Small Countries and Preferential Trade Agreements * How severe is the innocent bystander problem?

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1 Small Countrs and Prfrntal Trad Agrmnts * How svr s th nnocnt bystandr problm? M. Ayhan Kos a and Raymond Rzman b Rvsd: 9/2/99 Prntd: 1/6/99 Abstract: Ths papr xamns th wlfar mplcatons of prfrntal trad agrmnts (PTAs) from th prspctv of small countrs n th contxt of a mult-country, gnral qulbrum modl. W calbrat our modl to rprsnt on rlatvly small country and two symmtrc bg countrs. W consdr two cass. In on cas, th small country s an nnocnt bystandr, that s, t s lft out of a PTA btwn th two larg countrs. In th scond cas, th small country sgns a PTA wth on of th larg countrs. W smulat th modl and calculat consumpton allocatons, prcs, trad volum, and tarffs n ths two cass consdrng thr dffrnt qulbra: Fr Trad (FT), Fr Trad Ara (), and Customs Unon (). W fnd that fr trad s th bst outcom for th small country. If th larg country PTA taks th form of a thn th cost of bng an nnocnt bystandr s vry larg. If t s a thn th cost of bng an nnocnt bystandr s rlatvly modst. In fact, th small country prfrs to b an nnocnt bystandr to bng a mmbr of a wth on of th larg countrs. JEL Classfcaton: F2, F13, F15 Ky Words: Prfrntal trad agrmnts, gnral qulbrum, tarffs, wlfar, small countrs. * W would lk to thank Carstn Kowalczyk and Mchal Plummr for hlpful suggstons. An arlr vrson of ths papr was prsntd at 1999 Economc Thory Confrnc of Th Socty for th Advancmnt of Economc Thory n Rodos. W also would lk to thank confrnc partcpants for thr commnts. Th usual dsclamr appls. a Graduat School of Intrnatonal Economcs and Fnanc, Brands Unvrsty, Waltham, MA 2454, -mal: akos@brands.du. b Dpartmnt of Economcs, Unvrsty of Iowa, Iowa Cty, IA 52242, -mal: raymond-rzman@uowa.du.

2 1. Introducton Th 199s hav wtnssd a sgnfcant ncras n th numbr of prfrntal trad agrmnts (PTAs). On notabl fatur of ths agrmnts s that a numbr of rlatvly small countrs hav sgnd PTAs wth largr countrs whl grantng a lot of maor concssons to bcom mmbrs. 1 For xampl, U.S. and Canada hav protctd thr agrcultur sctor, whl Mxco substantally lbralzd t as a rsult of NA. Svral smallr countrs, such as Hungary, Poland, Turky hav to accpt a varty of protcton masurs for snstv sctors,.. agrcultur and txtls, of th xstng mmbrs to sgn PTAs wth th Europan Communty. Thr has bn a rapdly growng ltratur xamnng th dffrnt aspcts of PTAs n rcnt yars. 2 Nvrthlss, thr hav bn only a fw studs analyzng th rcnt surg of PTAs from th prspctv of small countrs: Krugman (1991a) provds a smpl xampl to llustrat th mportanc of th nnocnt bystandr problm,.. th problm facd by a small country that s xcludd from a PTA, and concluds that th bystandr can suffr from sgnfcant wlfar losss. 3 Prron and Whally (1996) study th rol of small countrs n th rcnt PTAs mployng a computabl gnral qulbrum modl. Thy clam that th man motv of small countrs s to provd thmslvs wth saf havns by scurng accss to largr country markts. Kowalczyk (1999) xamns th wlfar ffcts of ths agrmnts on small countrs and fnds that a small country can noy wlfar gans through ts accss to a larg markt but a larg tradng partnr mght dmand som transfr paymnts from th small country to stablsh th PTA. 4 Th purpos of ths papr s to xamn th mpact of PTAs on small countrs wlfar consdrng th stratgc aspcts of PTAs n a gnral qulbrum sttng. In partcular, w study th followng qustons: frst, what ar th ffcts of dffrnt typs of PTAs on wlfar, tarffs, prcs, and th trad volum of small countrs,.. nnocnt bystandrs, that ar xcludd from ths trad agrmnts? Scond, what ar th stratgc mplcatons of PTAs from th prspctv of small countrs 1 S Wntrs (1993), Ethr (1996), and Prron and Whally (1996) for svral common faturs of PTAs and th rol of small countrs n ths agrmnts. Whl rvwng rcnt PTAs btwn th Europan Communty and svral small countrs, Wntrs calls ths agrmnts managd lbralzaton snc accdants hav to accpt xstng polcy uncondtonally, vn though xstng mmbrs may b xmpt from parts of t th EC dcds what t wants and th E countrs tak t or lav t. Ethr also obsrvs that rcnt rgonal agrmnts ar onsdd n th sns that thy contan asymmtrc concssons. 2 S D Mlo and Panagarya (1993), Rzman (1999), and Kos and Rzman (1999) for rvws of ths ltratur. 3 In partcular, h nots that.. nward turnng fr trad aras, whl dong lttl damag to thmslvs or ach othr, can asly nflct much mor harm on conomcally smallr playrs that for on rason or anothr ar not part of any of th bg blocks. 4 Knnan and Rzman (1988) study th mplcatons of a possbl trad war btwn a small country and a bg on. Thr rsults suggst that by havng trad agrmnts wth th bg countrs, small countrs could avod losng a possbl trad war. Whally (1998) documnts svral obctvs of small countrs for bcomng mmbrs of PTAs. 1

3 that ar abl to stablsh a PTA wth a larg country whl rulng out a trad agrmnt wth anothr larg country? W construct a smpl mult-country, gnral qulbrum modl basd on comparatv advantag consdratons. In our modl, thr ar thr countrs, two of whch ar rlatvly larg and th thrd on s small. Throughout th papr w us th trm small country to man rlatvly small n sz, but not nfntsmal as n th mor common manng of small country. All thr countrs st tarffs optmally and consdr all possbl trad agrmnts whn thy dcd what to do 5. Countrs can form a PTA, thr a Fr Trad Assocaton () or a Customs Unon (), or thy can stablsh fr trad (FT). In th, mmbr countrs agr to fr trad wthn th Assocaton, but ar allowd to st thr xtrnal tarffs ndpndntly. A s a wth th addtonal provson that th xtrnal tarff s st ontly by th mmbrs. W xamn th ffcts of th changs n th rlatv sz of ths countrs on svral ndognous varabls. For ach tradng rgm, w calculat qulbrum prcs, consumpton allocatons, tarffs, and trad volum. W, thn, study th wlfar mplcatons of ths agrmnts for ach country. Our study xtnds th scop of th ongong rsarch program n thr man drctons: frst, w focus on th stratgc ntractons btwn small and larg countrs and xamn comptng cass n whch larg and small countrs play dffrnt rols as mmbrs or nonmmbrs of PTAs. To undrstand th mportanc of ths ssus, w study two dffrnt cass: w frst consdr an xprmnt smlar to th on n Krugman (1991a). In partcular, n Cas 1 th small country s lft out of th PTA formd by th bg countrs. Howvr, ths xprmnt s ust on sd of th story snc t gnors potntal stratgc ntractons btwn small and larg countrs. W thn turn to Cas 2 n whch th small country sgns a PTA wth on of th larg countrs and th othr larg country s now th bystandr. In othr words, th small country has som stratgc powr n Cas 2 as t s part of a rlatvly larg PTA. Consdrng that small countrs ar not ust dl playrs n th multlatral tradng systm and thy ar n fact actvly skng small and larg partnrs, ths cas s partcularly rlvant for undrstandng th mpact of PTAs on small countrs. Scond, whl som of th rcnt agrmnts tak th form of s, som ar arrangmnts. Exstng studs do not nvstgat dffrnt typs of agrmnts, such as s and s, and, hnc, ar unabl to documnt varous mplcatons of ths agrmnts on small conoms. Howvr, ths ssu s an mportant on for small countrs bcaus dffrnt typs of PTAs affct th atttud of larg countrs towards small ons dffrntly whn small and larg countrs dcd to stablsh PTAs. 6 W xplctly 5 In our modl small countrs optmal tarffs wll gnrally b non-zro. 6 In a rcnt papr, Kos and Rzman (1999) show that dffrnt typs of PTAs can hav sgnfcantly dffrnt ffcts on th wlfar of th mmbr and nonmmbr countrs. 2

4 xamn dffrnt typs of PTAs, such as s and s, and compar th mplcatons of ths arrangmnts wth thos of fr trad. Thrd, th mpact of chang n th sz of mmbr and nonmmbr countrs on modl varabls, such as trms of trad, domstc prcs, tarffs, and most mportantly wlfar hav not bn xamnd n th contxt of a gnral qulbrum modl. For xampl, non of th xstng studs analyzs th lnk btwn th rlatv sz of th bystandr and th wlfar mplcatons of dffrnt typs of PTAs. W systmcally xamn th rlaton btwn th rlatv sz of small countrs and th mpact of dffrnt typs of PTAs on small countrs. W start wth provdng dtald nformaton about th bhavor of ndognous varabls of th modl n dffrnt typs of tradng arrangmnts by documntng svral rgularts assocatd wth tarffs, prcs, and th trad volum. Ths rgularts lay th groundwork for undrstandng th basc ntutv mchansms drvng our wlfar rsults. Hr s a brf summary of th man fndngs. Frst, whn th small country s th nonmmbr n Cas 1, th tarff rat chargd by th larg mmbrs of th s much hghr than that of th small country. In contrast, th larg nonmmbr country chargs a hghr tarff rat than th mmbr countrs n a qulbrum n Cas 2. Scond, th small country chooss a hghr tarff rat whn t s a mmbr (Cas 2) than that whn t s not a mmbr of a (Cas 1). Unlk n a, n a qulbrum, th small country chargs a lowr tarff rat whn t s a mmbr (Cas 2) than that whn t s a nonmmbr (Cas 1). Thrd, th dtroraton n th trms of trad of th bg mmbr of a PTA s largr than that of th nonmmbr conomy as countrs mov from a PTA qulbrum to FT n both cass. Howvr, th small country s trms of trad s hghst whn thr s FT n both cass. Fourth, th bg mmbrs trad mor wth th othr countrs whn thr s a n Cas 1. Both small and larg mmbrs xport a largr fracton of thr GDP n a qulbrum than that n a qulbrum n Cas 2. W thn xamn th wlfar mplcatons of PTAs on small countrs n th two cass. Ths nvstgaton also rvals svral ntrstng rgularts consstnt wth thos documntd abov: frst, f a small country s lft out of a PTA, n othr words, f t s an nnocnt bystandr, t has to pay vry hgh costs n our modl. Whl th nnocnt bystandr problm can b vry svr for small conoms that ar not abl to partcpat n a PTA, th svrty of th problm gts wors as th rlatv sz of th bystandr gts smallr. For xampl, whn th two bg countrs, ach of whch has an xport good ndowmnt of 2 (1) unts, stablsh a arrangmnt, th small country can fac up to a loss of roughly 5 (75) prcnt of consumpton. If th tradng bloc s a, thn th small country agan has to pay a hgh cost but th wlfar cost assocatd wth ths s much smallr than that of th. Scond, stablshng fr trad by accptng th small country nto a tradng bloc of th two larg countrs rsults n lowr consumpton n th larg countrs. Ths rsult suggsts that small countrs hav to compnsat 3

5 th larg countrs n som way to gt thm to agr to mov from a PTA to fr trad. Thr ar suggstons n th ltratur (s Kowalczyk and Sostrom (1994), and Whally (1998)) that ths s xactly what has happnd wth NA and th EU n th rcnt past. Thrd, th small nonmmbr conomy gans and th larg mmbr conoms los whn thr s a mov from a PTA to fr trad n Cas 1. In Cas 2, both small and larg mmbrs of a PTA gan n th mov to fr trad. Fourth, movng from Cas 2 to fr trad, th small country gts som sgnfcant wlfar gans f th Cas 2 PTA s a, but ts consumpton gos down (for most ndowmnts) f th Cas 2 PTA s a. Ffth, as th rlatv sz of th larg countrs ncrass, th gan (loss) assocatd wth a () agrmnt gts largr for th small country. For xampl, sgnng a agrmnt wth on of th larg countrs, dcrass th consumpton of th small country by 2 prcnt whn th xport good ndowmnt of th larg country s qual to 4. Sxth, th typ of th PTA sgnfcantly affcts th magntud of wlfar gans of th small country n our modl. If th agrmnt s a () n Cas 1, stablshng fr trad wth th larg countrs n Cas 2 ncrass th wlfar of th small country by roughly 1 (19) prcnt whn th xport good ndowmnt s qual to 5. Svnth, t s bnfcal for th small country to bcom a mmbr of th n Cas 2 nstad of bng an nnocnt bystandr n a qulbrum n Cas 1. If a small nonmmbr country n a qulbrum n Cas 1 bcoms a mmbr of a agrmnt n Cas 2, ths nducs wlfar losss n th small country. Th organzaton of th papr s as follows: In scton 2, w prsnt th modl, dscrb ts calbraton, and xplan th numrcal soluton mthod usd to solv th modl. W provd nformaton about our masur of wlfar chang n scton 3. Nxt, w prsnt th rsults of our smulatons and answr th qustons posd abov. W conclud wth a brf summary of our fndngs n scton Th Modl W construct a gnral qulbrum modl that s suffcntly comprhnsv to ncorporat an arbtrary numbr of countrs. 7 Countrs st tarffs optmally and consdr all possbl trad agrmnts whn thy dcd what to do. Thy could b part of a, a, or an n country coalton fr trad. In th, mmbr countrs agr to fr trad btwn thmslvs, but ar allowd to st thr xtrnal 7 Ths modl was dvlopd n Rzman (1985) and Knnan and Rzman (199). A numbr of rsarchrs hav rcntly usd ths stup to analyz dffrnt ssus: s Kos and Rzman (1999), Syropoulos (1999), Havman (1996) among othrs. Th problm w addrss hr s substantally dffrnt than thos xamnd n th arlr paprs as w xamn th mpact of PTAs on small countrs wlfar. Our modl can b consdrd as a modl of a natural tradng rgon n whch countrs ar n clos proxmty to ach othr and natural tradng costs ar qual to zro. 4

6 tarffs ndpndntly. A customs unon s a wth th addtonal provson that th xtrnal tarff s st ontly by th mmbrs. A customs unon (or ) of all countrs s, of cours, Fr Trad Th Envronmnt Consdr n countrs. Th agnts drv utlty by consumng m dffrnt goods n ach country. Each country s ndowd wth a fxd amount of ach commodty. Lt y b country s ndowmnt of good. Each country conssts of ndvduals wth dntcal Cobb-Douglas prfrncs mplyng that th utlty functon of a rprsntatv agnt s th sam as th aggrgat and gvn by (1) U m = β ln x = 1 whr U s th utlty of country, and β s th wght country puts on commodty m ( β = 1, = 1,..., n). x = 1 dnots th aggrgat consumpton of good n country. Ths prfrnc formulaton rsults n a lnar xpndtur systm allowng us to mploy numrcal mthods to solv th modl. Furthr, wth ths structur w do not hav to spcfy lastcts and can stat our rsults n trms of fundamntal ndowmnt paramtrs. Th nt mports of ach good, z, s dfnd to b z = x - y. Dnot th ad-valorm tarff chargd by country on mports of good by t. If th qulbrum prc for good s p, thn th domstc prc of good n country s q = ( 1 + t ) p. Gvn that ach country conssts of dntcal ndvduals, aggrgat dmand s obtand from maxmzng th utlty subct to th budgt constrant m (2) p (1 + t ) x = I = p (1 + t ) y + p t z = 1,2,..., n, = 1,2,..., m. = 1 m = 1 whr I s ncom of country and conssts of ncom from th ndowmnt plus tarff rvnu whch s rbatd to consumrs lump-sum. 8 W do not consdr th qulbra whch ar consstnt wth Artcl XXIV and Kmp-Wan adustmnt. S Syropoulos (1999) for an xtnsv dscusson of thos qulbra. Whl th assumpton that th x-post tarff rats should b consstnt wth Artcl XXIV s a smngly plausbl on, th World Trad Organzaton (1995) rports that only sx out of sxty-nn trad agrmnts ar found to b n full conformty wth Artcl. 5

7 2.2. Th Equlbrum Th aggrgat xpndtur n ach country must qual th valu of ts ndowmnt at th qulbrum. Snc w do not allow trad dfcts or surpluss, th balanc of paymnts constrant of ach country s gvn by (3) W = p x = p y = 1, 2,..., n. m m = 1 = 1 W s th aggrgat xpndtur of country. In addton to ths constrant, th total dmand for ach good, should b qual to total supply, Y : n (4) x = y = Y = 1, 2,..., m. n = 1 = Th Numrcal Soluton Mthod Th logarthmc utlty rsults n a lnar xpndtur systm, n whch agnt allocats a fxd fracton of thr ncom on ach good. Th frst ordr condtons of th maxmzaton problm lad to th followng dmand functons, (5) x β I = ( 1+ t ) p, = 1, 2,..., n, = 1, 2,..., m. Dnot xpndtur of country on good wth W. It s asy to show that xpndtur s allocatd across goods n proporton to β and t. Hnc, W = α W whr α s a functon of β and t. Th qulbrum prc of ach good s qual to total aggrgat xpndtur on that good (6) n W = p, = 1, 2,..., m. = 1 Usng quatons (1), (5), and (6), w drv an analytcal xprsson for utlty of ach country as a functon of tarffs, for any gvn prfrnc and ndowmnt dstrbuton. W mploy a rcursv numrcal soluton mthod to fnd an approxmat soluton for qulbrum allocatons, prcs, and tarffs snc w cannot obtan a closd form soluton for ach qulbrum. Th ntuton of our soluton mthod s straghtforward: for a gvn ndowmnt matrx, w can comput th qulbrum wth optmal tarffs. Thus, whn a country consdrs changng ts tarff, t has to mak ths calculaton for any proposd tarff chang. Onc a country changs ts tarff w hav to r-comput optmal tarffs for th othr countrs. Ths contnus untl no country wants to altr ts tarff rats. 6

8 Opratonally, s and s put constrants on th fasbl tarff matrx. For a, tarffs btwn th mmbr countrs ar st to zro, and xtrnal tarffs ar st ndpndntly. Ths mans to comput th qulbrum, th approprat tarffs ar constrand to b zro. On can thnk of a as a wth th addd fatur that th xtrnal tarff s st ontly Calbraton In ordr to utlz th soluton algorthm, w should spcfy th numbr of countrs, th numbr of goods and ndowmnt of ach country. W assum that m=n=3 and β =1/3 for all,=1,2,3. W calbrat our modl to rprsnt on rlatvly small country and two symmtrc bg countrs. Th ndowmnt matrx can b wrttn as: E = In othr words, th frst country s th small on wth 1 y =.2 for =1,2,3. Th scond and thrd countrs ar th larg countrs wth y =.4 for and y = for =. dnots xport good ndowmnt of a bg country. W lt vary from.6 to 1. In othr words, w systmatcally chang th xport good ndowmnt of th bg countrs whl kpng th ndowmnt of th small on unchangd. Ths changs th sz dstrbuton of ndowmnts across countrs. Our tratmnt of a small country s qut dffrnt than th xstng ltratur: frst, th small country s abl to dtrmn ts tarff lvls n our modl. Scond, t has a mor vn ndowmnt dstrbuton than th larg ons mplyng that ts rlanc on ntrnatonal trad s lss than th larg othr countrs. W calbrat our modl ths way to gv th small country a bttr chanc of bnftng from a potntal trad war. Prsumably, f th small country s ndowmnt wr unvn, t would suffr mor from such a trad war. W consdr two cass: n th frst cas, th two bg countrs gt togthr and sgn a PTA. Ths cas, dscrbng th nnocnt bystandr problm, has bn wdly dscussd n acadmcs as wll as n polcy crcls rcntly. For ach, w comput qulbrum allocatons n,, and FT. In and 9 Thr ar two mportant ssus about th tarff dtrmnaton problm. Frst, f th two mmbrs xrcs dffrnt tarff rats, thn ths rsults n trad dflcton and dffrnt tarff rats cannot b sustand. Rchardson (1993) dscusss th frst ssu, and shows that vn f ruls of orgn ar strctly nforcd t stll may not b possbl 7

9 qulbra, th two bg countrs ar th mmbrs of th PTA, and th small country s th nonmmbr. Snc w lmt our analyss wth PTAs btwn th larg countrs n ths cas, w do not hav to modl th choc of coalton partnrs. 1 Snc bg countrs hav symmtrc ndowmnts, th dtrmnaton of tarff rats n th qulbrum dos not lad to conflct of ntrst btwn th unon mmbrs,.. th mmbrs agr on what th optmal tarff should b. Th scond cas nvolvs wth a PTA agrmnt btwn th small country and on of th larg countrs. Ths cas consttuts a maor dpartur from th arly ltratur snc t consdrs a small country actvly partcpatng n a PTA. W agan comput qulbrum allocatons n,, and FT for ach. In and qulbra, on of th bg countrs and th small country ar th mmbrs of th PTA, and th othr larg country s nonmmbr. Whn thr s a, w assum that th bg country dtrmns th optmal tarff rat of th unon consdrng th sz dffrnc btwn th bg and small mmbrs. Ths s a plausbl smplfcaton, whch also lmnats th dffcult problm of ont tarff dtrmnaton n a qulbrum. W study th rlatonshp btwn th ndowmnt of countrs and thr sz dstrbuton n Tabl 1. Ths tabl prsnts th changs n, that s th xport good ndowmnt of a bg country, and ts mpact on th rlatv sz of countrs n th modl. Snc th prcs ar ndognously dtrmnd n our modl, w should dcd whch prc vctor s gong to b usd to comput th sz of th countrs at an qulbrum. W us th prc vctor assocatd wth fr trad qulbrum to xamn th rlatonshp btwn th xport good ndowmnt of countrs, and thr rlatv sz. As tabl 1 ndcats, whn a bg country s ndowd wth.8 unts of xport good, th valu of ts total ndowmnt s 2.59 tms largr than that of th small country. It s mportant to strss that th rlatonshp btwn th xport good ndowmnt and th rlatv sz s not lnar. Whn a bg country has xport good ndowmnt of 1 (1) unts, t s 2.83 (6.85) tms largr than th small country. An ncras n th xport good ndowmnt of bg countrs dos not lnarly rflct tslf n thr rlatv sz, snc ths ncras rsults n a dcras n th qulbrum prc of th xport good of th bg country. Th fourth column of th tabl prsnts th sz rato of th total walth of th mmbr countrs to that of th small nonmmbr country n cas 1. If th xport good ndowmnt of on of th larg countrs s qual to 1 (1), th total ndowmnt of th mmbr countrs of th agrmnt s 4.63 (13.71) tms largr than th small nonmmbr country. Th ffth column of th tabl prsnts th sz rato for th cas 2. In ths cas, whn th xport good ndowmnt of on of th larg countrs s qual to 1 (1), th total ndowmnt of th mmbr countrs s 3.31 (7.85) tms largr than th nonmmbr country. to sustan dffrnt tarff rats. Scond, n gnral, thr s a conflct of ntrst btwn th mmbr countrs as to what th xtrnal tarff should b n a. 1 Rzman (1985) studs partnr choc problm durng customs unon formaton. 8

10 3. Wlfar Chang Calculatons W us th masur of Compnsatng Varaton n Consumpton to valuat th wlfar changs assocatd wth trad agrmnts. 11 In partcular, th masur of th wlfar chang w us s th fracton δ by whch th consumpton allocatons should b dcrasd n th fr trad qulbrum to kp th rprsntatv agnt wth th sam utlty as th on n an qulbrum wth tarffs. Th wlfar gan δs calculatd as N F U ( x, x, x ) = U (( 1 δ ) x,( 1 δ ) x,( 1 δ ) x ) U U N F : utlty undr an qulbrum wth postv tarffs : utlty undr a fr trad agrmnt Unlk som othr wlfar masurs, such as utlty lvl of th rprsntatv consumr, our wlfar chang masur provds a transparnt ntrprtaton of wlfar ffcts of trad agrmnts, snc wlfar changs ar masurd n consumpton unts. For xampl, t s possbl to assss th prcntag chang n consumpton wth th stablshmnt of a PTA. 4. How do th PTAs affct small countrs? W frst prsnt th rsults of our smulatons concrnng th ffcts of PTAs on tarffs, prcs, and th trad volum of larg and small countrs n ths scton. Ths sctons, whl provdng dtald nformaton about th bhavor of ndognous varabls of th modl n dffrnt typs of tradng arrangmnts, also supply an xtnsv account of th basc ntutv mchansms drvng our wlfar rsults. Nxt, w xamn th wlfar mplcatons of s and s for ths countrs. In ach subscton, w frst consdr Cas 1 whr th two larg countrs form a PTA lavng th small country out, and, thn, w study Cas 2 whr th small country and on of th larg countrs sgn a PTA Changs n Tarff Rats W analyz th ffcts of changs n th ndowmnt dstrbuton of larg countrs on tarff rats n ths scton. W frst xamn Cas 1 whr th small country s not a mmbr of any PTA. W 11 Ths masur s slghtly dffrnt than th Equvalnt Incom Varaton masur whch looks at th chang n ncom at constant prcs. Th masur of Compnsatng Varaton n Consumpton s wdly usd n macroconomcs and fnanc ltratur to valuat th costs of busnss cycls and of th lack of ntrnatonal consumpton rsk sharng. S Lucas (1987), Col and Obstfld (1991) for th us of ths masur n dffrnt contxts. S Prron and Whally (1994) for th us of Equvalnt Incom Varaton. Rzman (1999) and Kos and Rzman (1999) us ths masur to analyz th wlfar mplcatons of PTAs. 9

11 prsnt our rsults n fgur 1. As shown n fgurs 1a and 1c, th xtrnal tarff of th PTA ncrass as th mmbr countrs bcom largr n thr xport good n both and qulbra. Th ky to ths rsult s that th rs n th sz of th tradng bloc rsults n ncrasd markt powr, whch n turn nducs hghr tarff rats. In a rcnt papr, Bond and Syropoulos (1996) drv a smlar rsult: as a tradng bloc xpands by ncrasng th numbr of ts mmbrs, ts xtrnal tarff rat also rss. Whn th tradng arrangmnt btwn bg countrs taks th form of a, th ont tarff rat of th unon s hghr than th nonmmbr country s tarff (s fgur 1b). Intrstngly, ths rgularty s rvrsd whn th bg countrs form a : th small nonmmbr country chargs hghr tarff rats thn th bg mmbrs (s Fgur 1a). Ths surprsng rsult occurs bcaus th formaton of th has mprovd th nonmmbr s stratgc poston snc t now has two stratgs (tarff rats) to us compard to th mmbrs that hav only on. Ths lads to th small nonmmbr country bng mor aggrssv and chargng hghr tarffs n a qulbrum. In contrast, nonmmbr s tarffs fall n a qulbrum bcaus th tarff coordnaton of th mmbr countrs rsults n thm bng mor aggrssv. In othr words, whn th bg countrs form a, thy ntrnalz th tarff xtrnalty. Ths lads to th hghr tarff and lowr small country tarff. Mmbrs of a cannot ntrnalz ths xtrnalty, snc thy do not ontly dtrmn tarff rats. 12 As th mmbr countrs of a PTA gts largr, th tarff rat chargd by th mmbrs ncrass mor rapdly n a qulbrum than t dos n a qulbrum (s fgur 1c). For xampl, an ncras n th ndowmnt of th xport good of a bg country from 3 to 5 rsults n an almost sx fold ncras n th tarff rat of th. Th sam chang n th ndowmnt lads to a lss than two fold ncras n th tarff rats chargd by th mmbr countrs of th (s fgur 1a). Intrstngly, our smulatons suggst that th tarff chargd by th small nonmmbr country ncrass, as th rlatv sz of t bcoms smallr. W prsnt ths rsult n fgur 1d. Bond and Syropoulos (1996) fnd th oppost: as th rlatv sz of a tradng bloc gts smallr, t ntally dcrass ts tarff rat, and thn ncrass t. Th dffrnc btwn our fndng and thrs s du to dffrnt ndowmnt structurs w mploy. In our modl, as th tradng bloc gts largr, ts dpndncy to trad also ncrass snc th ndowmnt structur of mmbr countrs bcoms mor unvn. Th small country dos not suffr from ths problm snc ts ndowmnt s vnly dstrbutd among th thr goods. Th magntuds of tarff rats w rport ar consstnt wth thos of arlr studs mployng gnral qulbrum mthods (s Prron and Whally (1994)). For xampl, whn th bg mmbr 12 In a rcnt papr, Kos and Rzman (1999) show that ths rsult s also vald whn countrs hav symmtrc ndowmnt dstrbutons. In partcular, thy fnd that n an () qulbrum, th nonmmbr (mmbr) country chargs hghr tarffs on mports from th mmbr (nonmmbr) country. 1

12 country has an ndowmnt of 1 unts of ts xport good, t chargs approxmatly 16 (135) prcnt tarffs on th xports of th small country n a () qulbrum. Ths vry hgh tarff rats sgnal that bng a small bystandr can b xtrmly panful spcally f th bg countrs stablsh a arrangmnt. Nxt, w xamn th tarff rats n Cas 2 whr th small country and on of th larg countrs form a PTA. Our rsults ar prsntd n fgur 2. Fgur 2a dmonstrats that th nonmmbr country chargs a hghr tarff rat on th xports of th bg mmbr of th than on thos from th small mmbr. Smlarly, th tarff rat chargd by th bg mmbr of th on th nonmmbr country s largr than th tarff chargd by th small mmbr (s Fgur 2b.) Thnk of th larg nonmmbr country as bng nvolvd n two tarff wars wth mmbrs of th. Ths rsult says that w s lowr tarffs n th tarff war btwn a larg and small country than btwn two larg countrs. As Fgur 2c shows, th nonmmbr country chargs hghr tarffs than th mmbr countrs n a qulbrum. Ths s somwhat dffrnt than Cas 1n whch th small country s th nonmmbr. Thr, th tarff rat chargd by th larg mmbrs of th s much hghr than that of th small country. Th dffrnc btwn ths two rsults s du to th dffrnc n th sz and ndowmnt dstrbuton of th nonmmbr countrs. In th frst cas, th small nonmmbr country has an vnly dstrbutd fxd ndowmnt. In th scond cas, as th tradng bloc gts largr, th larg nonmmbr country also gts largr, and ts ndowmnt dstrbuton gts mor skwd towards ts xport. Ths puts th larg nonmmbr country n a much mor comfortabl poston snc t s abl to utlz ts rsng markt powr mor ffctvly as th gts largr. To llustrat, consdr th xampl n whch th ndowmnt of th xport good of a larg country s 1,.. th tradng bloc s almost 7 tms largr than th nonmmbr country. Th tarff rat chargd by th nonmmbr country to th bg mmbr of th unon s 4 tms largr than that of th rat chargd by th unon to th nonmmbr country (s fgur 2c). Ths mpls that whn a small and a larg country stablsh a, ths dos not rsult n sgnfcantly ncrasd markt powr, and dos not ncssarly nduc much hghr tarff rats. Ths occurs bcaus whl th mmbr country s ndowmnt s larg, t s also skwd towards ts xport good. Fgur 2d suggsts that th small country chargs a hghr tarff rat n a than n a. Fgurs 2 and 2f compar th two cass from th prspctv of small countrs: fgur 2 ndcats that th small country xrcss a hghr tarff rat whn t s a mmbr than that whn t s not a mmbr of a. Howvr, n a qulbrum, th small country chargs a lowr rat whn t s a mmbr than that whn t s a nonmmbr. Two factors xplan ths rsult. Frst, th small country s at an xtrm dsadvantag whn t s th nonmmbr playng aganst a of th two larg countrs. Scond, th small country fars wll as th nonmmbr of a bcaus t has an vn ndowmnt and th 11

13 puts th larg countrs at a stratgc dsadvantag. As w dscuss latr n th papr, ths two rsults hav mportant mplcatons drvng som of our fndngs on wlfar changs Changs n Prcs W study th changs n th trms of trad and domstc prcs n rspons to th changs n th ndowmnt dstrbuton n ths scton. Our rsults about Cas 1 ar prsntd n fgur 3. Fgurs 3a and 3b show th prcntag changs n th trms of trad whn countrs mov from a or qulbrum to FT. Th trms of trad of th mmbr countrs ar bttr n a PTA qulbrum than that n FT. In othr words, movng from a or to FT worsns th trms of trad of th mmbr countrs as shown n Fgur 3a. Ths fgur also dsplays that movng from th agrmnt to FT dtrorats th trms of trad of th bg mmbr countrs lss than that f thy ar n a qulbrum ntally. Ths s bcaus n a qulbrum mmbr countrs coordnat thr tarff rats. For th small country movng to fr trad from any PTA rsults n a trms of trad mprovmnt. Th trms of trad mprovmnt s largr f th ntal qulbrum s a. Also, as th rlatv sz of a PTA gts largr, th small country obsrvs a hghr mprovmnt n ts trms of trad. For xampl, consdr th followng scnaro: th mmbrs of th and th small country gt togthr and stablsh fr trad. As a rsult of ths, th trms of trad of th small country mprovs by mor than 1 prcnt, whn s 1 (s Fgur 3b). Kowalczyk (1999) also suggsts that small countrs can mprov thr trms of trad by sgnng trad agrmnts wth largr countrs. Movng from a or to FT rsults n lowr domstc prcs n all thr countrs. As fgurs 3c and 3d ndcat, th dcras n domstc prcs as a rsult of movng from to FT qulbrum s much hghr than that of movng from to FT qulbrum. Whn th bg country has an ndowmnt of 1 unts of ts xport good, gong from a () to FT lads to approxmatly 28 (7) prcnt fall n th prcs of mport goods comng from th small country n th bg countrs domstc markts (s fgur 3c). Smlarly, consumrs n th small country pay about 31 (19) prcnt lss for goods mportd from bg countrs whn thr s FT nstad of () formd by th two larg countrs (s fgur 3d). Fgur 4 prsnts th rsults about Cas 2 whr th small country and on of th larg countrs stablsh a PTA. Fgur 4a ndcats that movng from a PTA to FT mprovs th trms of trad of th small mmbr country. Unlk th small mmbr, th larg mmbr of a PTA obsrvs a dcln n ts trms of trad as t movs to FT (s Fgur 4b). Ths rsult s consstnt wth that for th larg mmbr countrs n Cas 1. Howvr, Cas 2 mpls that f th mmbr country s small, havng FT nstad of a PTA rsults n hghr trms of trad for th small mmbr of th PTA. Ths rsults xpand th ntuton that small countrs los tarff wars. Thr trms of trad also dtrorat movng from FT to any PTA. 12

14 Fgurs 4c and 4d rval an ntrstng rgularty: th dcras n th trms of trad of th bg mmbr of a PTA s largr than that of th nonmmbr conomy as countrs mov from a PTA qulbrum to FT. Coupld wth th obsrvatons abov, ths rsults suggst that larg countrs prfr to b n a PTA to manpulat th trms of trad. Contrary to ths, th mssag of Fgurs 4 and 4f s that small countrs would rathr hav fr trad snc thr trms of trad s hghst whn thr s FT Changs n th Trad Volum W prsnt th rsults of our smulatons assocatd wth th changs n th trad volum of mmbr and nonmmbr countrs n Cas 1 n fgur 5. W masur a country s trad volum wth th rato of xports to GDP. As fgurs 5a and 5b show, a larg mmbr country of a PTA can hav a largr or smallr trad volum than th nonmmbr small country dpndng on ts xport good ndowmnt. As th dsparty btwn th ndowmnt dstrbuton of th mmbr and nonmmbr countrs gts largr, th trad volum of th nonmmbr conomy ncrass much fastr than that of th mmbr conomy n a qulbrum (s Fgur 5a). Ths rsult has an ntutvly appalng xplanaton: snc our ndowmnt spcfcaton maks th larg mmbrs mor dpndnt on mportd goods comng from th small conomy as thy bcom largr, th prc of th xport good of th small conomy ncrass n a qulbrum. Ths s also gnrally tru for th qulbrum. Howvr, th bg mmbrs of th coordnat thr tarff rats and push down th rlatv prc of th xport good of th small nonmmbr country. Hnc, th trad volum of th nonmmbr conomy xcds thos of th mmbrs n a qulbrum, only f th ndowmnt dstrbutons of th mmbr and nonmmbr conoms ar substantally dffrnt. For xampl, w obsrv that ths s possbl f s largr than 9 n our smulatons. Fgurs 5c and 5d rval a coupl of ntrstng rgularts: frst, mmbr countrs of a PTA xport a largr fracton of thr GDP n a qulbrum than that n a qulbrum. In contrast, th small nonmmbr country has a largr xport shar n th qulbrum than that n th qulbrum. Scond, mmbr countrs hav th smallst xport shar whn thr s fr trad. Th nonmmbr country, n contrast, attans ts largst xport shar whn thr s fr trad. 13 Fgur 6 rports our rsults n Cas 2. Fgurs 6a and 6b show that th small mmbr of a PTA agrmnt has a largr rato of trad to GDP than th larg mmbr, rgardlss PTA typ. Fgurs 6c and 6d dmonstrat that both small and larg mmbrs xport a largr fracton of thr GDP n a qulbrum than that n a qulbrum whl attanng thr largst trad volum n fr trad. Ths rsult s dffrnt than what w fnd wth Cas 1 whr th bg mmbrs trad mor wth th othr 13 W also xamn th trad btwn mmbr countrs of th tradng bloc. A mov from a to a mprovs th trms of trad of th mmbr countrs and ncrass th ntra-bloc trad. 13

15 countrs whn thr s a, and thy trad lss whn thr s fr trad. Th dffrnc btwn th two s that n Cas 1 th mmbrs of th ar abl to utlz thr markt powr mor ffctvly chargng hghr prcs for thr xport goods. Fgurs 6 and 6f compar Cas 1 and Cas 2 from th prspctv of th small country. In a, whn th small country s a mmbr of th agrmnt, t trads lss than that whn t s not a mmbr. In contrast, n a qulbrum th small mmbr of th agrmnt trads mor than that whn t s not a mmbr of th unon Wlfar Implcatons W xamn th wlfar mplcatons of PTAs for small countrs n ths scton. W frst study Cas 1 whr th small country s not a mmbr of any PTA. Fgur 7 prsnts our fndngs. As fgurs 7a and 7b show, attanng fr trad lads to vry larg wlfar gans for th small conomy. For xampl, f th larg mmbr countrs ar ndowd wth 5 unts of xport good, consumrs n th small country ar abl to ncras thr consumpton by approxmatly 9 (65) prcnt compard to th () stuaton. Ths rsult shows on sns n whch th cost to th small country of bng an nnocnt bystandr s vry larg. Gvn that th small country s lft out of a PTA t has a strong ncntv to s that fr trad s adoptd. Fgur 7d suggsts that whl th nnocnt bystandr problm can b vry svr for small conoms that ar not abl to partcpat n a PTA, th svrty of th problm gts wors as th rlatv sz of th bystandr gts smallr. Whn th two bg countrs, ach of whch has an xport good ndowmnt of 2 (1) unts, stablsh a arrangmnt, th small country can fac up to a loss of roughly 5 (75) prcnt of consumpton. If th PTA s an, thn th small country agan has to pay a cost, but a much smallr on. Ths wlfar rsults, suggstng that wlfar losss assocatd wth a agrmnt ar much largr than thos of a for a small nonmmbr conomy, ar n ln wth th followng rgularts w documnt n th prvous sctons. Frst, w obsrv that whl th tarff rat chargd by th small nonmmbr conomy s hghr than th larg mmbrs of a, th larg mmbrs mplmnt much hghr tarff rats than th small nonmmbr conomy n a. Scond, movng to a FT qulbrum from a rsults n a much largr mprovmnt n th trms of trad of th small conomy than that from a qulbrum. Thrd, w fnd that a small nonmmbr conomy trads mor n a qulbrum than n a qulbrum. Ths thr rgularts ar consstnt wth our wlfar calculatons provdng an ntutv ntrprtaton why bng an nnocnt bystandr can b vry costly. On of th stylzd faturs of rcnt PTAs btwn small and larg countrs s that small countrs oftn mak concssons on othr polcy mattrs n ordr to hav PTAs wth largr countrs. 14

16 Th rsults of our smulatons provd a smpl, yt vry powrful xplanaton to ths obsrvaton. Establshng fr trad (or accptng th small country to th tradng bloc) rsults n lowr consumpton n th mmbr countrs (s fgur 7c). For xampl s qual to.8, havng fr trad wth th small nonmmbr conomy nducs roughly 3.5 (.5) prcnt dcras n th consumpton of th larg mmbrs of a (). Hnc, th small nonmmbr country mght hav to offr somthng to bcom a mmbr of th larg tradng bloc. Th sz of ths paymnts dpnds on th typ of th PTA btwn th bg countrs. If th agrmnt taks th form of a, th small country mght hav to mak largr concssons to bcom a mmbr. How larg ar ths concssons or transfr paymnts? To answr ths quston, w provd th followng rough calculaton. Assum that th paymnt from th small country to bg countrs should b at last as larg as th lost tarff rvnu of th bg countrs rsultng from movng to fr trad. 14 In our xampl whn th sz of th PTA s roughly 11 tms largr than th small country,.. whn th bg countrs ar ndowd wth 8 unts of xport good, th lost tarff rvnu of th s approxmatly qual to 7.3 prcnt of th small country s ndowmnt. Ths mans that th small country has to transfr at last 7.3 prcnt of ts natonal product to th bg countrs to partcpat n th customs unon. Surprsngly, th rsult of ths smpl calculaton s consstnt wth that of Prron and Whally (1996) who also dscuss th possblty that small countrs mght hav to mak sd paymnts to partcpat n tradng arrangmnts. 15 Thr fndngs ndcat that th PTA btwn Canada and th U.S. would not b sgnd f Canada dd not mak som transfr paymnts to th U.S. snc th agrmnt rsultd n larg wlfar gans for Canada, but th U.S. gav up ts rtalatory powr aganst Canada. Employng a coopratv soluton concpt thy calculat th sz of ths sz paymnts whch support Parto mprovmnts for both conoms. In partcular, th outcom of thr study suggsts that dpndng on th coffcnt of rlatv rsk avrson and subctv probablty of a potntal trad war, th sz of transfr paymnts, mad by Canada to th U.S., rangs from.64 prcnt to 13 prcnt of Canada s GDP. Fgur 8 dsplays our rsults about Cas 2 whr th small country sgns a PTA wth on of th larg countrs and th othr larg country s a nonmmbr n th modl. Fgurs 8a and 8b show an ntrstng dffrnc btwn th wlfar mplcatons of Cas 1 and Cas 2. Th small nonmmbr conomy gans and th larg mmbr conoms los whn thr s fr trad n Cas 1. In Cas 2, both small and larg mmbrs of a PTA gan whn thr s fr trad. Morovr, for th larg nonmmbr conomy, havng fr trad nducs wlfar losss for most of th ndowmnt spac w consdr. To llustrat th magntud of th wlfar changs consdr th cas whr s qual to 5. If th agrmnt 14 S Kowalczyk (1999) for a smlar argumnt about th transfr paymnts. 15 Kowalczyk and Sostrom also fnd that small countrs whch gt larg wlfar gans from PTAs hghly lkly to pay ntrnatonal sd paymnts to bg countrs whch gt rlatvly much smallr gans from ths agrmnts. 15

17 s a, movng to fr trad ncrass th consumpton by almost 3 (4) prcnt n th small (larg) mmbr country, whl rducng th consumpton roughly 1 prcnt n th nonmmbr conomy (s fgur 8a.) Why dos th larg nonmmbr conomy fac wlfar losss n Cas 2? Ths can b xpland wth th two rgularts w documnt n th prvous sctons: frst, th larg nonmmbr conomy chargs hghr tarff rats than th mmbr conoms n both and qulbra. Scond, movng to FT dtrorats th trms of trad of th larg nonmmbr conomy n both and qulbra. In othr words, th nonmmbr dos wll n both th and qulbra. Th ntuton for ths s that th larg mmbr country s constrand by ts small country partnr n thr PTA qulbrum by bng forcd to hav fr trad wth ts partnr country. Fgurs 8c and 8d suggst that for th small (larg) mmbr country, movng from a () qulbrum to fr trad nducs largr wlfar gans than that of (). In ths sns, th bg mmbr country would prfr a to a wth th small country. Th small country s prfrnc s th oppost. Ths rsult s also n ln wth our fndng n Cas 1 that th small nonmmbr country gts largr gans by movng from a qulbrum to fr trad than that from a qulbrum to fr trad. Fgur 8 ndcats that whn s rlatvly small,.. th ndowmnt dstrbuton of th larg country s mor vn, thn th larg nonmmbr conomy gts som wlfar gans by havng fr trad wth othr countrs. In th cas of, for all valus of lss than 15, all countrs would bnft from a mov to fr trad. For hghr valus th bg nonmmbr country s wlfar wll fall. Thus, as th ndowmnt dstrbuton bcoms mor polarzd, th wlfar losss assocatd wth th nonmmbr conomy s partcpaton n fr trad gts largr. Ths rsults ar also consstnt wth our fndngs rgardng prc changs. W also consdr som xprmnts nvolvng th changs n th small country s wlfar as t movs from an qulbrum n Cas 1 to an qulbrum n Cas 2. To b mor spcfc, suppos th small conomy s ntally an nnocnt bystandr (Cas 1), thn t sgns a PTA wth on of th larg countrs (Cas 2). Fgur 9 rports our fndngs. Fgur 9a (9b) shows th wlfar changs whn th small country bcoms a mmbr of th (). Ths two fgurs suggst that f th small country sgns a PTA wth on of th larg countrs, whl t gts som sgnfcant wlfar gans wth a agrmnt, ts wlfar gos down n a for most of th ndowmnt spac. As th rlatv sz of th larg countrs ncrass, th gan (loss) assocatd wth a () agrmnt gts largr for th small country. For xampl, sgnng a agrmnt wth on of th larg countrs, dcrass th consumpton of th small country by 2 prcnt whn th xport good ndowmnt of th larg country s qual to 4. Comparng tarff rats chargd by th nonmmbr conoms provds th ntutv argumnt drvng ths 16

18 rsult: th small nonmmbr conomy mposs a hghr tarff rat than th mmbrs of th n Cas 1. In Cas 2, th small mmbr conomy chargs a lowr tarff rat than th larg nonmmbr conomy. Ths two fgurs also ndcat that havng fr trad wth th two larg countrs s always bnfcal for th small country. Th typ of th PTA sgnfcantly affcts th sz of wlfar gans of th small country n our modl. If th agrmnt s a (), stablshng fr trad wth th larg countrs ncrass th wlfar of th small country by roughly 1 (19) prcnt whn th xport good ndowmnt s qual to 5. Fgurs 9c and 9d provd th rsults of our smulatons n whch w consdr th wlfar changs whn a small nonmmbr conomy n a () qulbrum sgns a () agrmnt wth on of th larg countrs. It s bnfcal for th small country to bcom a mmbr of th nstad of bng an nnocnt bystandr n a qulbrum (s Fgur 9c). Fgurs 9a and 9c togthr show that for th small country mmbrshp n a s attractv whn compard wth bng an nnocnt bystandr n a qulbrum, but s qut unattractv f t s ntally an nnocnt bystandr n a qulbrum. Fgur 9d shows that f a small nonmmbr country n a qulbrum bcoms a mmbr of a agrmnt, ths nducs wlfar losss n th small country. Th basc ntuton for ths rsult coms from our prvous rsults on tarff rats n Cas 1 and Cas 2. As a nonmmbr n a qulbrum th tarff rat chargd by th small country s hghr than that chargd by th larg mmbr countrs. In a qulbrum n Cas 2, th small mmbr conomy lvs a tarff that s lowr than that mplmntd by th larg nonmmbr country. Ths shows that for th small country bng an nnocnt bystandr s bad f th bg countrs form a, but s a good thng f thy form and. 5. Concluson W hav usd a pur xchang, gnral qulbrum modl to nvstgat how small countrs ar affctd by PTAs. Whl w fnd that bng an nnocnt bystandr can potntally b vry costly for th small country, thr ar a numbr of cavats to ths concluson. Th most mportant cavat s that th typ of PTA formd by th largr countrs s crucal. If th small country s lft out of a th wlfar losss can b xtrmly larg, up to 7 prcnt of GDP n our modl. Howvr, f th larg countrs nstad, opt for a, th cost of bng an nnocnt bystandr ar much mor modst, lss than 1 prcnt of GDP. In fact, th small country dos bttr whn t s an nnocnt bystandr to a of th two larg countrs than t dos onng on of th larg countrs n a. If th larg countrs form a, thn th small country s much bttr off to form a wth on of th larg countrs. In all cass, th small country dos bst at global fr trad. If PTAs tak th form of s thn th small country would chos to b an nnocnt bystandr. Whn PTAs tak th form of s th small country would b wllng to pay to on n a wth on of th larg countrs rathr than b an nnocnt bystandr. 17

19 Rfrncs Bond, E., and C. Syropoulos, 1996, Th sz of tradng blocs: Markt powr and world wlfar ffcts, Journal of Intrnatonal Economcs, 4, Col, H.L., and M. Obstfld, 1991, Commodty trad and Intrnatonal rsk sharng: How much do Fnancal Markts Mattr?, Journal of Montary Economcs 28,3-24. D Mlo, J., and A. Panagarya, 1993, Nw dmnsons n rgonal ntgraton, Cambrdg Unvrsty Prss. Ethr, F., 1996, Rgonalsm n a multlatral world, mmo, Unvrsty of Pnnsylvana. Havman, J., 1996, Som wlfar ffcts of squntal customs unon formaton, Canadan Journal of Economcs 29, Knnan, J., and R. Rzman, 1988, Do bg countrs wn tarff wars?, Intrnatonal Economc Rvw 29, Knnan, J., and R. Rzman, 199, Optmal tarff qulbra wth customs unons, Canadan Journal of Economcs 9, Kos, M. A., and R. Rzman, 1999, Undrstandng th wlfar mplcatons of prfrntal trad agrmnts, forthcomng, Rvw of Intrnatonal Economcs. Kowalczyk, C, 1999, Wlfar and customs unons, forthcomng, Intrnatonal Economc Rvw. Kowalczyk, C. and T. Sostrom, 1994, Brngng GATT nto th cor, Economca, 61, Krugman, P., 1991a, Th mov toward fr trad zons, n Polcy Implcatons of Trad and Currncy Zons. A symposum sponsord by th Fdral Rsrv Bank of Kansas Cty. Krugman, P., 1991b, Is blatralsm bad?, n E. Hlpman and A. Razn, ds., Intrnatonal Trad and Trad Polcy, Cambrdg, MIT Prss Lucas, R.E., 1987, Modls of Busnss Cycls, Oxford, Blackwll Prron, C. and J. Whally, 1996, Th nw rgonalsm: trad lbralzaton or nsuranc?, mmo, Unvrsty of Wstrn Ontaro. Prron, C. and J. Whally, 1996, How svr s global rtalaton rsk undr ncrasng rgonalsm?, Amrcan Economc Rvw 86, Rchardson, M., 1993, Endognous protcton and trad dvrson, Journal of Intrnatonal Economcs 34, Rzman, R., 1985, Customs unons and th cor, Journal of Intrnatonal Economcs 19, Rzman, R., 1999, Can blatral trad agrmnts hlp nduc fr trad?, Canadan Journal of Economcs 32,

20 Syropoulos, C., 1999, Customs unons and comparatv advantag, Oxford Economc Paprs 51:2, Whally, J., 1998, Why do countrs sk rgonal trad agrmnts?, n J. A. Frnkl (d.), Th Rgonalzaton of th World Economy, Th Unvrsty of Chcago Prss, Wntrs, L. A., 1993, Expandng E.C. mmbrshp and assocaton accords: rcnt xprnc and futur prospcts, n K. Andrson, and R. Blackhurst (ds.), Rgonal Intgraton n th Global Tradng Systm, Harvstr Whatshaf,

21 Fgur 1. Tarff Rats (Cas 1).25 Nonmmbr Fgur 1a Fr Trad Assocaton 1 Fgur 1b Customs Unon Tarff Rat/ Mmbr Tarff Rat/ Mmbr Nonmmbr Fgur 1c Mmbr Country.3 Fgur 1d Nonmmbr Country Tarff Rat/ Tarff Rat/ s th xport good ndowmnt of th bg country. On th vrtcal axs, tarff rats, dvdd by 1, ar rportd. rfrs to Customs Unon and rfrs to Fr Trad Assocaton. S txt for dtals. 2

22 Fgur 2. Tarff Rats (Cas 2) 2 Fgur 2a Fr Trad Assocaton Nonmmbr Country 1. Fgur 2b Fr Trad Assocaton Mmbr Country Tarff Rat/ Bg Mmbr Small Mmbr Tarff Rat/ Bg Mmbr Small Mmbr Fgur 2c Customs Unon 1.5 Fgur 2d Mmbr Country Tarff Rat/ Bg Mmbr Mmbr Small Mmbr Tarff Rat/ Fgur 2 Customs Unon.25 Fgur 2f Fr Trad Assocaton.2 Tarff Rat/ Small Mmbr Small Nonmmbr Tarff Rat/ Small Nonmmbr Small Mmbr s th xport good ndowmnt of th bg country. On th vrtcal axs, tarff rats, dvdd by 1, ar rportd. rfrs to Customs Unon and rfrs to Fr Trad Assocaton. In Fgur 2a, Bg (Small) rfrs to th tarff chargd by th Nonmmbr country to th Bg (Small) mmbr of th. In Fgur 2b, Bg (Small) rfrs to th tarff chargd by th Bg (Small) Mmbr of th to th Nonmmbr country. In Fgur 2c, Bg (Small) rfrs to th tarff chargd by th Nonmmbr country to th Bg (Small) 21 mmbr of th. In fgur 2c, Mmbr rfrs to th tarff chargd by th. In Fgur 2d, and rfrs to th tarffs chargd by th small country n (). In Fgur 2 (2f), Small mmbr (Small Nonmmbr) rfrs to th tarff rats chargd by th small country whn t s a mmbr/nonmmbr of a (). S txt for dtals.

23 Fgur 3. Chang n Prcs (Cas 1) Fgur 3a Chang n Trms of Trad Mmbr Country 9 Fgur 3b Chang n Trms of Trad Nonmmbr Country Chang n Trms of Trad (%) Chang n Trms of Trad (%) Fgur 3c Chang n Domstc Prcs Mmbr Country Fgur 3d Chang n Domstc Prcs Nonmmbr Country Chang n Prcs (%) Chang n Prcs (%) s th xport good ndowmnt of th bg country. rfrs to Customs Unon and rfrs to Fr Trad Assocaton. On th vrtcal axs, chang n prcs or trms of trad ar rportd. For xampl, n fgur 3a, changs n trms of trad of th mmbr country nducd by a chang n qulbrum from a or to Fr Trad ar rportd. S txt for dtals. 22

24 Fgur 4. Chang n Prcs (Cas 2) 5 Fgur 4a Chang n Trms of Trad Mmbr Country (Small) Fgur 4b Chang n Trms of Trad Mmbr Country (Bg) Chang n Trms of Trad (%) Chang n Trms of Trad (%) Fgur 4c Chang n Trms of Trad Fr Trad Assocaton 5 Fgur 4d Chang n Trms of Trad Customs Unon Chang n Trms of Trad (%) Bg Mmbr Small Mmbr Nonmmbr Chang n Trms of Trad (%) Bg Mmbr Nonmmbr Small Mmbr Fgur 4 Chang n Trms of Trad Fr Trad Assocaton 85 Fgur 4f Chang n Trms of Trad Customs Unon Chang n Trms of Trad (%) Small Nonmmbr Small Mmbr Chang n Trms of Trad (%) Small Nonmmbr Small Mmbr On th vrtcal axs, chang n trms of trad s rportd. For xampl, n fgur 4a, changs n trms of trad of th mmbr country nducd by a chang n qulbrum from a or to Fr Trad ar rportd. In Fgur 4 (4f), Small mmbr (Small Nonmmbr) rfrs to th changs n trms of trad of th small country 23 nducd by a chang n qulbrum from a or, n whch th small country s a mmbr/nonmmbr, to Fr Trad, rportd. S txt for dtals.

25 Fgur 5. Trad Volum (Cas 1) Exports/GDP Nonmmbr Fgur 5a Fr Trad Assocaton Mmbr Exports/GDP Mmbr Fgur 5b Customs Unons Nonmmbr Fgur 5c Mmbr Country Fgur 5d Nonmmbr Country FT Exports/GDP 3 2 FT Exports/GDP s th xport good ndowmnt of th bg country. Export-GDP rato n prcntag trms s rportd on th vrtcal axs. () rfrs to Customs Unon (Fr Trad Assocaton), and FT rfrs to Fr Trad. S txt for dtals. 24

26 Fgur 6. Trad Volum (Cas 2) 8 Fgur 6a Fr Trad Assocaton 6 Fgur 6b Customs Unons Exports/GDP Small Mmbr Bg Mmbr Exports/GDP Small Mmbr Bg Mmbr FT Fgur 6c Mmbr Country (Small) FT Fgur 6d Mmbr Country (Bg) Exports/GDP 4 2 Exports/GDP Fgur 6 Fr Trad Assocaton Small Mmbr Fgur 6f Customs Unon Exports/GDP Small Mmbr Small Nonmmbr Exports/GDP Small Nonmmbr s th xport good ndowmnt of th bg country. Export-GDP rato n prcntag trms s rportd on th vrtcal axs. () rfrs to Customs Unon (Fr Trad Assocaton), and FT rfrs to Fr Trad. In Fgur 6 (6f), Small Mmbr (Small Nonmmbr) rfrs to th Export/GDP of th small country whn t s a mmbr/nonmmbr 25 of an (). S txt for dtals.