Abstract: The entry of a low-wage country into a world economy with pre-existing wage differentials puts the gains from trade in a former low-wage and then medium-wage country under pressure. If negotiations over the formation of a free trade area cover international transfers, there is a strong presumption that they bring about global free trade. Full compensation of the medium-wage country for the reduction in its gains from trade, however, does not necessarily occur. In the absence of international transfers the medium-wage country is never compensated when global free trade causes a reduction in its gains from trade, and it may in fact happen that the medium-wage country is not part of the equilibrium free trade area. Furthermore, the entry of a low-wage competitor may give the high-wage country an incentive to reap welfare gains in a tariff war at the expense of the medium-wage country, and capital may drain away from the medium-wage country to the high-wage country and, simultaneously, to the low-wage country.
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