Welfare effects of preferential trade agreements under optimal tariffs

In a three country model with endogenous tariffs, this paper evaluates and contrasts the welfare effects of free trade agreements (FTAs)and customs unions (CUs) — the two most commonly occurring pref-erential trade agreements (PTAs). We show that if the external tariffof a PTA is not too high, it benefits both members and non-members.We also highlight the implications of a key (but commonly ignored)distinction between the two types of PTAs: while an FTA member canform an another (independent) FTA with an existing non-member, aCU member cannot. Under a pair of independent bilateral FTAs,the common member’s welfare is higher than that under free trade.Furthermore, if the common member is relatively efficient comparedto the other two countries, such a ‘hub and spoke’ pattern of FTAscan yield higher global welfare than free trade. By contrast, such anoutcome is never possible under a CU.