Uncertainty and Trade Agreements

Abstract

In this paper we explore the potential gains that a trade agreement (TA) can provide by regulating trade-policy uncertainty, in addition to the more standard gains from reducing the mean levels of trade barriers. We show that in a standard trade model with income-risk neutrality there tends to be an uncertainty-increasing motive for a TA. With income-risk aversion, on the other hand, the uncertainty-managing motive for a TA is determined by interesting trade-offs. For a given degree of risk aversion, an uncertainty-reducing motive for a TA is more likely to be present when the economy is more open, the export supply elasticity is lower and the economy is more specialized. Governments have stronger incentives to sign a TA when the trading environment is more uncertain. As exogenous trade costs decline, the gains from decreasing trade-policy uncertainty tend to become more important relative to the gains from reducing average trade barriers. We also derive simple