Preferential Trade Liberalization with Endogenous Cartel Discipline: Implications for Welfare and Optimal Trade Policies

We consider an international cartel whose members interact repeatedly in their own as well as in third-country segmented markets. Cartel discipline-an inverse measure of the degree of competition between firms-is endogenously determined by the cartel's incentive compatibility constraint (ICC), which links strategically markets that are seemingly unrelated. Owing to this linkage, trade cost reductions induce cartel members to adjust their sales, not only due to direct effects, but also due to spillover effects related to cartel discipline. We apply these ideas to preferential trade agreements (PTAs) and show that the indirect effects can give rise to trade diversion. We also characterize the welfare effects of preferential tariff cuts for all countries under various circumstances regarding the determination of external PTA trade policy. A persistent finding is that, in the absence of appropriate regulation, preferential trade liberalization can be welfare-reducing even when external policy is jointly optimal.