Preferential Trade and Welfare with Differentiated Products

We consider analytically and numerically the welfare tradeoffs inherent in a preferential trade area (PTA) with products differentiated by region of origin. For a small open economy in such a setting, welfare gains are associated with higher trade volumes within the PTA. However, welfare losses are induced by declining tariff revenues on trade with nonmember countries. We show that both effects are concave, while one is a non-monotonic and the other a potentially non-monotonic function of pre-PTA partner trade shares. Therefore, the relationship between initial partner import shares and direct static welfare impacts of a PTA are theoretically ambiguous. This finding contrasts with conventional results in the homogeneous-goods case, whereby the smaller is the pre-agreement trade volume with a potential partner the more beneficial is a PTA.

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