Organization. 42(Summer 1988): Robert D. Putnam. "Diplomacy and Domestic Politics: The Logic of Two-Level Games.

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1 CGE and Game Theoretical Approach in Bilateral FTA Negotiation Fei Chai, Academy of Shanghai Social Science 1. Intruduction The aim of this paper is to propose a CGE and game theoretical approach in bilateral FTA negotiation. During the process of FTA negotiation, it is commonly recognized that game theory is a key tool in determining FTA clauses, especially in tariff cutting details. And CGE is popular in simulating the potential economic effects for forthcoming FTAs. Although nearly every country applied these two instruments simultaneously in FTA negotiation, not many countries looked inside of the interaction between them. Thus, this left space for further studying. To simplified this research, this paper focuses on bilateral FTA negotiation, which, of course, so not loss generality. 2. Two level Game in Bilateral FTA Negotiation Two-level game theory is a political model of international conflict resolution derived from game theory and originally introduced in 1988 by Robert Putnam 1. Bilateral FTA negotiation is a typical two level game, which include national and international level games. Only when all players in both levels games get satisfied, FTA reaches agreement, otherwise negotiation whether restarts or fails. The national level game involves consumer, producer and government. Generally, there are a great amount of consumers, some producers and single government. Although consumers have dominating advantage in numbers among national players, there is no feasible channel for them neither to get united nor to express their interest in FTA negotiation. Producers number is not as many as consumers, but they have different industries association to represent their preferences in FTA negotiation. For the government, it usually has its own interest in FTA negotiation, also play a key intermedium between two level games. In national level game, the output is the national negotiation strategy to be applied in the international level game. While, in 1 Robert D. Putnam. "Diplomacy and Domestic Politics: The Logic of Two-Level Games." International Organization. 42(Summer 1988):

2 the process of determining national strategy, consumers have no power, for simplicity, government could be treated as neutral, so producer is the very interest group to decide the strategy. Producers can be divided by industries, since different industry need different special production factor. Division by this way is natural and could avoid free riding in national game. Actually, before deciding one s own national strategy, producers always have rational expectations of the counterpart s strategy. This is not only theoretically possible, but also realistically feasible. The best rational expectation is borrowing the counterpart s already signed FTA agreements, and chose the one that has similar situation with this ongoing negotiation. Thus, the procedure of deciding national strategy could be changed from game to optimization. Since producer only care about his own interest, optimization of producer could be taken as a partial equilibrium. The international game involves domestic and foreign central government. Each government represents its own country s position. In this level game, both sides have to get agreement under the constrain of their national strategy. This is because if government gets an agreement beyond domestic tolerance, this not only means the agreement has no chance to be approved by domestic players, but also brings threaten to the government s governance. So, the government had better responsibly play the role of intermedium, not to make any decision by its own willingness. Till now, it is the two level game analysis of the bilateral FTA negotiation. And in reality, this does happen. In this whole procedure, CGE may show up only once to simulate the potential economic effects after the national strategy is determined. 3. CGE and Game Synthesis Actually, the reason why CGE only show once in this two level game is that we take CGE only as a simulation tool. This means CGE is just a one-way tool, form policy shock to potential economic effect. But, in fact, there exists a return way from the economic effect to the policy shock, which is helpful in further policy decision. In bilateral FTA negotiation, CGE may not alter the structure of two level game, but CGE offers another factor that impacts policy decision in Figure 1.

3 Figure 1 two level game and CGE synthesis Policy National strategy shock CGE reaction Potential Effect 1 Policy International shock CGE Potential strategy reaction effect 2 From Figure 1, by comparing potential effect 1 and 2 deriver from national and international strategy respectively, we can see that the final agreement can not only be determined by two countries producers, but also by two governments. This is because by comparing the CGE outcomes from different strategies, governments can choose potential international strategy. And national strategy is not a constrain any longer, as long as the outcomes show there is beneficial from alternative strategy. The reason why this potential effects reaction to strategies happens, is because: (1) producer is rational, who do not care about his strategy s impacts on others; (2) producer s optimization procedure is a partial equilibrium, which do not take the other parts of economy s reaction into account. And the side effects from the above two reasons are remedied by CGE, which take the whole economy as a system and do take into account of all interactions among all parts. So, CGE actually make up two level game s shortcomings derived from its partial equilibrium characteristics. 4. Model 4.1 National Strategy National strategy s decision is made by different producers from different industries. Here, this paper incorporate Armington assumption, which is products traded

4 internationally are differentiated by country of origin. And the CES function follows: 1 Q f(m,d) [ M (1 )D ] (1) Where Q is the compound product of domestic product (D) and import products(m), is share parameter, is substitution parameter. P M By some deduction, we can get: P M 2 2 P M 1 2 M=M Q Q P P (2) 1 2 where M and M are import of two negotiation country from its counterpart. and P are import price and domestic compound price separately. Equation (2) offers us the equilibrium condition for producer to determine the national strategy on the base of rational expectation. 4.1 International Strategy For this part, this paper incorporates dynamic game 2 as follow: Domestic behaviour: Max X 1, t Subject to: (3) (X ) (X ) 0 (4) 1 1,t 1 1,t (5) X 1 1,t 1 (X ) ( X ) (6) 1 1,t 1 1 1,t (X ) (X ) (7) 1 1,t 1 1,t 1,t From domestic view, the counterpart s aim is to minimize strategy Counterpart behaviour: Mi n X 2, t Subject to: (8) X 2, t, thus 2 P. V. (Sundar) Balakrishnan and Jehoshua Eliashberg, 1995, An Analytical Process Model of Two-Party Negotiations, Management Science, Vol. 41, No. 2 (Feb., 1995), pp

5 (X ) (X ) 0 (9) 2 2,t 2 2,t X 2 2,t 2 (10) (X ) (X ) (11) 2 2,t 2 2,t 2 (X ) ( X ) (12) 2 2,t 2 2,t 2,t Where t is round of game,t N,N 0,X is strategy, is ideal strategy, is bottom strategy, is two country s relative negotiation power, 0,, is negotiation pressure, 0,, is power of going forward, is recession power. By some deduction, we can get: limx t limx t 1, t 2, t X X kx 1, 1 1, 0 1 k kx 2, 1 2, 0 1 k k ( )( ) and 1 k 1. Where CGE Simulation This paper applies GTAP and its version 6 data base as the simulation tool. The most important procedure here is to update the data base from 2001 to This paper incorporates Walmsley and McDougall s methodology 3. And in scenario 1, by forcasting some macro-variable s growth, we can get a baseline of Then in scenario 2, by shocking the CGE with domestic strategy, we can get potential effect 1. In scenario 3, by shocking the CGE with international strategy, we can get potential effect 2. Comparing potential effect 1 and 2, we can get difference between two strategies, and we can get a rough comparison table 1. 3 Terrie L. Walmsley and Robert A. McDougall, 2000, A Base Case Scenario for the Dynamic GTAP Model, GTAP working paper

6 Table 1 strategies and CGE outcomes comparison Domestic strategy CGE outcomes Decision More reduction Less reduction higher lower higher lower Domestic International Domestic Domestic/International From table 1, we can see that compared with international strategy, if domestic strategy is of more reduction in tariff, at the same time, if CGE outcome is relatively higher than that from international strategy, then domestic strategy is chosen from domestic government s view. In the other three situations, according to different domestic strategy and CGE outcomes, different strategies are chosen. Thus, with help of CGE and rebuilding government s role in international level game, bilateral FTA negotiation could have a game and CGE synthesis approach.