GEP Research Paper 00/04

The Sustainibility of Economic Unions in the Third-Market Model

Bernado Moreno and José L. Torres

Abstract

This paper considers the formation of economic unions as an alternative to an export subsidies trade war situation in the context of the third-market model of Brander and Spencer (1985). We consider the possibility of an economic union of two producing countries plus a third importing country, with a common economic authority choosing an optimal common output subsidy in the union. We show that even although an economic union formed by all the countries may Pareto dominate the non-union situation, if we take account of all possibilities of coalition formation in hand of the countries, the coalition formed by all the countries is not stable in the single-shot game. Specifically, the only stable coalition is the one formed by the more competitive country and the consuming country when the more efficient firm is sufficiently more competitive than the less competitive firm. Finally, it is shown in an infinitely repeated version of the game that the economic union formed by the three countries is sustainable as a perfect equilibrium if the two producing countries are sufficiently similar and the discount factor is sufficiently large.

Issued in March 2000.

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