This paper develops a theory of the endogenous formation of a common market in a three-country, two-factor political economy model. In the status quo, Home and Foreign implement nondiscriminatory policies toward international factor flows in order to maximize the domestic median voter's welfare. Then the two countries simultaneously hold referenda on a common market initiative, leading to the removal of the pre-existing policies for factor flows between the member countries, while no coordination is imposed on policies vis-à-vis the Rest of the World. Several interesting results emerge. In a common market, the returns on factors moving between the members are more likely to increase the larger is the import demand of one country relative to the factor supply of the exporting partner. Factors that do not relocate are more likely to see their returns decrease when flows are large and import demands are inelastic. Importantly, for the common market to emerge as an equilibrium, some factors must continue to experience enhanced protection when the integration process is completed. This result highlights the potential tension between social desirability and the political feasibility of the integration process. (JEL: F1, F2, P16) (c) 2009 by the European Economic Association.
