Implications of multilateral tariff bindings on the formation of preferential trade agreements and quest for global free trade

Using an endogenous preferential trade agreement (PTA) formation model under all possible multilaterally negotiated bound tariff rates, we examine the effects of multilateral trade liberalization on the role of PTAs in achieving global free trade. We first show that, when countries are completely symmetric, no country has an incentive to unilaterally deviate (free ride) from free trade network while exclusion incentives arise when bound tariffs are sufficiently low. Due to the relatively flexible nature of the FTA formation, such exclusion incentives go unexercised and free trade always obtains as the coalition-proof Nash equilibrium (CPNE) of the FTA game. However, such flexibility does not exist under the CU game and thus countries are able to exercise the exclusion incentive and free trade fails to be CPNE when the bound tariff rates are sufficiently low. We then consider a scenario where countries are asymmetric with respect to their comparative advantage. The country with a weaker comparative advantage has an incentive to free ride on trade liberalization of the other two countries and lower bound tariff rates disciplines this incentive via limiting the ability to set optimal tariffs. As a result, multilateral free trade is more likely to be a CPNE as the multilateral negotiated bound tariff rates decline. This result provides support for the idea that multilateral trade liberalization acts as a complement to the FTA formation in achieving global free trade.