Endogenous formation of free trade agreements in vertically related markets

• We examine the endogenous formation of FTAs in a model with vertical trade.
• We analyze the coalition-proof Nash equilibria in an FTA formation game.
• An FTA induces each member to lower their tariffs on intermediate and final goods.
• Given symmetric countries, multilateral free trade is the unique stable equilibrium.

We study the endogenous formation of free trade agreements (FTAs) in a symmetric three-country model with vertically related markets characterized by Cournot competition. We analyze the coalition-proof Nash equilibria in an FTA formation game in which each country forms an FTA with one, both, or none of its trading partners. We show that multilateral free trade is the unique stable equilibrium of the FTA formation game. In other words, FTAs act as building blocks for multilateral trade liberalization in the presence of vertical trade structures.