Implications of multilateral tariff bindings on the extent of preferential trade agreement formation

Abstract

Using an endogenous preferential trade agreement (PTA) formation model, we examine the effects of continual reduction in tariff bindings on the extent of PTA formation and its role in attaining global free trade. When countries are completely symmetric, no country has an incentive to free ride from global free trade while exclusion incentives arise when tariff bindings are sufficiently tight. Due to the relatively flexible nature of the free trade area (FTA) formation, such exclusion incentives go unexercised and free trade always obtains as the coalition-proof Nash equilibrium (CPNE) of the FTA game. However, since customs union (CU) expansion leads directly to global free trade and member countries are able to veto CU expansion, they exercise the exclusion incentive and thus free trade fails to be a CPNE. We then consider a scenario where countries are asymmetric with respect to their comparative advantage. The country with a weaker comparative advantage has an incentive to free ride on trade liberalization of the other two countries and lower tariff bindings discipline this incentive via constraining the ability to set optimal tariffs. As a result, continual reduction in tariff bindings facilitates FTA formation in attaining global free trade.