WHY A FREE TRADE AREA? THE TARIFF ALSO RISES*

Abstract

This paper considers the choice between a customs union (wherein partners share a common external tariff) and a free trade area (wherein each partner chooses its own tariff against non‐members). Following the result that a customs union dominates a free trade area, with coordination of domestic tax policies, we show that a free trade area may nevertheless be chosen if tariffs are determined endogenously through industry lobbying. This is so even when the free trade area equates producer prices within its borders and induces tariff revenue competition and whether or not there is domestic free‐riding in lobbying.