Media Briefings

BILATERAL TRADE DEALS AFTER BREXIT: Evidence that both sides may lose

  • Published Date: April 2017

Post-Brexit bilateral trade deals with big countries like China, India and the United States may leave the UK worse off, according to research by Kwok Tong Soo, to be presented at the Royal Economic Society's annual conference at the University of Bristol in April 2017.

Conventional economic models imply that the smaller nation within a trade partnership enjoys the greater gain. But this study finds, empirically, that there is in fact a positive relationship between the size of an economy and its terms of trade.

In consequence, the analysis predicts that a deal on these terms may become a lose-lose compared with trading freely: the smaller nation is worse off; and while the bigger country gains from the higher relative price of its exports, this may be offset as high prices reduce demand and make it less practical to specialise.

‘These results may prove important as the UK government engages in Brexit-related negotiations with partners both within and outside the EU’, the author says.

More…

This study develops a model of international trade in which the terms of trade (the relative price of exports to imports) are positively related to the size of the economy. This prediction, although contrary to the results of standard models of international trade, finds empirical support in the data.

The vote for Brexit in the UK and the election of President Trump in the United States in 2016 marked a shift away from multilateral trade agreements, with the UK voting to withdraw from the EU, and President Trump withdrawing from various international trade agreements, including the TPP (Trans-Pacific Partnership). As multilateral agreements decline, bilateral trade agreements are likely to become increasingly important.

Conventional economic analysis from David Ricardo onwards suggests that when countries open up to trade with each other, there exist mutual gains from trade. But the gains from trade may be unevenly distributed.

Standard models of international trade generally indicate that the smaller nation within a trade partnership enjoys the greater gain. This can be the result of increasing returns to scale, increased product variety or an improvement in the terms of trade. Focusing on the latter, conventional models predict a negative relationship between the size of an economy, and its terms of trade.

But my research finds, empirically, that there is in fact a positive relationship between the size of an economy and its terms of trade. The relationship holds for a large number of countries, over extended periods of time. This positive relationship cannot be explained using the standard models of international trade. Hence the objective of this study is to develop a model of international trade that does explain the relationship, and trace out the further implications of the model.

In the model, countries bargain over the terms of trade, where bargaining power depends on economic size. With two economies of unequal size, the larger economy, with more bargaining power, has more favourable terms of trade than the smaller economy.

But this does not mean that the larger country necessarily gains more from trade. As the (relative) price of the larger country’s export good rises, consumers in both countries consume less of the good. This prevents the larger country from specialising in the production of its export good (even though that country is the superior producer).

Hence, for the larger country, bargaining over prices leads to welfare gains resulting from the higher relative price of its export good, but welfare losses due to reduced specialisation in this good. It is possible for the larger country to be worse off under this bargaining solution, than under free trade with market-determined prices.

For the smaller country, the outcome under the bargaining solution is always inferior to that under free trade.

These results, while theoretical in nature, may prove important as the UK government engages in Brexit-related negotiations with partners both within and outside the EU.

ENDS


‘It’s a jungle out there: International trade when bargaining power matters’
Kwok Tong Soo, Lancaster University

Contact:

Dr Kwok Tong Soo
Department of Economics
Lancaster University Management School
Lancaster LA1 4YX
Tel (Work): 01524 594418
Email: k.soo@lancaster.ac.uk