to prove the existence of welfare-enhancing free trade areas. Startingfrom an arbitrary initial world
trade equilibrium involving countries H,F, and W there exists an alternative Pareto improving
free trade area equilibrium characterized by free trade between countries H and F, rules of origin
specified in Assumption 2, and external tariffs of H and F selected to freeze pre-existing trade
flows of each country with W.
Our equilibrium existence proof applies the Gale and Mas-Colell Theorem to the formation
of FTAs. Their theorem is very flexible since it proves equilibrium for an economy where agents’
income can be described by any continuous function of prices a [p] and the economy can produce
a bounded amount of output from zero input. The income function a [p] can represent any
arbitrary transfer of income among households. In particular, it can represent the income transfers
represented in this paper by the fair sharing distribution rule. Consumers in countries H and
F have the ability to purchase their original consumption bundle or a strictly superior bundle.
Conditions in W are unchanged. The rules of origin in Assumption 2 are needed to generate
the stated results. More restrictive rules of the type often applied in practice are equivalent to
imposing a reduced production set, for which the existence of Pareto improving equilibria cannot
be guaranteed in general.
Free trade is often opposed by individuals, regions, sectors and/or industries that lose in
the move to freer trade. The need to internationally coordinate common tarifs constitutes an
additional impediment. The existence of a free trade area equilibrium for countries H and F that
is Pareto superior to an arbitrary initial trade equilibrium and does not require coordination of
countries’ tarifs addresses these points. This may partly explain the popularity of free trade areas
compared to other forms of preferential trading arrangements. The analysis also explains why
more restrictive rules of origin that are encountered in practice are often insufficient for gains,
and provides arguments against more restrictive forms.
Free trade areas represents a viable and general strategy with which to extract gains from
freer trade, with limitations. Choosing external tarifs to freeze trade with the rest of the world
may be difficult given the amount of information needed, for example. The analysis also explains
why “hub-and-spoke” expansions of free trade areas cannot in general guarantee welfare gains
to all parties. Thus, assume a world of countries H, F, and W. Let H form an FTA with F.
Consider next that H decides to form an FTA with W, but countries F and W apply tarifs on
products traded between them. In this case, country H becomes what is known in the literature
as a “hub” and countries F and W become the “spokes”. Forming such an FTA is not necessarily
welfare-enhancing since H can not apply tarifs on W to hold H — W trade flows fixed. Except by
12