Welfare Effect of Free Trade Agreements: A Theoretical Note

Abstract

Kemp and Wan (1976, Journal of International Economics, 6(1), 95–97) show that customs unions can be welfare enhancing if the imports from the rest of the world (ROW) by the union members are fixed both before and after the formation of the union. This note extends their argument to the case of (a) two small open economies (SOEs) joining a free trade agreement (FTA) and (b) a single SOE joining a pre-existing FTA among similar economies. The particular compensation principle considered is the one suggested by Grinols (1981, Journal of International Economics, 11(2), 259–266). According to this argument, welfare gain is ensured if tariff revenue rises in the post-FTA situation. For our case, this compensation principle translates to the following: welfare gain can be ensured only when import from ROW (with whom the FTA was not signed) rises. Since this will amount to a (meaningless) negative trade diversion effect in the context of the FTA, the source of any such revenue rise has to be external. The general conclusion of the article is therefore that it may be impossible for an FTA per se to ensure increased welfare for SOEs. JEL Codes: F13, F15