The customs union issue : Why do we observe so few of them ? ☆

a r t i c l e i n f o The number of preferential trade agreements has greatly increased over the past two decades, yet most existing arrangements take the form of free trade areas, and less than 10% can be considered to be fully fledged customs unions. This paper develops a political economy model of trade policy under imperfect competition to provide a positive explanation for the prevalence of free trade areas. In a three‐country setting, a representative from each prospective member is elected to determine the tariffs to be applied on imported goods. Under a customs union, the necessity to coordinate tariffs leads voters to strategically delegate power to more protectionist representatives. We show that strategic delegation may imply that free trade areas increase the prospective member countries' welfare compared to customs unions. Moreover, the model also indicates conditions under which free trade areas are more likely to be politically viable than customs unions. In the last two decades the world economy has witnessed an impressive increase in the number of preferential trade agreements that entered into force. Interestingly, as reported by the World Trade Organization, 1 over 90% of the agreements effective April 2008 take the form of free trade areas (FTAs) or other limited scope deals, whereas slightly less than 10% are represented by customs unions (CUs) (see Fig. 1). This evidence is in many ways surprising, as the existing literature has indicated that CUs are – at least from the point of view of the welfare of the member countries – the optimal form of preferential agreements. 2 How can the role of FTAs as the dominant preferential trading arrangement be explained? We answer this question by developing a political economy model of trade policy determination that enables us to analyze the formation of preferential trade arrangements and to compare the social welfare effects and political viability of free trade areas and customs unions. To this end we construct a simple three‐country, three‐good model, in which two potential member countries strategically interact to choose the tariff levels to be implemented vis à vis each other and the rest of the world, whereas the rest of the world implements most-favored-nation tariffs. The underlying economic structure is the oligopolistic model used in several analyses of regionalism, 3 and in our benchmark setting each prospective member produces different subsets of final goods (i.e. we have " perfect …