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Abstract

This paper explains why free trade agreements (FTAs) are more popular than customs unions (CUs), and it identifies the optimal rule in FTAs and CUs to achieve global tariff-free trade. Employing an equilibrium theory of trade agreements with tariff coordination, I demonstrate that two FTA members can keep their external tariff higher than separately decided external tariffs by keeping the status-quo. This "implicit" tariff coordination can benefit each member through trade diversion. In a CU, each member country must have a common, optimal external tariff, and it must incur costs because each country has its own opinion regarding what tariff to impose on each good. The coordination factor accounts for the popularity of the FTA. This paper also compares equilibrium results for both types of trade agreements and each rule. FTA with coordination is best to support global tariff-free trade. CUs cannot make a noticeable change when an FTA is also possible.

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