Dynamic formation of preferential trade agreements: The role of flexibility

Abstract

In practice, free trade agreements (FTAs) vastly outnumber customs unions (CUs). Nevertheless, the literature traditionally views CUs as optimal for members because CU members coordinate external tariffs. I show that a dynamic FTA flexibility benefit can help explain the prevalence of FTAs: individual FTA members have the flexibility to form their own future FTAs whereas CU members must jointly engage in future CU formation. I show how the relative prevalence of FTAs versus CUs depends on the structure of market size asymmetry across countries and use these predictions to shed some light on FTA versus CU formation in Europe and South America.

Tariff Bindings and the Dynamic Formation of Preferential Trade Agreements

“…Our dynamic model follows Lake and Yildiz (2016) and Lake (2019), and is similar to Seidmann (2009). We assume at most one PTA can form in a period and that PTAs formed in previous periods cannot be severed.…”

Trade in intermediate inputs, customs unions, and global free trade

“…For instance, Lake and Yildiz () in the model with transport costs show that with sufficient geographic asymmetry, CUs are intra‐regional only, while FTAs are inter and intra‐regional. Moreover, Lake () emphasizes the flexibility advantage the FTA members have over CU members in forming the additional trade agreements with other countries in explaining why in practice FTAs vastly outnumber CUs. In light of this, from the perspective of intermediate inputs trade and globalization, given in practice each country has different degree of use of intermediate inputs from other countries, the flexibility advantage of FTAs seems to be even more important in this setup.…”

Tariff bindings and the dynamic formation of Preferential Trade Agreements

“…Melatos and Dunn (2013) and Appelbaum and Melatos (2016) analyze the FTA versus CU choice in, respectively, evolving and uncertain trading environments and Facchini et al (2012) focus on the role played by income inequality and production structures. 6 Lake (2019) shows how the dynamic trade o¤ between FTA ‡exibility and CU coordination bene…ts can help explain the prevalence of FTAs over CUs and Lake and Yildiz (2016) show how this trade o¤ can help explain why, in practice, FTAs are intraand inter-regional while CUs are always intra-regional.…”