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External Trade Diversion, Exclusion Incentives and the Nature of Preferential Trade Agreements

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  • Missios, Paul
  • Saggi, Kamal
  • Yildiz, Halis Murat

Abstract

In a game of endogenous trade agreements, we examine whether the pursuit of free trade agreements (FTAs) affects the prospects of global free trade differently than the pursuit of customs unions (CUs). Our analysis is driven by a fundamental difference between these two types of preferential trade agreements (PTAs): while CU members impose jointly optimal common tariffs on non-members, members of an FTA adopt individually optimal external tariffs. This implies that (a) FTAs are relatively more flexible than CUs in the sense that an FTA member can decide to undertake further trade liberalization with respect to non-members on its own whereas a CU member can do so only if all other members also wish to do the same and (b) coordination during tariff setting allows CU members to pool their market power. In our comparative advantage based three country framework, the formation of either type of PTA induces the non-member to lower its external tariffs due to the reduction in the volume of exports flowing from members to the non-member (we call this external trade diversion). While the pursuit of CUs prevents free trade from emerging as a coalition-proof Nash equilibrium, the pursuit of FTAs does not. This key result is driven by the relative flexibility of FTAs; the higher market power of CUs by itself does not undermine the objective of reaching global free trade.

Suggested Citation

  • Missios, Paul & Saggi, Kamal & Yildiz, Halis Murat, 2014. "External Trade Diversion, Exclusion Incentives and the Nature of Preferential Trade Agreements," MPRA Paper 60063, University Library of Munich, Germany.
  • Handle: RePEc:pra:mprapa:60063
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    References listed on IDEAS

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    Cited by:

    1. Moise Nken & Halis Murat Yildiz, 2017. "Implications of multilateral tariff bindings on the formation of preferential trade agreements and quest for global free trade," Working Papers 068, Ryerson University, Department of Economics.
    2. Saggi, Kamal & Wong, Woan Foong & Yildiz, Halis Murat, 2017. "Preferential Trade Agreements and Rules of the Multilateral Trading System," MPRA Paper 76330, University Library of Munich, Germany.
    3. Hinnerk Gnutzmann & Arevik Gnutzmann-Mkrtchyan, 2016. "The Silent Success of Customs Unions," CESifo Working Paper Series 5944, CESifo Group Munich.
    4. Lake, James & Yildiz, Halis M., 2016. "On the different geographic characteristics of Free Trade Agreements and Customs Unions," Journal of International Economics, Elsevier, vol. 103(C), pages 213-233.
    5. James Lake, 2016. "Why don't more countries form Customs Unions instead of Free Trade Agreements? The role of flexibility," Departmental Working Papers 1601, Southern Methodist University, Department of Economics.
    6. Gabriel Felbermayr & Feodora Teti & Erdal Yalcin, 2018. "On the Profitability of Trade Deflection and the Need for Rules of Origin," CESifo Working Paper Series 6929, CESifo Group Munich.
    7. James Lake, 2017. "Free Trade Agreements As Dynamic Farsighted Networks," Economic Inquiry, Western Economic Association International, vol. 55(1), pages 31-50, January.
    8. James Lake & Moise Nken & Halis Murat Yildiz, 2018. "Tariff Bindings and the Dynamic Formation of Preferential Trade Agreements," Working Papers 072, Ryerson University, Department of Economics.

    More about this item

    Keywords

    Free Trade Agreement; Customs Union; Hub and Spoke Agreements; Free Trade; Optimal Tariffs;

    JEL classification:

    • F12 - International Economics - - Trade - - - Models of Trade with Imperfect Competition and Scale Economies; Fragmentation
    • F13 - International Economics - - Trade - - - Trade Policy; International Trade Organizations

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