Dynamic formation of preferential trade agreements: The role of flexibility

Abstract

Abstract In practice, free trade agreements (FTAs) vastly outnumber customs unions (CUs). Nevertheless, the literature traditionally views CUs as optimal for members because CU members coordinate external tariffs. I show that a dynamic FTA flexibility benefit can help explain the prevalence of FTAs: individual FTA members have the flexibility to form their own future FTAs whereas CU members must jointly engage in future CU formation. I show how the relative prevalence of FTAs versus CUs depends on the structure of market size asymmetry across countries and use these predictions to shed some light on FTA versus CU formation in Europe and South America.