Dynamic endogenous formation of trade agreements: Flexibility versus coordination

This paper endogenizes the choice between any type of trade agreement -- Customs Union (CU), Free Trade Agreement (FTA) or Most Favored Nation (MFN) agreement-- and shows how the presence of Preferential Trade Agreements (i.e. CU or FTA) affects the possibility of free trade. The dynamic nature of the model captures an important tradeoff between the equilibrium type of Preferential Trade Agreement (PTA): while CU members coordinate tariffs imposed on nonmembers, individual FTA members have the flexibility of forming future PTAs. CUs can emerge in equilibrium because of this coordination benefit. However, in such cases, CUs may not lead to free trade implying PTAs can prevent free trade since free trade is only attained when PTAs do not exist. Moreover, if free trade is not attained when PTAs do not exist then it is not attained in their presence either. Despite this negative view of PTAs, FTAs play an important role in limiting the destructive role of PTAs: a path of FTAs leading to free trade can emerge in equilibrium because of the FTA flexibility benefit. Moreover, surprisingly, FTA free riding incentives actually strengthen this positive role of FTAs.