Trade costs and free trade agreements: Implications for tariff complementarity and welfare

Abstract This paper develops a three-country model of intra-industry trade under imperfect competition with trade costs between countries to examine the effects of a free trade agreement (FTA). Under sufficiently high trade costs, FTA member countries might have an incentive to set optimal external tariffs that are higher than the pre-FTA optimal tariffs (i.e., the tariff complementarity effect may not exist) and the formation of an FTA may worsen the non-member country’s welfare. Whether the member countries benefit from the FTA depends on the trade costs and the degree of substitutability among differentiated goods.