The role of non-discrimination in a world of discriminatory preferential trade agreements

In a three-country model of endogenous trade agreements, we study the implications of the most-favoured-nation (MFN) clause when countries are free to form discriminatory preferential trade agreements (PTAs). Under current rules of the World Trade Organization (WTO), although non-member countries face discrimination at the hands of PTA members, they themselves are obligated to abide by MFN and treat PTA members in a non-discriminatory fashion. The non-discrimination constraint of MFN reduces the potency of a country's optimal tariffs and therefore its incentive for unilaterally opting out of trade liberalization. Thus, MFN can act as a catalyst for trade liberalization. However, when PTAs take the form of customs unions, the efficiency case for MFN as well as its pro-liberalization effect is weaker because one country finds itself deliberately excluded by the other two as opposed to staying out voluntarily.