Trade Agreements and the Nature of Price Determination

The terms-of-trade theory of trade agreements holds that governments are attracted to trade agreements as a means of escape from a terms-of-trade–driven prisoner’s dilemma (see Bagwell and Staiger 1999). One of the termsof-trade theory’s most striking predictions is about the treatment of behind-the-border policy measures in trade agreements. According to this prediction, in the noncooperative Nash equilibrium from which countries would begin in the absence of a trade agreement, tariffs are set inefficiently high but behind-the-border policies are set at efficient levels. Hence, even in the context of a complex policy environment there is no need for member governments of a trade agreement to negotiate directly over the levels of their behind-the-border policies. Rather, according to the terms-of-trade theory, the fundamental problem for a trade agreement to solve is to prevent terms-of-trade manipulation and to thereby reduce tariffs and raise trade volumes, without introducing distortions into the unilateral choices of domestic tax/subsidy and regulatory policies as a result of the negotiated constraints on tariffs (see Bagwell and Staiger 2001). Importantly, this result holds for a wide variety of government preferences and has also been shown to hold in imperfectly competitive environments. The terms-of-trade theory of trade agreements therefore provides strong support for “shallow” integration as the most direct means to solve the policy inefficiencies that would arise absent a trade agreement. Simply put, according to the terms-of-trade theory, negotiations over tariffs alone, coupled with an effective “market access preservation rule” that prevents governments