۱- Introduction

۲- Tariffs and trade

۳- Endogenous trade agreements

۴- Equilibrium agreements

۵- Further analysis

۶- Conclusion

References

Abstract

In a three-country model of endogenous free trade agreements (FTAs), we study the effects of requiring FTA members to eliminate tariffs on one another, as is essentially stipulated under current WTO rules. We explain why, in the absence of such a requirement, FTAs members impose positive tariffs on each other even when maximizing their joint welfare. We show that requiring FTA members to eliminate internal tariffs induces them to lower their external tariffs. Such external trade liberalization by FTA members undermines the prospects of global free trade since it reduces the non-member’s incentive to enter into trade agreements with them.

Introduction

Under the current rules of the World Trade Organization (WTO), countries entering into a preferential trade agreement (PTA) are required to eliminate tariffs on “ substantially all trade” with each other.This condition and other related provisions governing PTAs are specified in Article XXIV of the General Agreement on Tariffs and Trade (GATT), the key multilateral agreement governing international trade in goods amongst WTO members. This paper develops a model of endogenous trade agreements to investigate the welfare implications of this free internal trade requirement facing PTAs at the WTO as well as the effect it has on the likelihood of achieving global free trade. In the existing literature, Article XXIV has often been invoked as a justification for the assumption that PTA members impose zero tariffs on each other. Though reasonable, this approach masks the incentives underlying the tariff-setting behavior of PTA members and, by design, fails to shed light on the consequences of requiring them to fully liberalize internal trade. We focus on free trade agreements (FTAs), the most commonly occurring type of PTA in today’s global economy. Our conceptual approach to the formation of trade agreements follows Saggi and Yildiz (2010) who develop an equilibrium theory of FTAs in a modified version of the three-country competing exporters framework of Bagwell and Staiger (1999a). Assuming FTA members impose zero tariffs on one another, they compare the relative merits of bilateralism and multilateralism as alternative routes to global trade liberalization. Although the WTO system sanctions discrimination in the specific form of PTAs, it also requires all member countries to grant most favored nation (MFN) status to one another which generally forbids discrimination on their part.