Free-Trade Areas and Welfare: An Equilibrium Analysis

This paper examines the welfare effects of the formation of a free-trade area (a set of countries that abolish tariffs among member countries but let individual member countries to set external tariffs). If a representative consumer has love-of-variety preferences, the welfare function exhibits supermodularity in external tariffs: when a country is constrained to charge lower tariffs on imports of some countries (because of a free-trade agreement), it is in the self-interest of that country to reduce external tariffs as well, because the reduction in external tariffs helps restore a balanced consumption portfolio. The reduction in external tariffs induced by free-trade agreements is shown to be sufficiently large to make nonmember countries better off. Since only privately beneficial free-trade agreements are voluntarily signed, the formation of a free-trade area is a Pareto improvement. Due to free-riding problems, however, the global free-trade area may not be an equilibrium outcome under either the Open Regionalism rule or the Unanimous Regionalism rule.