te erXw, rK wpaa of such
Static Economic Theory, Quantitativee
Findings, and Policy Guidelines
Dean A. DeRosa
The World Bank
Development Research Group
Public Disclosure Authorized
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POLICY RESEARCH WORKING PAPER 2007
DeRosa reviews the static theory of regional integration
arrangements, identifying and analyzing the impact of
such arrangements on the trade and welfare of member
countries,nonmember countries, and the world at large.
He develops eight policy guidelines that apply mainly
to small trading countries unable to influence their
international terms of trade or to cease trading entirely
with nonmember countries, assuming increasing cost
conditions in member countries, homogeneous traded
goods, and perfect competition.
The guidelines advise establishing regional facilities for
compensatory lump-sum transfers or other intrabloc
payments to avoid the possibility that, where a trading
bloc would be welfare-improving overall, the bloc would
not be formed because of the (justified) recalcitrance of
one or more would-be member countries whose
economic welfare might be reduced by the adoption of
the regional trade arrangement.
Other guidelines are appropriate on commonsense
grounds. For example: Regional trade arrangements will
be welfare-improving if they are formed by countries that
are predominantly least-cost producers of exportables, or
if they give rise to increased imports from all trading
Yet few if any extant customs unions or free trade
areas meet such simple guidelines fully.
To some extent, customs unions and free trade areas
are expected to result in cessation of trade (in
homogeneous goods) with nonmember countries. Where
trade between member countries and nonmember
countries is expected to continue under regional
arrangements (as real-world data suggest), internationally
determined terms of trade rather than regionally
determined terms of trade are likely to prevail within the
trading bloc, limiting the welfare-improving effects of
creating trade but not the welfare-reducing effects of
Among the most interesting and arguably
"operational" policy guidelines to emerge from DeRosa's
analysis a:re those concerning countries that might choose
to join (1) a large rather than small regional trading bloc,
(2) a regional integration arrangement to overcome
hindrances facing exports to third countries, or (3) a
regional integration arrangement that could have strong
pro-competitive effects under imperfect competition and
increasing, returns to scale. Guidelines 1 and 2 concern
mostly developing countries; guideline 3 concerns mostly
advanced countries. But the economic bases for the three
guidelines are relevant and compelling.
This paper-a product of Trade, Development Research Group-is a background paper prepared for a World Bank Policy
Research Report, Regionalism and Development. Copies of the paper are available free from the World Bank, 1818 H Street
NW, Washington, DC 20433. Please contact Lili Tabada, room MC3-333, telephone 202-473-6896, fax 202-522-1159,
Internet address firstname.lastname@example.org. November 1998. (118 pages)
The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about
development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The
papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this
paper are entirely those of the authors. They do not necessarily represent the view of the World Bank, its Executive Directors, or the
countries they represent.
Produced by the Policy Research Disseinination Center
Regional Integration Arrangements: Static Economic Theory,
Quantitative Findings, and Policy Guidelines
Dean A. DeRosa
ADR International, Ltd.
200 Park Avenue, Suite 202
Falls Church, Virginia 22046 U. S.A.
Tel/Fax: 703 532-8510
Background paper for a World Bank Policy Research Report entitled Regionalism and
Development, prepared under short-term contract for the InLernational Trade Division of the
World Bank. The author is Principal Economist of ADR International, Ltd., an economic research
and policy consulting firm.
Regional integration arrangements have been the subject of considerable economic
analysis, beginning with seminal contributions to the "customs union issue" by Viner (1950) and
Meade (1955). Today, both theoretical work and quantitative work on regional integration
arrangements have been newly inspired by the current resurgence of regionalism and the issues it
poses for both advanced countries and less developed countries, and for the international
community of nations which is concerned for continued progress in international development and
the global trading system.
This paper reviews the static theory of regional integration arrangements and considers the
relevant findings of recent quantitative studies of new and "revitalized" regional integration
arrangements, identifying and analyzing, as possible, the expeclted or actual impacts of regional
integration agreements on trade and welfare of member countries, non-member countries, and the
world at large. The paper also derives a limited number of policy guidelines for advanced
countries and less developed countries considering joining either large or small regional trading
The impacts of regionalism and discriminatory trade policies in static economic theory are
frequently dependent upon the circumstances surrounding individual regional integration
arrangements and member countries, consistent with the theory of second-best in which seeming
movements in the direction of Pareto-optimality are not adways welfare-improving. Thus,
beginning with Viner's early conclusion that regional integration arrangements might be
predominantly trade-diverting and therefore welfare-reducing, the static theory of regional
integration arrangements has mainly failed to yield universally applicable guidelines for policy
The paper derives eight policy guidelines from the staLtic theory of regional integration
arrangements. The policy guidelines are applicable mainly to small trading countries unable to
influence their international terms of trade or to cease trading entirely with non-member countries,
under the assumptions of increasing cost conditions in member countries, homogenous traded
goods, and perfect competition. The policy guidelines apply appropriately to many advanced
countries and most less developed countries whose combined trade accotnts for only a small
fraction of world trade.
The policy guidelines indicate the advisability of establishing regional facilities for
compensatory lump-sum transfers or other intra-bloc payments to avoid the possibility that, where
a trading bloc would be welfare-improving in the aggregate, the bloc would not be formed
because of the (justified) recalcitrance of one or more would-be member countries whose
economic welfare might be reduced by the adoption of the regional integration arrangement.
Other policy guidelines are appropriate on common-sense if not tautological grounds. For
instance, that regional integration arrangements will be welfare-improving if they are formed by
countries that are predominantly least-cost producers of exportables or if they give rise to
increased imports from all trading partners are reasonable policy guidelines in simplest economic
terms. Yet, few if any extant customs unions or free trade areas meet such simple guidelines fully.
A subtly important aspect of the policy guidelines and underlying static theory of regional
integration arrangements is the extent to which customs unions and free trade areas are expected
to result in cessation of trade (in homogenous goods) with non-member countries. Where trade
between member countries and non-member countries is expected to continue under a regional
integration arrangement (as suggested by real world data), internationally determined terms of
trade rather than regionally determined terms of trade are likely to prevail within the trading bloc,
limiting welfare-improving trade creation effects but not welfare-reducing trade diversion effects.
This is readily apparent in the Vinerian model, and is likely to be relevant to similar outcomes in
the Meade model that are not treated extensively in the economic literature.
Among the most interesting and arguably "operational" policy guidelines to emerge from
the analysis of the paper are those concerning countries that mnight choose to join (1) a large
rather than small regional trading bloc, (2) a regional integration arrangement to overcome
hindrances facing exports to third-countries, or (3) a regional integration arrangement that could
have strong pro-competitive effects under imperfect competition and increasing returns to scale.
The first two policy guidelines confront mainly less developed countries, while the third policy
guideline confronts mainly advanced countries. Quantitative support for the three policy
guidelines is rather "thin,"' and quantitative support for the third policy guideline is particularly
subject to further theoretical and methodological refinement. Nonetheless, the economic bases for
the three policy guidelines are among the most relevant and compelling presented in the paper.
With regard to the body of quantitative "evidence" on regional integration arrangements,
few ex post (empirical) quantitative studies or ex ante (analytical) quantitative studies directly
investigate policy guidelines per se. Presumably owing to the exigencies of the theory of second
best, both ex post and ex ante quantitative studies have mainly investigated the effects of
regionalism on net trade creation and economic welfare on a "one-off' or case-by-case basis,
neglecting more direct or systematic analysis of the limited number of general propositions that
emerge from the static theory of regional integration arrangements.
Increasingly wide use of CGE models and other analytical models of regional integration
arrangements has raised critical questions about the appropriate specification and functional form
of key behavioral and technical relationships in these models. In particular, different assumptions
regarding the extent of firm-level economies of scale and different specifications of demand
systems for differentiated traded goods (rather than homogeneous traded goods favored in
neoclassical trade theory) can matter importantly for the magnitude of trade and welfare impacts
simulated by analytical models. Thus, ex ante studies employing CGE models need to be
confronted more frequently by real world data in the process of their construction and the
evaluation of their simulation results.
Nonetheless, the paper concludes that CGE and other analytical models are among the
most important tools that both applied economists and economic theoreticians today bring to the
problem of deriving useful policy guidelines on regional integration arrangements. This conclusion
applies particularly to deriving policy guidelines from the so-called large union Meade model - the
theoretical model that comes closest to encompassing the circumstances of the emerging "global
economy" in which extensive if not pervasive regionalism might be expected to have appreciable-
to-significant spillover and feedback effects on international trade and welfare.
2. "First Principles" of Regional Integration Arrangements
Basic Viner Model
Viner Model with Increasing Costs of Production
3. Modern Static Theory of Regional Integration Arrangements
Meade and the Theory of Second-Best
The Meade Model
Basic Small Union Model
Small Union Model with Incomplete Trade Diversion
Free Trade Area
Large Union Model
4. Extensions and Special Cases
Country Size and "Natural" Trading Partners
Foreign Trade Barriers and Transport Costs
Imperfect Competition, Scale Economies, and
5. Quantitative Studies and Findings
Early Empirical Studies of Regional Integration Arrangenments
Regional Integration Arrangements among Advanced Countries
North American Free Trade Agreemenit
Regional Integration Arrangements among LDCs
Asean Free Trade Area
Asia-Pacific Free Trade Area
Latin America and Greater Western Hemisphere
Chile's Trade Policy Options
Western Hemisphere Free Trade Area
A Summing Up
6. Guidelines for Policy Making: Summary and Final Remarks
Figures and Tables
Amid strong centripetal forces forging closer economic relations among countries today,
regionalism has emerged as a force potentially rivaling multilateralism with, as yet, uncertain
implications for the world trading system and the process of globalization itself The European
Union (EU) and the North American Free Trade Agreement (Nafta) among Canada, Mexico, and
the United States are the two most prominent regional integration arrangements. However, well
over 50 regional integration and trading arrangements are currently in force around the world,
with the vast number of these arrangements involving mainly less developed countries (IMF
Both regionalism and multilateralism might be expected to result inl economic integration
of neighboring countries. However, economic integration, which is defined here broadly as the
equalization of relative prices for traded goods among countries, need not be the same in both
cases because of the fundamental gulf between multilateralism's reliance on non-discriminatory
trade policies and regionalism's reliance on discriminatory trade policies. During the last half
century, multilateralism has been pursued through multilateral trade negotiations based on the
most-favored-nation (MFN) principle underlying the General Agreement on Tariffs and Trade
(GYATT) and its successor, the World Trade Organization (WTO), and it has been widely
regarded as the most appropriate path to achieving the "first-best" outcome of world economic
integration. However, since the late-1980s and frustrations growing out of the protracted length
of the Uruguay Round negotiations concluded in 1994, regionalism has come to be regarded in
many quarters as a "stepping stone" (rather than "stumbling block") to achieving world economic
integration, albeit by a more circuitous path involving, from an international political economy
perspective, potential competition if not conflict with multilateralism as a means of achieving
wider trade liberalization in the world economy.'
Bilateralism and regionalism have a longer history than multilateralism in modern history.
Regionalism dates to the 19t" Century when, in the wake of the first commercial treaty to
incorporate an unconditional MFN clause, the Cobden (Anglo-French) Treaty of 1860, a number
of small European states that had established customs unions among themselves also sought to
form trading alliances with France featuring the same MFN clause negotiated by France with
Britain. Notably in this case, regionalism contributed to the spread of lower trade barriers in much
of Western Europe as bilateral trade agreements based on the MVFN principle multiplied in number
during the late-1800s.2
Regional integration arrangements have been the subject of considerable economic
analysis, beginning with the seminal contributions to the "customs union issue" by Viner (1950)
and Meade (1955). Decisions facing both advanced and less developed countries about
participation in and design of regional integration arrangements have newly inspired both
theoretical work and quantitative work on regional integration arrangements. More generally,
needs of the international community for better understanding and insight to the actual or
potential effects of regionalism on the global trading system and emerging new global economy
have also spurred new work on regional integration arrangements.
' See, Lawrence (1991), Summers (1991), and Bhagwati (1992).
2 The Cobden Treaty and subsequent bilateral trading arrangements between France, on the one hand, and the
Zollverein states and other small European states, on the other hand, resulted in an effective multilateral
arrangement, ushering in an unprecedented era of liberal trade in Europe that lasted until the 1914, as discussed
recently by Irwin (1993). Although bilateral and regional trading arrangements played an integral role, the liberal
outcome for trade stemmed from the widespread adoption of the MFN principle and, arguably, the "domino effect"
of smaller states falling in line with the more liberal trade policies of Britain and France.
This paper reviews the static theory of regional integration arrangements and considers the
relevant findings of recent quantitative studies of regional integration arrangements, identifying, as
possible, the expected impacts of regional integration agreements on member countries and the
world at large. In addition, this paper attempts to derive policy guidelines concerning regional
integration arrangements for national economic decision makers and their advisors.
The remainder of the paper is divided into five sections. Section 2 considers the "first
principles" of regional integration arrangements as promulgated by Viner (1950) and the
subsequent development of a partial equilibrium framework that has come to be closely associated
with his name. Section 3 takes up the modern static theory of regional integration arrangements
which is based on more models of international trade that allow for greater adjustment of
domestic and international terms of trade, and for more explicit and directly derived measures of
national economic welfare. Section 4 takes up a number of extensions and special cases of the
Vinerian and Meade models that are important in their own right and which have led to the
development of particularly complex quantitative economic models. Section 5 examines the
findings of recent quantitative studies of the impacts of regional integration arrangements which,
in the absence of definitive theoretical results, have come to hold considerable sway in recent
discussions and evaluations of regional trading arrangements. Finally, in the concluding section,
Section 6 utilizes the guidelines for policy making on regionalism identified in Sections 2-to-4 as a
focal point for summarizing the findings of the paper.
Before turning to the main analysis, it should be noted that the paper considers mainly the
two most common forms of regional integration arrangements: customs unions and free trade
areas.3In a free trade area (FTA), countries enforce discriminatory trade policies by eliminating all
tariff and other political barriers to imports that originate wholly or in substantial measure (as
determined by so-called rules of origin) within the trading bloc. A customs union (CU), on the
other hand, is a free trade area in which member countries also adopt a common set of external
tariffs, quantitative restrictions, and other measures to limit imports from outside of the free trade
area.4Notwithstanding the considerable analytical challenges posed by customs unions and free
trade areas, economic analysis of higher orders of economic integration poses still more
formidable challenges.5Accordingly, in considering the static economic theory and findings of
recent quantitative studies of regional integration arrangements, this paper deals principally with
the two primary forms of regional integration arrangements treated in the economic literature.
3 In addition to free trade in goods (and services), regional economic integration can involve unrestricted
movement of labor, capital, or other productive primary resources; and harmonization of sectoial and
macroeconomic policies, economic institutions, and even civil and constitutional laws between neighboring
countries. These dimensions of regional integration arrangements are usually considered with reference to four
(increasing) degrees of economic integration: free (or preferential) trading area, customs union, common market,
and economic union.
4With regard to the other two major institutional forms of economic integration between countries, a common
market is a customs union in which unrestricted movement of labor and possibly other primary factors of
production is permitted, and an economic union is a common market in which fiscal, monetary, and other major
economic policies (e.g., industrial policies) are harmonized or otherwise closely coordinated. For further
discussion, see for instance Robson (1987).
5 Despite the complexity of higher orders of regional integration, some if not many policy and other conclusions
derived from considering only free trade areas and customs unions might still be expected to hold in regard to
cormmon markets and economic unions. For instance, in neoclassical economic theory the mobility of labor and
other primary resources between countries can be viewed as a perfect substitute for the unrestricted movement of
goods between countries (Mundell 1957). Similarly, the harmonization of economywide policies and especially
monetary policies might be viewed as providing an "enabling environment," reducing concerns for differences in
national monetary and other macroeconomic policies that are not usually considered in the pure (barter exchange)
theory of international trade underlying most analyses of free trade areas and customs unions (e.g., Mundell 1961
and O'Connell 1997).
2. "First Principles" of Regional Integration Arrangements
The literature on customs unions .... is a strange phenomenon which unites
free-traders and protectionists in the field of commercial policy, and its
strangeness suggests that there is something peculiar in the apparent
economnics of customs unions. The customs union problem is entangled in
the whole free-trade-protection issue, and it has never yet been properly
Viner (1950, p.41)
So begins the celebrated contribution of Viner (1950) to the econormic theory of regional
integration arrangements. In the quotation, Viner points to the fact that customs unions were a
feature of the international econornic landscape during (and, iII fact, long before) the early post-
World War II period, when the two Bretton Woods organizations - the International Monetary
Fund and the International Bank for Reconstruction and Development (World Bank) - were first
getting underway, and a third international organization, the International Trade Organization,
was waiting ratification of its enabling document, the Havana Charter. The quotation also
indicates that regional integration arrangements had been investigated by economists before
Viner, but without resolution.
Today, nearly 50 years after the Havana Charter was rejected by the United States, the
World Trade Organization has been established, finally institutionalizing many of the principles
and basic functions that were originally envisioned for the International Trade Organization and
supported only partially during the intervening years by the General Agreement on Tariffs and
Trade and its interim caretaker, the GATT Secretariat. Also today, major aspects of Viner's
seminal analysis of the customs union issue have endured, finding their way into most textbooks
on international trade theory and policy.
The enduring Vinerian framework is a highly stylized one, and it bears review here for not
only its strengths but also its weaknesses. Viner's original investigation of the customs union issue
was devoid of modem-day diagrammatic and mathematical methods of analysis. In this respect,
Viner's analysis was "deficient," requiring later development of the "textbook" analysis that bears
his name today. Nonetheless, Viner's analysis was extremely rich in insights to some important
circumstances still surrounding the customs union issue today, including economies of scale,
differentiated products, imperfectly competition, and changes in international terms of trade.6
Discussion of these circumstances is deferred mainly to subsequent sections of this paper. In the
present section, the basic Viner model is introduced and extended to the especially important case
of increasing costs of production in member countries, under the maintained assumption that only
homogeneous goods (i.e., non-differentiated products) are produced and consumed in both
member countries and non-member countries.
Basic Viner Model7
The basic Viner model provides a partial equilibrium framework for considering the effects
of customs unions. The framework consists of economic relationships depicting demand, supply,
6 Viner is duly credited with raising substantive questions about the welfare effects of customs unions, which were
widely believed to be positive following World War II (not unlike today). However, the rather strident tone of his
final rejection of regional integration arrangements on mainly political-economy grounds, found in the concluding
paragraph of his volume on the customs union issue, is not often reported:
.. [I]f one looks only to the day, an apparently promising path to a solution can often be found
whose first stages, if token in character, are fairly easy to pursue and whose last stages are
pleasant to contemplate, though what is at its ultimate end is but a mirage. This, I fear, is the
present-day role of customs union.... [I]t will almost inevitably operate as a psychological
barrier to the realization of the more desirable but less desired objectives of the Havana Charter-
the balanced multilateral reduction of trade barriers on a non-discriminatory basis. (Viner 1950,
The discussion of the Vinerian framework here draws importantly on Robson (1987), Pomfret (1988), and
Bhagwati and Panagariya (1996).
and trade in homogeneous goods (for final consumption) by three representative countries: the
home country (H), a partner member country (P), and a non-member country (N) representing the
rest of the world.
Most important, in addition to a number of "orthodox" (but not inconsequential)
assumptions shared with the pure theory of international trade,8the basic Viner model assumes
that, although import-competing goods may be produced under increasing (marginal) cost
conditions, exportable goods are produced under constant cost conditions in each country. In
Figure 1, the non-member country is assumed to be the most efficient producer of good 1, which
is imported by the home country after levying a specific tariff, TH1. Similarly, the home country is
assumed to be the most efficient producer of good 2, which is imported by the partner country
after levying a specific tariff, Tp2.
Under a customs union (or free trade area) between the home country and partner
country,9the home country reduces its tariff on imports of good 1 from the partner country to
8 As enumerated by Robson (1987), in addition to the homogeneous goods assumption, these assumptions include:
-- pure competition in commodity and factor markets;
-- mobility of factors of production within but not between countries;
-- no transportation costs;
-- trade restrictions only in the form of specific or ad valorem tariffs;
-- opportunity costs of production fully reflected in prices;
-- balanced trade in goods; and
-- full employment of resources.
9 Customs unions and free trade areas are assumed mostly equivalent throughout much of the analysis of this
paper. As mentioned in the introduction, countries forming a free trade area eliminate tariffs and other restrictions
to intra-bloc trade, but they do not necessarily adopt a common external tariff system as do countries forming a
customs union. To avoid trade "deflection," whereby exports by countries outside the free trade area to countries
that are members of the free trade area might be re-routed through member countries with lower-tariff levels, free
trade areas generally enforce "rules of origin" that stipulate the extent of intra-bloc content or processing that
goods must possess in order to qualify for duty-free importation by rmember countries. However, as noted by,
among others, Bhagwati and Panagariya (1996), rules of origin do not prohibit diversion of domestically produced
goods in countries forming a free trade area, in which case differing external tariff rates under a free trade area can
lead to little or substantially different results than under a customs unioii, depending upon the variance of external
tariff rates and capacity of member countries in a free trade area to divert their output of exportables from domestic
markets to markets in other member countries.
zero, providing would-be exporters of good 1 in the partner country with a "margin of
preference" sufficient to overcome their cost disadvantage vis-a-vis more efficient producers in
the non-member country.'° This causes exports from the partner country to supplant exports of
good 1 from the non-member country to the home country entirely. The replacement of erstwhile
exports from efficient producers in non-member countries by exports from less efficient producers
in member countries is termed trade diversion. In Figure l(a), trade diversion resulting from the
regional integration arrangement is equal to the entire initial value of imports of good I (evaluated
at the border price PN') by the home country from country N, area (k). 1
The customs union may also give rise to trade creation. Trade creation corresponds to the
expansion of home country imports of good 1 (evaluated at the border price Ppl) by the area
[(e+j) + (g+l)]. In economic terms, trade creation involves the substitution in both home country
production and home country consumption of lower-priced units of good I produced by country
P than were previously available to the home country through domestic production [area (e+j)l or
imports from the rest of the world [area (g+l)].
In Figure 1(b), the hypothesized customs union has qualitatively different effects on trade
of the partner country. Because the home country is the least-cost producer of good 2, elimination
of the partner country's tariff on imports of good 2 from the home country results solely in trade
creation. No diversion of erstwhile exports from non-member countries occurs in connection with
the increase in imports by the partner country. Moreover, the expansion of exports of good 2
from the home country to the partner country gives rise solely of substitution in production and
consumption in country P of lower-cost units of good 2 produced in the home country than were
'° With reference to Figure 1, the home country margin of preference in favor of exports of good 1 from the partner
country is equal to TH -(PP -PN1).
11 For ease of exposition, the analysis here is conducted in terms of trade values rather than trade volumes.
available previously to the partner country through domestic production or imports from the non-
Since Viner's seminal analysis, trade creation and diversion have been treated as virtually
synonymous with the impact of customs unions and other regeional integration arrangements on
economic welfare. Accordingly, many empirical and quantitative studies have sought to estimate
trade creation and diversion on either an ex ante (before the -Fact) basis or ex post (afterwards)
basis. To the extent that a regional integration arrangement is trade creating on a net basis (i.e.,
measured trade creation is greater than measured trade diversion), the arrangement is considered
to contribute positively to the combined if not individual welfare of member countries, measured
in terms of traditional economic surpluses (so-called Harberger triangles of consumer and
producer surpluses) or more sophisticated indices of economic welfare such as Hicksian
equivalent variation in income.12
Table 1 provides a summary of the effects on trade and economic welfare of the
hypothetical customs union considered in Figure 1, for the home country, the partner country, and
the customs union formed by the two countries. The changes illustrate that net trade creation is
not always unambiguous in sign, as emphasized by Viner (1950). Whereas the customs union
results in net trade creation for the partner country in respect to its imports of good 2, the
customs union does not necessarily result in net trade creation for the home country in respect to
its imports of good I or for the custom union as a whole itn respect to trade in both goods.13
These results are "rnirrored" in the changes in economic welfare for the two countries. Whereas
economic welfare improves unambiguously for the partner country owing to the dominance of
12 See, for instance, Harberger (1954, 1971) on the measurement of consumer and producer surplus and Shoven
and Whalley (1984, 1992) on the measurement of Hicksian equivalent variation in inconme.
13 It is also notable that net trade creation is not necessarily equal to the change in import value for either country.
positive consumption and production effects of trade creation, the change in economic welfare is
uncertain for the home country (and customs union) because even though the combined net
consumption and production effects related to trade creation and diversion in the home country
[area (a + b +c) in Figure 1(a)] are positive, they might not be sufficiently large in magnitude to be
greater than the forgone home country tariff revenues on imports diverted from the non-member
country to the partner country [area (b + f)].
These results, of course, follow from the assumptions depicted in Figure 1 regarding the
relative efficiency of producing exportables in the home country, partner country, and non-
member country. For the partner country, the customs union gives rise to trade creation only and
greater welfare because the home country is the (assumed) least cost producer of good 2. For the
home country, the welfare change is uncertain because the partner country is assumed to be less
efficient than the rest of the world in producing good 1. Thus, under assumed constant costs of
production, trade with non-member countries is completely diverted, giving rise to forgone tariff
revenues that rnight or might not be larger than the production-related and consumption-related
benefits to the home country of a lower import price and increased imports from the partner
country. In effect, in a customs union under constant cost conditions, member country gains in
economic welfare attributable to trade creation will be partially offset, if not more than fully
offset, by added costs of importing goods from high-cost producing countries within the customs
union area and forgone tariff revenues. Obversely, in a customs union formed among countries
that are predominantly internationally competitive producers of exportables, the regional
integration arrangement will be trade-creating on a net basis and unambiguously welfare-
Quantitative studies of regional integration arrangements have found nearly universally,
beginning with ex post empirical studies of the European Commnunity during the 1960s and 1970s
and continuing today with mostly ex ante quantitative studies of the many new and "revitalized"
free trade areas emerging since 1990, that regional trading blocs are predominantly trade-creating
on a net basis. Quantitative "evidence" on welfare gains under regional integration arrangements
has traditionally been more sporadic, except in recent years with the advent of sophisticated
computable general equilibrium (CGE) models employed in ex ante studies of regional integration
arrangements. An early ex post study of trade in maliufactures and agriculture under the European
Community by Balassa (1975) found that formation of the European Community, including
establishment of its strongly trade-diverting Common Agricultural Policy, contributed an
economic gain of just 0.3-to-0.4 percent of Community GDP per annum. Recent ex ante studies
using multi-country CGE models find similarly modest welfare impacts of regional integration
arrangements among "small" less developed countries and advanced countries whose firns are
predominantly perfect competitors in domestic and international markets.
Policy Guideline 1
4 At this point, the partial equilibrium nature of the basic Vinerian framework begins to strain credulity on some
important counts that are developed in the next subsection and Section 3. For instance, comparative advantage
theory suggests that neighboring countries are unlikely to be internationally competitive producers of the large
number of products consumed by residents of most countries today. This consideration would limit the number of
cases in which regional integration arrangements among especially small countries might be predominantly trade
creating owing to member countries' international competitiveness
unlimited capability to produce exportables at constant unit costs is an extreme one. Moreover, the assumption
creates a bias in favor of finding positive trade creation effects under regional integration arrangements.
Specifically, the assumption causes erstwhile trade with non-member countries to be supplanted entirely by trade
in many products. Also, the assumption of
Under constant cost conditions, a customs union or free trade area established among "small"
countries unable to influence their external terms of trade will be predominantly trade-creating and
welfare-improving for the trading bloc and its individual member countries if member countries
are predominantly least-cost producers of exportables by international standards. If one or more
member countries are inefficient producers of exportables, causing substantial diversion of trade
with non-member countries, the inefficient member countries will gain from the regional
integration arrangement. Efficient member countries, on the other hand, will not necessarily gain
because welfare gains resulting from trade creation might not be sufficient to offset welfare and
tariff revenue losses resulting from trade diversion. It is also uncertain in such circumstances
whether the trading bloc as a whole will gain.
Few if any quantitative studies of regional integration arrangements have examined the
implications of forgone tariff revenues under regional integration arrangements for the
development (or lack of development) of intra-regional compensatory payment schemes.
Nonetheless, the importance of forgone tariff revenues under regional integration arrangements in
the Vinerian framework needs to be emphasized. Whereas the Harberger triangles in Figure 1
measuring economic gains associated with the consumption and production effects of trade
creation might be small in many cases, the rectangles in Figure 1 representing tariff revenue losses
will often be comparatively large. Although tariff revenues are frequently considered transfers
between domestic consumers and government (with no net impact on national welfare), reduced
tariff revenues under regional integration arrangements are not fully captured by domestic
consumers when imports from high-cost member countries replace imports from low-cost non-
member countries, as shown in Figure 1(a). Thus, in trade-diverting regional integration
arrangements, tariff revenue losses can be decisive in determining the overall welfare effect of the
regional integration arrangement on individual member countries and the trading bloc as a whole.
In t cases where the formation of a customs union would result in net economic benefits for the
with member countries at reduced intra-bloc terms of trade, thereby giving rise to positive Hiarberger welfare
trading bloc, a facility for apportioning tariff revenues among union members might be necessary
to enable the countries that gain from formation of the regional integration arrangement to
compensate the countries that lose.
triangles associated with induced production and consumption effects.
Policy Guideline 2
A customs union or free trade area that results in welfare losses for one or more member
countries might still be successfully implemented if welfare gains for other member countries are
sufficiently large to provide a net welfare gain for the trading bloc as a whole and if a facility for
compensatory intra-bloc payments, typically involving apportionment of tariff revenues among
member countries, can be successfully implemented such that member countries that gain from the
regional integration arrangement compensate member countries that lose.
In the Vinerian framework, spillover effects of regional integration arrangements on non-
member countries do not occur. The customs union or free trade area is assumed to be "small" in
terms of its share of world trade. Accordingly, the customs union is a "price-taker" in world
markets and unable to affect international terms of trade for goods. In Figure 1, this assumption is
represented by the constant price for exportables produced by the non-member country.
Consequently, within the stylized Vinerian framework, the economic welfare of non-member
countries is unaffected by the formation of a regional integration arrangement, and the change in
world economic welfare is identical to the aggregate change in welfare of countries in the
preferential trading arrangement. Thus, if the contribution of the customs union to economic
welfare in the trading bloc is uncertain, the contribution of the customs union to world economic
welfare is also uncertain.
The uncertainty of welfare effects under regional integration arrangements contrast sharply
with the certainty of welfare effects under MFN liberalization (i.e., non-discriminatory trade
liberalization). As evaluated in Table 1 (based on Figure 1), concerted MFN liberalization by the
would-be members of the customs union is everywhere trade-creating and nowhere trade-
diverting. That is, MIFN liberalization results in net trade creation and improved economic welfare
everywhere, including for each would-be customs union member. Consider, for instance, the
home country in Figure 1. Under a customs union, the home country's trade with non-member
countries would be diverted in some if not substantial measure. On the other hand, under MFN
liberalization consumers increase their consumption of traded goods guided solely by
nondiscriminatory price considerations, eliminating the possibility of trade diversion. Thus, under
MFN liberalization consumers would be expected to increase their purchases of goods produced
in not only prospective member countries but also non-mernber countries, fully reaping the
potential consumption gains [area (c+g+h) in Figure 1(a) and (b)] and resource allocation gains
[area (a+d+e)] in both the home country and the partner country.
Viner Model with Increasing Costs of Production
The Viner model can be extended to consider the important case of increasing costs of
producing exportables in the countries forming a customs union, as illustrated in Figure 2. The
case of increasing costs of production is appropriate to the circumstances of individual countries
and small groups of countries whose natural resource base and other productive endowments are
typically limited, especially in comparison to the world economy at large. The earlier assumption
that unit costs of production are constant in the non-member country is maintained, enforcing the
condition that the home country and the partner country are both price-takers in world markets."5
Finally, for ease of exposition, the analysis here considers ordy the home country's imports of
goods 1, as if formation of a customs union between the home country and partner country would
result only in expanded imports of good 1 from the partner country by the home country.
15 For ease of analysis and exposition, the partner country is assumed to have no domestic demand for good 1, and
therefore in Figure 2 the partner country's supply schedule for good 1 is also the partner country's export supply
schedule for good 1.
As before, a customs union between the home country and partner country gives rise to
trade diversion in the home country, area (e + f). However, it does not necessarily give rise to
trade creation because the partner country's margin of preference does not necessarily result in a
lower price for good 1 in the home country. Indeed, so long as the partner country's capacity to
increase exports is less than the home country's initial total demand for imports of good 1, the
home country will continue to import good 1 from the non-member country (country N) and the
equilibrium price of good 1 in the home country will remain unchanged at PH' (equal to PN1plus
the specific tariff of the home country, TH1).
That trade with non-member countries is not entirely diverted in Figure 2 occurs because
total capacity to produce good 1 in the customs union area is insufficient to meet total demand for
the good at any price less than the pre-customs-union price, PH1. This seems an appropriate
assumption for many low-income developing countries forming a regional integration
arrangement. It is also arguably an appropriate assumption for advanced countries. Production
capabilities of advanced countries may be greater than those of less developed countries, but they
still might not be sufficient to satisfy intra-bloc demands for tradables entirely and to result in
complete cessation of trade with non-member countries as predicted by the Viner model under
constant cost conditions (and assumed homogeneous goods).
The trade and welfare effects of forming a customs union between the home country and
partner country under the increasing cost conditions shown in Figure 2 are summarized in Table
2. From the home country's perspective, the customs union is trade-diverting on a net basis, and
the customs union has no impact on the economic welfare of either individual producers or
individual consumers. Because exports of good 1 by the partner country are insufficient to meet
fully the home country's demand for imports under a regional integration arrangement, the price
of good 1 in the home country is unchanged and, accordingly, both demand. and production of
good 1 in the home country are also unchanged. The improved competitiveness of producers of
good 1 in the partner country simply goes to diverting a portion of the home country's imports of
good 1 from non-member countries.
Overall economic welfare in the home country is adversely affected however. In extending
a tariff preference to the partner country, the home country gives up previously collected tariff
revenues on both initial imports and "new" imports from the partner country [area [l+m+2(a+b)]
in Figure 2]. The forgone tariff revenues are "captured" in their entirety by producers of good 1 in
the partner country, at a comparatively small resource cost [area (a+b)]. Thus, the home country
loses, and the partner country gains from formation of the customs union. Moreover, as pointed
out by Bhagwati and Panagariya (1996) and Schiff (1996) with respect to the case of "natural"
trading partners, the forgone tariff revenues of the home country and the welfare gain of the
partner country are greater, the greater is the initial volume of trade between the home country
and partner country (so long as the non-member country initially supplies an appreciable volume
of imports to the home country, as depicted in Figure 2).
Finally, the customs union and the world economy both lose from formation of the
hypothetical customs union in Figure 2. Specifically, welfare of the trading bloc and, by extension,
welfare of the world economy are reduced by the incremental cost of the resources utilized to
expand production of good 1 at higher cost in the partner country than the non-member country
[area (a+b)] .6
16 Notwithstanding that the customs union and world economy lose from formation of the custom union under the
increasing costs depicted in Figure 2, the direct impact of the formation of the customs union on private economic
surplus is either neutral (home country) or positive (partner country). The losses to the home country, the customs
union, and the world economy, respectively, hinge crucially on the disposition of tariff revenues. Although it is
generally assumed that tariff revenue gains and losses are shared through lump-sum transfers by the government to
Are regional integration arrangements pursued by relatively open economies more likely to
be trade-creating, as sometimes claimed? Bhagwati and Panagariya (1996) demonstrate that the
answer to this question is no. Under high protection in the home country (and therefore
substantially smaller volume of initial imports by the home country than depicted in Figure 2), a
regional integration arrangement between the home country and partner country might well result
in a lower price for imports in the home country and complete cessation of trade between the
home country and non-member country. In this circumstance, net trade creation might occur, and
the home country might achieve welfare gains similar to those found under constant costs of
production. In contrast, under a relatively open trading regime in the home country, such as
depicted in Figure 2, a regional integration arrangement between the home country and partner
country will not result in a lower price for imports in the home country, nor will imports from
non-member countries be completely diverted. In fact, under increasing cost conditions in the
Viner model, a relatively open trading regime will tend to ensure that a regional integration
arrangement will be trade diverting on a net basis and that welfare of the home country, trading
bloc, and world economy will decline, as summarized in Table 2.
Policy Guideline 3
Under increasing costs conditions, a customs union or free trade area established among small
countries unable to influence their external terms of trade will be predominantly trade diverting so
long as non-member countries continue to supply imports to member countries. Although member
country producers whose exports to other member countries are increased under the regional
integration arrangement will enjoy welfare gains, the welfare of member countries will typically
decline because they give up substantial tariff revenues and enjoy no overall increase in their
imports. Welfare of the trading bloc and (equivalently) the world economy will also typically
decline, owing to the greater resources necessary to expand exports by member countries than
consumers, such transfers may be heavily discounted by consumers in the modem age of large govermment
bureaucracies and deficit spending, in which case private sector support for regional integration arrangements
might be stronger than otherwise.
necessary to supply the same exports by non-member countries. The certainty of welfare losses
occurring under increasing cost conditions is greater, the less highly protectionist are, initially, the
countries forming the regional integration arrangement.
The implications of highly protected economies versus more open economies formling a
regional integration arrangement have not been specifically explored in recent quantitative studies
of regional integration arrangements. Also, notwithstanding the increasing use of multi-country
CGE models to investigate the possible effects of customs unions and free trade areas, few
quantitative studies have purposely considered the global trade and welfare effects of increasing
regionalism among less developed countries if not advanced countries. Most recent quantitative
studies either fall back on the maintained assumption of the Viner model (and "small union"
Meade model discussed in the next section) that countries forming a regional integration
arrangement have little or no power to influence international terms of trade for goods (and
services) or volume of world trade significantly, or they simply provide little indication of what
the estimated or simulated spillover effects of recent regional integration arrangements on the
greater world economy are.
Finally, it is again interesting to consider the comparable trade and welfare effects of
concerted MFN trade liberalization, also summarized in Table 2. As found in the case of constant
production costs, MIFN trade liberalization under increasing costs of production in the customs
union results solely in trade creation in the home country."' Also again, trade creation has its
counterparts in both production and consumption effects, and, notwithstanding forgone tariff
revenues, MFN liberalization results in a net welfare gain for the home country. This welfare gain
derives from the improved allocation of domestic resources [area (a+k+m) in Figure 2] and
increased consumption possibilities [area d]. Moreover, becausie the partner country is unaffected
by nondiscriminatory trade liberalization in the home country, both the customs union and world
economy at large gain from unilateral trade liberalization in the home country, namely, by the total
amount of the welfare gain in the home country [area (a+k+m+d)].
Two recent ex ante studies of the new free trade area among the Association of Southeast
Asian Nations (Asean), the Asean Free Trade Area (Afta), by DeRosa (1995) and by Lewis and
Robinson (1996) provide basic support for the dominance of (concerted) M:FN trade liberalization
over preferential regional trade liberalization, albeit using CGE models that represent the Asean
economies in considerably more complex terms than depicted in Figure 2. Both studies find that
the predominantly middle-income countries of Southeast Asia (the so-called Asean-4: Indonesia,
Malaysia, Philippines, and Thailand) gain significantly more in terms of improved welfare from
simultaneously liberalizing their trade regimes on a nondiscriminatory basis (MiFN liberalization)
than on a discriminatory basis (Afta). For instance, DeRosa finds that whereas economic welfare
(measured by real absorption) in the Asean-4 improves typically by less than about 0.5 percent
under Afta, it improves by more than 4.0 percent under concerted MEFN liberalization.
3. Modern Static Theory of Regional Integration Arrangements
The Viner model and its framework for analyzing regional integration arrangements do not
lie comfortably within the bounds of modem neoclassical trade theory, whose boundaries are
defined fundamentally by general equilibrium theory and its emphasis on interrelationships among
markets for goods and factors of production throughout an economy. Moreover, regionalism in
the world economy today involves not only "small" blocs of countries but also "large" blocs of
countries that count potentially for an appreciable share of world trade. Therefore, in principle, a
17 Production and exports of good 1 by the partner country are unchanged because the effective world price of good
more general framework for considering the static economic; effects of regional integration
arrangements is desirable, namely, a framework admitting substitution of goods in demand and
supply, simultaneous adjustment of interrelated markets for goods and factors of production in
trading countries, and possible international terms of trade effects impinging significantly on trade
and economic welfare in individual countries and the world at large.
Meade and the Theory of Second Best
In a less widely recognized volume on the theory of customs unions than Viner's
contribution, Meade (1955) outlined if not fully developed the modern static theory of regional
integration arrangements."' Meade's analytical framework explicitly admitted trade by many
countries in many commodities. Reflecting the "culture" oif the day, Meade relied upon
macroeconomic policies to ensure full equilibrium (including equtilibrium in international payment
balances). However, his framework pointed clearly to the central role of prices and international
terms of trade for achieving and maintaining equilibrium in international trade and payments under
preferential trading arrangements. Finally, Meade focused his analysis on the economic welfare of
the world economy, not simply the countries forming a regional integration arrangement. In going
beyond the "small country" perspective of the Vinerian framework, he recognized the potential for
significant secondary effects of regional integration arrangements on third-countries and the world
economy at large owing to adjustment in world markets for traded (and nontraded) goods.
I is unaffected by MEN trade liberalization in the home country, as shown in Figure 2.
18 For a recent and thoroughgoing discussion of Meade's theory of customs union, see Panagariya (1996). Notably,
notwithstanding the title of his volume, Meade did not analyzed the implications of customs unions per se but
rather the broader class of preferential trading arrangements which do not necessarily stipulate the adoption of
common external tanffs or other import control measures.
Meade's volume also lent considerable inspiration to the development of the so-called
theory of second-best (Lipsey and Lancaster 1956/57). The theory of second-best holds that for
distorted economic systems, eliminating one set of distortions does not guarantee an improvement
in overall economic welfare so long as other economic distortions remain unchanged. As it applies
to the static theory of regional integration arrangements, the theory of second-best implies that
reducing tariffs on a discriminatory basis under a regional integration arrangement (and so
seemingly moving in the direction of Pareto optimality) does not guarantee an improvement in
welfare for individual countries or the world economy, as maintained originally by Viner (1950).19
Accordingly, the numerous circumstances surrounding individual regional integration
arrangements in the Meade tradition of general equilibriumn analysis matter importantly for
whether the arrangements are welfare-enhancing. Moreover, they make generalizations regarding
the economic benefits of customs unions and free trade areas extremely difficult.
The Meade Model
Meade abandoned the Vinerian assumption of constant costs of production in trading
countries and recognized the necessity of ensuring equilibrium. in international payments balances.
Thus, Meade brought to the fore adjustment in both international and domestic relative prices to
achieve (general) equilibrium under regional integration arrangements. These refinements to the
static theory of regionalism admit the possibility of not only spillover effects of regional
integration arrangements on non-member countries but also feedback effects of international
19 More generally, unilateral trade liberalization by an individual country may not be welfare-improving if the
country is sufficiently "large" or other trading countries are sufficiently highly protected to cause the individual
country's terms of trade to deteriorate as it reduces its trade barriers unilaterally and expands its exports to
maintain balance of payments equilibrium.
adjustments to the formation of regional integration arrangements on member countries
Basic Small Union Model
Meade's general or "large union" model is not easily represented in textbook or policy
discussions. More widely considered is the "small union" Meade model in which the conditions for
international payments equilibrium by member countries are observed under increasing cost
conditions in all sectors but in which the international terms of trade are assumned constant.
Figure 3 illustrates the basic small union model for two small countries that form a
preferential trading arrangement and trade in only two goods (goods 1 and 2).20 The schedules
depicted in Figure 3 are general equilibrium trade offer curves rather than partial equilibrium
demand and supply schedules. The offer curves, OH and Op, indicate the volume of exports that
the home country and the partner country are respectively willing to exchange for imports under
very general demand and supply conditions in both countries at different international terms of
trade, while maintaining balance of payments equilibrium. Initially, the two countries are assumed
to enforce substantial tariffs against imports, and to trade "short" of their free-trade offer curves,
at points EHN° and EPN°, respectively, along the ray ON that represents the offer curve of the non-
member country (representing, again, the rest of the world). That the slope of ON is constant
reflects the fact that the international terms of trade for goods 1 and 2 are not affected by the
volume of trade by either the home country or partner country.
Under a customs union or free trade area in which external tariffs and other trade
restrictions are sufficiently high that the home country and the partner country trade exclusively
20 Figure 3 and the discussion of the figure in the text are adapted from Pomfret (1988).
with one another (i.e., the regional integration arrangement is completely trade-diverting), the
trade and intra-bloc payments equilibrium for the two countries occurs at point EHp. This
equilibrium determines the domestic and intra-bloc terms of trade for members of the regional
integration arrangement given by the dashed line in Figure 3. From the perspective of the partner
country, the equilibrium at EHP is superior to equilibrium under either protection or free-trade.21
However, from the perspective of the home country, the equilibrium at EBP is inferior to
equilibrium under protection or free trade. First, the home country's "income terms of trade" (i.e.,
the international terms of trade multiplied by the country's export volume) are lower, and,
consequently, its volume of imports is lower, under the regional integration arrangement than
under protection. And second, as is apparent in Figure 3, under free trade rather than the regional
integration arrangement, the home country could admit a greater volume of imports from all
countries on a duty-free basis and, in so doing, expand its exports along the more favorable
international terms of trade, ON, offered by the non-member country until equilibrium is reached at
point EHN, corresponding to a higher level of welfare than a point EHP.
Thus, in the small union Meade model the distribution of economic gains among member
countries in a regional integration agreement is extremely important for the stability of the
agreement. In fact, in the simple two-good model underlying the trade offer-schedules in Figure 3,
one member country always loses from formation of a regional integration arrangement, relative
to the pre-integration circumstances of the member countries or to the opportunities for member
countries to improve their trade and welfare under unilateral nondiscriminatory trade
21 If the partner country liberalizes its imports on a nondiscriminatory basis, its new trade equilibrium would occur
at point EPN. Figure 3 shows that the free trade equilibrium for the partner country is superior to the initial
equilibrium at EPN°, but it is inferior to the equilibrium under the regional integration arrangement at EHP. Thus,
the partner country should be expected to prefer joining the regional integration arrangement depicted in Figure 3
to undertaking unilateral nondiscriminatory tariff reduction.
liberalization. Again, as in the Vinerian analytical framework, compensatory schemes involving
lump-sum or other transfers between member countries would be necessary to ensure that all
member countries benefit from a regional integration arrangement. Also, from the welfare changes
for the home and partner country depicted in Figure 3, it is not clear that the trading bloc as a
whole necessarily gains from the regional integration arrangement.22
Finally, with regard to welfare in the rest of the world, in Figure 3 the assumption of a
perfectly elastic trade offer curve for the rest of the world implies that, even though trade between
member countries and non-member countries ceases completely under the regional integration
arrangement,23 global spillover effects of the regional integration arrangement are negligible, not
unlike in the Vinerian framework.
In the discussion here, the welfare benefits of the regional integration arrangement are
considered mainly in terms of underlying community preferences for traded goods, without
necessary reference to the Vinerian notions of trade creation or diversion. This means of
evaluating regional trading arrangements is in keeping with modern international trade theory, as
discussed by Kowalczyk (1990), and with recent ex ante quantitative studies of regional
integration arrangements (considered in Section 5).
Small Union Model with Incomplete Trade Diversion
22 In Figure 3, if protection in the home country and partner country is so high as to restrict imports to near-
autarkic levels initially, then a regional integration agreement between the two countries will be unambiguously
welfare-improving for both countries.
23 In Figure 3, the home country and the partner country trade exclusively with one another under a regional
integration arrangement. Illustrations of customs unions and free trade areas admitting incomplete diversion of
trade between member countries and non-member countries in the small union Meade model are considered in the
Direction of trade data for members of regional integration arrangements indicate that
trade with non-member countries does not cease after regional integration arrangements are
formed, contrary to the outcome in Figure 3 and similar analyses using the basic small union
Meade model (e.g., Wonnacott and Wonnacott 1981). This direction of trade evidence may
reflect the existence of traded goods that are differentiated by their place of production (discussed
in Section 4). However, incomplete trade diversion under regional integration arrangements is
also a possible outcome in the small union Meade model assuming trade in homogeneous goods.
Customs Union. Unfortunately, when trade continues with non-member countries under a
customs union, diagrammatic analysis becomes more complicated. For the exposition here,
assume that a customs union sets its common external tariff equal to the average tariff level of the
home country and partner country. This case conforms importantly to GATT Article XXIV which
stipulates that a regional integration arrangement should not raise the average level of protection
against non-member countries.
In the depiction of this case in Figure 4, the home country and the partner country both
continue to trade along the international terms of trade ON. Because the initial level of import
tariffs is assumed higher in the home country than the partner country, equilibrium of the home
country under the customs union occurs at a point such as EHN
1 (closer to the free-trade
equilibrium at EHN), where economic welfare in the home country is greater than at the initial
equilibrium of the home country at EHN°. At the same time, equilibrium of the partner country
under the customs union occurs at a point such as EPN (further away from the free-trade
equilibrium at EPN), where economic welfare in the partner country is less than at the initial
equilibrium of the partner country at EPN°.
Thus, not (qualitatively) unlike the outcome in Figure 3 using the basic small union Meade
model, the home country gains while the partner country loses from the formation of the customs
union. Unfortunately, it is not clear from Figure 4 whether the home country might compensate
the partner country for its loss and thereby ensure formation of the regional integration
arrangement. However, it would not be difficult to demonstrate that, if the two countries adopt a
common external tariff much closer to the initially lower tariff level of the partner country, the
welfare gain of the home country would become sufficiently larger than the welfare loss of the
partner country to guarantee existence of a compensatory scheme whereby the home country
could more than compensate the partner country for any welfare loss associated with formation of
the customs union.
Free Trade Area. With continued trade between member countries and non-member
countries, a free trade area is subject to a number of possible outcomes in the small union Meade
model, depending upon the commodity composition of trade between member countries and non-
member countries after the free trade area is formed.24If the assumption here is maintained, both
before and after the free trade area is formed, that on a combined basis the home country and the
partner country are net exporters of the first comrnodity and net importers of the second
commodity, then under the free trade area the protection levels and domestic relative prices of the
home country will prevail in both member countries of the regional integration arrangement. As
depicted in Figure 5, the partner country will benefit from the opportunity to trade exclusively
with the home country at the higher (to the partner country) intra-bloc terms of trade (P1/P2)H.
However, it is likely that the home country will suffer a loss in economic welfare because under
the free trade area, after account is taken of the home country's duty-free trade with the partner
24 See Kemp (1969) for a comprehensive treatment of possible outcomes under different assumptions.
country, the home country can only exchange a smaller proportion of its exports of good 1 for
imports of good 2 at the more favorable international terms of trade ON. Thus, as found
previously in the case of a customs union with incomplete trade diversion, it is not clear that the
home country and the partner country will both benefit from a free trade area, or that either
country will gain sufficiently to compensate the other country for its possible economic loss under
the free trade area.
In both its basic form and more complex forms, including variants that assume trade in
three goods,25the small union Meade model has been widely studied. Among the most widely
cited analytical results of the small union model, initially reported by Meade (1955, p.35) himself,
is the result that if a country entering into a regional integration agreement increases its imports
from all sources (including non-member countries), the country will enjoy an improvement in its
economic welfare.26This result is appealing and sensible, including in terms of Viner's concept of
net trade creation. However, from a policy perspective, it provides little insight into what
circumstances or conditions surrounding countries forming a regional integration agreement might
25 In the three-country, three-good variant of the small union Meade model, it is typically assumed that the home
country and partner country specialize in the production of one good each, while the non-member country produces
all three goods. Under restrictive assumptions regarding the degree of substitutability of the three goods in
demand, all three countries may produce the three goods without sacrificing some of the interesting analytical
results found using the simpler three-country, three-good variant of the small union Meade model. See McMillan
and McCann (1981) and Panagariya (1996).
26 For further discussion, see Lipsey (1970), Baldwin and Venables (1995) and Panagariya (1996). Lipsey (1970)
reports three other interesting results based on the small union Meade model:
1. A regional integration arrangement that reduces the tariff on the partner country's good is
more likely to be beneficial than the arrangement that removes the tariff entirely;
2. A regional integration arrangement is more likely to raise welfare the higher is the level of
tariff on the partner country initially in relation to the tariff on the non-member country; and
3. A necessary condition for preferential liberalization to improve a country's welfare is that it
lower the country's expenditure on its domestic good thereby increasing the volume of imports,
both measured at world prices.
guarantee that the arrangement would result in an expansion of the trade of member countries
from all sources. Moreover, most quantitative studies find that regional integration arrangements
result in at least some diversion of trade with non-member countries. Thus, it is frequently
recommended that countries forming a preferential trading arrangement should simultaneously
lower their external barriers to trade so that their imports from all trading partners will increase
and the impact of the arrangement on regional economic welfare and world economnic welfare will
both be positive.
Policy Guideline 4
In a general equilibrium setting under increasing cost conditions in both memnber and non-member
countries, a customs union or free trade area established among countries unable to influence their
external terms of trade individually or as a trading bloc will be welfare-improving for individual
member countries and the trading bloc if the regional integration arrangement increases imports
by member countries from all trading partners. To ensure this outcome, member countries of a
new trading bloc should simultaneously reduce their barriers to trade with non-member countries.
Barring this strategy, a regional integration arrangement formed by a relatively small number of
countries will result in at least one member country being madle better off and the possibility of
one or more member countries being made worse off, raising the advisability of establishing a
facility for compensatory intra-bloc payments to ensure that all member countries enjoy economic
gains when the trading bloc as a whole is welfare-improving.
Large Union Model
The large union Meade model encompasses possible global spillover effects of regional
integration arrangements operating through not only diversion of trade but also changes in
international terms of trade. It is also appropriate for assessing the avowed objective of many
regional integration arrangements to defend and, as possible, improve member countries'
See Panagariya (1996) for further discussion and the derivation of these results in terms of a compact version of the
international terms of trade in response to new or reinvigorated regional integration arrangements
in other areas of the world.
Unfortunately, the large union Meade model has not been fully explored by modem-day
27Broadly speaking, the large union Meade model poses analytical and
policy issues similar to those associated with the optimal tariff issue for individual countries. In
this connection, changes in intra-regional and extra-regional trade may have significant impacts on
international prices for traded goods impinging on the economic welfare of both member
countries and non-member countries. If either the volume of non-member countries' exports or
their international terms of trade are adversely affected by a regional integration arrangement,
then the welfare of non-member countries and possibly the welfare of the world economy might
be significantly repressed.28
This possibility, which has been discussed in the context of large blocs of not only
advanced countries but also large blocs of less developed countries with potential market power,
is among the most prominent issues surrounding regionalism today. Based on early insights by
Meade (1955, p. 98), Ohyama (1972) and Kemp and Wan (1976) offer an interesting theoretical
perspective on this issue. In what is popularly termed the Kemp-Wan theorem, these economic
theoreticians proved that for any proposed customs union or free trade area there exists a set of
common external tariffs that would precisely leave the new trading bloc's trade with non-member
countries unchanged, so that the welfare of the latter countries would not be affected and any
improvement to the welfare of the integrating countries would strictly add to world welfare.
small union Meade model.
27 For an early analysis of the welfare implications of customs unions under endogenous international terms of
trade, see Mundell (1964).
Despite its elegance, the Kemp-Wan theorem has not proven to be operationally relevant
to date. Recently, Srinivasan (1996) usefully derived an operational "characterization' of the
Kemp-Wan common external tariff structure for a customs tnion, namely, as a consumption-
weighted average of pre-union tariffs and subsidies in member countries. Notwithstanding this
seemingly practical, development, there remains the political-economy problem of reaching a
consensus in favor of establishing such a common external tariff structure, inclusive of possibly
requisite lump-sum transfers to ensure all member countries share in the welfare gain of the
customs union or free trade area.29
The Kemp-Wan theorem has occasionally been invoked as a "test" of the desirability of
existing regional integration arrangements. Specifically, some analysts have suggested that if a
regional integration arrangement promotes exports from non-member countries to the members of
the trading arrangement, the arrangement must improve the welfare of non-member countries and
the world economy as a whole. Richardson (1995) and Winters (1997) have both objected to such
interpretations of the Kemp-Wan theorem.
Richardson argues that in a world in which countries behave optimally, any attempt by
members of a customs union to set their common external tariffs in a manner to guarantee that no
non-member country is harmed by the union would likely be met by retaliatory tariff adjustments
by non-member countries that would leave members of the customs union (as a bloc) no better off
and possibly worse off than before.
Winters demonstrates that increased exports by non-member countries to member
countries under a regional integration arrangement is an inappropriate application of the Kemp-
28 Feedback effects of international terms of trade changes on the welfare of individual member countries would be
mainly positive or mainly negative accordingly as the member counbies are net exporters or net importers,
respectively, of commodities whose terms of trade increase in international markets.
Wan theorem. This follows because the welfare of non-member countries is not monotonically
related to their exports to member countries. Essentially, the welfare impacts of a regional
integration arrangement on non-member countries must be estimated more directly, for instance,
on the basis of changes in imports by non-member countries (and changes in their terms of trade),
because residents of non-member countries, like residents of other countries, fundamentally derive
enjoyment from consumning rather than producing goods.30
4. Extensions and Special Cases
The large union Meade model does not yield ready guidelines on regional integration
arrangements for policy makers owing to both the difficulty of deriving analytical solutions to the
model and the problem of making generalizations about policy options that fall within the
particularly wide bounds of the theory of second-best. For these reasons, economists have been
drawn to a process of identifying special cases and circumstances that are more amenable to
solution in general equilibrium models, and more amenable to deriving clear insights or policy
prescriptions to issues surrounding regional integration arrangements.
This section discusses some prominent extensions and special cases of not only the Meade
model but also the Viner model, with a view to identifying and delineating additional policy
guidelines that emanate from the static theory of regional integration arrangements. As in Sections
2 and 3, unless otherwise stated, most orthodox assumptions underlying the pure theory of
international trade are maintained, including especially the assumptions of perfect competition and
production and consumption of homogeneous traded goods.
29 For further discussion, see, for instance, Bhagwati (1992).
Country Size and "Natural" Trading Partners
The economic size of countries joining a regional integration arrangement has been of
considerable interest to economists recently (e.g., Bhagwati and Panagariya 1996; Schiff 1996).
Principally at issue is whether a small country can expect to gain more from joining a large
regional integration arrangement than a small regional integration arrangement.
A related issue is whether trading countries that have a. mutual affinity for trade with one
another (so-called natural trading partners), owing, for instanice, to strong complementarity of
resource endowments or geographic proximity, should expect to gain more substantially from
forming a regional integration arrangement than other countries, as maintained recently by some
prominent policy makers and special reports on regionalism.31
Being a small country unable to influence the terms of Trade of would-be partner countries
in a regional integration agreement can be a distinct advantage. Schiff (1996) finds that a small
country joining a large regional trading arrangement is likely to gain in a similar manner to a small
country liberalizing its trade on a unilateral MFN basis. By reducing tariffs on imports from
member countries of a trading bloc that is sufficiently large to satisfy a small country's entire
import demands at little or no increase above the prevailing international terms of trade, a small
country will unambiguously increase its welfare, specifically, through welfare-improving
combinations of increased consumption of low cost imports, reduced production of high cost
domestic substitutes, and reduced consumption of imports from inefficient "small" third-counties.
Moreover, Schiff finds that the smaller the initial level of trade with the large trading bloc, the
30 A similar difficulty can arise in connection with attempting to assess the welfare impacts of a regional
integration arrangement on member countries using solely net trade creation as an indicator. See, for instance,
greater will be the welfare gain for the small country because of the greater margin for
substitution in demand by the small country away from high cost goods produced domestically or
high cost goods imported from third-countries, to lower cost goods imported from efficient
countries in the large trading bloc.
Conversely, if a small country joins a small regional integration arrangement that is unable
to meet its total demand for imports except at substantially higher border prices, so that
consumers in the country must continue to purchase imports from third-countries at a high price
(namely, the international terms of trade adjusted for the import tariff originally levied on an MFN
basis), then not only the small country but also the regional trading bloc as a whole will be worse
off as a consequence of accession of the small country to the small regional integration
arrangement. Analogous to the outcome in the Viner model under increasing costs of production,
the small country will be worse off by the amount of its forgone tariff revenues on imports from
member countries in the small regional integration arrangement, and the trading bloc as a whole
will be worse off by the amount of resources in member countries devoted to expanding exports
to the small country (see Table 2).
Policy Guideline 5
Under increasing cost conditions, a small country unable to affect its international terms of trade
will increase its welfare by joining a "large" regional integration arrangement whose intra-bloc
relative prices will not be affected by accession of a small country to the arrangement. Conversely,
a small country will reduce its welfare by joining a "small" regional integration arrangement that
cannot supply a greater volume of imports to the small country except at higher intra-bloc prices,
in which case welfare of the trading bloc itself will also be reduced.
31 See, for instance, Summers (1991) and EU (1995).
With regard to the issue of "natural" trading partners, it has been suggested that
neighboring countries or countries whose relative resource endowments are highly complementary
- in both cases, giving rise to appreciable initial levels of tradle - should be expected to expand
their trade relations significantly under a regional integration arrangement and, thereby, derive
particularly large benefits from forming a regional trading bloc. However, as reported by
Bhagwati and Panagariya (1996) and Schiff (1996), under a regional integration arrangement
between natural trading partners, tariff revenue losses ("rectangle" effects) arising because natural
trading partners will initially enjoy more extensive mutual trade relations than other countries are
likely to be substantial. Moreover, in the event that margins of preference under a regional
integration arrangement give rise to welfare gains from positive consumption or production
effects ("triangle" effects), the tariff revenue losses are likely to be greater than the production-
related and consumption-related welfare gains. Thus, contrary to the natural trading partners
hypothesis, economic gains from forming a trading bloc are likely to be smaller, the greater is the
initial volume of trade between would-be members of the arrangement for "natural" or other
Policy Guideline 6
Under increasing cost conditions, "natural" trading partners that are unable to affect their
international terms of trade will not experience substantial trade diversion on forming a regional
integration arrangement among themselves. However, on forning a regional integration
arrangement, natural trading partners will also not enjoy substantial gains in welfare because
forgone tariff revenues will be nearly equal to, if not greater than, welfare gains from consumption
and production effects.
Foreign Trade Barriers and Transport Costs
Among the most enduring issues surrounding regional. integration arrangements is why
countries choose to form customs unions or free trade areas when most analyses within either the
Vinerian framework or the Meade framework suggest that unilateral trade liberalization on a
nondiscriminatory basis is usually a superior policy option. Wonnacott and Wonnacott (1981,
1992) provide a possible answer to this question that highlights two real-world obstacles to
international trade: foreign trade barriers and transportation costs.
Foreign trade barriers and transport costs both drive a wedge between the price that
consumers in importing countries pay and the price producers in exporting countries receive for
the same traded goods. The Wonnacotts argue that this wedge might be sufficiently large to offer
neighboring countries opportunities for expanding their mutual trade on a preferential basis in a
manner that captures the price wedge arising from substantial protection in third-countries or
from high transport costs for goods shipped to third-countries. Specifically, with the adoption of a
customs union or free trade area, the member countries might be able to trade on more favorable
terms exclusively with one another than with highly protected or distant third-countries.32
This possibility is illustrated in Figure 6, which is based on the two-good representation of
the basic small union Meade model considered earlier. Recall that the offer curve of the non-
member country (representing the rest of the world) is given by the ray ON, and that the slope of
ON is the effective international terms of trade facing the home country and partner country in the
absence of trade restrictions or transportation costs. Suppose, however, that the home country's
exports of good 1 to the non-member country face either a substantial tariff or particularly high
32 The Wonnacott and Wonnacott analysis of regional integration arrangements does not consider the possibility of
continued extra-bloc trade by member countries seeking to circumvent foreign trade barriers or high trade
transport costs.33As suggested by the Wonnacotts, this situation might be the case for, say,
German exports of steel to the United States versus the United Kingdom, against the background
of the European Union in which Germany and the United Kingdom are both members. Such
circumstances would cause the non-member country's offer curve faced by the home country to
become ON', with equilibrium for the home country under unilateral nondiscriminatory trade
liberalization at EHN'. The free-trade equilibrium at EHN' is inferior to the equilibrium under a
regional integration arrangement between the home country and partner country at EHP for two
reasons: (1) the regional terms of trade facing the home country, (Pi/P2)Bp, are greater than the
international terms of trade given by the slope of the offer curve ON', and (2) the volume of trade
at EBp is greater than the volume of trade at EHN'.
34Thus, in Figure 6 both the home country and
the partner country (rather than solely the partner country, as found in discussion of the small
union Meade model and Figure 3) prefer a customs union or free trade area to unilateral MFN
In Figure 6, the home country and partner country exchange trade preferences (giving up
tariff revenues on imports from one another) in order to capture the greater savings from the high
costs of protection or transport of goods associated with the home country's exports to the non-
member country. This is a relevant finding, but one that is contingent upon the real-world
occurrence of significant transactions costs for trade with non-member countries.
transportation costs, in which case prospects for welfare gains under a regional integration arrangement might be
33 Solely for ease of exposition, in Figure 6 only the home country is assumed to face high protection and/or high
transport costs in connection with its exports to the non-member country.
34 The partner country also prefers regional free-trade equilibrium at EBp to the multilateral free-trade equilibrium
at EPN for the same two reasons, namely, the more favorable terms of trade and more favorable trade volume under
the regional free-trade equilibrium at EHp.
35 As Pomfret (1988) notes, although the home country and partner country both gain, under the regional
integration arrangement in Figure 6 the non-member country loses owing to reduced imports and lost tariff
Amjadi and Winters (1997) provide a rare study of this issue that focuses on
transportation costs facing exports by member countries of the South American Common Market
(Mercosur). They investigate whether transportation costs between Mercosur countries and non-
member countries (represented by the United States) are sufficiently high to afford significant
gains to Mercosur countries under their new customs union. They find that transportation costs
for exports destined for countries outside Mercosur are appreciably higher than intra-regional
transportation costs. However, they judge that the margin between the two costs is not
sufficiently large to result in a net welfare gain for Mercosur countries.
No recent quantitative studies using multi-country economic models have directly
investigated the "'missing foreign tariff' hypothesis advanced by the Wonnacotts. Nonetheless, it is
implicitly true that, to the extent recent multi-country CGE models incorporate information about
levels of protection in not only member countries but also non-member countries, simulations of
these models must account in some measure for the benefits of regional integration arrangements
attributable to circumventing extra-regional levels of protection. In this connection, an issue for
future analysis is whether such benefits are indeed being captured by these models, and, if they
are, whether such benefits are contributing appreciably if not critically to the generally positive
welfare effects of regional integration arrangements reported by studies using these models.36
Policy Guideline 7
revenues. Thus, the implications for world welfare are uncertain depending upon the relative magnitudes of the
welfare gain by the customs union and welfare loss by the non-member country.
36 As discussed further below in this section and the next section, a complicating factor in interpreting the results
of recent quantitative studies vis-a-vis predictions of Vinerian and Meade models is that CGE models employed in
recent studies generally assume differentiated goods rather than homogenous goods, introducing possible (but
uncertain) biases in the results.
Under increasing cost conditions, two or more neighboring countries facing substantial foreign
trade barriers, transport costs, or other "hindrances" to their exports to third-countries might form
a regional integration arrangement that will be welfare-improving to individual member countries
and possibly the trading bloc as a whole if the benefits of "capturing" the costs of the hindrances
to exports to third-countries through formation of the regional integration arrangement outweigh
the tariff revenue losses and other possible welfare costs of formiing the trading bloc.
Imperfect Competition, Scale Economies, and Differentiated Goods
During the last two decades with the advent of the so-called "new trade theory,"
international trade theoreticians have explored the implications for international trade and welfare
of imperfect competition between firms in an increasingly integrated world economy.37Under
imperfect competition, natural, technological, or policy-based barriers to market entry by firms
give rise to monopolistic profits, often in the presence of increasing returns to scale and
production of differentiated goods, rather than homogeneous or like goods, by competing firms.
Among the earliest findings of empirical studies of economic integration in Western
Europe is that the European Community stimulated trade in similar products (so-called intra-
industry trade) rather than trade in complementary products (so-called inter-industry trade),
contrary to the prediction of traditional comparative advantage theory in which countries do not
both export and import goods produced in the same industry.38This finding, which is
substantiated by more general studies of price competitiveness in international trade,39has led to
both theoretical and quantitative studies of regional integration under different assumptions about
the competitive structure of markets, scale economies, and product differentiation.
If scale economies can be realized, they offer individual firms valuable opportunities for
achieving greater international competitiveness. For high-technology firms in advanced countries,
achieving scale economies in the production of new products can limit if not exclude entry by
other firms in "thin" or comparatively small-scale markets for new products (e.g., Krugman
1980). For firms in less developed countries, achieving scale economies in the production of
37 See Helpman and Krugman (1985) and Krugrnan (1995).
38 See, for instance, Verdoorn (1960), Balassa (1966), and Grubel (1967). By 1977, according to Drabek and
Greenaway (1984), intra-industry trade among European Community countries amounted to more than two-thirds
of intra-bloc trade in Western Europe.
S see, in particular, Kravis and Lipsey (1971).
nontraditional products can contribute to the transformation Of so-called infant industries, which
are frequently a burden on public resources, into industries that are more likely to be
internationally competitive (e.g., Pearson and Ingram 1980).
Although both Viner (1950) and Meade (1955) suggested that significant gains from
regional integration arrangements might be associated with scale economies, Corden (1972) was
first to set down a formal theory of their potential importance to trade and welfare under customs
unions, albeit within an analytical framework that did not iformally link scale economies and
market structure. Later, Either and Horn (1984) and Smith and Venables (1988) offered more
sophisticated models of firm behavior integrating economic relationships among increasing returns
to scale, imperfect competition, and segmented markets in which firms set different prices for the
same product in markets at home and abroad.40
Essentially, inclusion of scale economies in the modern static theory of customs unions
identifies possibilities for "fortunate" firms in member countn'les to produce greater quantities of
either differentiated or homogenous products after formation of a customs union or free trade
area when trade preferences and resulting shifts in demand in favor of intra-regional trade enable
these firms to achieve greater economies of scale and lower ouitput prices as they not only capture
but also create larger markets for their output at home and abroad. Increased production by these
firms gives rise to economic gains in member countries, termed cost reduction effects by Corden
(1972), that are additional to production and consumption gains identified in the Viner and Meade
40 These models are discussed extensively by Baldwin and Venables (L995). The two models are also discussed
further below in this section.
41 Scale economies can also give rise to trade suppression effects that are additional to trade diversion effects under
a customs union or free trade area. Trade suppression effects occur when scale economies give rise to reductions in
non-member country exports to member countries. See Corden (1972), Robson (1987), and Pomfret (1988).
Thus, in simple economic models in which scale economies are not related formally to
market structure, scale economies offer a possible additional source of economic gains for
countries forming regional integration arrangements. However, unlike in the case of high foreign
protection or transport costs considered previously, scale economies do not offer a reason why
regional integration arrangements might be preferred to unilateral MFN trade liberalization.
Indeed, the benefits of greater scale economies might be realized to an equal if not greater extent
under MFN trade liberalization.
In addition to achieving cost reduction effects related to increasing returns to scale,
regional integration arrangements might successfully erode market power of dominant firms in
member countries through encouraging market entry of competing firms from other member
countries. This "pro-competitive" effect is widely cited in popular discussions of regionalism.
However, the significance of the pro-competitive effect is not assured in recent theoretical studies
that point to other effects that might be offset the pro-competive effect.42For instance, a regional
integration arrangement might result mainly in shifting production of goods among member
countries with little or no reduction in market segmentation, and little or no increase in the
number of firms in the trading bloc producing similar products at higher volume and lower profit
margin than attributable to the realization of greater economies of scale.
Also, offsetting simultaneous effects might occur even when a regional integration
arrangement causes segmented regional markets to become fully integrated. If initially segmented
markets are characterized by firms practicing so-called reciprocal dumping of their products in
foreign markets (financed by higher profits on sales in their domestic market than abroad), then
regional integration arrangements could result in less extensive intra-regional trade than before,
42 See Baldwin and Venables (1995) for extensive and highly technical discussion of this issue.