Transition and Compensation in E¢ cient Trade Agreements

This paper examines e¢ cient paths of trade liberalization in a symmetric two country model where countries choose a (cooperative) trade agreement that maximizes national welfare, subject to the constraint that capital initially located in the import-competing sector receive some compensation for losses from liberalization. If lump sum transfers are available to compensate capital owners, free trade is reached immediately. In the absence of lump sum transferes, the e¢ cient agreement will have a tari¤ rate and subsidy to the movement of capital located outside the importcompeting sector that decline at the rate of depreciation of capital. This policy results in a non-monotonic path for capital in the import-competing sector that is everywhere below that in the …rst best agreement. If the government’s only policy instrument is the tari¤, the e¢ cient tari¤ will decline at a rate that exceeds the rate of depreciation of capital. The steeper decline in the tari¤ rate in the third best case results from the desire to compensate capital while still encouraging capital to move out of the import-competing sector . The path of capital stock in the importcompeting sector will be monotonic in this case, and will exceed that under the …rst best trade agreement.