Free-Trade Areas and Welfare: An Equilibrium Analysis

This paper examines the welfare effects of the formation of a free-trade area (a set of countries which abolish tariffs among member countries but let individual countries to set external tariffs). If a representative consumer has love-of-variety preferences, the welfare function exhibits supermodularity in external tariffs: when a country is constrained to charge lower tariffs on imports of some countries (because of a free-trade agreement), it is in the self-interest of that country to reduce external tariffs as well, since the reduction in external tariffs helps restore a balanced consumption portfolio. The reduction in external tariffs induced by free-trade agreements are shown to be sufficiently large to make nonmember countries better off. Since only privately beneficial free-trade agreements are voluntarily signed, the formation of a freetrade area is a Pareto improvement. Due to free-riding problems, however, the global free-trade area may not be an equilibrium outcome under either the Open Regionalism rule or the Unanimous Regionalism rule. *Department of Economics, Dartmouth College, Hanover, NH 03755, U.S.A. Tel: (603) 646-2944. Fax: (603) 646-2122. E-mail address: [email protected]. Homepage: http://www.dartmouth.edu/~ssyi This is a revised version of Sections 2 and 5 of Yi (1994), which has been split into Yi (1996) and the current paper.