Small Countries and Preferential Trade Agreements: How Severe is the Innocent Bystander Problem?

This paper examines the welfare implications of preferential trade agreements (PTAs) from the perspective of small countries in the context of a multi-country, general equilibrium model. We calibrate our model to represent one relatively small country and two symmetric big countries. We consider two cases. In one case, the small country is an "innocent bystander," that is, it is left out of a PTA between the two large countries. In the second case, the small country signs a PTA with one of the large countries. We simulate the model and calculate consumption allocations, prices, trade volume, and tariffs in these two cases considering three different equilibria: Free Trade (FT), Free Trade Area (FTA), and Customs Union (CU). We find that free trade is the best outcome for the small country. If the large country PTA takes the form of a CU then the cost of being an "innocent bystander" is very large. If it is a FTA then the cost of being an "innocent bystander" is relatively modest. In fact, the small country prefers to be an "innocent bystander" to being a member of a FTA with one of the large countries.

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