External Trade Diversion, Exclusion Incentives and the Nature of Preferential Trade Agreements

In a game of endogenous trade agreements, we examine whether the pursuit of free trade agreements (FTAs) affects the prospects of global free trade differently than the pursuit of customs unions (CUs). Our analysis is driven by a fundamental difference between these two types of preferential trade agreements (PTAs): while CU members impose jointly optimal common tariffs on non-members, members of an FTA adopt individually optimal external tariffs. This implies that (a) FTAs are relatively more flexible than CUs in the sense that an FTA member can decide to undertake further trade liberalization with respect to non-members on its own whereas a CU member can do so only if all other members also wish to do the same and (b) coordination during tariff setting allows CU members to pool their market power. In our comparative advantage based three country framework, the formation of either type of PTA induces the non-member to lower its external tariffs due to the reduction in the volume of exports flowing from members to the non-member (we call this external trade diversion). While the pursuit of CUs prevents free trade from emerging as a coalition-proof Nash equilibrium, the pursuit of FTAs does not. This key result is driven by the relative flexibility of FTAs; the higher market power of CUs by itself does not undermine the objective of reaching global free trade.