Optimal tariffs of preferential trade agreements and the tariff complementarity effect

Purpose – The purpose of this paper is to evaluate and contrast the welfare effects of free trade agreements (FTAs) and customs unions (CUs) on member and non‐member countries when tariffs of both members and non‐members are endogenously determined. It also aims to provide sufficient conditions under which both types of preferential trade agreement (PTA) are likely to lower tariffs on non‐members relative to that under most favored nation (MFN). Design/methodology/approach – The paper employs a three country Cournot oligopoly model of trade with segmented markets. Findings – It is shown that under symmetry CU members enjoy higher welfare relative to that under an FTA or MFN. Furthermore, the non‐member country gains from the formation of a PTA so long as the PTA's external tariff falls below a certain threshold. However, for FTA members to necessarily gain, their external tariff needs to be greater than this threshold but smaller than twice their MFN tariffs. Outside this tariff range, welfare effects of FTAs are ambiguous in the absence of further assumptions. The paper also isolates sufficient conditions under which a PTA member is less likely to impose a positive tariff on the non‐member relative to that under MFN. Originality/value – Unlike existing literature, we do no assume demand linearity to obtain our main welfare results and use this assumption only for illustrative purposes. Another contribution of the paper is to provide sufficient conditions under which a PTA member is less likely to impose a positive tariff on the non‐member relative to that under MFN.