The role of non‐discrimination in a world of discriminatory preferential trade agreements

In: The Canadian journal of economics: the journal of the Canadian Economics Association = Revue canadienne d'économique, Volume 55, Issue 1, p. 174-212

Abstract

AbstractIn a three‐country model of endogenous trade agreements, we study the implications of the most‐favoured‐nation (MFN) clause when countries are free to form discriminatory preferential trade agreements (PTAs). Under current rules of the World Trade Organization (WTO), although non‐member countries face discrimination at the hands of PTA members, they themselves are obligated to abide by MFN and treat PTA members in a non‐discriminatory fashion. The non‐discrimination constraint of MFN reduces the potency of a country's optimal tariffs and therefore its incentive for unilaterally opting out of trade liberalization. Thus, MFN can act as a catalyst for trade liberalization. However, when PTAs take the form of customs unions, the efficiency case for MFN as well as its pro‐liberalization effect is weaker because one country finds itself deliberately excluded by the other two as opposed to staying out voluntarily.