Working Paper: CEPR ID: DP6847
Authors: Giovanni Facchini; Cecilia Testa
Abstract: This paper develops a theory of the endogenous formation of a common market in a three-country, two-factor political economy model. In the status quo, Home and Foreign implement non-discriminatory policies towards international factor flows, as to maximize the domestic median voter's welfare. Each of the two countries simultaneously holds then a referendum on a Common Market initiative leading to the removal of the pre-existing policies for factor flows occurring between the member countries, while no coordination is imposed on policies vis-à-vis the rest of the world. Several interesting results emerge. In a common market, factors moving between the members are more likely to gain, the bigger is the import demand of one country as compared to the factor supply of the exporting partner. Factors which instead do not relocate are more likely to see their return decrease when flows are big and import demands are inelastic. Importantly, for the common market to emerge as an equilibrium, some factors must continue to experience enhanced protection when the integration process is completed. This result highlights the potential tension between social desirability and political feasibility of the integration process.
Keywords: economic integration; factor mobility; political economy
JEL Codes: F1; F2; P16
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| median voter's welfare (D69) | political feasibility of a common market (F15) |
| median voter's welfare (D69) | government policies towards the rest of the world (F68) |
| gains from relocation for median voter (R23) | emergence of common market as Nash equilibrium (D40) |
| larger import demands relative to factor supplies (F16) | likelihood of successful integration (F15) |
| large factor flows (F16) | political support for common market (F55) |
| protection for non-relocating factors (F20) | political sustainability of common market (F55) |
| distribution of factor ownership (D33) | median voter's support (D79) |