Trade Agreements with Cross-Border Unbundling

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Does cross-border unbundling of production process introduce a new reason for trade policy intervention and change the role of trade agreements? This paper revisits the purpose and design of trade agreements in a theoretical framework that considers the firm’s global production operations with cross-border sourcing of intermediate inputs subject to trade costs, inclusive of trade policy interventions by governments. The paper highlights an interrelationship among market-clearing prices of final goods and the associated domestic and imported intermediate inputs due to their dependence on trade policies through production linkage, which gives a novel feature to the purpose and design of trade agreements beyond the conventional market-access argument associated with the terms-of-trade theory. Specifically, local price externality arises in the sense that a government uses a combination of trade policies to manipulate the local price for domestically-sourced intermediate inputs in the trading partner country. To achieve globally efficient outcomes through trade agreements, we propose to specify market access using the trade-weighted version of terms of trade so that governments effectively coordinate in changing value-added created from trade within the production chain in a reciprocal manner.