A strategic and welfare theoretic analysis of free trade areas (original) (raw)

2004, Journal of International Economics

We utilize a three-country trade model to determine how the formation of a free trade area (FTA) between welfare-maximizing countries affects equilibrium tariffs and welfare of members and nonmembers. Our analysis reveals that, at constant nonmember tariffs, the liberalization of internal trade by symmetric members induces them to reduce their individually optimal external tariff below the Kemp-Wan (1976) tariff level thereby causing the outside country's terms of trade to improve and its welfare to rise. For this reason, FTA members find the complete elimination of internal tariffs unappealing. We also extend the analysis to allow the nonmember country to behave strategically. Our work clarifies that, upon the formation of the FTA, the outside country behaves more aggressively in its tariff policy while FTA members do not. As a consequence, the nonmember country benefits from integration even more; in contrast, FTA members benefit only if the relative size of the FTA is sufficiently large.

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