Bilateral free trade agreement in vertical trade structure

We investigate the welfare effect of the bilateral free trade agreement (FTA) in a vertical trade structure. We consider a three-country model with one country exporting intermediate goods (upstream country) and two countries exporting final goods (downstream countries). We focus on the situation where both the upstream and downstream countries impose positive import tariffs before forming the FTA. We then consider an FTA between the upstream country and one of the downstream countries. The other downstream country is regarded as a nonmember country. After forming the FTA, all of the tariffs between the member countries are eliminated, whereas the tariffs between the FTA member and nonmember are maintained. We have two scenarios in relation to the FTA; the first one is the case where external tariff reform by the FTA member country is not allowed, and the second one is the case where external tariff reform is allowed. Then, in the first scenario, the FTA unambiguously decreases the nonmember's welfare, while it may or may not increase the FTA members' welfare. The latter result depends on the number of firms producing the intermediate and the final goods and on the levels of the initial tariffs. Irrespective of an increase of the FTA members' welfare, Pareto-improving FTA is not possible. In contrast, in the second scenario, if an external tariff reform, i.e., a reduction of tariff by the FTA member, is available, there exist some possibilities that the FTA increases both of the FTA members' welfare without changing the nonmember's welfare. Therefore, Pareto-improving welfare is possible.