Uncertainty and Trade Agreements

Abstract

In this paper we explore the potential gains that a trade agreement (TA) can provide by regulating tradepolicy 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 uncertaintyincreasing 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 uncertaintyreducing 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 "sufficient statistics" to determine the direction of the uncertainty motive for a TA and the associated welfare gains, and we apply them to the trading relationship between US and Cuba before 1934.Finally, we examine how the uncertainty motive for a TA is affected by the presence of ex-ante investments, and examine conditions under which an uncertainty-reducing TA will increase investment in the export sector.

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