optimal tari¤s under asymmetry. If country i does not participate in any trade agreement, it chooses a nondiscriminatory (or MFN) tari¤ ti to maximize its own welfare:ti

Arg max wi ( ) =18

ej + ek
8(22)

Note that country i’s optimal tari¤ ti increases with the endowments of its trading partners. Similar to (13), when countries i and j form a CU hiji, they abolish tari¤s on eachother and choose their external tari¤s to maximize their joint welfare wi (ij) + wj (ij).22
We have:
tui =

2ek

ej
5

2ek

and tuj =

ei
5

(23)

It is easy to see that each CU member’s external tari¤ increases with the endowmentof the non-member whereas it decreases with that of its CU partner. This is intuitive. If
the endowment of a CU member country increases, its exports to the partner country’s
market increase relative to the non-member and this induces the partner to reduce itstari¤ on the non-member.
As noted earlier, to minimize the potential harmful e¤ects of PTAs on non-members,
Article XXIV article requires that member countries not raise their external tari¤s on
non-members. Such a constraint on the tari¤ choices of country i as a CU member bindsi¤ tui > ti . We havetuiti , 11ek

(24)

13ej

For now, we ignore the restriction imposed by the Article XXIV and assume that a CU
can impose its optimal tari¤s. In Section 6, we examine the case where CUs must abideby this restriction on their external tari¤s.
mUnder the multilateral agreement hijim countries i and j choose the pair (tmi , tj ) to

maximize wi (ij m ) + wj (ij m ). We have
tm
i =

2ek

ej
7

and tm
j =

2ek

ei
7

(25)

As under symmetry, the comparison of the external tari¤s under hiji and hijim impliesumthat (i) the non-member faces lower tari¤s under hijim relative to hiji: tm
i < ti and tj <22

It is worth noting that under asymmetry it is still optimal for the CU member countries to reducethe internal tari¤s to zero.

19

tuj ; (ii) the non-member country is subject to discriminatory treatment in each member
country’s market under the CU hiji relative to the agreement hijim . This implies:23
Lemma 1: The welfare comparison of hiji and hijim from the perspective of members
and the non-member is as follows:(i) The non-member is strictly worse o¤ under hiji relative to hijim : wk (ij) <wk (ij m ); and(ii) if ei = ej , the member countries are strictly better o¤ under hiji relative to hijim :wi (ij) = wj (ij) > wi (ij m ) = wj (ij m ).
As explained before, the …rst part of the lemma is an immediate consequence of thehigher external tari¤ under hiji relative to hijim and the discriminatory nature of the CU
hiji. Symmetric member countries are strictly better o¤ under the CU hiji relative to themultilateral agreement hijim since only under the latter agreement do they have to abideby the non-discrimination constraint.
An important aspect of our model deserves comment. Recall that the member countries of a CU import di¤erent goods from the non-member country since each country isa unique importer of a good. As a result, the formation of a CU requires member countries to alter their tari¤s solely because they internalize the export surplus of the partnercountry and not due to any enhanced market power on their part since their tari¤s apply
to di¤erent goods. An implication of this is that the gains from the formation of a CU
are not evenly split across countries when their endowments di¤er. The larger exporter ina CU (i.e., the one with the larger endowment) gains relatively more from the formationof the CU since the tari¤ it faces in the other member’s market is relatively higher under
the status quo.
Before proceeding further, we note that a restriction on the degree of endowment
asymmetry must be imposed for the underlying pattern of trade assumed in the model(i.e., the competing exporters structure) to remain valid. To this end, let xIj (r) denote23

Welfare levels under all possible regimes are reported in the appendix and these can be used to prove
Lemmas 1-3.

20

the export of country j of good I to country i under regime any regime r. We show in the
appendix that country j exports good I to country i under all trade regimes i¤ 3ek

5ejor
xIj (r)0 i¤ 3ek

5ej

(26)

From hereon we assume that the above condition holds.
To derive equilibrium agreements, it is useful to brie‡y examine the incentives ofasymmetric countries for bilateral and multilateral trade liberalization.24 We begin bystating the following lemma:

Lemma 2: Let country j be either a CU or free trade partner of country i underregime r where r = hiji or hF i but not under regime v where v = h i, hiki, or hjki.
Then, the following hold:@ wi (r v)@ wi (r v)
<0<
;
(i)
@ej
@ei
(ii)

@ wi (ij@ek)> 0 and@ wi (F ij)
> 0.
@ej

The intuition for part (i) of Lemma 2 is as follows. The smaller a country’s endowment,
the lower its volume of exports and the less it bene…ts from tari¤ reductions granted byothers. Similarly, the larger the endowment of a country’s partner, the larger the termsof trade loss su¤ered by it from granting the partner free access to its market. Thus, acountry’s willingness to eliminate its tari¤ on a trading partner depends positively on its
own endowment and negatively on that of its partner. The second part of the lemma
captures two related points. The inequality@ wi (ij@ek)> 0 says that, beginning at thestatus quo h i, the advantage gained by country i in country j’s market from signing theCU hiji increases in country k’s size, making such a CU more valuable from its welfare
perspective. Recall that both countries i and k export the same good to country j (i.e.,24

In the competing exporters model of Bagwell and Staiger (1997b and 1998) utilized by us, asymmetry in endowments translates directly into asymmetries of export volumes: an increase in a country’s
endowment increases its exports of non-numeraire/protected goods without a¤ecting its imports of such
goods since the model lacks any income e¤ects. Indeed, the country with the largest endowment of
non-numeraire goods faces the smallest imports of such goods.

21they are competing exporters). Thus, a country always prefers to form a CU with thesmaller of its two trading partners:

wi (ij)

The inequality@ wi (F ij)@ej

wi (ik) i¤ ek

ej

(27)

> 0 says that when country j is already a CU partner ofcountry i, country i’s welfare gain from moving to multilateral free trade increases withthe endowment of country j. This is because the value of the preferential treatment
enjoyed by country i in country j’s market under hiji decreases with the endowment of
the competing exporter j.
How do the incentives of countries to form (or join) an MFN-consistent trade agreement depend on the underlying endowment structure?
Lemma 3: Under Multilateralism, the following hold:))@ wi (ij m@ wi (ij m)@ wi (ij m> 0,< 0 and< 0; and
(i)
@ei
@ej
@ek
(ii)

@ wi (F ij m )@ wi (F ij m )@ wi (F ij m )> 0,< 0 and
< 0.
@ei
@ej
@ek

The intuition underlying the inequalities reported in Lemma 3 is quite analogous tothat which underlies the results reported in Lemma 2 with one exception –i.e., whereas@ wi (ij@ek@ wi (ij m@ek)> 0 under Bilateralism, the opposite is true under Multilateralism – i.e.,)< 0. To see why this is the case recall that under the agreement hijim ,countries i and j lower their tari¤s on each other as well as on country k whereas under
the CU hiji they only lower tari¤s on each other. As a result, the larger is country k’s
endowment, the smaller the increase in the export surplus that countries i and j obtainfrom the agreement hijim since their rival exporter (i.e., country k) captures a larger shareof their markets.
Part (i) of Lemma 2 implies that a country prefers to enter into an MFN-consistent22

agreement with the smaller of its two trading partners:

wi (ij m )wi (ik m ) i¤ ek

(28)

ej

To highlight the crucial role played by asymmetry in our model, it proves instructive tofocus on two special cases: (i) two countries (denoted by l and l0 ) have larger endowments
than the third (denoted by s) and (ii) two countries (denoted by s and s0 ) have smaller
endowments than the third (denoted by l). We consider each in turn.

6

If one country is smaller

Let the pattern of endowment asymmetry be given by:
Assumption 2a:es =e< el = el0 = e and 1

5
3

(29)

5
is necessary to ensure that the pattern of trade assumed by the3

The restriction

competing exporters structure remains valid under asymmetry.

6.1

Equilibrium agreements

To avoid redundancy, we focus directly on stable agreements under Bilateralism (i.e., weskip the discussion of Nash equilibria). First consider the perspective of the larger countries. We know from (14) and (17) that starting from global free trade, under symmetry,
two countries have no incentive to jointly deviate from hF i to h i. Lemma 2 implies that@wl (F@)=@ wl0 (F@)> 0 and thus it follows that the larger countries have no incentive

to deviate from hF i to h i:
wl (F

)=

wl0 (F23) > 0 for all(30)

Similarly, we know from (16) that under symmetry ( = 1), a country has no incentive tounilaterally deviate from free trade to become an outsider facing a CU. From Lemma 2,
we have@ wl0 (F sl)@ wl (F sl0 )=> 0. Thus, it follows that
@
@

wl (F

sl0 ) =

wl0 (Fsl) > 0 for all(31)

Do the larger countries have an incentive to exclude the small country by deviatingfrom hF i to hll0 i? We know from (17) that this is not the case under symmetry ( = 1).
Further, note from Lemma 2 thatwl (F@ wl (F ll0 )@ wl (F ll0 )=> 0. This implies that@@ll0 ) =

wl0 (Fll0 ) > 0 for all(32)

Only two possible defections from free trade remain to be considered:(UF): Unilateral deviation of country s from hF i to hll0 i.
(JF): Joint deviation of countries s and l (or l0 ) from hF i to hsli (or hsl0 i).
Let

i (r

v) denote the critical degree of endowment asymmetry at which country i

is indi¤erent between regimes r and v. Direct calculations show that the deviation (UF)occurs when country s is su¢ ciently smaller than others:

ws (F

ll0 )

0 i¤

s (F

ll0 )

(33)

Now consider deviation (JF). It turns out that a larger country (say l) has an incentive
to jointly deviate with the smaller country provided it is su¢ ciently small:

wl (F

sl)

0 i¤

24

l (F

sl)

(34)

Similarly, we havews (FWe show in the appendix that
s (F
s (sl

l (F

sl)
sl) <

0 i¤
s (F

s (F

sl)

(35)

sl) so that deviation (JF) occurs whensl). Note further that this joint deviation is self-enforcing only when); otherwise, the smaller country has an incentive to further deviate unilaterally

from hsli to h i:
ws (sl

)

0 i¤

s (sl

)

(36)

The deviation conditions speci…ed in (33), (34), (35) and (36) imply that free tradeis stable only whens (Fsl). By considering the stability of each of the otherremaining Nash equilibria, we prove the following result in the appendix:
Proposition 3: Given Assumption 2a, the stable equilibria under Bilateralism are as
follows:(i) free trade obtains over
sl);
s (F
(ii) the CU hsli obtains over l (F sl)); ands (sl(iii) the CU hll0 i obtains over(sl);
s–Figure 1 here –Proposition 3 relates the degree of underlying asymmetry to the nature of stable agreements. Part (i) simply says that if the degree of endowment asymmetry is su¢ ciently
small, free trade is uniquely stable. Part (ii) says that if the degree of endowment asymmetry is moderate, a CU between two asymmetric partners is stable.25 When the degreeof endowment asymmetry is su¢ ciently large, only a CU between the two larger countries
is stable. Over this range, the smaller country faces relatively low tari¤s under the CU
hll0 i and it prefers to remain an outsider.
25

Note that when l (F sl)sl), both hfF gi and hfslgi or hfsl0 gi are stable. Sinces (Ftheory o¤ers no guidance about which of these equilibria might be observed, we examine both of these
possibilities hereafter.

25

6.2

Article XXIV and multilateral liberalization

In order to evaluate the e¤ects of Article XXIV, we now analyze our Multilateralism gamebetween asymmetric countries. Using arguments similar to those employed under symmetry, it can be shown that there are four possible Nash equilibria under Multilateralism:
h i, hslim , hll0 im and hF i. From (20) and Lemma 3, it follows that the joint deviationof the two larger countries from h i to hll0 im is self-enforcing. Thus, h i is not stable.
Similarly, inequality (21) and Lemma 3 imply that one of the larger countries (say l0 )has an incentive to unilaterally deviate from hslim to hfF gi so that hslim is not a stableagreement.
To see when and why the other two agreements are stable, …rst note that (30) implies that there can be no deviations from hfF gi to h i. Furthermore, as argued above,
inequality (21) and Lemma 3 imply that the larger country l0 has no incentive to unilaterally deviate from hfF gi to hslim . In fact, the only deviation from free trade that weneed to consider is the unilateral deviation of the smaller country to hll0 im . It turns out
this deviation occurs only when the degree of endowment asymmetry is su¢ ciently large:
m

ll0 )

ws (F

0 i¤

s (F

m

ll0 )

(37)

It immediately follows that free trade is stable under Multilateralism when

s (F

m

ll0 ).
What if

>

s (F

m

ll0 )? We know from inequality (20) thatsymmetry ( = 1). Since

@ wl

m
(ll0

@

)

wl (ll0m) > 0 under> 0 (Lemma 3) we havewl (ll0m) > 0 for all(38)

Then using inequalities (37) and (38) we can argue that the multilateral agreement hll0 im
is stable over the range

>

s (F

m

ll0 ).

26

Proposition 4: Given Assumption 2a, free trade is a stable equilibrium whenm(Fll0 ). Otherwise, the MFN-consistent agreement hll0 im is stable.
s
Figure 2 shows stable agreements under Multilateralism.

–Figure 2 here –Recall that under Bilateralism, global free trade is stable when <is stable under Multilateralism only when

s (F

s (F

sl) whereas itmll0 ). A straightforward comparisonof these critical thresholds along with Figures 1 and 2 delivers a central result of ourpaper:
Proposition 5: Given Assumption 2a, the following hold:m(i) s (F ll0 ) < s (F sl); andm(ii) over the parameter range s (F ll0 ) <sl) the unique stable agreementl (Funder Bilateralism is free trade whereas under Multilateralism it is the MFN-consistentagreement hll0 im .
Part (i) of proposition 5 says that free trade is stable over a larger parameter spacewhen countries are free to form CUs relative to when they cannot. Part (ii) isolates theparameter range over which the freedom to pursue CUs is necessary for achieving global
free trade. Over this range, because >

s (F

m

ll0 ) the smaller country has an incentive tounilaterally deviate from free trade to hll0 im under Multilateralism whereas there exist no
such incentive (either unilateral or coalitional) under Bilateralism. It is important to note
that, under Multilateralism, the stability of free trade hinges on the unilateral deviation
incentive of the smaller country whereas under Bilateralism it depends on the coalitional
deviation incentive of the smaller country and one of the larger countries. As indicatedearlier, the smaller country faces a higher tari¤ under a CU hll0 i relative to the agreement
hll0 im . Moreover, under the CU hll0 i the smaller country is discriminated against in its
export markets whereas it su¤ers no such disadvantage under the agreement hll0 im . The

27

joint e¤ect of these two factors –a higher tari¤ and the discriminatory nature of the CU–makes opting out of global free trade relatively costlier for the smaller country.26–Figure 3 here –What if global free trade fails to obtain under both Bilateralism and Multilateralism?
Under such a situation, one possible way forward is to ask how global welfare compares
under the equilibrium agreements that obtain under these two games. From Proposition 3
we know that, when free trade is not feasible under Bilateralism –i.e., when

>

s (F

sl)

–either hsli or hll0 i are stable agreements. Similarly, Proposition 4 says that when global
free trade does not obtain under Multilateralism, hll0 im emerges as the unique stableequilibrium.
To compare Bilateralism and Multilateralism when free trade fails to materialize, …rst
consider the range

s (F

sl)

). Over this range, the CU hsli is stables (slunder Bilateralism while hll0 im obtains under Multilateralism. Compare global welfare
under these agreements and using the formulae reported in the appendix we …nd thatMultilateralism yields a superior outcome:ww (ll0msl) > 0(39)

The intuition for this result is straightforward: unlike the multilateral agreement hll0 im ,the CU hsli diverts trade from country l0 to country s and this problematic because, under
non-discriminatory tari¤s, country l0 has a lower relative price of the good exported tocountry l.
26

It is also important to note that Proposition 5 focuses only on the parameter range where free
trade is uniquely stable under Bilateralism. However, we know from Proposition 3 that both free trade
and an asymmetric CU are stable over l (F sl)sl). Thus, one can argue that whens (Fsl)sl), the freedom to pursue CUs acts as a force in favor of trade liberalization in
l (F
s (F
a weaker sense.

28

Similarly, whens (sl), the CU hll0 i arises under Bilateralism while the agree-

ment hll0 im obtains under Multilateralism which is once again a superior outcome:ww (ll0mll0 ) > 0(40)

Thus, when free trade is infeasible, the option to pursue CUs leads to inferior outcomes.
What are the policy implications of this result? As any observer of the global policy
landscape can see, international trade barriers are very much present today, have been withus essentially forever, and might always be part of the global policy landscape. If global
free trade is truly out of reach, then there is an argument to be made in favor of excluding
CUs from Article XXIV of GATT since non-discriminatory multilateral liberalization
avoids the type of distortions that result from the formation of CUs.
Of course, aggregate world welfare does not necessarily speak to the fate of individual
countries. In this regard, we can state the following:
Proposition 6: Suppose Assumption 2a holds. Then, the following hold:m(i) when s (F ll0 ) <sl), the two larger countries are better o¤ unders (FBilateralism whereas the smaller country is better o¤ under Multilateralism.
(ii) when s (F sl)); the smaller country and the larger country thats (slis excluded from the CU (that arises under Bilateralism) are worse o¤ under Bilateralism
whereas the other larger country is better o¤ under Multilateralism.
(iii) when > s (sl); the two larger countries are better o¤ under Bilateralism
whereas the smaller country is better o¤ under Multilateralism .
Since world welfare is higher under free trade relative to hll0 im , the …rst part of the
proposition is a direct implication of inequality (37). Next, consider the second part.
When

s (F

sl)

s (sl

), suppose the CU hsli is the stable agreement under

Bilateralism while hll0 im obtains under Multilateralism. Using Lemma 1 and (27), we notemwl (sl) > wl (ll0 ) > wl (ll0 ). This implies that the larger country that ends up as a CU
member (i.e., country l) is better o¤ under Bilateralism relative to Multilateralism. The‡ip side of this is that the excluded larger country under Bilateralism prefers Multilateralm

ism: wl0 (sl) < wl0 (ll0 ). But why is the smaller country worse o¤ under Bilateralism even29though it is a willing member of the CU hsli? Direct calculations establish that when
s (F

sl)

s (sl

m

) we have ws (sl) < ws (ll0 ). In other words, over this range,

the smaller country would prefer to be an outsider facing an MFN-consistent agreement
between the two larger countries rather than being a member of a CU, which is what ends
up happening under Bilateralism.
Finally, the last part of the proposition is a direct implication of Lemma 1 since (i)the smaller country faces discriminatory treatment and higher external tari¤s under hll0 i
relative to hll0 im ; and (ii) the large countries, provided they are symmetric, are better o¤under CU hll0 i relative to the agreement hll0 im since only under the latter agreement dothey have to abide by the non-discrimination constraint.
The combination of proposition 4 and proposition 5 implies that, when the freedom
to pursue bilateral CUs is necessary for achieving global free trade, Bilateralism leadto higher world welfare. However, when free trade is not feasible under either regime,
the smaller country’s preference for Multilateralism is consistent with the world welfare
ranking.
We now consider the case where one country is larger than the other two.

7

If one country is larger

Let the pattern of endowments be given by:
Assumption 2b: es = es0 = e < el = e and 53> 1.

In other words, the endowments of countries s and s0 are smaller than that of countryl.

7.1

Equilibrium agreements

To conserve space, we directly state the following result and prove it in the appendix:

30

Lemma 4 Suppose Assumption 2b holds. Then, there exist no unilateral or coalitional
deviation from free trade that involves the large country.
Using Lemma 4 and arguments analogous to those used in section 6, we can show:
Proposition 7: Suppose Assumption 2b holds. Then, free trade is stable under Bilateralism ifss0 ). Otherwise, the CU hss0 i is stable.
s (F–Figure 4 here –The above proposition hinges on the fact that the joint incentive of the two smaller
countries to discriminate against the larger country determines the stability of free trade.
As before, in order to examine how the ability to form CUs matters, consider the equilibrium outcomes of the Multilateralism game. This game has four Nash equilibria: h i,
hss0 im , hslim and hF i. From (21) and Lemma 3 it follows that the larger country has no
incentive to unilaterally deviate from hF i to hss0 im :wl (Fss0m ) > 0 for all(41)

Thus, hss0 im is not stable. Note also that h i is not stable since the smaller countries
have a joint incentive to deviate from h i to hss0 im and it is a self-enforcing deviationsince
ws (ss0m) > 0 for all(42)

On the other hand, country s0 has an incentive to unilaterally deviate from hF i to hslim
if

is su¢ ciently large:

ws0 (Fslm ) < 0 i¤ >

s0 (F

slm )

The smaller countries have incentives to jointly deviate from hF i to h i provided they31

are su¢ ciently small relative to the larger country:) < 0 i¤ >ws (FHowever, since

s (F

)>

s (F

slm ), it is not a binding deviation for the stabilitys0 (Fof free trade. Thus hF i is stable i¤s0 (Fslm ) holds. Finally, country s has anincentive to unilaterally deviate from hslim to h i if
ws (slm
Thus hslim is stable i¤

s0 (F

)

) < 0 i¤ >slm ) <s (slis su¢ ciently large:

s (sl

m

m

)

) holds. Therefore, we have thefollowing result:
Proposition 8: Suppose Assumption 2b holds. Then, the stable agreements under
Multilateralism are as follows:(i) free trade obtains over < s0 (F slm ); andm(ii) the MFN-consistent agreement hslim obtains over s0 (F slm ) <).
s (sl–Figure 5 here –The above proposition shows that under Multilateralism the unilateral deviation incentive of one of the smaller countries determines the stability of free trade. Another important observation is that the set of stable equilibria is now empty when the larger country
has a su¢ ciently big endowment relative to the smaller countries - when

7.2

>

s (sl

m

).

When a CU supplants multilateral free trade

What light does our model shed on the e¤ects of Article XXIV when two countries are
relatively smaller? We directly state our main result:
Proposition 9: Suppose Assumption 2b holds. Then, when s (F ss0 ) <s0 (Fmsl ) holds, Multilateralism yields free trade as the stable equilibrium whereas Bilateralism
yields the CU hss0 i.
32

–Figure 6 here –Proposition 9 argues that, unlike the case of two larger and one smaller countries, free
trade is stable over a larger parameter space when countries cannot form bilateral CUs.
Thus over the parameter ranges (Fss0 ) <s0 (Fslm ), the freedom to pursue CUs

prevents the attainment of global free trade. This is in sharp contrast to the results ofSaggi and Yildiz (2010) who analyzed the case of FTAs. Together, these results suggestthat the concern that PTAs might undermine the multilateral trading system maybe more
relevant for CUs than for FTAs.
When countries are free to pursue CUs ands (Fss0 ) <s0 (Fslm ), thesmaller countries have a joint incentive to exclude the larger country via deviating fromhF i to hss0 i and this deviation is self-enforcing since neither of the smaller countries hasa unilateral incentive to further deviate. On the other hand, over the same range, there
exists no unilateral or joint deviation from free trade under Multilateralism.
Why does the freedom to pursue CUs supplant free trade when the pattern of asymmetry is given by Assumption 2b (one country is smaller) whereas it has the oppositee¤ect under Assumption 2a (one country is larger)? The intuition behind this result canbe built in steps. First, note that regardless of the pattern of asymmetry, under Multilateralism it is the unilateral deviation incentive of a smaller country that determines thestability of free trade. Second, the bene…t of the external tari¤ reduction enjoyed by thesmaller country under the agreement hll0 im – relevant under Assumption 2a – is larger
than that under hslim –applicable under Assumption 2b. This in turn implies that when
the pattern of asymmetry is given by assumption 2a, the smaller country is less willingto participate in free trade relative to the case when it is given by Assumption 2b –i.e.,s0 (Fslm ) >s (Fll0m ).

The third point to note is that in the Bilateralism game, it is the joint deviation
incentive of two countries to exclude the larger country from free trade – of countries sand l under Assumption 2a and countries s and s0 under Assumption 2b –that determines
33the stability of free trade. In this regard, we …nd that this joint incentive to exclude isstronger under Assumption 2b (when two countries are smaller than the third) relative tothat under Assumption 2a because, in the former scenario, each of them bene…ts relatively
more from being able to impose its optimal CU tari¤ on the relatively large volume ofimports supplied by the non-member. This implies that the region over which free tradeis stable under Bilateralism is larger under Assumption 2a:s (Fss0 ) <

s (F

sl).

These three points together help explain how the underlying pattern of endowment
asymmetry ends up determining the role of Article XXIV. Relative to Assumption 2a,
the pattern of asymmetry under 2b yields free trade over a larger parameter space in theMultilateralism game while it yields free trade over a smaller parameter space under the
Bilateralism game. This is why Article XXIV ends up harming the prospects for global
free trade under Assumption 2b whereas it has the opposite e¤ect under Assumption 2a.
Finally, what if

>

s0 (F

slm ) and global free trade fails to obtain under both

Bilateralism and Multilateralism? As before, under such a situation, we can ask how global
welfare compares under the equilibrium agreements that obtain under the two games. We
know that when
s (sl

m

>

s0 (F

slm ), the agreement hslim is stable under Multilateralism if) while the CU hss0 i is stable under Bilateralism. Comparing global welfare

under these agreements yields

ww (slmss0 ) > 0(43)

Once again, Multilateralism yields the more preferred outcome from an aggregate welfare
perspective. The preferences of individual countries are as follows:
Proposition 10: Suppose Assumption 2b holds. Then, the larger country is better o¤under Multilateralism relative to Bilateralism whereas the preference of each of the smaller
countries is the opposite.
When

s (F

ss0 ) <s0 (Fslm ), the joint deviation of the smaller countries

determines the stability of free trade and they are better o¤ under the CU hss0 i relative34

to free trade. Since world welfare is higher under free trade relative to the CU hss0 i, thisautomatically implies that the larger country is better o¤ under Multilateralism relative to
Bilateralism over this parameter range. Whenunder Multilateralism if

s (sl

m

>

s0 (F

slm ), recall that hslim is stable) while the CU hss0 i is stable under Bilateralism.

Over this range it is immediate from Lemma 1 and (28) that ws (ss0 ) > ws (ss0m ) >mws (sl ), thus country s is better o¤ under Bilateralism relative to Multilateralism. When
>

s0 (F

m

slm ), the same result obtains for country s0 : ws0 (ss0 ) > ws0 (sl ) while theopposite result obtains for the larger country which is better o¤ under Multilateralism
relative to Bilateralism.
Our …nal task in this paper is to examine the consequences of the tari¤ restriction
imposed on CU members by Article XXIV.

8

Constraining external tari¤s of a CU

If CU members are prohibited from raising tari¤s on non-members, none of our results
under symmetry are a¤ected since CU members actually …nd it optimal to lower theirtari¤s on non-members when countries have symmetric endowments.
Suppose endowments are as speci…ed in Assumption 2a. Under this assumption, theonly agreement for which the tari¤ constraint of Article XXIV can potentially bind is the
CU between a larger country and the smaller country, say hsli. Speci…cally, under the CU
hsli, the tari¤ restriction speci…ed in Article XXIV binds for country l when

>

13
11

since over this range tl < tul . It is easy to see that our entire analysis under Assumption
2a remains unchanged when

. But when

> , as a member of the CU hsli, country

l retains its optimal MFN tari¤ as a CU member (i.e., tul = tl ) and this alters the welfare
levels of the CU members and that of the non-member country.
Let sl denote the CU between countries s and l when the tari¤ restriction of Article
XXIV binds (tul = tl ). This tari¤ restriction has three main implications. First, the range
over which free trade is stable under Bilateralism remains una¤ected. Second, the range
35

over which the CU between countries l and s is stable shrinks. And third, the range overwhich the CU between the two larger countries is stable expands.

–Figure 7 here –As a result, the tari¤ constraint imposed by Article XXIV on CU members improvesworld welfare due to two reasons. First, when

l (F

sl)

s (sl

) the CUhsli is stable agreement with/without the tari¤ constraint but since the tari¤ protection
under the constrained CU sl is relatively lower, higher world welfare obtains when CU
members have to abide by the tari¤ constraint of Article XXIV. Second, when
s (sl

s (sl

)>

), the CU hsli is stable without the tari¤ constraint whereas the CU hll0 iarises when it is in place, again an outcome that is preferable from an aggregate welfare
perspective.
Next, we brie‡y discuss how the tari¤ restriction of GATT Article XXIV alters theanalysis under Assumption 2b. Under this assumption, the only agreement for which thetari¤ constraint of Article XXIV matters is the CU between the two smaller countries.
Speci…cally, under the CU hss0 i, both members are unable to impose their optimal CU
tari¤s (tus = tus0 ) when>since over this range ts < tus . Under such a case, each CU

member imposes tus = tus0 = ts = ts0 on the non-member. Denote this constrained CU by
ss0 . It is easy to show that, as under Assumption 2b, the region over which free tradeis stable remains unaltered, as does the region over which the two smaller countries forma CU. Indeed, the only e¤ect of the tari¤ restriction under Assumption 2b is to replace
the unconstrained CU hss0 i by the constrained CU ss0 , once again an outcome that ispreferable from an aggregate welfare perspective.

–Figure 8 here –36

9Conclusion

Ever since Jacob Viner (1950) …rst drew attention to the issue, the economics of preferential trade agreements such as Customs Unions (CUs) has received intense scrutiny from
economists and policy-makers alike. In this paper, we conduct an analysis that sheds
light on whether and how the freedom to pursue CUs provided under GATT Article
XXIV a¤ects the process of multilateral trade liberalization. Our model is novel in thatboth the type of trade liberalization (preferential versus multilateral) and the magnitudeof tari¤ cuts undertaken by countries under each type of liberalization are endogenously
determined.
We provide an analytical comparison of two alternative games of trade liberalization.
Under the Bilateralism game, countries are free to liberalize trade bilaterally via theformation of a CU, multilaterally, or not at all whereas under the Multilateralism gamethey can either liberalize multilaterally or not at all. This is in sharp contrast to themuch of the existing literature that has tended to take either preferential trade agreements
or multilateral liberalization as exogenously given. Comparing equilibrium outcomes ofthese two games helps provide an evaluation of GATT Article XXIV –perhaps the mostimportant exception to the principle of non-discrimination available to WTO members
today.
Our analysis shows that if governments base decisions on national welfare, no twocountries would choose to form a preferential CU if endowment levels are relatively symmetric across countries. Instead, under such a scenario, global free trade would obtainas the unique stable equilibrium and the freedom to pursue discriminatory CUs would
go unused. This result implies that some type of heterogeneity across countries maybe
necessary to induce countries to opt out of multilateral liberalization. To verify this intuition, we consider two scenarios: one where one country is larger than the other two andanother where it is smaller. Under the former scenario, the key result is that the freedom
to form CUs can actually further the cause of global free trade by changing the outside37

option facing the country that is reluctant to liberalize multilaterally – i.e., the smaller
country. However, under the latter scenario, the relationship between the preferential andmultilateral route is much more strained: the concern that CUs can serve as exclusionary
devices that undermine the prospects of multilateral free trade is indeed borne out in this
scenario. Finally, we also examine the impact of a key condition of Article XXIV –i.e.,countries forming a CU should not raise tari¤s on outsiders. Such a tari¤ restriction yields
a more desirable CU from a global welfare perspective since it softens the adverse impact
on outsiders. However, it does nothing to enhance the prospects of global free trade.

10

Appendix

In this Appendix we provide the necessary supporting calculations and proofs.

10.1

Welfare levels

We begin by reporting welfare levels under di¤erent policy regimes as a function of tari¤s.
Let t = (ti ; tj ; tk ). Since countries i and j impose MFN consistent tari¤s under both thestatus quo and the agreement hij m i, for a given vector of tari¤s t, we can write
wi ( ) = wi (ij m ) = wi (jk m ) = CSi (ij m )+ P Si (ij m )+ T Ri (ij m )where

CSi (ij m ) =and1(ei + ej + tk )2 + (ei + ek + tj )2 + (ej + ek
18
0

2ei +

B
P Si (ij m ) = ei @2P(ez + tz )

z6=i

3

38

1
C
A

2ti )2(44)

and
T Ri (ij m ) =

ti
3

P

ez

z6=i

2ti

!

Under the status quo h i country i chooses its non-discriminatory tari¤ ti to maximize
its own welfare. We have:
ej + ek@wi ( )
=
@ti
9

8ti

= 0 =) ti =ej + ek
8(45)

Note further that ti (jk m ) = ti since the excluded country under the MFN-consistentagreement hjkim continues to impose its optimal MFN tari¤ on its trading partners.
Under the agreement hijim , countries i and j jointly choose their non-discriminatorymmmtari¤s (tmi , tj ) to maximize wi (ij ) + wj (ij ). The relevant …rst order conditions andthe associated optimal tari¤s are:@(wi (ij m ) + wj (ij m ))
2ek
=
@ti
m
@(wi (ij ) + wj (ij m ))
2ek
=
@tj

ej
9
ei
9

7ti
7tj

= 0 =) tm
i =2ek= 0 =) tm
j =

2ek

ej
7

(46)

ei
7

Under the CU hiji, members abolish tari¤s on each other (tij = tji = 0) and impose
jointly optimal tari¤s on the non-member. Let ti and tj denote member countries’externaltari¤s and tk denote the non-member’s non-discriminatory tari¤. Then, the welfare ofmember i equals(47)

wi (ij) = CSi (ij)+ P Si (ij)+ T Ri (ij)where
CSi (ij) =1(ei + ej + tk )2 + (ei + ek
1839tj )2 + (ej + ek

ti )2

and

0

B
P Si (ij) = ei @2

andT Ri (ij) =

2ei +

P

ez + tk

z6=i

ti
(2ek
3

3

ej

tj

1
C
A

2ti )

Member countries choose their external tari¤s to maximize their joint welfare wi (ij) +wj (ij). This gives:@(wi (ij) + wj (ij))
4ek
=
@ti
@ (wi (ij) + wj (ij))
4ek
=
@tj

2ej
9
2ei
9

10ti
10tj

= 0 =) tui =2ek= 0 =) tuj =

2ek

ej
5

(48)

ei
5

Now, consider the welfare of a non-member country i under hjki:wi (jk) = CSi (jk) + P Si (jk) + T Ri (jk) = wi ( )where CSi (jk). Thus, the non-member country i’s tari¤ under the CU hjki equals ti :ej + ek@wi (jk)
=
@ti
9

8ti

= 0 =) ti (jk) = ti =ej + ek
8

Finally, by imposing ti = tj = tk = 0 in (44), we obtain wi (F ) –the welfare of country iunder free trade:wi (F ) = wi ( )jti =tj =tk =0(49)

Using the welfare and tari¤ levels reported above, we can easily obtain the formulae
for welfare levels under all possible regimes. Lemmas 2 and 3 and the various inequalities
reported in the main text follow from a direct application of the relevant formulae. For
example, consider the world welfare comparisons reported in (39) and (40). A direct40ww (ll0

the same parameter restriction (i.e.,ws (ll0msl)

wl0 (ll00; (3)

m

0 i¤

5) ensures that (1)3

ww (ll00; (4)

sl)

m

sl)

application of the relevant formulae yields:

ww (sl

m

ss0 )

m

5
.
3

Indeed,ll0 )0; (2)

0. To save space, we

do not include the algebraic details underlying these straightforward calculations.

10.2

Inequality (26)
5ej 3ek8

We have xIj ( ) = xIj (jk) = xIj (jk m ) =CU hiji we have xIj (ij) =3ej ek50 i¤ ek

0 i¤ ek

5ej.
3Furthermore, under the

3ej and xIj (ik) =2ej ek5

Next, under the MFN consistent agreement hijim we have, xIj (ij m ) =
5ej
3

ek

and xIj (ik m ) =4ej 2ek7

0 i¤ ekxIj (F ) =2ej ek3

10.3

Proof of Proposition 30 i¤ ek

0 i¤ ek2ej .

5ej 3ek
7

0 i¤

2ej . Finally, under free trade, we have

2ej .

Consider …rst the CU hll0 i. There are three possible defections from it:(ULL) Unilateral deviation of l or l0 from hll0 i to h i.
(JLL1) Joint defection of s and l (or l0) from hll0 i to hsli (or hsl0 i)(JLL2) Joint defection of s, l and l0 from hll0 i to hF i
We know from (14) that under symmetry no member country has an incentive tounilaterally deviate from a CU to the status quo. From Lemma 2, we have
(ll0

@ wl0
@

)

@ wl (ll0@)=< 0. Next note thatwl (ll0)=wl0 (ll0) > 0 when=53

Thus, we can argue that (ULL) never occurs:wl (ll0)=wl0 (ll0) > 0 for all(50)

Now consider (JLL1). From (27), we know that a larger country (say l) always has an41

incentive to deviate from hll0 i to hsli while the smaller country deviates only when the
degree of endowment asymmetry is not large:

ll0 )

ws (sl0 i¤ll0 ) = 1:28

s (sland that this joint deviation is self-enforcing when

s (sl

(51)

) = 1:27.

Now consider (JLL2). It is immediate from (32) and (33) that (JLL2) occurs whens (Fll0 ) = 1:23 and it is self enforcing i¤

together imply that hll0 i is stable when

s (F

s (sl

sl) = 1:048. These deviations).

Now consider the stability of hsli. Note from (36) that country s has an incentive tounilaterally deviate from hsli to h i when>). It is straightforward from (27)s (slthat there exist no joint deviations from hsli to hll0 i. Furthermore, all countries deviate
to free trade when

<

l (F

sl) = 1:045 and this joint deviation is self-enforcing. As aresult, hsli or hsl0 i is stable when

l (F

sl)

s (sl

).

Finally, we examine the stability of the status quo under Bilateralism. Note from(50) that two larger countries jointly deviate from h i to hll0 i and this deviation is selfenforcing. Thus h i is not stable.

10.4

Criticalvalues in Propositions 4, 5, 6, 8 and 9

In the multilateralism game,
s0 (F

10.5

slm ) = 1:03 and

s (sl

m

ll0 ) = 1:015 obtains under Assumption 2a whiles (Fm) = 1:15 obtain under Assumption 2b.

Proof of Lemma 4

It is immediate from (16) and Lemma 2 thatwl (Fss0 ) > 0 for all

42

(52)

Moreover, we know from Lemma 2 that@ wl (F sl)@> 0. Then, combining this withinequality (17) yieldssl) > 0 for allwl (FFinally, combining (14) and Lemma 2 implies that
inequality and (53) it is immediate that

10.6

wl (F

(53)

wl (sl) > 0. Then, from this) > 0.

Proof of Proposition 7

In light of Lemma 4, we focus on the perspective of countries s and s0 . Direct calculations
yield
ws (F

ss0 )

0 i¤

s (F

ss0 ) = 1:02

(54)

Moreover, Lemma 2 and (14) together implies thatws (ss0) > 0 for all(55)

Thus, the joint deviation from hF i to hss0 i is self-enforcing. Inequality (55) also implies
that the status quo is not stable since the smaller countries jointly deviate from h i to
hss0 i and this deviation is self-enforcing.
Further note thatws (FHowever,

s (F

)>

s (F

)

0 i¤

s (F

) = 1:39(56)ss0 ) and thus the above deviation is not binding for thestability of hF i. Finally, note from (14), (15) and Lemma 2 that the smaller countries
have an incentive to jointly deviate from hsli to hss0 i and this deviation is a self-enforcing
deviation –see (55). Thus, the CU between a small country and the large country hsli is
not stable.

43

10.7

When the tari¤ restriction of Article XXIV binds

Under assumption 2aFirst, consider the stability of free trade. To this end, note that whensl) < 0 and

wl (F

ws (F

sl) < 0 when

and this joint deviation is self-enforcing only when

> , we have

(57)

>

); otherwise country ss (slhas an incentive to further deviate unilaterally from sl to h i:
ws (sl

)

0 i¤

s (sl

)=

5
4

(58)

Combining this with (30), (32) and (33), we …nd that the region over which free tradeis stable does not change relative to the case where the CU between countries s and l is
free to raise its tari¤s on the non-member.
Next we examine the stability of sl . As before, we havewl (ll0(59)sl) < 0Thus, it is immediate from (57), (58) and (59) that sl is stable whens (sl). Note that since

s (sl

)<

s (sl

l (F

sl)

), the region over which CU between

countries s and l is stable is smaller when Article XXIV binds (tul = tl ). Finally note thatcountries s and l have no joint incentive to deviate from hll0 i to sl whenis su¢ ciently

small:
ws (ll0sl)0 i¤

and this deviation is self-enforcing only whens (slll0 ) = 1:26

s (sl

(60)

). If we combine this resultwith (32), (33) and (50), it follows that hll0 i is stable whens (sl). Thus, theregion over which the CU between countries l and l0 is stable expands if members cannot
raise tari¤s on the outsider.
44

Under assumption 2b
First, consider the stability of free trade. To this end, note that when

> , thefollowing holds:
ws (Fss0 ) =

ws0 (Fss0 ) < 0(61)

ws (ss0)=ws0 (ss0

)>0

(62)

Furthermore, we haveThus, it is immediate that the region over which free trade is stable does not change withthe binding tari¤ constraint. Moreover, it is clear from (55) and (62) that the status quo
is not stable. Finally note that, the joint deviation from ss0 to hsli does not occur.
This analysis implies that ss0 is stable whens (Fss0 ) and therefore the region

over which CU between two smaller countries is stable remain una¤ected by the tari¤constraint imposed by Article XXIV.
However, whens (Fss0 ), the CU hss0 i arises as the stable agreement without

the constraint while ss0 obtains with the constraint. Since the total tari¤ protection
is lower (thus trade diversion is smaller) under the constrained CU ss0 relative to theunconstrained hss0 i, higher world welfare obtains under the constrained CU.

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48

 l ( F  sl ) s ( F  sl )1

F , slF s ( sl   )
sl

ll '

5
3

Figure 1: Stable agreements under Bilateralism: one country is smaller s ( F  ll ' m )
1

ll'

{F }

5
3

m

Figure 2: Stable agreements under Multilateralism: one country is smaller s ( F  ll ' m )1

F under bothF - Bilateralismm s ( sl  ) s ( F  sl )ll' - Multilateralism

sl - Bilateralismmll' - Multilateralism

Figure 3: Bilateralism versus Multilateralism: one country is smaller

ll ' - Bilateralismmll' - Multilateralism

53

 s ( F  ss ' )
1

5
3

ss '

F

Figure 4: Stable agreements under Bilateralism: one country is larger s ' ( F  sl m )1 s ( sl m  )
sl

F

m

empty

5
3

ss ' - Bilateralism

5
3

Figure 5: Stable agreements under Multilateralism: one country is larger s ( F  ss ' )1F under both

 s ' ( F  sl m ) s ( sl m  )

ss ' - Bilateralism

ss ' - Bilateralism

F - Multilateralismslm- Multilateralism

Figure 6: Bilateralism versus Multilateralism: one country is larger

Empty - Multilateralism s ( sl   )  s ( sl  )
13
11

w/o constraintsl

w/o constraintslslwith constraint

ll ' with constraint

ll ' with and w/o constraint

5
3

Figure 7: Binding tariff constraint of Article XXIV: one country is smaller

13
11

ss '

w/o constraintss'with constraint

Figure 8: Binding tariff constraint of Article XXIV: one country is larger

53