Understanding the Welfare Implications of Preferential Trade Agreements

This paper examines various implications of Preferential Trade Agreements (PTAs), namely Customs Unions (CUs) and Free Trade Areas (FTAs), in the context of a multi-country general equilibrium model based on comparative advantage considerations. We calibrate the model to represent countries with symmetric endowments, and compare the impact of those agreements with free trade and a non-cooperative Nash equilibria. Utilizing aggregate and disaggregate welfare change measures, we quantify the welfare effects of trade arrangements. In particular, we develop a numerical approximation procedure to decompose the welfare changes into two components associated with the variations in terms of trade and volume of trade. The results of our analysis indicate that FTAs are better than CUs on welfare grounds for the world as a whole since both member and nonmember economies enjoy welfare benefits in an FTA. Further, we show that, for certain endowment distributions, upon formation of an FTA, nonmember economies get larger welfare benefits than member economies do. Nonetheless, member economies have larger welfare gains in CUs than in FTAs. Our welfare decompositions suggest that a significant fraction of the welfare changes in both member and nonmember countries is explained by the volume of trade effect for both types of PTAs. This implies that, having free access to larger markets, along with greater market power are both important aspects of PTAs. Comparison across endowment distributions indicates that as countries become more divergent in their endowments, the volume of trade effect gets more pronounced for CUs as well as for FTAs. The absence of policy coordination between the members of FTAs decreases the market power of the member economies and induces welfare losses that are associated with the terms of trade effect. However, the terms of trade effect results in significant welfare gains for the members of CUs since they jointly determine their tariff rates. JEL Classification: F02, F13, F15