Free Trade Agreement and Vertical Trade with a Manufacturing Base

We examine the effects of free trade agreement (FTA) on tariffs and welfare in a three-country model with vertical trade, where an FTA is formed between a country exporting a final good whose production involves using an intermediate good, and a country exporting the intermediate good in exchange for the final good. We demonstrate that the FTA reduces its member country's external tariff, whereas it raises the non-member country's tariff. The non-member country unambiguously becomes better off. In contrast, the FTA may or may not make its member countries better off. This implies that the formation of an FTA may not always be Pareto-improving.