Enlargement Decisions of Regional Trading Blocs with Asymmetric Members

This paper analyzes the conditions under which an existing bilateral free trade area (FTA) prefers to expand in size and when it prefers consolidation through customs union (CU) formation when the existing members of the FTA are asymmetric, both with respect to production technology and domestic market sizes. The analytical framework employs a standard oligopolistic strategic trade model in a three-country world. In presence of technology asymmetry, there will exist a clash of interest between the FTA members while the non-member will always prefer to join the bloc. Global free trade can be sustained as a subgame perfect Nash equilibrium only for lower degrees of production inefficiency while for higher degrees of production inefficiency a CU between the initial members can be sustained in the presence of some side payments.