Tariff Adjustments in Preferential Trade Agreements

In this paper we examine how preferential trade liberalization affects the terms of trade, external tariffs and welfare of the integrating countries and the rest of the world. Our analysis is based on a three-country, three-good, general equilibrium model with symmetric customs union (CU) members. The model generalizes previous work by considering more general consumer preferences and production, which allows for the possibility that exports of CU members are complements for exports of the rest of the world. We find that Kemp-Wan tariff adjustments require a decrease (increase) in the external tariff of signatories to a preferential trade agreement to accompany internal liberalization in the neighborhood of internal free trade when member goods are substitutes (complements) for those of non-members. In contrast to the analysis based on special case of CES consumer preferences, the adjustment path of the external tariff to reductions in the internal tariff could be non-monotonic when preferences are general. Our results are of interest for the design of rules for multilateral trade agreements with respect to preferential liberalization, since they indicate how tariffs must be adjusted to eliminate negative impacts on non-member countries.