Regional economic integration: Why do free trade agreements exist and expand

The General Agreement on Tariffs and Trade (GATT) Committee allows a subset of its member countries to form regional integration agreements to eliminate all tariff barriers erected among these members as long as these members do not raise their import tariffs towards members outside the subset. In recent years, many countries have moved to form new free trade areas (FTAs) or enter existing trade agreements, suggesting that these arrangements may well be welfare enhancing for individual countries. The existing literature on regional integration agreements, however, yields inconclusive results on whether such agreements will promote global free trade. In addition, the literature does not adequately explain the initial formation of regional integration agreements or the incentives that lead to their expansion.; This study addresses these gaps by comparing the effects of the FTA and the most favored nations regimes on the optimal external tariffs, equilibrium prices, and welfare of member and non-member countries. Using a partial equilibrium framework and taking into account that countries set their tariffs strategically and non-cooperatively, the analysis shows that the optimal external tariffs under the FTA regime will not be higher than the most favored nations optimal tariffs under any circumstances. The FTA effects on the equilibrium prices and welfare depend on the price elasticities of excess supply and excess demand of all countries and also on the relative tariff reduction of the importing countries.; National welfare of exporting sectors tends to improve while national welfare of importing sectors tends to decline when the country enters an FTA. Therefore, the formation of an FTA is likely to occur between export-intensive countries and can occur between import- and export-intensive countries if a monetary transfer system exists among countries. When on member is a competing exporter and its excess supply is highly price elastic, the formation of the FTA appears to be a stepping stone toward global free trade. The formation of the FTA, in contrast, is a likely stumbling block toward global free trade when the non-member is a competing importer.