Do free trade agreements affect tariffs of non-member countries? A theoretical and empirical investigation

In this paper, we investigate both theoretically and empirically the effects of free trade agreements (FTAs) on the tariffs of non-member countries. Our theoretical framework draws on the comparative advantage based trade model of Horn, Maggi, and Staiger (2010). In this model, since marginal costs of production are increasing with output, if a few countries form an FTA and start trading more with each other, they simultaneously become less willing to export to rest of the world -- a phenomenon we call external trade diversion. Such diversion reduces the ability and the incentive of non-member countries to manipulate their terms of trade, a mechanism that induces them to lower their tariffs on FTA members. We provide an empirical confirmation of this insight using industry-level bilateral trade data for 192 importing and 253 exporting countries, along with the information on all FTAs formed in the world during 1989-2011. Our analysis provides a rather convincing verification of the terms of trade theory since the formation of an FTA between a few countries can be reasonably interpreted as an exogenous event from the perspective of the rest of the world.