Gains from Free Trade Agreements: A Theoretical Analysis

Empirical estimates from various studies on impact assessment of free trade agreements show that there are limited economic gains from concluding such arrangements. It has been argued by trade negotiators of many countries that while some partners gain more from an agreement, others gain less or, even suffer from a rise in their current account deficits and overall economic losses. Even the Indian scenario is not an outlier in such a case. This question about unequal gains from an FTA has raised various policy concerns. We attempt to provide an answer to this debate by incorporating the role of the type of commodities that countries trade with each other. In an imperfectly competitive setup with three countries and two types of commodities viz. a final good and an intermediate input, our findings reveal that bilateral free trade in final goods is more welfare-enhancing for the member countries vis-à-vis bilateral free trade in intermediates. However, the former possibility is feasible only for a very small range of parametric values given the pre-requisites for ensuring the formation of an effective FTA. More specifically, we find that a horizontal FTA covering final goods becomes feasible only when the degree of market size asymmetry between the two partners is very less. On the contrary, when we emphasise on the role of vertical trade, i.e., where one of the FTA members exports intermediate inputs to the other, and imports the final good in return, we find that FTA is feasible only when the larger partner is an exporter of final goods and an importer of intermediate inputs, vis-à-vis the smaller partner. In such a case, the larger partner accrues higher gains from such a bilateral engagement. While capturing the role of tradable intermediates, we also show that in the presence of well-connected GVCs, RTAs actually become a less attractive option for enhancing trade and welfare of an economy.