European economic integration entails pressures to develop common political institutions, as trade increases and transaction costs increasingly entail economic loss from exchanges across different currencies, languages and legal systems. On the other hand, different political institutions can accommodate different preferences over public goods across the common market. In Discussion Paper No. 511, Research Fellow Alessandra Casella and Jonathan Feinstein model the trade-off between these two forces. They assume that the output of any two agents matched in a market depends on their combined endowments, an exogenous productivity parameter and the available quantity of a trade-enhancing public good, such as a legal system. Each individual simultaneously joins a political institution or `club' which supplies a public good, and a `market', which matches agents randomly. When `foreigners' (members of different clubs) are matched, they choose which public good to use and incur transaction costs. Agents are free to move among different clubs and markets, whose size and composition are determined simultaneously in equilibrium.

When all agents are restricted to one club, markets evolve in response to the exogenous productivity parameter from a variety of local trading pools into an integrated common market which in equilibrium encompasses all types of trader. A rising supply of the public good provides the institutional basis required for profitable exchange as markets expand. Once agents can choose from two clubs, however, an international market may emerge in equilibrium despite agents' ability to avoid transaction costs by changing market or club at zero cost because international trade stems from their desire to exploit foreigners' public goods and not from differences in agents' endowments. As the productivity parameter rises and markets integrate, agents migrate towards one of the clubs until the other disappears, and de facto political union is achieved. At higher levels of productivity, however, transaction costs decline in importance and agents again divide into separate clubs to satisfy their heterogeneous preferences over public goods.

Casella and Feinstein finally compare the one- and two-club equilibria in terms of aggregate welfare and voters' preferences in a referendum on the two. These results confirm the expected preference for a single club at low productivity, while at high productivity diversity improves welfare. Such a referendum can also side-step individuals' problems in deciding in isolation whether to migrate, so political unification can be achieved earlier by referendum than by migration.

Public Goods in Trade: On the Formation of Markets and Political Jurisdictions
Alessandra Casella and Jonathan Feinstein

Discussion Paper No. 511, February 1991 (IM)