Option Values and the Choice of Trade Agreements

This paper analyzes how uncertainty influences the formation and design of regional trade agreements (TAs). Two sources of uncertainty — in demand and costs — are considered. Using a multi-stage game we show that, as long as some decisions are made after uncertainty is resolved, all TAs have option values. But, because TAs differ in their flexibility and degrees of coordination these option values vary across TAs. Thus, under uncertainty, the usual cost/benefit analysis that underlies the formation and design of TAs is altered to reflect these option values. We also show that due to the flexibility and coordination differences among TAs, their option values are affected differently by uncertainty. Consequently, the formation and design of TAs is also affected by the nature and degree of uncertainty. We demonstrate that the effects of an increase in uncertainty on the choice of TAs depend on the relative responsiveness of the TAs’ option values with respect to the change in uncertainty, which in turn depends on the convexity properties of the countries’ welfare functions under the different TAs. In particular, a TA whose option value is more responsive to a change in uncertainty becomes relatively more attractive when uncertainty increases. This enables us to predict which TAs are likely to emerge in an uncertain world. Using a specific example, we then show the effects of a change in both demand and cost uncertainty on the choice of TAs. We also examine the timing of the resolution of uncertainty and its effect on the choice of TAs and show that it can significantly impact the type of trade agreement that countries wish to form.