Preferential Trading and Welfare: The Small-Union Case Revisited

The welfare analyses of preferential trading arrangements have been characterized by generally inconclusive and messy results. In this paper, I attempt to give order to the analysis of one important case: a union between two small countries. The analysis has two key advantages over the existing literature. First, the model employed is fully general in that it allows for goods that are exported and imported by both partners as well as those that are exported by one and imported by the other partner. Second, the results are derived for finite changes in tariff rates rather than being limited to infinitesimally small changes. The main results of the paper can be summarized as follows. First, assuming all goods to be normal in consumption, if two small countries form a free trade area or exchange some tariff preferences, their joint welfare falls or rises as their joint output, valued at world prices, rises or falls. Second, if, in addition, the numeraire good uses only labor and all other goods use labor and a sector-specific factor, the exchange of preferences or free trade area necessarily lowers the union’s joint welfare. Third, a union member is necessarily hurt by its own preferential liberalization. The higher are its external tariffs and the larger its imports from the partner, the more it loses from extending the preferences. Fourth, in the specific-factors case just mentioned, a union member necessarily benefits from the tariff preference it receives from the partner. The more it exports to the partner and the higher the latter’s tariffs, the greater the gain. Finally, in the specific-factors case, an FTA benefits a member more the larger its bilateral trade surplus with the partner and the lower its external tariffs relative to the partner.