Role of Economies of Scale for the External Tariffs and Trade Agreement Formation: A Theoretical and Empirical Investigation

In this paper, we provide a comprehensive theoretical and empirical analysis of the role of economies of scale on external tariff setting following the formation of free trade agreements (FTAs). We build an oligopoly model of trade with flexible degrees of economies of scale and show that the member countries have an incentive to reduce their external most favoured nation (MFN) tariffs following the FTA formation regardless of the degree of economies of scale. We further show that such effect strengthens as the degree of economies of scale rises. We empirically test these predictions and confirm that post-FTA tariff adjustments are consistent with our theoretical expectations, highlighting the importance of incorporating the economies of scale in the FTA analysis. Next, we develop a three-country dynamic FTA formation model to examine how the degree of economies of scale shapes the welfare implications of FTA formation and countries’ incentives to enter into such agreements. Our findings suggest that the equilibrium path of FTA formation is fundamentally shaped by the degree of economies of scale in production technology: when countries exhibit strong preference for short-term gains, the FTAs are more likely to lead to global free trade with increasing or decreasing economies of scale than with constant return to scale.