Domestic Product Standards and Free Trade Areas: Implications for the EU-Japan FTA

This study considers endogenous determination of domestic standards on products that cause negative consumption externalities in the presence of a preferential trade agreement (PTA) in a three-country world. In particular, we examine how a PTA affects the optimal levels of external tariffs and standards, which are chosen by each country, and national welfare. In light of recent importance of standards or regulations that may act as nontariff barriers in PTAs, several questions will arise. Do standards become more or less stringent under a PTA than in the absence of it? After a formation of the PTA, do member or nonmember countries become better off? Do potential PTA members have an incentive to harmonize their standards? Among the several forms of PTAs, we focus on free trade areas (FTAs), where each member country chooses its external tariffs independently. We build a three-country oligopolistic trade model by incorporating the endogenous determination of standards by national governments. In this paper, we consider standards for controlling negative externalities generated by consumption of goods: setting a stringent standard eliminate negative consumption externality, and cost rise with the standard. In order to enter the importer country's market, foreign exporters must produce goods that meet the import's standard, and thus the standard can be a nontariff barrier. Governments are assumed to be benevolent, without any political incentives to set their respective standards. In this paper, we obtain the following results: (i) Compared with the policy game in the absence of FTAs, an FTA makes the member countries to choose more stringent standards. (ii) Regarding the national welfare in each country, the FTA member countries may or may be better off under the formation of an FTA, while the nonmember country becomes better off for the case of low degree of transboundary externalities. and (iii) By comparing the case in which FTA members independently determine their respective national standards with the case in which the FTA member countries harmonize their standards within the FTA, such harmonization of standards will lead the member countries to choose less stringent standards, and make the formation of the FTA more favorable, provided the degree of transboundary externalities is not so high.