Small Countries and Regionalism

Transcription

1 Small Countris and Rgionalism M. Ayhan Kos and Raymond Rizman Dpartmnt of Economics Univrsity of Iowa Iowa City, IA This vrsion: January 2, 1997 Abstract: Th numbr of rgional trad agrmnts has narly doubld in th last four yars. Intrstingly, rlativly small countris hav put normous ffort into oining rgional agrmnts with largr countris during this priod. In this papr, w addrss th following qustion: why ar small countris so agr to b a part of ths agrmnts? W construct a gnral quilibrium modl of a natural trading block to answr this qustion. Using this modl, w xamin th wlfar implications of a varity of rgional trad agrmnts btwn larg and small countris. W simulat th modl and calculat consumption allocations, prics, trad volum, and tariffs undr thr diffrnt quilibria: Fr Trad, Fr Trad Association, and Customs Union. Th rsults of this invstigation indicat that a rlativly small nonmmbr country might fac significant wlfar loss if a larg rgional trading block uss its monopoly powr to manipulat xtrnal tariffs chargd on th xports of th small country. In othr words, our findings suggst that bing an innocnt bystandr might b xtrmly costly for a small conomy in a natural trading rgion. JEL Classification: F2, F13, F15 Ky Words: Gnral quilibrium, trading blocks, fr trad agrmnts, tariffs, wlfar.

2 1. Introduction In rcnt yars, rgional trad agrmnts hav mushroomd all ovr th glob. Spcifically, th numbr of rgional agrmnts has narly doubld in th last four yars. Two maor charactristics of ths agrmnts ar particularly intrsting: first, rlativly small countris hav gnrally initiatd th ngotiation procss and formd rgional agrmnts with big countris. For xampl, NAFTA was signd by two rlativly small countris, Canada and Mxico, and a much biggr country, th Unitd Stats. Th EC has rcntly discussd accpting svral rlativly small countris as mmbrs. Scond, th small countris hav compromisd on svral dimnsions to hav rgional agrmnts with largr countris or with xisting rgional trading blocs. For xampl, Mxico accptd svral additional provisions about nvironmntal clan-up, and nrgy pricing policis to oin NAFTA. On th othr hand, th big partis of NAFTA and EC continud thir managd protction practics by limiting intrnational accss to som of thir snsitiv sctors. 1 Ths dvlopmnts as wll as th ongoing dbat about thir contribution to th multilatral trading systm has put various implications of rgional agrmnts in th forfront of rsarch in intrnational trad. 2 Nvrthlss, thr hav bn vry fw studis which xamin th rgional trad agrmnts from th prspctiv of a small country in 1 S Ethir (1996), and Prroni and Whally (1994) for svral common faturs of rcnt rgional agrmnts. As Prroni and Whally not U.S. and Canada hav protctd thir agricultur sctor, whil Mxico substantially libralizd it as a rsult of NAFTA. In Europ, nw mmbrs hav to adopt nvironmntal and labor standards of th Europan Community, and, morovr, thy hav to accpt a varity of protction masurs for snsitiv sctors, such as agricultur, and txtils, of th xisting mmbrs. Wintrs (1993) rviws rcnt prfrntial trad arrangmnts btwn th Europan Community and svral rlativly small countris, such as Hungary, Poland, and th Czch and Slovak Rpublics. H calls ths agrmnts as managd libralization, sinc accdants hav to accpt xisting policy unconditionally, vn though xisting mmbrs may b xmpt from parts of it th EC dcids what it wants and th EFTA countris tak it or lav it. Ethir also obsrvs that rcnt rgional agrmnts ar on-sidd in th sns that thy contain asymmtric concssions. Sampson (1996) provids information about th incras in th numbr of rgional trad agrmnts. S D Mlo and Panagariya (1993), and Andrson and Blackhurst (1993) for a comprhnsiv rviw of svral issus associatd with rcnt rgional trad agrmnts. 2 In particular, th impact of rcnt wav of rgional trad agrmnts on global trading systm has a hotly dbatd issu: on on sid w hav Bhagwati (1995) who argus that, furthr xpansion and cration of fr trad aras, instad of concntration now on multilatralism at th WTO, is a mistak. Summrs (1991), on th othr sid of th dbat, argus that, holding th dgr of multilatral progrss constant, th world will b bttr off with mor rgional libralization. S Rizman (1996) for an xtnsiv discussion about ths issus. 2

3 th contxt of a gnral quilibrium modl. Our main obctiv is to valuat th bnfits of bing a mmbr of a rgional trading block for a small country using a fully spcifid multi-country gnral quilibrium modl. In particular, w addrss th following qustions: first, why ar small countris so agr to b a part of ths agrmnts? Scond, what ar th ffcts of diffrnt typs of rgional trad agrmnts, such as customs unions and fr trad associations, on wlfar, tariffs, prics, and th volum of trad of small countris? W construct a simpl multi-country gnral quilibrium modl of a natural trading rgion. 3 This modl was dvlopd in Rizman (1985) and Knnan and Rizman (199). W assum that all transaction costs associatd with intrnational trad ar zro in th modl. This assumption can b ustifid for svral rasons. For xampl, countris in a natural trading rgion ar locatd nar ach othr, or hav similar languags, culturs, or lgal systms. On of th common charactristics of rcnt trad agrmnts is that thy ar rgional, i.. ths agrmnts hav bn stablishd by nighboring countris (s Ethir (1996).) As on would xpct, a trad agrmnt among th countris in a natural trading rgion could potntially rsult in significant wlfar gains. In our modl, thr ar thr countris: two of which ar rlativly big and hav a symmtric ndowmnt distribution. Th third country is small with an important advantag ovr th big countris: it has a mor vn ndowmnt distribution than th big ons. Thrfor, its rlianc on intrnational trad is lss than th othr countris in th rgion. W calibrat our modl this way to giv th small country a bttr chanc of bnfiting from a potntial trad war. Prsumably, if th small country s ndowmnt was unvn, it would suffr mor from such a trad war. In this rgion, countris st tariffs optimally and considr all possibl trad agrmnts whn thy dcid what to do. To b mor spcific, countris optimiz at all stags both in trms of who thy cooprat with and what tariffs thy charg givn th constraints imposd by thir cooprativ agrmnts. Our rsults dpnd only on th ndowmnt structur w spcify, sinc all th variabls, including tariffs, ar ndognously 3 Natural trading rgion is dfind as a group of countris with low natural trading costs. W assum that transaction costs ar prohibitiv btwn th natural trading rgion and th rst of th world. 3

4 dtrmind in th modl. Morovr, our prfrnc formulation gnrats a linar xpnditur systm which can b solvd using numrical mthods. Th big countris gt togthr and form a rgional agrmnt, ithr a Fr Trad Association (FTA) or a Customs Union (CU), in our simulations. In th FTA, mmbr countris agr to fr trad btwn thmslvs but ar allowd to st thir xtrnal tariffs indpndntly. A customs union is an FTA with th additional provision that th xtrnal tariff is st ointly by th mmbrs. First, w simulat our modl conomy by assuming that th small country is lft out of th rgional agrmnt. Thn, w analyz th fr trad quilibrium in which small country also bcoms a participant in th agrmnt. W xamin th ffcts of th changs in th rlativ siz of ths countris by simply changing th siz of big countris in thir xport markts. For ach ndowmnt structur and trading rgim, w calculat quilibrium prics, consumption allocations, tariffs, and trad volum. W, thn, study th wlfar implications of ths agrmnts for ach country in th rgion. As th numbr of rgional trad agrmnts has incrasd, th rsarch program that aims to provid answrs to a varity of qustions about ths agrmnts has also xpandd. Knnan and Rizman (1988) study th implications of a possibl trad war btwn a small country and a big on in a gnral quilibrium modl. Thy find that big countris can win tariff wars. This implis that by having trad agrmnts with th big countris, small countris could avoid losing a possibl trad war. 4 Markusn and Wigl (1989) analyz th implications of fr trad arrangmnt btwn Canada and th U.S. Employing a computabl gnral quilibrium modl, thy find that moving from th Nash quilibrium to fr trad rsults in much largr wlfar gains for Canada than for th Unitd Stats. Krugman (1991a) discusss th rcnt xpansion of rgional trad agrmnts and its impact on countris which ar lft out of this procss. H provids a simpl xampl to illustrat th importanc of th innocnt bystandr problm, i.. th problm facd by a country which is xcludd from a rgional agrmnt. H concluds that th bystandr can 4

5 suffr from significant wlfar losss noting that.. inward turning fr trad aras, whil doing littl damag to thmslvs or ach othr, can asily inflict much mor harm on conomically smallr playrs that for on rason or anothr ar not part of any of th big blocks. Prroni and Whally (1994), mploying a computabl gnral quilibrium modl, study th rol of small countris in th rcnt rgional trad agrmnts. Thy claim that th main motiv of small countris is to provid thmslvs with saf havns by scuring thir accss to largr country markts. In othr words, thy intrprt th rcnt rgional agrmnts as insuranc arrangmnts for small countris. Thy also find that small countris hav to mak som transfr paymnts to b a part of rgional trading arrangmnts, sinc a big rgional block can b bttr off by simply manipulating th trms of trad in its favor. In a rcnt papr, Bond and Syropoulos (1996) xamin th implications of bloc siz for tariffs and wlfar. Thy xtnd Krugman (1991b) s modl and show that a trading bloc can achiv a wlfar lvl, that is highr than that of th fr trad, through an incras in its rlativ siz. In anothr study, Nordstrom (1995) invstigats th ffcts of trad agrmnts on rgional outsidrs using a multi-country intraindustry trad modl. Th rsults of his simulations indicat that th cost of rgional trad agrmnts can b significant in wlfar trms for nonmmbr countris if thr ar larg transaction costs associatd with trad with othr rgions. Morovr, mmbr countris can noy wlfar gains by xcluding som countris from th rgional agrmnt and by incrasing th tariffs chargd on th xports of thos countris. Kowalczyk (1996) studis th dcision of a small country to participat in a fr trad arrangmnt. H xamins th gains and losss associatd with trms of trad and volum of trad ffcts whn th small country bcoms a mmbr of a fr trad ara. His rsults suggst that a small country noys gains through its accss to th agrmnt, but a larg trading partnr might dmand som transfr paymnts from th small country to stablish fr trad with it. 4 Rsults of th Knnan and Rizman study imply that if on of th countris in a natural trading rgion is substantially biggr than th othrs, thn th big country can gt larg wlfar gains by initiating a tariff war. 5

6 Whally (1996) documnts svral obctivs of small countris for bcoming mmbrs of rgional agrmnts. Apart from noying th wlfar gains associatd with fr trad, ths countris can harmoniz thir conomic policis with thos of largr conomis and can gain momntum in rforming thir conomic systms. To illustrat, Mxico s mmbrship to NAFTA, and th fforts of Eastrn Europan countris to participat in th EC can b xplaind by thir dsir to spd up th conomic rform procss. Furthrmor, bcoming a mmbr of a rgional trading block subsquntly incrass bargaining powr of th small conomy in multilatral trad ngotiations. Dspit th rcnt intrst in ths issus, our knowldg about th rlation btwn th siz of countris and wlfar implications of rgional agrmnts is far from prfct. First, th xtnt of th innocnt bystandr problm, raisd by Krugman (1991a), has not bn thoroughly xamind yt. For xampl, how dos th rlativ siz of th bystandr affct th wlfar gain or cost associatd with rgional agrmnts? Scond, whil som of th rcnt agrmnts tak th form of FTAs, som ar CUs arrangmnts. Existing studis do not invstigat diffrnt typs of agrmnts, such as FTAs and CUs, and, hnc, ar unabl to documnt various implications of ths agrmnts. In a rcnt papr, Kos and Rizman (1996) show that diffrnt typs of fr trad arrangmnts can hav dramatically diffrnt ffcts on th mmbr and nonmmbr countris. Third, th impact of changs in th siz of mmbr and nonmmbr countris on th inhrnt dynamics of modl variabls, such as trms of trad, domstic prics, and tariffs, hav not bn xamind in th contxt of a gnral quilibrium modl. Our study xtnds th scop of th ongoing rsarch program in thr dirctions: first, w provid a fully spcifid, yt tractabl, multi-country gnral quilibrium modl that is wll-suitd to addrss th issus raisd abov. Scond, our study of th rlation btwn th siz of th small country and th wlfar costs of trading agrmnts in a natural rgion shds light on th svrity of th innocnt bystandr problm. Third, w xamin th ffcts of changs in th rlativ sizs of countris in diffrnt quilibria, such as FTA and CU, and documnt rgularitis across diffrnt typs of agrmnts. Th rsults of our study suggst that small conomis can gt vry larg wlfar gains by participating in rgional agrmnts. If thy ar lft out of ths agrmnts, thy 6

7 might fac vry larg losss in a possibl trad war with th rgional trading bloc. In othr words, bing an innocnt bystandr can b xtrmly costly for a small conomy in a natural trading rgion. W also find that small conomis might hav to mak larg transfr paymnts to bcom mmbrs of rgional agrmnts, if th big countris wr unwilling to giv up thir powr on thir trms of trad unlss such paymnts wr mad. Th organization of th papr is as follows: in sction 2, w prsnt th modl, dscrib its calibration, and xplain th numrical solution mthod. Sction 3 discusss our wlfar cost masur. W answr th qustions posd abov in sction 4. W conclud with a brif summary of our findings and suggstions for futur rsarch in sction Th Modl W construct a gnral quilibrium modl of a natural trading rgion. Our modl is sufficintly comprhnsiv to incorporat an arbitrary numbr of countris which ar in clos proximity to ach othr. In othr words, w assum that natural trading costs ar qual to zro in th modl. Howvr, transaction costs btwn th natural trading rgion and th rst of th world ar assumd to b prohibitivly high, i.. thr is no trad btwn th countris in th rgion and th rst of th world. Countris st tariffs optimally and considr all possibl trad agrmnts whn thy dcid what to do. Thy can choos to not b part of any trad agrmnt and charg th optimal tariff or thy could dcid to oin a coalition with othr countris. Thy could b part of an FTA, a CU or an n country coalition fr trad. In th FTA mmbr countris agr to fr trad btwn thmslvs, but ar allowd to st thir xtrnal tariffs indpndntly. A customs union is an FTA with th additional provision that th xtrnal tariff is st ointly by th mmbrs. A customs union (or FTA) of all countris is, of cours, Fr Trad. 2.1 Th Environmnt Considr a natural trading rgion of n countris. Each country is ndowd with a fixd amount of ach final commodity. Lt y i b country i s ndowmnt of good. In ach country, th agnts driv utility by consuming m diffrnt goods. Assum that ach 7

8 country consists of individuals with idntical Cobb-Douglas prfrncs. Thn th utility function of a rprsntativ agnt is th sam as th aggrgat and is givn by i (1) U = β i ln x m = 1 i whr U i is th utility of country i, and β i is th wight trading block i puts on commodity. x i dnots th aggrgat consumption of good in country i. Whil th assumption of a spcific functional form is limiting, it rsults in a linar xpnditur systm which allows us to mploy numrical mthods to solv th modl. Furthr, with this spcification w do not hav to spcify lasticitis, and can stat our rsults in trms of mor fundamntal ndowmnt paramtrs. Th volum of trad, z i, is dfind to b z i = x i - y i. Positiv valus of z i indicat imports, ngativ valus xports. As w hav alrady statd abov, countris charg optimal tariffs on imports. Dnot th tariff chargd by country i on imports of good by t i. Thn if th world pric for good is p, thn th domstic pric of good in i i country i is p = ( 1 + t ) p. Givn that ach trading block consists of idntical individuals, aggrgat dmand is obtaind from maximizing utility subct to th budgt constraint m i i i i i i i (2) p ( 1+ t ) x = I = p ( 1+ t ) y + p t z i = 1, 2,..., n, = 1, 2,..., m = 1 = 1 m whr I i is incom of country i and consists of incom from th ndowmnt plus tariff rvnu which is rbatd to consumrs lump sum Th Equilibrium Th countris solv thir optimization problms by maximizing (1) subct to (2). W do not allow trad dficits or surpluss. At th quilibrium, th aggrgat xpnditur in ach country must qual th valu of th ndowmnt vctor. In othr words, th balanc of paymnts constraint of ach country i is givn by 8

9 i (3) p x = p y m m = 1 = 1 In addition to this constraint, th world dmand for ach good, should b qual to world supply, Y: i i i (4) x = y = Y n n i= 1 i= Th Numrical Solution Mthod. Bcaus w cannot solv th modl analytically, w us a rcursiv numrical solution mthod to find an approximat solution for quilibrium allocations, prics and tariffs. Th intuition of our solution mthod is simpl: for a givn ndowmnt matrix, w can comput th quilibrium with optimal tariffs. Thus, whn a country considrs changing its tariff it has to mak this calculation for any proposd tariff chang. Onc a country changs its tariff w hav to r-comput optimal tariffs for th othr countris. This continus until no country wants to altr its tariff rat. 5 W structur our simulations in such a way that in all th possibl quilibria ach country xports on good (country i xports good i) and imports all th othr goods. Transfr paymnts btwn countris ar not allowd. Kowalczyk and Sostrom (1994) analyz a modl of customs unions in which sid paymnts ar prmittd, but thir framwork rquirs that thr ar no spillovrs to non-mmbrs whn a customs union forms. Thy find that th us of intr-block transfrs can facilitat th attainmnt of fr trad. W discuss this issu in sction 4.4. Oprationally, FTAs and CUs put constraints on th fasibl tariff matrix. For an FTA, tariffs btwn th mmbr countris ar st to zro, and xtrnal tariffs ar st indpndntly. 6 Altrnativly, on might considr a mor gnral cas in which w lt coalitions hav tariffs btwn th mmbr countris. W rquir that fr trad b 5 S Knnan and Rizman (199) for dtails of our solution mthod. 6 As shown by Richardson (1993) thr is a problm if two FTA mmbrs try and sustain diffrnt tariff rats on th sam good. Evn if ruls of origin ar strictly nforcd it still may not b possibl to sustain diffrnt tariff rats. Howvr, for th purposs hr w ignor this complication. 9

10 practicd within th coalition bcaus articl XXIV of th GATT rquirs this. This mans to comput th quilibrium, th appropriat tariffs ar constraind to b zro within th rgional trading block. Computing customs unions quilibria is a bit mor complicatd: on can think of a CU as an FTA with th addd fatur that th xtrnal tariff is st ointly. In gnral, (xcpt whn th ndowmnt pattrn is symmtric) thr will b a conflict of intrst btwn th mmbr trading blocks as to what th xtrnal tariff should b. Sinc w considr CUs btwn countris with symmtric ndowmnts, this is not a problm hr Calibration In ordr to utiliz th solution algorithm, w spcify th numbr of countris, th numbr of goods and ndowmnt of ach country. W assum that m=n=3 and β i =1/3 for all i,=1,2,3. Th assumptions on prfrncs ar not as limiting as thy sm: any variation in cross country prfrncs or prfrncs across commoditis could b rplicatd by a suitabl adustmnt of ndowmnts. Sinc our focus is on th rlationship btwn siz of countris and wlfar gains associatd with trad agrmnts, w concntrat on variation in th ndowmnt matrix, but th rsults can apply to mor gnral situations. W calibrat our modl for a trading rgion which contains on rlativly small country and two symmtric big countris. Th ndowmnt matrix can b writtn as E = How potntial customs union mmbrs rsolv this conflict is a srious problm dsrving of carful analysis. Gatsios and Karp (1991) addrsss this issu dirctly. In thir modl, mmbrs somtims hav congrunt intrsts and somtims opposing intrsts. Hr mmbr s intrsts ar always opposd in th sns that if thir ndowmnt structur is not symmtric thy want diffrnt xtrnal tariffs. Thr is no simpl or obvious solution to this problm. In a rcnt papr, Rizman (1996) assums that mmbrs compromis on th xtrnal tariff by splitting th utility diffrnc to rsolv this problm. 1

11 whr dnots xport good ndowmnt of a big country. Th ndowmnt of th small country is mor vn, which givs hr a bttr chanc of bnfiting from a tariff war. W lt vary from.6 to 1. In othr words, w systmatically chang th siz of big countris whil kping th siz of th small on unchangd. This changs th distribution of ndowmnts across countris, and also affcts th siz of ndowmnts. For ach, w comput quilibrium allocations in CU, FTA, and FT. In CU and FTA quilibria, two big countris gt togthr and lav th small country out. Sinc w limit our analysis with fr trad agrmnts btwn th larg countris, w do not hav to modl th choic of coalition partnrs. Rizman (1985) studis partnr choic problm during customs union formation. Sinc big countris hav symmtric ndowmnts, th dtrmination of tariff rats in th CU quilibrium dos not lad to conflict of intrst btwn th union mmbrs, i.. th mmbrs agr on what th optimal tariff should b. 3. Wlfar Cost Calculations Th masur of th wlfar cost w us is th fraction δ by which th consumption allocations should b dcrasd in th fr trad quilibrium to kp th rprsntativ agnt with th sam utility as th on in an quilibrium with tariffs. W us th masur of compnsating variation in consumption to valuat th wlfar costs associatd bilatral agrmnts. 8 Th wlfar cost δ is calculatd as N F U ( x, x, x ) = U (( 1 δ ) x,( 1 δ ) x,( 1 δ ) x ) U U N F : utility undr an quilibrium with positiv tariffs : utility undr a fr trad agrmnt 4. Small Countris and Rgional Trad Agrmnts 8 This masur is slightly diffrnt than th Equivalnt Incom Variation masur which basically looks at th chang in incom at constant prics. Th masur of compnsating variation in consumption is widly usd in macroconomics and financ litratur to valuat th costs of businss cycls and 11

12 W first stablish th rlationship btwn th ndowmnt of countris and thir siz distribution. In tabl 1, w prsnt th changs in, that is th xport good ndowmnt of a big country, and its impact on th rlativ siz of countris in th rgion. Sinc th world prics ar ndognously dtrmind in our modl, w should dcid which pric vctor is going to b usd to comput th siz of th countris at an quilibrium. W us th pric vctor associatd with fr trad quilibrium to xamin th rlationship btwn xport good ndowmnt of countris, and thir rlativ siz. As tabl 1 indicats, whn a big country is ndowd units of xport good, th valu of its total ndowmnt is 2.59 tims is largr than that of th small country. It is important to strss that th rlation btwn xport good ndowmnt and th rlativ siz is not linar. If a big country has xport good ndowmnt of 1 units, this mans that it is 6.85 tims largr than th small country. In othr words, if th ndowmnt ratio of xport goods incras by 125 tims, th rlativ siz ratio riss almost 3 tims only. An incras in th xport good ndowmnt of big countris dos not linarly rflct itslf in th rlativ siz, sinc this incras rsults in a dcras in th quilibrium pric of th xport good of th big country Siz of rgional bloc and th tariff rats In this sction, w analyz th ffct of an incras in th siz of rgional bloc on tariff rats. W prsnt th impact of th siz of rgional bloc on tariff rats in figur 1. First, as shown in figurs 1a and 1c, th xtrnal tariff of th rgional block incrass as it bcoms largr in its xport good in both quilibria. This rsult can b intrprtd as that th ris in th siz of th rgional bloc rsults in incrasd markt powr. In a rcnt papr, Bond and Syropoulos (1996) rach th sam rsult: as a trading bloc xpands by incrasing th numbr of its mmbrs its xtrnal tariff rat also riss. Whn th rgional trading arrangmnt btwn big countris tak th form of CU, th oint tariff rat of th union is highr than that of th nonmmbr country (s figurs 1a and 1b). Intrstingly, this rgularity is rvrsd if th big countris form an intrnational risk sharing. S Lucas (1987), Col and Obstfld (1991) for th us of this masur in diffrnt contxts. 12

13 FTA: th small country chargs highr tariff rats thn th big ons. This can b xplaind with th following intuition: whn th big countris form a CU, thy intrnaliz th tariff xtrnality. This lads to th highr CU tariff and lowr small country tariff. Mmbrs of an FTA cannot intrnaliz this xtrnality, sinc thy do not ointly dtrmin tariff rats. In a rcnt papr, Kos and Rizman (1996) show that this rsult is also valid whn countris hav symmtric ndowmnt distributions. In particular thy find that in an FTA (CU) quilibrium, th nonmmbr (mmbr) country chargs highr tariffs on imports from th mmbr (nonmmbr) country. As th mmbr countris of th rgional trading bloc gts largr, th tariff rat chargd by th trading bloc incrass mor rapidly in a CU quilibrium than it dos in an FTA quilibrium (s figurs 1a and 1b). For xampl, an incras in th ndowmnt of xport good of a big country from 3 to 4 rsults in a fiv fold incras in th tariff rat of th CU (s figur 1c). Th sam chang in th siz of ndowmnt lads to much lss than two fold incras in th tariff rats chargd by th mmbr countris of th FTA (s figur 1a). Intrstingly, our simulations suggst that th tariff chargd by th small nonmmbr country incrass, as th rlativ siz of it bcoms smallr. W prsnt this rsult in figur 1d. Bond and Syropoulos find th opposit: as rlativ siz of a trading bloc gts smallr, it initially dcrass its tariff rat, and thn incrass it. Th diffrnc btwn our finding and thirs is du to diffrnt ndowmnt structurs w mploy. In our modl, as th rgional trading block gts largr, its dpndncy to trad also incrass sinc th ndowmnt structur of mmbr countris bcoms mor unvn. On th othr hand, th small country dos not hav this problm, it can still manipulat th tariff rat by using its powr in its xport good markt. Th magnitud of tariff rats w rport ar consistnt with thos of arlir studis which mploy gnral quilibrium modls (s Prroni and Whally (1994)). For xampl, whn th big country has an ndowmnt of 1 units of its xport good, it chargs approximatly 16 (22) prcnt tariffs on th xports of th small country in an FTA (CU) quilibrium. Ths vry high tariff rats signal that bing a bystandr in a natural trading rgion can b xtrmly painful spcially if th big countris stablish a CU arrangmnt. 13

14 4.2. Prics Nxt, w xamin th changs in trms of trad and domstic prics in rspons to th changs in th siz of rgional trading bloc. Our rsults ar prsntd in figur 2. Figurs 2a and 2b show th prcntag chang in th trms of trad, whn countris mov a CU or FTA quilibrium to fr trad. As th rlativ siz of rgional trading bloc bcoms biggr, th small country gts highr improvmnt in its trms of trad by bcoming a mmbr of th rgional agrmnt. For xampl, considr th following rgim chang: th mmbrs of th CU and th small country gt togthr and stablish fr trad in th rgion. As a rsult of this chang, th trms of trad of th small country improvs by mor than 1 prcnt, whn is 5. Sinc mmbr countris ar unabl to coordinat th tariff rats in an FTA quilibrium, moving from th FTA agrmnt to FT dtriorats th trms of trad of th big country lss than that if thy wr in a CU. This rsult is shown in figur 2a. Moving from CU (FTA) to FT rsults in lowr prics in th rgion. As figurs 2c and 2d indicat, th dcras in domstic prics as a rsult of moving from CU to FT quilibrium is much highr than that of moving from FTA to FT quilibrium. To illustrat, whn th big country has an ndowmnt of 1 units of its xport good, stablishing fr trad in th rgion, instad of CU (FTA), lads to approximatly 28 (7) prcnt fall in th prics of import goods coming from th small country in th big countris domstic markts. Similarly, consumrs in th small country pay almost 3 (2) prcnt lss to th goods importd from big countris whn th small country signs a fr trad agrmnt with th mmbrs of th rgional CU (FTA) Export Shar W prsnt th rsults of our simulations associatd with xport shar of mmbr and nonmmbr countris in figur 3. As figurs 3a and 3b show, a mmbr country of a rgional agrmnt can hav a largr or smallr xport shar than th nonmmbr small country dpnding on th siz of its xport good ndowmnt. Figur 3 dmonstrats that this is also tru whn thr is fr trad in th rgion. Sinc our ndowmnt spcification 14

15 maks th big country mor dpndnt on importd goods as it bcoms largr in its xport good ndowmnt, th pric of xport good of th small conomy incrass as its rlativ siz gts smallr. Figurs 3c and 3d rval a coupl of intrsting rgularitis prtaining to xport shar of mmbr and nonmmbr countris in a natural trading bloc. First, mmbr countris of th rgional bloc xport a largr fraction of thir GDP to th small country in a CU quilibrium than an FTA quilibrium. In contrast, th small nonmmbr country has largr xport shar with th rgional FTA than with th rgional CU. Scond, mmbr countris hav th smallst xport shar whn thr is fr trad in th rgion. Th nonmmbr country, in contrast, rachs its largst xport shar whn thr is fr trad in th rgion. In figur 3f, w xamin th trad btwn mmbr countris of th rgional bloc. Th mov from FTA to CU improvs th trms of trad of th mmbr countris, and incrass th intra-bloc trad Wlfar gains In sctions 4.2 and 4.3, w show that th small nonmmbr country can improv its trms of trad and incras its volum of trad by bcoming a mmbr of th rgional agrmnt. Do ths positiv ffcts gnrat larg wlfar gains? If thy do, thn w can asily answr th qustion w hav askd at th bginning of th papr. In this sction, w study th siz of wlfar gains using th wlfar cost masur which is xplaind in sction 3. Figur 4 prsnts our findings: As figur 4a and 4b show, bcoming a mmbr of th rgional agrmnt lads to vry larg wlfar gains for th small conomy. For xampl, if th big countris ar ndowd with 3 units of xport good, consumrs in th small country can incras thir consumption by approximatly 8 (6) prcnt, whn it is accptd to th rgional FTA (CU) agrmnt. This rsult xplains th main incntiv of small conomis to bcom mmbrs of rgional agrmnts: ths agrmnts rsult in vry larg wlfar gains for th small conomis. Furthrmor, if thy ar lft out of ths agrmnts, in othr words if thy bcom innocnt bystandrs, thy might pay vry high costs. Figur 4d suggsts that th innocnt bystandr problm can b vry svr for small conomis: whn th two big countris, ach of which has an xport good ndowmnt of 15

16 1 units, stablish a CU arrangmnt, th small country in th rgion can fac up to 75 prcnt of consumption loss during a potntial tariff war with th mmbrs of th union. W also notd that rlativly small countris compromis on svral dimnsions to hav rgional agrmnts with largr countris. Th rsults of our simulations provid a simpl, yt vry powrful xplanation to this obsrvation: stablishing fr trad in th rgion by accpting th small country to th rgional bloc rsults in lowr consumption in th mmbr countris (s figur 4c). Hnc, th small nonmmbr country might hav to mak transfr paymnts to bcom a mmbr of th rgional trading bloc. Th siz of ths paymnts dpnds on th typ of th rgional agrmnt btwn th big countris. If th agrmnt taks th form of CU, th small country might hav to mak largr transfr paymnts to bcom a mmbr. How larg ar ths transfr paymnts? To answr this qustion, w provid th following rough calculation: As a point of dpartur assum that th paymnt from th small country to big countris should b at last as larg as th lost tariff rvnu of th big ons du to rgional fr trad agrmnt. 9 In our xampl, whn th siz of th rgional trading bloc is roughly 11 tims largr than th small country, i.. whn th big countris ar ndowd with 8 units of xport good, th lost tariff rvnu of th rgional customs union is approximatly qual to 7.3 prcnt of th small country s ndowmnt. This mans that th small country has to transfr almost 7.3 prcnt of its national product to th big countris to participat in th trad union. Surprisingly, th rsult of our simpl calculation is consistnt with thos of Prroni and Whally (1994): thy also discuss th possibility that small countris might hav to mak sid paymnts to participat in rgional trading arrangmnts. Thir findings indicat that th rgional agrmnt btwn Canada and th U.S. would not b signd if Canada did not mak som transfr paymnts to th U.S. sinc th agrmnt rsultd in larg wlfar gains for Canada, but th U.S. gav up its rtaliatory powr against Canada. Employing a cooprativ solution thy calculat th siz of ths siz paymnts which support Parto improvmnts for both conomis. In particular, th outcom of thir study suggsts that dpnding on th cofficint of rlativ risk avrsion and subctiv 9 S Kowalczyk (1996) for a similar argumnt about th transfr paymnts. 16

17 probability of a potntial trad war, th siz of transfr paymnts, mad by Canada to th U.S., rangs from.64 prcnt to 13 prcnt of its gross national product. 5. Summary and Concluding Commnts Th numbr of rgional agrmnts has narly doubld in th last four yars. Two maor charactristics of ths rcnt agrmnts ar particularly intrsting: first, rlativly small countris hav gnrally initiatd th ngotiation procss and formd rgional agrmnts with big countris. Scond, th small countris hav compromisd on svral dimnsions to hav rgional agrmnts with largr countris or with xisting rgional trading blocs. In this papr, w provid som simpl xplanations for ths rcnt dvlopmnts using a gnral quilibrium modl in which countris bhav optimally. W first provid an xtnsiv rviw of th rlatd litratur. This rviw suggsts that our knowldg about th rlation btwn th siz distribution of countris and wlfar implications of rgional agrmnts is far from prfct. Thn, w construct a gnral quilibrium modl of a natural trading rgion. In this modl, thr ar thr countris: two of which ar rlativly big and hav a symmtric ndowmnt distribution. Th third country is small with an important advantag ovr th big countris: it has a mor vn ndowmnt distribution than th big ons. Using this modl, w xamin th wlfar implications of a varity of rgional trad agrmnts btwn larg and small countris. W simulat th modl and calculat consumption allocations, prics, trad volum, and tariffs undr thr diffrnt quilibria: Fr Trad, Fr Trad Association, and Customs Union. Th rsults of our study indicat that small conomis can gt vry larg wlfar gains by participating in rgional agrmnts. If thy ar lft out of ths agrmnts, thy might fac vry larg losss in a possibl trad war with th rgional trading bloc. In othr words, bing an innocnt bystandr can b xtrmly costly for a small conomy in a natural trading rgion. W also find that small conomis might hav to mak larg transfr paymnts to bcom mmbrs of rgional agrmnts, if th big countris wr not willing to giv up thir powr on thir trms of trad unlss such paymnts wr mad. 17

18 Considring that rcnt wav of rgional trad agrmnts has rcivd widsprad attntion in policy circls, it is particularly important to undrstand various implications of ths agrmnts on small countris. Whil shdding light som intrsting issus, our study also indicats som futur rsarch dirctions: first, w nd to dvlop bttr masurs of transfr paymnts. Hr w provid a vry simpl calculation to show that small conomis might hav to mak larg transfr paymnts to participat in rgional agrmnts. Undrstanding th magnitud of ths paymnts can rsult in bttr valuation of rlativ mrits of ths agrmnts for small countris. Scond, our wlfar gain calculations associatd with rgional agrmnts should also b xtndd. In particular, dtrmination of thos gains associatd with trms of trad and volum of trad ffcts mploying a disaggrgatd wlfar masur can advanc our knowldg about th wlfar issus associatd with ths agrmnts whil providing a usful instrumnt for mpirical rsarch. Finally, our study dos not considr th stratgic aspcts of th rgional agrmnts. For xampl, th small country can sign an agrmnt with on of th big countris and try to lav th othr big country out of this agrmnt. This possibility can rsult in complx stratgic intractions whn th siz diffrnc btwn th conomis in th rgion gts smallr. W plan to xtnd our rsarch program to xamin ths issus. 18

19 Rfrncs: Andrson, K., and R. Blackhurst, 1993, Rgional intgration and th global trading systm, Harvstr Whatshaf. Bhagwati J., 1995, U.S. trad policy: Th infatuation with fr trad aras, in J. Bhagwati and A. O. Krugr (ds.), Th dangrous drift to prfrntial trad agrmnts, Th AEI Prss, Washington D.C., Bond, E., and C. Syropoulos, 1996, Th siz of trading blocs: Markt powr and world wlfar ffcts, Journal of Intrnational Economics, 4, 1/2, Col, H.L., and M. Obstfld, 1991, Commodity trad and Intrnational risk sharing: How much do Financial Markts Mattr?, Journal of Montary Economics 28,3-24. D Mlo, J., and A. Panagariya, 1993, Nw dimnsions in rgional intgration, Cambridg Univrsity Prss. Ethir, F., 1996, Rgionalism in a multilatral world, mimo, Univrsity of Pnnsylvania. Frankl, J. A., E. Stin, and S. J. Wi, 1996, Rgional trading agrmnts: natural or supr-natural?, Amrican Economic Rviw 86, Knnan, J., and R. Rizman, 1988, Do big countris win tariff wars?, Intrnational Economic Rviw 29, Knnan, J., and R. Rizman, 199, Optimal tariff quilibria with customs unions, Canadian Journal of Economics 9, Kos, M. A., and R. Rizman, 1996, Wlfar implications of fr trad agrmnts, mimo, Univrsity of Iowa. Kowalczyk, C. and T. Sostrom, 1994, Bringing GATT into th cor, Economica, 61, Kowalczyk, C, 1996, Wlfar and customs unions, mimo, Tufts Univrsity. Krugman, P., 1991a, Th mov toward fr trad zons, in Policy Implications of Trad and Currncy Zons. A symposium sponsord by th Fdral Rsrv Bank of Kansas City. Krugman, P., 1991b, Is bilatralism bad?, in E. Hlpman and A. Razin, ds., Intrnational Trad and Trad Policy, Cambridg, MIT Prss Lucas, R.E., 1987, Modls of Businss Cycls, Oxford, Blackwll 19

20 Fig. 4: Wlfar Cost Nordstorm, H., 1995, Customs unions, rgional trading blocks and wlfar, in R. Baldwin, P. Haaparanta, and J. Kiandr (ds.), Expanding mmbrship of th Europan Union, Cambridg Univrsity Prss, Markusn, J. R., and R. M. Wigl, 1989, Nash quilibrium tariffs for th Unitd Stats and Canada: Th rols of country siz, scal conomis, and capital mobility, Journal of Political Economy 97, Prroni, C. and J. Whally, 1994, Th nw rgionalism: trad libralization or insuranc?, NBER WP#4626 Prroni, C. and J. Whally, 1996, How svr is global rtaliation risk undr incrasing rgionalism?, Amrican Economic Rviw 86, Richardson, M., 1993, Endognous protction and trad divrsion, Journal of Intrnational Economics 34, Rizman, R., 1985, Customs unions and th cor, Journal of Intrnational Economics 19, Rizman, R., 1997, Can bilatral trad agrmnts hlp induc fr trad?, mimo, Univrsity of Iowa. Sampson, G. P., 1996, Compatibility of rgional and multilatral trading arrangmnts: rforming th WTO procss, Amrican Economic Rviw 86, Summrs, L., 1991, Rgionalism and th world trading systm, in Fdral Rsrv Bank of Kansas City, Policy implications of trad and currncy zons., Wintrs, L. A., 1993, Expanding E.C. mmbrship and association accords: rcnt xprinc and futur prospcts, in K. Andrson, and R. Blackhurst (ds.), Rgional Intgration in th Global Trading Systm, Harvstr Whatshaf,

21 Tabl 1 Siz Distribution of Countris nd. ratio siz 1 siz = xport good ndowmnt of a big country nd. ratio= ratio of xport good ndowmnt of a big country to that of small country= /.2 siz 1= siz ratio of th walth of a big country to that of small on in fr trad. This ratio is calculatd with th following formula 2 siz = p y / p y = 1 = 1 siz 2= 2* siz 1. This masurs th siz ratio of th walth of a rgional trading block formd by th big countris to that of th small country. To comput this masur, w us fr trad prics. 1 21

22 Fig. 1: Tariff Rats Tariff Rat/ Tariff Rat/ Nonmmbr Fig. 1a Fr Trad Association Fig. 1c Mmbr Country CU Mmbr FTA Tariff Rat/1 Tariff Rat/ FTA 3. Fig. 1b Customs Unions Mmbr Fig. 1d Nonmmbr Country Nonmmbr CU is th xport good ndowmnt of th big country. On th vrtical axis, tariff rats, dividd by 1, ar rportd. CU rfrs to Customs Union and FTA rfrs to Fr Trad Association. S txt for dtails. 22

23 Fig. 2: Chang in Prics Fig. 2a Chang in Trms of Trad Mmbr Country 9 Fig. 2b Chang in Trms of Trad Nonmmbr Country Chang in Trms of Trad (%) FTA CU Chang in Trms of Trad (%) CU FTA Fig. 2c Chang in Domstic Prics Mmbr Country Fig. 2d Chang in Domstic Prics Nonmmbr Country Chang in Prics (%) FTA CU Chang in Prics (%) FTA CU is th xport good ndowmnt of th big country. CU rfrs to Customs Union and FTA rfrs to Fr Trad Association. On th vrtical axis, chang in prics and trms of trad ar rportd. For xampl, in figur 2a, changs in trms of trad whn moving from a CU or FTA quilibrium to Fr Trad ar rportd. S txt for dtails. 23

24 Fig. 3: Export Volum Fig. 3a Fr Trad Association Nonmmbr 5 4 Mmbr Fig. 3b Customs Unions Exports/GDP Mmbr Exports/GDP Nonmmbr Exports/GDP Fig. 3c Mmbr Country 5 FTA 4 CU FT Exports/GDP Fig. 3d Nonmmbr Country FTA 6 5 FT 4 3 CU Exports/GDP SMALL Fig. 3 Fr Trad BIG Exports/GDP Fig. 3f Intrablock Trad (Trad Btwn Big Countris) CU FTA FT

25 Fig. 4: Wlfar Cost 1 Fig. 4a Fr Trad Association 8 Fig. 4b Customs Union Wlfar Cost (%) Nonmmbr Mmbr Wlfar Cost (%) Nonmmbr Mmbr Fig. 4c Mmbr Country -.5 Wlfar Cost (%) CU FTA is th xport good ndowmnt of th big country. CU rfrs to Customs Union and FTA rfrs to Fr Trad Association. On th vrtical axis, wlfar costs ( in prcnt) associatd with fr trad agrmnts ar rportd. For xampl, in figur 4a, wlfar costs moving from an FTA quilibrium to Fr Trad ar rportd. S txt for dtails. 25