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

Author

Listed:
  • Muhammad Azeem

    (Department of Economics, Toronto Metropolitan University)

  • Andrey Stoyanov

    (Faculty of Liberal Arts and Professional Studies, York University)

  • Halis Murat Yildiz

    (Department of Economics, Toronto Metropolitan University, Toronto, Canada)

Abstract

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.

Suggested Citation

  • Muhammad Azeem & Andrey Stoyanov & Halis Murat Yildiz, 2026. "Role of Economies of Scale for the External Tariffs and Trade Agreement Formation: A Theoretical and Empirical Investigation," Working Papers 100, Toronto Metropolitan University, Department of Economics.
  • Handle: RePEc:rye:wpaper:wp100
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    References listed on IDEAS

    as
    1. 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.
    2. Antoni Estevadeordal & Caroline Freund & Emanuel Ornelas, 2008. "Does Regionalism Affect Trade Liberalization Toward Nonmembers?," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 123(4), pages 1531-1575.
    3. Eric Conglin Chi & Halis Murat Yildiz, 2024. "Bilateralism vs. multilateralism: Role of political economy for the prospect of multilateral free trade," Canadian Journal of Economics/Revue canadienne d'économique, John Wiley & Sons, vol. 57(3), pages 870-900, August.
    4. John McLaren, 2002. "A Theory of Insidious Regionalism," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 117(2), pages 571-608.
    5. Eric W. Bond & Raymond G. Riezman & Constantinos Syropoulos, 2013. "A strategic and welfare theoretic analysis of free trade areas," World Scientific Book Chapters, in: Raymond Riezman (ed.), International Trade Agreements and Political Economy, chapter 8, pages 101-127, World Scientific Publishing Co. Pte. Ltd..
    6. Raymond Riezman, 1999. "Can Bilateral Trade Agreements Help Induce Free Trade," Canadian Journal of Economics, Canadian Economics Association, vol. 32(3), pages 751-766, May.
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