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Baldwin Venables Handbook

Baldwin Venables Handbook

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Sections

  • 1.1 Definitions
  • 1.2 Outline
  • 1.3 A framework for welfare analysis
  • 2.1.1 National Welfare for a Small Country
  • 2.1.2 Large Country and Regional Welfare Results
  • 2.2.1 Variety effects and production shifting in the 'large group case'
  • 2.2.2 The pro-competitive effect: Scale and variety implications
  • 2.2.3 Market segmentation and integration
  • 3.1 Medium-term effects: Investment creation and diversion
  • 3.2 Long run growth effects
  • 4.1 Location of firms
  • 4.2 Linkages and agglomeration
  • 4.3 Labour Mobility
  • 4.4 Integration and industrial agglomeration
  • 5.1 Sources of errors in empirical evaluations
  • 5.2.1 Trade creation and diversion
  • 5.2.2 Growth regressions
  • 5.3.1 Description of three generations of CE models
  • 5.3.2 Evaluations of EC92
  • 5.3.3 Why the Estimates Vary So Widely

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wp 14 August 2004 (11 SeptD Draft)


REGIONAL ECONOMIC INTEGRATION

RICHARD E. BALDWIN
Graduate Institute of International Studies, Geneva.

ANTHONY J. VENABLES
London School of Economics.


Contents

1 Introduction
1.1 Definitions
1.2 Outline
1.3 A framework for welfare analysis
2. Allocation effects
2.1 Perfect competition and constant returns
2.2 Market structure, scale economies and imperfect competition
3. Accumulation effects
3.1 Medium-term effects: Investment creation and diversion
3.2 Long-term growth effects
4. Location effects
4.1 Location of firms
4.2 Linkages and agglomeration
4.3 Labour mobility
4.4 Integration and industrial agglomeration
5. Empirics
5.1 The antimonde problem
5.2 Econometric evidence
5.3 Empirical evaluations of NAFTA and EC92
6. Further issues
6.1 Multilateral, unilateral and regional liberalization
What is best for a single country?
Hub and spoke and concentric circle arrangements
6.2 Political economy issues
G&H paper and others.
6.3 Regionalism and the multilateral trading system
What determines the size of FTAs and CUs?
Is Bilateralism Bad?
Building blocks or stumbling blocs?

References



1


1. Introduction

1.1 Definitions

Geographically discriminatory trade policy is the defining characteristic of a regional
integration agreement (RIA). Traditionally three types of RIAs are distinguished. A free
trade area (FTA) is an RIA formed by removing tariffs on trade among nations that are FTA
members without changing tariffs on imports from non-members. A customs union (CU) is
an FTA where members' tariff structures on the extra-CU trade are equalized. A common
market (CM) permits free movement of factors as well as goods and services between states.
i

At present some 35 RIA's exist with a range and variety far richer than the traditional
distinctions.
ii
Some have very limited product coverage (eg??), and others function poorly or
have not been fully implemented.
iii
There is increasing awareness of the fact that non-tariff
barriers (NTBs) mean that duty free trade is not the same as free trade. Restrictions on
merchandise trade stem from contingent protection, government support of industries
(especially nationalized industries), health, safety and environmental standards, and
discriminatory government procurement. Trade in services is hindered by discriminatory
regulations (particularly the right to establish an enterprise and professional accreditation) and
government monopolies in the communications and energy sectors. Barriers to trade in
productive factors - labour, capital and technology - may be harmful in their own right, but
they also may distort merchandise and services trade. To deal with this range of barriers,
modern RIAs often involve thousands of pages of text and are accompanied by
administrative, political and judicial institutions.
Space limitations allow us to briefly describe only the two largest RIAs viz. those in
North America and Europe.
iv
Europe and North America account for two-thirds of world
trade; 60% of this trade is directly governed by RIAs, and RIAs' discriminatory tariff
structures indirectly affect the rest. Post war integration in North America began with a
1965 US-Canada agreement that provided free trade in the automobile sector.
v
In 1988 the
Canada-US FTA (CUSFTA) extended this to trade in most industrial goods and added some
investment guarantees. It did not forbid contingent protection measures but it did establish a
separate adjudication procedure for bilateral dumping and subsidies cases. In 1993 CUSFTA
became the North American FTA (NAFTA), incorporating Mexico. This provides for free
trade in most industrial goods with long phase out periods for certain 'sensitive' sectors. It
also includes guarantees for direct investment and intellectual property rights. NAFTA does
not rule out contingent protection and the special CUSFTA procedure were not extended to
US-Mexico trade cases.
European integration started much earlier and has gone much deeper than North
American integration.
vi
The European Community (EC) completed its CU in 1968. By that
date, contingent protection measures on intra-EC trade were forbidden and free labour
mobility was instituted.
vii
In addition to covering industrial products, this so-called Common
Market removed duties and quotas on intra-EC food trade, replacing them with a complex
system of subsidies, price supports and external trade barriers known as the Common
Agricultural Policy (CAP). A separate group of West European nations formed the European
Free Trade Area (EFTA), which is an FTA for industrial goods that was completed in 1968.



2
The EEC and all EFTAns signed bilateral FTAs in 1974, implicitly forming an a duty-free
zone for industrial goods covering most of West Europe. The membership of the EC was
enlarged in 1972 and ???.
The EC's 1986 Single European Act promised to establish the 'Single Market' by
removing all intra-EC barriers to the moment of goods, services, people and capital by 1992.
We refer to this as programme as EC92 and note that it is still not fully implemented.
Importantly, EC92 promised mutual recognition of product, health and safety regulations and
standard, unrestricted rights of establishment of EC firms, financial institutions and other
service providers. The Single European Act also centralized economic decision making on
matters concerning the Single Market and doubled EC funds available for intra-regional
transfers. The 1992 European Economic Area (EEA) agreement extended EC92 to the
EFTAns with the exception of food trade. EEA members account for about half of world
trade and a third of world GDP. The EC has recently, or soon will, sign agreements with 10
Central and Eastern European countries (CEECs). These 'Europe Agreements' are FTA in
industrial goods (with longer phase out of barriers for certain 'sensitive' sectors). They
include evolutionary clauses leading to deeper integration including eventual EC
membership.
RIAs are inconsistent with the GATT's MFN principle. However, the GATT Article
24 specifically allows RIAs unless they violate certain conditions. FTAs are allowed unless
they are shown to not promise to completely eliminate barriers on 'substantially all the trade'
among members. For a CU there is the additional requirement that external tariffs "shall not
on the whole be higher or more restrictive" than prior to the CU. Judgement on whether a
particular RIA violates these conditions requires a unanimous conclusion of a GATT
'working party'. None of the 50 or so such parties formed over the last three decades have
reached unanimity, so no RIA has been ruled inconsistent with the GATT.
viii




1.2 Outline

The formation of most RIAs appears to be driven primarily by concerns unrelated to
simple economic factors. Nevertheless, RIAs have important economic implications for
participating and non-participating nations. We categorize the economic effects of PTAs into
three types: allocation, accumulation and location. The first includes a RIA's impact on the
static allocation of resources. The second encompasses a RIA's impact on the accumulation
of productive factors. We define factors broadly enough to included knowledge capital (i.e.
the level of technological progress), so our accumulation effects have growth effects. The
third covers an RIA's impact on the spatial allocation of resources and draws on the recent
'economic geography' literature.
These effects are the principal topics of Sections 2 through 6. To organize
presentation, Section 2 introduces a core model. This permits us to illustrate the various
welfare effects in a coherent manner and with a consistent notation throughout the chapter.
Section 2 also deals with allocation effects in models which do and do not allow for scale
economies and imperfect competition. Section 3 covers medium-term and long-term
accumulation effects that are particular to preferential, as opposed to unilateral or multilateral,
liberalizations. Section 4 deals with location effects.
Empirical evidence and discussion of evaluations two real-world RIA (NAFTA and



3
EC92) are the subjects of Section 5. Section 6 deals with further issues. These include types
of regionalism (Section 6.1), regionalism and the world trading system (Section 6.2) and the
political economy of RIAs (Section 6.3).


1.3 A framework for welfare analysis

To introduce notation and organize our discussion of theoretical and empirical results,
we present a simple framework.
ix
Welfare of the representative consumer in country j at a
moment in time is given by an indirect utility function V
j
(p+t,n
*
,E), where p is the vector of
border prices (the border of the country in which the good is produced), t reflects trade costs
and the specific-tariff equivalent of import barriers, n
*
is a vector of number of varieties
available domestically and the scalar E is total consumption expenditure. Without loss of
generality, each good from every country enters V separately.
x
E is the sum of factor income,
profits and rent from trade barriers that accrues domestic agents (including the government)
minus investment expenditure. Namely:
Total factor income is wL+rK, where L and K are country j's supply of labour and capital, and
w and r are factor prices. Domestically-accruing trade rents equal αtm, where m is the net
import vector (positive elements indicates imports) and α is a diagonal matrix that measures
the proportion the wedge t that creates income for domestic agents (including the
government). α
i
= 1 for a tariff or other domestic rent creating barrier (DRC); α
i
= 0 for a
barrier where no trade rent is captured domestically (non-DRC).
xi
The third term is total
profit. It is the inner product of the economy's production vector X and the gap between
consumer prices and average cost. Firms are assumed to be symmetric by sector, so elements
of the vector a(w,r,β,x) give the sectoral average cost functions. Average cost in a typical
sector j depends on factor prices, the scale of firm-level production x
j
and a sector-specific
efficiency parameter β
j
(more on this below). The final term in (1) is gross investment equal
to the change in K and depreciation δK.
Totally differentiating V
j
(p+t,n
*
,E) and dividing through by the marginal utility of
expenditure yields (see appendix A):
We refer back to the terms in this expression throughout the chapter. The three terms in the
first row represent welfare effects that appear in models with perfect competition. We refer
to these as the 'trade volume', 'trade cost' and 'terms of trade' effects respectively. The three
terms in the second row are relevant only in models that allow for increasing returns to scale
and imperfect competition. We call them the 'output', 'scale' and 'variety' effects respectively.
The last two terms in the third row depend upon the accumulation of factors. A change in
K) + K ( - x)] , r, a(w, - t) + X[(p + tm + rK + wL = E δ β α

1

K d - )dK - (r + d
a
X -


dn
)
V
/
V
( + dx
a
X - a]dX - t + [p +

dp m - )t] - d[(I m - tdm =
V
dV/
*
E n x
E

δ β
α α
β
2



4
investment is instantaneously costly, but augments the capital stock with net return r-δ.
Capital stock changes only have first-order welfare effects if there is a wedge between the
private and social return capital. The first term in the third row reflects this possibility. Thus,
if there are spillovers due to the creation of new capital (physical, human or knowledge), as is
assumed in much new growth theory, β would be a function of the stock of capital. If ther are
economies of scale that are external to the firm, then β would be a function of X.




2. Allocation Effects

The first two row of (2) list ways in which regional integration can affect welfare via
changes in the allocation of resources. Sections 2.1 and 2.2 deal with the allocation effects of
PTAs under assumptions of constant returns and perfect competition and increasing returns
and imperfect competition respectively.


2.1 Perfect Competition and Constant Returns


Modern regional integration theory began life with Viner (1950) under the name of
customs union theory. His lucid, but informally, reasoning is full of insights and anticipates
many of the post-war theoretical and policy debates. His most famous result - that the
welfare impact of customs union formation is ambiguous - triggered a flood of paper.
xii
Most
of these assumed perfect competition and constant returns, and so dealt only with welfare
effects listed in the first row of (2). Many merely contribute to the a debate about what Viner
real meant.
xiii
The most useful of these illuminated interesting special cases where total
welfare effect can be signed despite the fundamental second-best nature of PTAs. We devote
relatively little space to this literature since econometric and simulation studies (see Sections
5 and 6) have shown these effects to be small and good surveys already exist (see Pomfret
(1986), Lipsey (1960), Krauss (1972) and Kowalczyk (1992)).
xiv


2.1.1 National Welfare for a Small Country

Border prices are fixed in a small country, so only the first two terms in (2) are
relevant. For each good i, these terms form a weighted average (the diagonal elements of α
are the weights) of the trade volume change times t and the change in t times the initial trade
volume. This abstracts from changes in α. The two polar cases are when α equals the
identity matrix and the zero matrix. The early CU literature assumed that α was the identity
matrix since it was concerned only with discriminatory tariff reductions. In this case, only the
trade volume effect, tdm, from (2) remains. Meade (1955 p.35) pointed out that the tariff
weighted change in a nation's trade volume is a sufficient statistic for the total welfare effect.
The empirical literature (see Section 5.1) went further by ignoring export barriers and
assuming all elements of t were equal. This yields an even simpler rule. A nation gains if
and only if the PTA formation raises its aggregate import volume. Traditionally, the



5
aggregate import volume change is decomposed into trade creation (the sum of extra imports
from PTA and nonPTA nations) and trade diversion (reduced imports from nonFTA
nations).
xv

The confusing but enduring, trade creation/diversion terminology generated a
substantial literature, so it must be addressed directly. Trade diversion occurs when
discriminatory tariff liberalization leads a private agent to import from a supplier that is not
the lowest cost supplier. This tends to reduce home welfare since it raises the nation's cost of
consuming such goods. Clearly trade diversion can arises from discriminatory, but not MFN,
tariff changes. Of course, if the bilateral tariffs are reduced on only on imports from countries
that already were the lowest-cost supplier, trade diversion does not occur in this good. This
observation motivates the claim by Lipsey (1975) that FTA are likely to be beneficial if, the
FTA partners initially account for large shares of each others imports. This motivation
assumes that relative cost is an important determinant of import shares.
Another special case in which welfare effects can be easily signed is presented by
Ethier and Horn (1984). When tariffs on intra-PTA imports, but not extra-PTA imports, are
in the neighbourhood of zero initially, the change in tariff revenues on external trade is a
sufficient statistic for welfare gains.
Most DRC barriers restricting intra-West European trade were eliminated by 1975, so
all recent RIAs involve only NTB removals. NTB liberalization is also an important part of
NAFTA and many other PTAs. Since most NTBs are nonDRC barriers, the other polar case -
where α is the zero matrix - is particularly relevant in the modern world. Moreover, this case
was largely ignored in the early CU literature. Fortunately it is trivial to deal with. When α is
the zero matrix, only the term '-mdt' is relevant, yielding another simple rule. When α is the
zero matrix, a nation gains from any PTA that lowers its average (trade-weighted) t's. Notice
that the amount of trade creation and trade diversion are entirely irrelevant in this case.
Evaluations of NAFTA (Section 6.2.1) show that the welfare effects of removing
NTB regionally are much larger than those of removing tariffs regionally. To motive the
relative magnitudes of these effects, we compare approximations of the gains from
liberalization in the two polar cases of α. Since m is a function of p+t, tdm and -mdt can be
re-written as the sum over all goods i of )]
t
+ p /(
t
[ )]
t
/
dt
- )(
m t
[(
i
i
i i m, i i i i
ε
1 and
)]
t
/
dt
- )(
m t
[(
i i i i
2 respectively.
xvi
Here ε
m,i
is the import demand elasticity. The ratio of the
former to the later is ε
m,i
τ
i
/(1+τ
i
) where τ
i
is the ad valorem equivalent of t
i
. Econometric
studies typically estimates ε
m,i
to be around 2 (Leamer and Stern (1970)), so unless τ
i
is very
large, the welfare impact of reducing DRC barriers will be much smaller than that of reducing
nonDRC barriers.

2.1.2 Large Country and Regional Welfare Results

The analysis for the large-country and multi-country cases rapidly increases the
complexity of the problem. There are two fairly general results. The first is the Meade-
Ohyama-Kemp-Wan Theorem. Meade (1955 p.98) showed that if all barrier are "fixed and
unchanging" quantitative restrictions, then a CU must increase the sum of the economic
welfare of member nations. Formation of the CU will have no impact on external trade, or
rest-of-world welfare, if the quantitative restrictions (QRs) remain binding. Removing
internal QRs, however, allows a more efficient allocation of CU resources and transfers
among CU partners can ensure a pareto improvement. Ohyama (19??), and Kemp and Wan



6
(1976) rediscovered and extended Meade's result by showing that a sufficiently intricate
change in the CU's external tariffs could also freeze external trade, so that standard gains
from trade arguments can be used to demonstrate the result. The Ethier-Horn result is also
valid when considering the sum of FTA partners welfare. Basically their assumption of
initially zero intra-regional tariffs allows one to treat CU members as a single nation.
Terms of trade considerations render the analysis much more complicated. A
framework with three large countries trading two goods is sufficient to motivate the basic
findings. Suppose initially the home country (country 1) exports good A and imports good B
from both country 2 and country 3. Consider a PTA consisting of a marginal reduction of t
jk

defined as the specific tariff applicable to goods exported from j to k. Country 1's terms of
trade effect depends on its import volume change. Using the standard inverse-elasticity
formula for optimal tariffs dp
m
=
dm t
i1
i1 i1 i1
~
3 for i=2,3, the sum of the first-row terms in (2)
can be written as:
where t
~
4is the vector of optimal tariffs and we assume α to be invariant.
We first consider when internal free trade is optimal. Supposing that α is the identity
matrix, the welfare change of countries 1 and 2 added together is:
The PTA's welfare is maximized when this expression equals zero. A sufficient condition for
the optimality of internal free trade (t
21
=t
12
=0) is that external trade is optimally taxed.
Moreover, if extra-PTA trade is optimally taxed in all members, then any internal
liberalization that increases tariff-weighted trade volume is beneficial to the members.
Focusing on two-good models, however, misses out a consideration pursued in one
branch of the literature. When the home country imports a single good, internal and external
trade are necessarily substitutes. More generally, this need not be so -- there may well be
complementarities between them. A literature using three-good three-country frameworks
have explored this in depth (see Lloyd (1982) survey). A more general analysis by McMillan
and McCann (1981) shows that complementarity between imports from the partner country
and from the rest of the world is sufficient to ensure gains from integration for a small
country with no export barriers. In this case, home welfare depends only on tdm and all
elements in this sum are positive.


2.2 Market structure, scale economies and imperfect competition

Much of recent literature on RIAs has focused on environments that are imperfectly
competitive. Econometric studies (see Section 5.2) suggest that the assumption of constant
returns and perfect competition is false, (???) and that RIAs have, at least in Europe, altered
firm scale and price-cost margins. Moreover, simulation studies of NAFTA and EC92
suggest that the 'second-row' effects of (2) are quantitatively the most important.
Additionally, many existing and proposed RIAs are explicitly limited to trade in industrial
products, for which scale economies are especially important. A related point is that most
dt] [m ) - (I + ] )dm t - t [( α α
~
3
]
dm
)
t
-
t
( +
dm
)
t
-
t
[( +
dm t
+
dm t
=
V
/
dV
+
V
/
dV 32 32 32 31 31 31 12 12 21 21 E 2 E 1
2 1
~ ~
4



7
RIAs cover two-way trade in similar products. Trade model that are consist with this involve
scale economies.
The theoretical literature on trade and imperfection competition does not contain a
systematic, formal treatment of discriminatory trade liberalization, although it has been
widely applied in numerical simulations.
xvii
In order to develop land build intuition for these
results, we start this section by developing an 'algebraic core'. Variants and extensions of this
are employed throughout the rest of the chapter. The core model of trade and imperfect
competition has N economies each with an X and Z sector. The X sector in has imperfectly
competitive firms producing differentiated goods with increasing returns to scale technology.
Z sector firms are perfectly competitive, face constant returns to scale and produces a
homogeneous product that we assume to be costlessly tradeable and use as numeraire.
xviii

Country j is endowed with L
j
units of the only productive factor, labor. Free trade in Z makes
wages invariant to X-sector trade policy changes, and units are chosen such that all wages are
unity.
The representative consumer in country j has indirect utility function V
j
(P
j
,1,E
j
) where
1 is the price of Z sector output, E
j
is consumption expenditure as in (1), and P
j
is the standard
CES consumer price index of varieties supplied to market j. That is:
where n
k
(k=1,...N) is the number of varieties produced in country k, p
j
is the producer price
of the ith variety produced in k and sold in j, and τ
kj
reflect the ad valorem trade costs of
selling products from k in j. This wedge between consumer and producer prices is due to
trade barriers or transport costs. Consumption demand c
j
is found by Roy's identity.
xix

Namely:
where E is country j total expenditure on X industry goods which is a function of the price
index and total expenditure. As in Section 1, firms are assumed to be symmetric by country
and by sector, so superscripts are dropped. To further simplify the discussion, we often
assume that the price elasticity of E
X
j
- denoted as 1-η - is constant, and that the τ
kj
's
represent 'iceberg' trade costs.
xx
That is, a proportion τ
kj
-1 of the goods 'melt' in transit, so
output exceeds consumption according to:
c
=
x kj kj kj τ
5.
The profit of a typical country j firm in the Z sector is:
where we assume technology has fixed cost f
j
and constant marginal cost b
j
. If firms play a
segmented market game then standard first order conditions (see Helpman and Krugman
1985) are:
( ) 1 > p =
P kj
i
kj
- 1
n
=1 i
N
=1 k
- 1
j
k
σ
τ
σ
σ






∑ ∑
5
( ) p
P
)
E
,
P
(
E
=
) p (
P
P
)
E
,1,
P
(
V
- =
c kj
i
kj
-
1 -
j j j
X
j
kj
i
kj
j
j
j j j
i
kj τ
τ
σ
σ




6
.
x x
, f -
b x
-
x
p =
jk
N
=1 k
j
j
j j jk jk
N
=1 k
j ∑ ∑

π
7
( )
b
)
s
( + 1 = p
j jk
jk
λ 8



8
where λ(s
jk
)is the price-marginal-cost mark up and s
jk
is the value share of a country-j firm's
sales in country k's market. If η is constant, λ
jk
depends only upon s
jk
and parameters, and its
exact form depends on the nature of strategic interaction between firms. For Nash
equilibrium in prices we have:
(Derivation and the case of quantity competition are in appendix B). Note that λ is an
increasing and strictly convex function of a firm's own market share in the relevant market.
The n
k
are treated as continuous variables, so when allowing free entry and exit
implies that equilibrium n
k
are such that all firms earn zero profits. Using (7) and (8) the zero
profit condition is:



2.2.1 Variety effects and production shifting in the 'large group case'

The formation of an RIA tends to shift production of the liberalized good into the
liberalizing region. This 'production shifting' effect has welfare implications, as well as
having important positive effects on accumulation and industry location. To explore it we
consider a three-country world where the PTA formation consists of lowering X industry
trade barriers only between the member countries, country 1 and 2, with no change in barriers
between these two and country 3. We want to establish first the impact on firms' sales
without entry or exit; second, the pattern of entry and exit necessary to re-establish zero
profits, and third, the welfare effects.
One special case of the core model - which we call the large group case - is particular
useful for illustrating the impact of integration the allocation, accumulation and location of
productive facts and thereby welfare. We use the special case in here and in Sections 3 and 4,
so it is worthwhile to point out its essential properties. The large group case abstracts from
game theoretic interactions by assuming that market shares of individual X firms, s
jk
, are
negligible. Inspection of (9) shows that under this assumption all λ
jk
equal (σ-1)
-1
, so
country-j firms charge producer prices equal to b
j
σ/(1-σ) in all markets. Furthermore, it is
apparent from (8) and (10) that equilibrium firm scale depends only on parameters. We
assume that the ratio of fixed to marginal cost is the same in all countries, and denote
equilibrium firm scale x = (σ-1)f
j
/b
j
; firms that are larger or smaller thanx earn positive or
negative profits respectively. Moreover, producer prices, mark ups and the free-entry
equilibrium firm scale are unaffected by trade policy.
We are now in a position to see how formation of an RIA affects firms' sales, profits,
and hence the location of the industry. Assuming iceberg trade costs, the value of sales of a
firm from country j in market i can be expressed as
( ) ) - (
s
- 1 - 1/ = )
s
(
jk jk
η σ σ λ 9

b
/ f =
x
)
s
(
j
j
jk jk
N
=1 k
λ

10



9
θ
ij
is defined as the ratio of an i firm's sales in j to a j firm's sales in j, and is a convenient way
of summarizing the effects of trade barriers and differences in marginal costs and hence
prices. Trade liberalization between i and j increases θ
ij
; clearly θ
jj
= 1 and infinite trade
costs mean θ
ij
= 0, i ≠ j. .
If the two countries in the union are symmetric, then we can write θ
12
= θ
21
= θ, and
θ
i3
= θ
3i
= θ
*
, i = 1, 2. Total sales of a firm located in 1 or 2 and those of a firm in country 3,
can then be written as:
We illustrate these relationships in figure *, with the further assumption that expenditures are
constant. Axes are n
3
and n
1
=n
2
. The heavy-lined curve labelled x
1
=x is the loci of n
1
=n
2

and n
3
at which country 1 and 2 firms would sellx units. The curve x
3
=x depicts the similar
loci for country 3 firms. To the northeast of each curve, the relevant firms are operating at
scales that imply negative profits. To the southwest firms have positive profits. The curves
need not intersect in the positive quadrant. If not some country will be specialized in the Z
industry. If they do, as we shall assume, then a sufficient condition for them to intersect in
the direction illustrated is that θ
*
∈ (0,1).
Point A is the initial equilibrium. The RIA increases θ, shifting the curves to
positions illustrated by the finer curves. Holding numbers of firms constant, we see that firms
in the union now have expanded production and make positive profits (A is below the new x
1

=x ) while firms in country 3 have contracted and make negative profits (A above the new x
3

=x ). This illustrates the production shifting aspect of RIAs.
The welfare effects of this experiment can be found by refering to the framework
given in equation (2). In our example, producer prices and the terms of trade are unchanged.
The only effects in the first-row of (2) are trade cost effects -mdt (if barriers are non-DRC), or
trade volume effects (if barriers are DRC). If the experiment is around a point of zero profits
(so producer prices equal average cost), then the only second row effect is the scale effect,
coming as changes in firms' production affects average costs, a
j
= b
j
+f
j
/x
j
. This is a source of
gain for countries in the RIA and loss for country 3.
Allowing entry and exit to occur restores all profits to zero and moves the new
equilibrium to A' in figure 1; a number of country 3 firms exit, and firms enter in countries 1
and 2. Once again, there is 'production shifting', into the RIA. These changes generate long
run welfare effects quite different from the short run. At equilibrium price equals average
cost, and firm scale is unchanged by the experiment. The only second row effect is therefore
a variety effect arising as the location of firms changes. This arises as each variety brings
consumer surplus, this being equal to 1/(σ-1) times expenditure on the product. Since
expenditure on each home produced variety exceeds expenditure on an imported variety (if θ
*












p
p
=
x
p
p
,
n
E
=
x
p
j
ij
i
- 1
jj
j
ix
ij
ik i
N
=1 i
jk
X
k
jk
j
ij
τ
θ
θ
θ
σ
11

n
+
n
+
n
E
+
n
+
n
+
n
E
+
n
+
n
+
n
E
=
x
p
3 2
*
1
*
* X
3
3
*
2 1
X
2
3
*
2 1
X
1
1
1
θ θ
θ
θ
θ
θ
θ
θ
12

n
+
n
+
n
E
+
n
+
n
+
n
E
+
n
+
n
+
n
E
=
x
p
3 2
*
1
*
X
3
3
*
2 1
* X
2
3
*
2 1
* X
1
3
3
θ θ θ
θ
θ
θ
θ
θ
13



10
< 1) the production shifting increases consumer surplus in RIA countries and reduces it in
country 3.
This 'large group case' has the merits of simplicity and helped us identifying an
important mechanism - production shifting - that plays a role in understand the allocation,
accumulation and location effects of regional integration. It has also been important in some
empirical work on the effects of NAFTA (Brown et al). However, its simplifying assumption
of constant mark ups rules out scale effects in the long run. Since scale effects have proved to
be important in studies on NAFTA and EC92, we turn next to a less restrictive version of the
core model in which scale effects may occur even in the long run.


2.2.2 The pro-competitive effect: Scale and variety implications

Allowing for oligopolistic interaction between firms in the industry makes price cost
mark-ups endogenous, so that policy may change the profits earned per unit sale; maintaining
zero profits may then necessitate changes in firm scale. For example, a lowering of the
average mark-up requires that there is an increase in long run equilibrium firm scale, and
consequent reduction in average costs of production. Simulation studies reported in Section 6
typically show that these effects are quantitatively significant and in this section we use our
core model to investigate the forces at work.
The mechanism through which RIA will change price cost margins is often referred to
as the pro-competitive effect of integration. Put very informally the argument is that
integration will lead to erosion of firms' dominant positions in their home markets, this
reducing their profitability. Maintenance of zero profits is then possible only with lower
average costs, this being achieved through increased firm scale. Although the argument is
intuitive, some care needs to be taken in developing it. Loss of profits on domestic sales is
associated with higher profits on export sales. In general, firms' average profit margins are
affected in a very complex manner and the analytics have not been worked out in the
literature.
To develop the argument we note that the zero profit condition (equation (**)) can be
rearranged to give an explicit expression for firm scale:
where cov and _ 6 are operators that denote the sample covariance and the unweighted average
over all markets.
xxi

Expression (1) illustrates the two channels by which integration alters equilibrium
firm scale: the average mark up and the covariance of sales and mark ups.
xxii
To see how this
operates, consider first a symmetric experiment in which similar economies all engage in
trade liberalisation. This will reduce the dispersion of market shares, s
jk
, (as firms gain
exports and lose home market sales) and, since λ is strictly convex, a reduction in dispersion
lowers the mean _ 7λ(s
jk
).
xxiii
Furthermore, since market shares are high where sales are high
there is positive covariance, cov[x
jk
, λ(s
jk
)], which will also decline as dispersion falls. Both
these factors mean that equilibrium firm scale must increase.

[ ] ( )
) ( _
) ( , cov - /
=
s
s x b
f
x
jk
jk jk j
j
jk
N
=1 k
λ
λ

14



11
Regional as opposed to global integration will usually amplify these effects. An
increase in the number of firms in the RIA (due to the production shifting effect of the
preceding section) will further reduce the home market shares of firms in RIA countries, this
again reducing the overall dispersion of market shares and of sales, and their covariance.
xxiv

The net effect is these asymmetric cases is difficult to characterise analytically, although
simulation studies suggest that net effects of regional integration, are typically pro-
competitive, tending to raise equilibrium firm scale.
The possibility that a RIA will have pro-competitive effects on price cost mark-ups
means that two additional welfare effects come into play in equation (2). In the second row
we add scale effects, as expansion of firms in RIA countries reduces average production
costs; as we shall see, these turn out to be quantitatively important. In the first row of
equation (2) we have trade volume and trade cost effects as before, and now also terms of
trade effects as price change. If marginal costs are constant then we would expect to see
some increase in producer prices charged on intra-union imports, and decrease in import
prices from the rest of the world, as market shares change. However, if marginal costs
depend on scale, these effects could easily be swamped by scale induced cost and price
changes.


2.2.3 Market segmentation and integration

So far, the experiment we have studied is the removal of tariffs or other trade barriers
between union countries, but European experience suggests that the removal of tariffs is not
sufficient to achieve a 'single market'. There is extensive evidence of wide price differentials
between European countries even for goods that can be traded at low cost. Flam et al (1994),
for instance, demonstrate this for automobile prices. Despite the removal of tariffs, it seems
then that firms have retained an ability to segment markets -- that is to price discriminate
between different countries, and thereby retain dominant positions in their domestic markets.
The EC92 policy measures can be viewed as an attempt to reduce the extent of segmentation,
and move towards a single 'integrated' market in Europe.
One way to explore the distinction between segmented and integrated markets is to
investigate different representations of the game between firms. Comparison of trade and
welfare levels in a variety of games provides a way of assessing the costs and benefits of
more or less 'integrated' outcomes, and in the first part of this section we make such
comparisons, and illustrate how different games support different volumes of trade and levels
of welfare. However, merely comparing the outcomes of different games leaves analysis
incomplete, and in the second part of this section we discuss the more difficult question of
how different degrees of market segmentation or integration could be endogenised within a
more general model.
The essence of segmentation is that firms have discretion to exercise market power in
each segment of the market independently. For example, the equilibrium characterized in
equations (*) and (*) has firms competing in each national market separately. That is, each
firm chooses a value of its strategic variable in each market, Nash equilibria are found market
by market, and the price cost mark up, λ, depends only on the firms share in that market, s
jk
.
Suppose alternatively that national boundaries are of no significance for competition between
firms which instead choose a single value of their strategic variable, union wide. Thus, in the
case of price competition, a single price is chosen, which we assume to be the producer price



12
(the 'mill pricing' assumption of location theory)
xxv
. The implication of this is that the
relevant market share in the mark up relationship, λ, becomes the share of the firm in the
union as a whole, _ 8[s
jk
], for countries k in the union. We shall refer to this as an 'integrated'
outcome, and the difference between this and segmentation is immediate. Firms have lower
prices in markets where they were formerly dominant, and higher prices in markets where
they have small market shares. This is typically a reduction in price in home markets and
increase in export markets, this, paradoxically, reducing trade volumes. The loss of market
power associated with integration reduces firms' profits, and hence increases equilibrium firm
scale. This can be seen from (*). The price cost mark up is given by λ( _ 9[s
jk
]), and no
longer varies across markets, and the covariance between λ and x
jk
goes to zero. If
cov[x
jk
,λ(s
jk
)] is positive and λ(s
jk
) is convex this brings an unambiguous increase in firm
scale and hence fall in average costs and welfare gain. Empirical estimates of these effects
are reported in section 6.
This reasoning suggests that substantial welfare gains might be achieved by the
equilibrium 'switching' from segmented to integrated market behaviour, but the comparison
raises several other issues. The first is, are either of these appropriate equilibrium concepts to
use for modelling multi-market interaction between firms? Segmented market equilibrium
has become the benchmark in the theory of trade under imperfect competition (from the early
work on 'reciprocal dumping' (Brander and Krugman (19??)) onwards), but is far from
compelling. If marginal cost curves are flat, then games played in each market are completely
separate from each other. It seems implausible that two firms compete in a number of
markets yet recognise no interaction between markets, thereby giving outcomes where
changes in one market have no influence on outcomes in another. At the other extreme, the
integrated market hypothesis outlined above has firms choosing a single decision variable at
the union wide level; it seems implausible that firms should not have at least some country
specific instruments.
A more satisfactory approach is to recognise that some variables are set at the national
level (perhaps price, or sales volume) and others set at a world or union wide level (R&D in
Brander and Spencer (), capacity (Ben-Zvi and Helpman (), Venables ()). In the case of a
two-stage game with world capacity choice followed by national price competition,
equilibrium has trade and welfare levels intermediate between the segmented and the
integrated outcomes. To see this, think of the second stage decisions of firms (when capacity
constraints are binding) and suppose that a home firm is considering a reallocation of sales
between markets, achieved by an increase in its home price and reduction in its export price.
If it does this it knows (given rival's prices) that there will be an increase in rival's sales in its
home market, and fall in its export market. This erodes its home market power and gives an
outcome with more (although not completely) uniform price cost margins across markets.
The general point here is that it is possible to characterise international competition in a
variety of different ways, with different degrees of cross market interaction.
Accepting that it is possible to write down games with more or less integrated
outcomes, the second issue is how might policy cause a movement to a 'more integrated'
equilibrium? This remains an area for future research.



3. Accumulation Effects



13

Viner denoted x-fraction of his 'Theory of Customs Union' to the dynamic effects of
RIA. Such effects often seem to be uppermost in the minds of policy makers and in popular
debate, yet they have received relatively little attention in recent academic literature. An RIA
will affect growth if it changes the returns to investment -- in physical, human, or knowledge
capital -- and hence leads to increased accumulation. These changes may be transient -- as
will be the case if increased accumulation reduces return to the accumulated stock; or may be
permanent if, as in new growth theory, diminishing returns to accumulation are not
encountered. In this section we first discuss the transient, or medium run growth implications
of an RIA, and then turn to the permanent, or long run effects.


3.1 Medium-term effects: Investment creation and diversion.

RIA's will usually effect factor prices, including the rate of return in participating and
non-participating nations. For example, suppose that in the 'core model' of section 2 we let
both sectors use capital as well as labour, and have the imperfectly competitive X sector (the
sector directly affected by the RIA) be the more capital intensive. The production shifting
effect identified in the preceding section will now require additional capital in RIA countries.
If capital is perfectly internationally mobile then this will show up as 'investment diversion'.
There will be capital flow into the RIA countries from the rest of the world, this raising GDP,
although not GNP, in the RIA. This may take the form of direct investment flows (see Motta
() for an analysis of multlinationals' decisions). Important in Scandinavian debate...ref..
If at the other extreme, capital is internationally immobile, then adjustment will occur
through domestic accumulation
xxvi
. Capital demand generated by production shifting will
raise the rate of return leading to increased saving and investment and faster growth of GNP
(and GDP). If there are diminishing returns to accumulation then this process will be
transient, as accumulation will drive the rate of return down to its previous level. However,
the additional capital will give permanent changes in the level of output and income, over and
above allocation effects. Baldwin (1989) has referred to these as the output multipliers
effects. The magnitude of these effects depends on the precise form of the production
function. For the simplest case in which technology is Cobb-Douglas (between capital and
labor) and in which allocation effects can be summarised by a efficiency parameter in the
production function, the final output change is 1/(1-ε) times the allocation effect, where ε is
the elasticity of output with respect to capital. We discuss evidence on the magnitude of this
in section 6. (IF very short, why not put it here).
The output multiplier tells us that GNP growth will exceed allocation effects, but this
extra GNP is not, of itself, a source of welfare gain. Extra income and consumption in the
future is purchased with present consumption foregone. Welfare effects arise if the social
return on capital is different from the private; Baldwin (1991) evaluates these effects (???).


3.2 Long run growth effects

The new growth theory investigates circumstances under which accumulation of
capital (physical, human or knowledge) does not run into diminishing returns, so that



14
continuing growth is possible. Under such circumstances a change which increases the return
to accumulation may raise the rate of growth permanently. Endogenous growth in an open
economy has been considered extensively in an absolutely brilliant masterpiece seminal work
by Grossman and Helpman (1991). We merely mention some mechanisms through which
regional integration may feed into the rate of growth.
Continuing growth is possible if spillovers (fn something .. what are these) from
accumulated factors serve to hold constant the rate of return of the factors. Grossman and
Helpman (1991 chapt..), Bertola, Romer & Rivera-Batiz?? consider cases in which the range
of spillovers is influence by boundaries between countries, concluding that, if spillovers are
national, then large economies will grow faster than small (am I correct on any of this??). In
this framework it is clearly the case that if formation of an RIA changes the domain of
spillovers from national to RIA wide, then it will lead to faster growth. Whether RIAs can
achieve this is a moot point (evidence??).
An alternative mechanism is that an RIA may directly affect the efficiency sectors
producing accumulated facator stocks. For example, if the knowledge-creation sector is
imperfectly competitive and integration has a pro-competitive effect, then integration may
have long run growth effects as showed by Baldwin (1993). Similarly in the capital goods
sector (someone must have done this -- Rivera-Batiz and Romer????). Capital market
integration may have similar effects, if it services to decrease the wedge between returns to
borrowers and lenders or improve the efficieny of the capital market in other ways (eg
monitoring ... check Blackburn and Hung??). Application of these ideas to RIAs remain to be
fully developed.



4. Location Effects

There has been long standing concern in that regional integration may be associated
with increased inequality between regions. In Europe there has been worry that there might
be agglomeration of economic activity in 'central' locations at the expense of the periphery.
(ref, also Wonnacott and Wonnacott, US Canada). Geographers have been concerned with
cumulative causation leading to vicious and virtuous circles of development for different
locations. These ideas have received renewed attention from economists, following recent
work by Krugman (eg Krugman (book)).
Analytically there are two separate issues here. The first is, if there are initial
inequalities between countries, will these be amplified or diminished by formation of an RIA?
The second is, even if initial differences are small, might integration cause economic activity
to agglomerate in particular locations, thereby creating inequality?
In a perfectly competitive world the expectation is that regional integration will reduce
intra-RIA income differences. The strongest statement of this is contained in the factor price
equalization theorem. If each country's endowment lies inside its cone of diversification then
integration, by equalizing goods prices, will equalize factor prices. This will not occur if
endowments lie outside cones of diversification, but if integration increases the number of
internationally traded goods or factors then it may increase the size (and possibly dimension)
of the cones of diversification, increasing the 'likelihood' that the each countries' endowment
vector is inside the cone. The strong suggestion then is that integration should lead to



15
equalization of factor returns within the union.
A different story holds in an environment characterised by imperfect competition and
increasing returns to scale. If firms operate under increasing returns to scale then they have to
make discrete location decisions -- they will not locate some productive capacity in every
country or region. It turns out, this environment of increasing returns integration may widen,
not reduce, factor price differences between different countries in an integrating region and
thereby lead to divergence in income levels. In the remainder of this section we investigate
these possibilities.


4.1 Location of firms

The possibility that a RIA may amplify inequalities between regions can be seen by
considering integration between two countries with different market sizes. The idea is that
the country with the large market is a 'central' region, with easy access to a large market; the
other country is 'peripheral', having relatively few local consumers. How does integration
change the location of industry between these two regions, and hence change labor demand
and relative incomes? We can see that there is a potential ambiguity here. On the one hand
firms in the small country benefit more from trade cost reduction than do firms in the large,
because a lot of their output is exported, so gain from a reduction in trade barriers. But on the
other hand there are relatively many firms in the large economy, each of which increases
exports to the small, so firms in the small economy suffer more from import growth.
This can be illustrated using the large group model of section 2.2.1. In order to
highlight intra-union issues we shall set external trade barriers prohibitively high (θ
*
= 0) and
concentrate on the two economies in the RIA. The first question is, what happens to the sales
of firms in each country as trade barriers are reduced? The total sales of a country 1 firm are,
from (12?):
As before, θ
ij
is imports per country i firm to market j, relative to home sales per country j
firm, and increases with integration. Suppose that p
1
= p
2
, so that θ
21
= θ
12
= θ, expenditures
are constant and start from a position of autarky. At autarky n
1
and n
2
must be such that n
i
p
ix

= E, wherex is the equilibrium firm scale, giving zero profits. Using this in (18) gives:
We see from this that the autarky number of firms is an equilibrium not only at autarky, θ =
0, but also at free trade, θ = 1. However, at all intermediate values of θ x
1
is greater or less
than its equilibrium value,x , according as expenditure is in country 1 is greater or less than
expenditure in 2.
This implies that if numbers of firms were held constant, then sales per firm in the
small economy must be a U-shaped function of trade costs, falling then rising during a
process of integration. The U-shape arises because as we have seen, there are two forces at

n
+
n
E
+
n
+
n
E
=
x
p
1 12 2
X
2 12
2 21 1
X
1
1
1
θ
θ
θ
15

)
E
+
E
)(
E
+
E
(
)
E
-
E
(
E
) - (1
+ 1 =
E
+
E
E
+
E
+
E
E
=
x
x
X
1
X
2
X
2
X
1
X
2
X
1
X
2
X
1
X
2
X
2
X
2
X
1
X
1 1
θ θ
θ θ
θ
θ
θ
16



16
work. Firms in the small economy benefit more from trade cost reduction, because a lot of
their output is exported; but they suffer as their are many firms in the large economy, each of
which increases exports to the small.
In the preceding thought experiment profits were non-zero, except at autarky and free
trade. They can be held at zero by letting numbers of firms adjust to keep x
1
=x . As would
be expected in view of the preceding discussion, reducing trade barriers causes movement of
firms from the small economy to the large, this continuing until θ = 1, at which point
location is indeterminate. It follows that the larger economy is net exporter of this industry's
products, (see Krugman AER).
This relocation of industry will be offset if factor supply considerations cause changes
in relative factor prices in the two economies. We can see this most starkly if we suppose that
labor used in the X industry is a specific factor, the supply of which is proportional to market
size. Full employment means that the relative number of firm in each economy will be equal
to relative endowments of labor, and hence relative expenditures at all levels of trade barriers,
n
1
/n
2
= E/E. The wage rate will change in order to ensure that this is an equilibrium, giving
zero profits in each economy. Equilibrium wages are given in figure 2. The horizontal axis in
the figure is the iceberg trade cost, τ, and the vertical gives wages, assumed to be the only
element of costs. The figure is constructed with E > E, and the curves w
1
and w
2
plot the
wage (=cost) levels which hold number of firms proportional to expenditure in each country.
At high trade barriers wages are similar in the two countries. Reducing barriers makes the
large market the more attractive location, as we have seen, so in order to hold firms in each
location there has to be a wage fall in location 1 and increase in location 2. However, as trade
barriers fall so location becomes increasingly sensitive to production cost differences. At low
enough trade barriers smaller wage differences are required to hold industry in the small
economy and, in the limit, factor price equalisation takes over. Curves w
1
and w
2
give wages
in terms of the numeraire. Real wages must be adjusted to allow for changes in price indices
in each country, and are given by curves v
1
and v
2
xxvii
. The small economy gains relatively
more from complete integration -- it gets access to many more varieties without bearing trade
costs; however, real wage reductions occur as trade costs are moved from high to
intermediate levels.
Figure 2 was constructed under extreme assumptions about labour supply to the
industry under study, but nevertheless is indicative of more general conclusions (see Krugman
and Venables ()). Firms in an imperfectly competitive industry will, during a process of
integration, be drawn towards 'central' areas of the region. Having good market access
becomes more not less important as costs of market access go down. If wages change little
(the rest of the economy releases or absorbs labour with little change in the wage) this will
lead to divergence of industrial structure. If changing industrial employment impacts on
wages, then it will lead to divergence of relative wages up to a point, and convergence
thereafter. Which side of the turning point actual economies are on is an empirical matter,
about which little is known.


4.2 Linkages and agglomeration

A second possibility is that an RIA might not just amplify existing income
differences, but may actually create differences by facilitating agglomeration of activity at
particular locations. motivate.



17
Agglomeration will occur if increasing the number of economic agents (eg firms or
workers) at a particular location raises the return to other agents in the location. In a standard
neo-classical model this will not occur; for example, putting more firms in a location will
tend to reduce output price and increase input prices, this reducing the profitability of other
firms. Agglomeration requires that these forces be overturned by positive 'linkages' between
the activities of agents at the same location. These linkages could be technological
externalities with a limited spatial range, or could be 'pecuniary externalities' which, as we
shall see, can operate in an imperfectly competitive industry. It turns out the relative
strengths of these forces depend critically on levels of trade barriers, hence the relevance of
the topic for RIA.
The remainder of this sub-section discusses some of the analytical issues raised by
these questions. Applications are discussed in sections 4.3 and 4.4. To develop the ideas we
ignore technological externalities and focus on the pecuniary externalities going through
firms' input and output markets. A demand or backwards linkage occurs if increasing demand
at a location makes that location more attractive to firms. Cost or forwards linkages occur if
increasing activity in a location reduces costs of other firms at the location, this also making
the location more attractive to firms. The issues can be explored in the two country model of
industrial location set out in the preceding section. There are two economies and the number
of firms in each are determined by the zero profit conditions (equation (20) with x
1
=x , and
the country 2 analogue). Evidently the right hand side of these equations depends on the
location of industry -- n
1
and n
2
-- directly. It also depends on expenditures, E and E and
relative costs, these determining prices and hence θ
12
and θ
21
(equation (14)). A demand (or
backwards) linkage occurs if expenditure depends on n
1
and n
2
. A cost (or forward) linkage
occurs if costs depend on n
1
and n
2
.
These linkages create centripetal forces; when do they dominate centrifugal forces?
To answer this question suppose that the two economies are identical in technology,
preferences and endowments. There will then be a symmetric equilibrium in which industry
is equally dispersed between the two countries, and there may also be other equilibria with
asymmetric industrial location. We want to find regions of parameters within which
symmetry is broken, and the system 'self organizes' into an asymmetric equilibrium with firms
concentrated in one location.
We can find the symmetry breaking point by looking at the stability of the symmetric
equilibrium. If we hypothesise that numbers of firms at each location adjust in response to
profits and losses then the symmetric equilibrium is stable if relocation of a firm from 2 to 1
reduces the total sales and therefore profits of a firm in 1, x
1
, and unstable if it increases x
1
.
In the neighbourhood of the symmetric equilibrium calculus is fairly straightforward. The
experiment is a marginal reallocation of firms from 2 to 1, denoted dn, dn ≡ dn
1
= -dn
2
, with
accompanying changes in endogenous variables dE
X
≡ dE = -dE, dp ≡ dp
1
= -dp
2
, dx ≡ dx
1
= -
dx
2
. Denoting the right hand side of (26) by R and totally differentiating gives:
and hence (evaluating the partials at the symmetric equilibrium and choosing units such that p
= 1 at this equilibrium),

dn
dp
x -
p
R
+
dn
dE
E
R
+
n
R
=
dn
dx
p
X
X













∂ θ
θ
17



18
The left hand side of these equations give the change in output, and hence the sign of the
change in profits. The right hand side of these equations contain three distinct terms. The
first is the direct effect of changes in n; as expected this is negative, a force for stability. The
second is the demand linkage; if dE
X
/dn > 0, then this is a positive effect tending to
destabilize the symmetric equilibrium. The third term is a price effect; if dp/dn < 0 (a linkage
saying that having more firms reduces costs) then the effect is positive, again tending to
destabilize the equilibrium.
Symmetry is broken and agglomeration occurs if the right hand side of (25) is
positive. The role of trade barriers is immediate. The coefficients on the linkage terms in
square brackets in (29) are strictly increasing in θ. Integration raises θ, so may push it
through the point of symmetry breaking, destabilizing an equilibrium with dispersed activity
and hence leading to an asymmetric equilibrium. We turn to examples of this in the next two
sections.


4.3 Labour Mobility


Integration may change both the barriers to, and the incentives for, labour migration.
In a perfectly competitive environment the story is, once again, provided by factor price
equalization. The expectation is that trade liberalization reduces the incentives for labour to
move. And if migration does occur, then it promotes convergence of income levels, raising
wages in the source economy and reducing them in the host.
Combining labour mobility with the location decisions of firms in imperfectly
competitive industries creates the possibility of a very different outcome. In section 4.1 we
saw how goods market integration and firms' location decisions could cause divergence of
wage levels between regions, with regions with a larger market having higher wages. Labour
migration is now, potentially, a destabilizing force. Workers move from the small economy
to the large, and as they move they take their expenditure with them, so increasing the
difference between market sizes. Migration may therefore increase the wage gap between
locations, this encouraging further migration and possibly leading to an outcome in which all
mobile factors concentrate in a few locations (Krugman (1991a)).
To see how this may break symmetry between regions which are initially identical,
consider the following simple model. Economy 1 has L sector Z workers and n
1

manufacturing workers. Each worker spends amount γ on manufacturing, so
If a firm relocates from 2 to 1 then it takes its worker with it. This clearly creates a demand
linkage, and

'

'

'

dn
dp
n 1 +
) - (1
4
-
dn
dE
E
n
- 1
+ 1
+ 1 -
+ 1
- 1
=
dn
dx
x
n
2
X
X
2
θ
θσ
θ
θ
θ
θ
18
)
n
+
L
( =
E 1
Z X
1
γ 19



19
We abstract from cost linkages by assuming that nominal wages change in neither country;
(the worker is happy to move since the price index is lower in the location with more firms).
Using the demand linkage, (25), in the symmetry breaking condition, (29), we see that the
symmetric equilibrium is unstable if
This condition is evidently more likely to be met the larger is the share of mobile workers in
the population (manufacturing workers compared to Z sector) and the lower are trade costs.
The story given here is incomplete. To give a complete description a fully developed
general equilibrium model specifying employment in both sectors, labour mobility between
sectors and migration between countries is needed, and these elements are contained in
Krugman (). Nevertheless, the argument illustrates how, given imperfectly competitive
industry and a demand linkage, labour mobility may not be a force for convergence. Moving
a firm and associated employment and consumer demand to a location makes that location
more profitable, encouraging other firms to move.


4.4 Integration and industrial agglomeration


In the preceding section agglomeration of activity was based on a positive feedback
between industrial location and migration, this generating a demand linkage, but not a cost
linkage. Evidently, this is relevant to regional economic integration only if migration within
the union is likely to occur on a significant scale. However, there are other forces for
agglomeration of activity -- such as externalities between firms, labour market pooling
effects, and access to intermediate inputs. All of these interact with trade liberalization in the
sense that liberalization reduces the tie between firms and their final market, and hence
increases the relative importance of these considerations in location decisions.
As an example of what can happen, consider our core model of location of an
imperfectly competitive industry, with the modification that industry now uses its own output
as an input in production. Firms in the industry therefore have average cost function
a(w
j
,P
j
,x
j
), where P
j
is the price index for products of the industry, which are now used as a
composite input.
xxviii
This modification generates both cost and demand linkages. We have
already seen that the price index depends on the location of firms (equation (8)), and that the
more firms there are in a location the lower is the location's price index. This is the cost
linkage. The demand linkage arises as demand for output now comes both from consumers
and from other firms. Formally, expenditure in location i on the industry is given by:

n
+
L
n
=
dn
dE
E
n
1
Z
1
X
X
20

θ
θ
+ 1
- 1
>
n
+
L
n
1
Z
1
21

P
)
x
,
P
,
w
a(
x n
+ (c)
E
=
E
j
j j j
j j
X
j
X
j


22



20
where E(c) is consumer expenditure, and the second term is the value of intermediate
demand.
Outcomes are illustrated on figures 3a-3c. These figures are similar to figure 1, but
now have numbers of firms in each of the union countries on the vertical axes. Figure 3a
describes the case when trade costs are high. Zero profits in each country are given by the
lines x
1
x
1
and x
2
x
2
, and the equilibrium is at point A, with production divided equally
between the two economies. Arrows indicate a hypothetical out-of-equilibrium adjustment
process in which entry (exit) occurs in each country in response to positive (negative) profits.
As is clear, the equilibrium at A is stable.
Figure 3b gives the picture at low trade costs. The crucial difference is that the
direction of intersection of the zero profit contours is reversed. The equilibrium at A is
unstable, and there are two stable equilibria at points labelled B. Agglomeration occurs --
although there is nothing in the theory to say in which location. Figure 3c gives the case of
intermediate trade costs. The symmetric equilibrium at A is stable, as are asymmetric
equilibria at B; in between the stable equilibria are unstable equilibria at points labelled U.
This example illustrates how trade liberalization may be associated with symmetry
breaking, and consequent agglomeration of activity, even in the absence of labour mobility, or
of any externalities. Its application depends, amongst other things, on the structure of the
input-output matrix. Depending on this structure, linkages could be important at an industry
wide level, or at the level of particular tightly linked groups of industries. In the former case
agglomeration forces effect industry as a whole, and the theory suggests that integration could
be associated with substantial widening of wage differences between countries. Linkages
attract industry to a single location, and employment in other locations can only be
maintained by these locations having substantially lower wages. In the latter case integration
would be associated not with aggregate wage differences, but with concentration of particular
industries in particular locations (Krugman and Venables (1993)). Thus, in the European
context, each country may give up a presence in some industries, and the economic geography
of Europe might become more regionally specialised, as in the US. The gains from
integration are, in this case, relatively large -- integration permits the benefits from
agglomeration to be achieved. However, adjustment costs and political frictions may be high,
as there is substantial relocation of activities between countries in the union.


@filename:\hb5.emp 14 August 2004 (September 7 Draft)
5. Empirics

Theory tells us that RIAs have ambiguous welfare implications, so each must be
evaluated seperately. This section discusses several generic problems (5.1) before turning to
econometric evaluations (5.2) and computable equilibrium evaluations (5.3).


5.1 Sources of errors in empirical evaluations

The literature evaluating RIAs has followed several approaches, and it is useful to
start by setting out a general framework to illustrate the relationships between these
approaches, and the different sources of errors in the approaches.



21
Suppose that the true model of the economy is Y = αP + βX where Y, P and X are
vectors of endogenous, policy and exogenous variables, the world is linear, and α and β are
matrices of coefficients. Superscripts 0 and 1 respectively refer to observations before and
after formation of the RIA, and P
0
= 0 (so policies other than the RIA are contained in X).
The change in endogenous variables due to the RIA is denoted δY. Two approaches have
been followed to learn δY. The 'analytical approach' (using terminology from Winters ()) is
to learn δY from the obvious relationship δY = αP
1
. The 'residual imputation' approach
learns δY from the equation δY = Y
1
- βX
1
; that is it looks at the difference between the
actual outcomes Y
1
, and the 'counterfactual' or 'anti-monde', βX
1
, giving values of
endogenous variables that woul have occured given pre RIA policy and post RIA exogenous
variables.
If the true model is known (and linear??) then the two approaches are evidently
identical. Since it is unknown they give rise to very different methodologies. To follow the
analytical approach the researcher has to know both P
1
the policy change, and α, the set of
parameters (or more generally functional relationships) through which policy affects
endogenous variables. This is the approach followed in computable equilibrium modelling --
discussed in section 5.3 below -- and in some econometric work. To follow the residual
imputation approach needs to know values of exogenous and endogenous variables in the
period after the policy change, and the relationship between them. This approach lends itself
to time series econometrics in which parameters β are estimated over a period including the
policy change, and δY is a coefficient of a dummy variable or variables for the policy.
Both these approaches have strenghts and weaknesses. The analytical method can be
used for ex post as well as ex ante evaluations. Residual imputation does not require
knowledge of the exact policy change (a considerable advantage given the scope and
complexity of many RIAs). Neither will be any better than the researchers' estimates of the
relationships represented here by the parameters α and β. (expand ??)


5.2 Econometric Evaluations

Existing econometric studies have focused on the effects of RIAs on trade flows and
growth (anything on pc margins -- Levinson et al??). We look at these two subjects in turn.

5.2.1 Trade creation and diversion

Most studies of trade creation and diversion have dealt with the European Community
and we limit ourselves to a subset of these. Surveys of this literature already exist (see
Srinivasan, Whalley and Wooton (1993), Mayes (1978), and Winters (1978)) and we
comment on it only briefly.
Both analytical and residual imputation methods have been used. An example of the
analytical approach is XX who estimated price elasticities of imports from various sources,
and then inserted actual tariff changes to give estimates of trade creation and diversion.
Results are given in table?? Residual imputation has been more commonly used, with a wide
range of different exogenous variable used to construct the counterfactual. Some were
extremely simple -- time trends for import growth from partner and non-partner nations,
(Clavaux 1969, EFTA 1972), constant shares in apparent consumption (Truman 1969) and



22
constant income elasticities of demand (Balassa 1974). Others were more sophisticated,
focusing on a nation's bilateral imports and exports and using the gravity model (Aitken
(1973), Aitken and Lowry (1973), Beissen (1991)), and demand systems of increasing
degrees of sophistication (Resnik and Truman (1973), Winters (1984), (1985)).
The general conclusion of these studies was that the EEC increased members' imports
from each other more than it decreased their imports from non-members, i.e., trade creation
exceeded trade diversion. (how uniform: analytical different from ri?? table ??)Some studies,
e.g. Winters (1987.. date?? not one of ones listed above??), even found that the UK's EEC
accession actually increased its imports from non-EEC members. To understand the low
degree of trade diversion, we note that much of Europe's trade was with itself even prior to
the Common Market. Thus EEC nations must already have been each others' lowest-cost
suppliers for many goods.
xxix
In such cases, the scope for trade diversion is limited. In sharp
constrast to the low level of trade diversion in manufactures, Thorbecke (1975) shows trade
diversion in food was quite important mainly due to tariff increases on external trade
necessary to establish the common external tariff.
Most of these studies were not concerned with the welfare implications of their
findings, and it is only under very special circumstances that trade volume effects alone (let
alone their sum) give an accurate measure of the welfare effects of an RIA. Those studies
that did compute the welfare effects of trade volume changes found the effects to be
extremely small. Winters (1987), for instance, found that the UK accession implied a welfare
gain from the trade volume effect of 0.11% of UK GDP.
Assessment ??


5.2.2 Growth regressions

A more recent type of econometric evaluation focuses on the growth effects of RIAs.
The method followed is that of residual imputation, typically estimating a single equation
growth model that includes several macroeconomic aggregates and a proxy for regional
integration. The parameters are estimated with ordinary least squares (OLS) on cross-country
data or time-series data for a single nation. Some studies draw implications from the sign and
significance of the RIA proxy. Others quantify the growth effect by using an approach like
(??). This literature is far from mature and new conclusions may emerge, but the existing
studies tentatively suggest that some RIAs have had a postive impact on growth, at least in
Europe.
Coe and Moghadam (1993) use multi-equation cointegration techniques on French
time-series data to estimate a linear relationship among the levels of GDP, labour, capital,
cumulated R&D spending and intraEU trade as a share of EU GDP. According to their
results, 0.3 percentage points of the French growth rate from 1984-1991 was due to EU
integration. This is similar to the analytic approximation of Baldwin (1989) and the Italianer
regression results, which we turn to next. Using EU time-series data, Italianer (1994)
regresses changes in EC founding members GDP on changes in physical capital and the
labour force, and regional and general openness proxies. These proxies are, respectively,
intraEC trade as a share of total EC trade and the trade/GDP ratio. The coefficients on
Italianer's openness proxies can be thought of as having been estimated in a regression on
Solow residuals. Thus the fact that both proxies turn out significantly positive is very much
in line with the idea that trade, especially regional trade in Europe, fosters knowledge



23
creation.
In contrast, De Melo, Panagariya and Rodrik (1992) find that RIAs have no growth
effects. Using OLS on cross-country data, they estimated a linear growth regression that
includes dummies for dozens (HOW MANY?) of RIAs as well as investment/GDP ratios and
other strandard growth correlates. They find that only one RIA dummy (for the South African
Customs Union) is significant.
Results from this literature are suggestive (!!!), but doubts surround the selection of
independent variables. First, growth is too complex a phenomenon to be captured by a simple
linear model that includes a handful of variables. And second, included variables need to be
exogenous; for example, if integration effects growth via investment, then it is uninformative
to learn that the RIA dummies are insigificant in a growth regression that includes investment
ratios.


5.3 Computable equilibrium evaluations

CE evaluations have two distinct uses. They can be used for policy evaluation and
they can be used as theory-with-numbers, i.e. to build intuition on how important various
effects are in models that are too complicated to study analytically. CE evaluations also have
two serious limitations. There are no standard errors for the results and the models are often
very nontransparent. Neither limitation is particularly severe for the theory-with-numbers
interpretations since it is understood that results are model dependent. Both limitations,
however, should be kept in mind when the results are intended for policy makers.
Nontransparency is by far the most serious of the two. As we shall see in more detail below,
many CE models are enormous and their implementation involves many arbitrary choices that
can affect the results. Since it is impossible to explain all the choices and their implications,
it is hard to know how much credence to place in the final results. One solution is to make
the model availble to other academics for inspection and experimentation, but this is not
always done. The lack of standard errors prevents us from judging the statistical significance
the results. Unfortunately there is no perfect solution to this.
Despite these limitations, the CE approach is the only way of performing an overall
evaluation. Looking at individual effects econometrically is incomplete. Moreover for large
policy changes, general equilibrium considerations and the complicated interplay of effects
should not be ignored. The only way to do this is with a CE model of the whole economy.

5.3.1 Description of three generations of CE models

CE models and their results vary widely. The details of each model matter, but much
of the variance in results can be understood by looking at broad differences. We distinguish
three generations of CE models. A typical third generation model has 10 to 20 sector in each
of 4 to 10 countries or regions. Most of the traded sectors have increasing returns and
imperfect competition (usually monopolistic competition). The nontrade sector is perfectly
competitive producing a homogenous good under constant returns. Costs are usually given
by a nested CES function which display output-invariant marginal and fixed costs. Typically
three factors (skilled labour, unskilled labour and capital) are present and their prices enter
sector-specific cost function via a CES price index. A CES index of goods prices is also
included to reflect the cost of intermediate inputs. Demands are homogeneous and generated



24
from a nested utility function with an top-level Cobb-Douglas function determining
expenditure per sector and bottom-level CES functions dividing demand among differentiated
varieties in a sector. These usually assume a home market bias. National aggregate capital
stocks are endogenous with the steady-state level determined by the equality of rates of
returns with national discount rates.
Second generation models differ from third generation models mainly in their
treatment of capital as exogenous. First generation models typically have only labour and
capital, which are assumed to be fixed exogenously. Each sector produces a homogenous
good under perfection competion and constant returns. These models are often very large,
e.g. the Michigan model (Deardorff and Stern 199?) has 25 sectors and 18 regions. Intra-
sectoral trade cannot arise under such assumptions, yet it is important in the data. An ad hoc
assumption on preferences is made to allow for such trade. This so-called Armingtion
assumption is that goods in each sector are perfect substitutes if they produced in the same
nations, but imperfect substitutes if they are produced in different nations.
To implement these models some parameters (scale economies, expenditure shares,
cost shares, trade barriers, etc.) are taken from econometric studies. Others (discount rates,
transport costs, etc.) are simply set according to the researcher's beliefs. The remaining
parameters (cost and demand function intercepts, etc.) are chosen so to make the model fit
exactly with production, trade and income data for a base year.

5.3.2 Comparing the generations

Constant returns and perfect competition are special cases of imperfect competition
and increasing returns, and an unvarying capital stock is a special case of capital endogeneity.
Thus in an abstract sense, earlier generations are special cases of subsequent generations. In
the same abstract sense, third generation models are preferable to second generation models
and these are preferable to first generation models. To use our sources-of-errors analysis,
there are systematically fewer incorrect parameter errors in the successive generations.
Econometric evidence shows that scale economies and imperfect competition are important,
and that capital stocks are endogenous and influenced by real rates of return. Thus in a very
concrete sense we should give more credences the results of each successive generation. Of
course, this general statement is subject to the sensibility of each model.
It is important to note that allowing for scale economies and endogenous capital does
not a priori imply that welfare results will be magnified. First generation models capture only
the first row effects in (2). The next two generations additionally captured the second and
third row effects respectively. However, since each effect in each row in independently
ambiguous, it could be the case that scale effects or accumulation effects would reverse gains
due to the trade volume effect. As we shall see, this the signs of affects tend to be correlated
in all the published CE evaluations of actual RIAs, but this need not be the case.


5.3.3 Evaluations of NAFTA

Excellent surveys of the results of NAFTA evaluations exist (ITC (1992), Francois
(1993) and Francois and Shields (1994)). These review results on many interesting policy
issues such as employment, wage and trade effects. Here we limit ourselves to the aggregate
income effects of representative sample of studies. These give a flavor of major conclusions



25
and allow us to illustrate the policy-with-numbers interpretation. Table 1 presents the
aggregate results of two individual studies and the medium estimates from the studies
surveyed in ITC (1992).
As far as the policy interpretation is concerned, there are three important points. First,
all economies show positive gains. Second, the small countries (Mexico and Canada) gain
much more as a percent of GDP than the large country (US). The median aggregate welfare
gain is 2.6% for Mexico, xy% for the US and xy% for Canada. RIA evaluations frequently
find that small countries gains more. Intuition for this common finding is simple. Roughly
speaking, liberalizations raise welfare by expanded the opportunity set facing private agents.
When large and small countries integrate, the opportunity set facing small-nation agents
expands proportionally more than that of large-nation agents. Of course, this tendency can be
and often is reversed by other considerations. For instance, Roland-Holst et al (1992) find
that Canada gains more from NAFTA than Mexico, even though its economy is bigger.
The third point is that the gains Canada and Mexico are quite sizeable, amounting
something like one year's worth of growth, yet the economic gains for the US are negligible.
It is also interesting to note that almost all of the NAFTA studies surveyed by the ITC project
that NAFTA would raises the return to capital in all three countries. This suggests that
NAFTA would not lead to investment diversion inside North America. Unfortunately, no
full-fledged third generation studies has been done on NAFTA. Bachrach and Mizharhi
(1992) endogenize capital in an otherwise first generation model and focus only on US-
Mexico trade. Comparing columns 1 and 2, we see that they find capital endogeneity doubles
the projected US gains and multiplies those of Mexico by 15 times.
The accumulation effects in Bachrach-Mizharhi findings maybe too extreme, but they
certainly illustrate the theory-with-numbers point that accumulation effects can be big. Recall
from Section 3 that accumulation-induced output gains cannot be interpreted diretly as
welfare gains. The notion that nonDRC barriers have more important welfare implications
than DRC barriers can be seen by comparing columns 4 and 5. Column 4 shows the impact
of removing only tariffs while column 5 shows the effects of removing tariffs and NTBs
(which are modelled as nonDRC barriers by the authors). Removing NTB and tariffs
produces gains that are at least an order of magnitude large than tariff removal alone. This
result reflects two facts. North American trade, like most of world trade, is now subject to
fairly low tariffs, but high NTBs still exist. Section 2.1 showed that removing NTBs that
create no domestic rents have much large welfare effects than the removal of DRC barriers
such as tariffs.
Finally, Table 1 allows us to compare the effects of allowing for increasing returns
and constant returns to scale. results from one first generation model (column 1) with two
second generation model (columns 3 and 6). Although each study

is less important from a welfare point of view Another theory-with-number point can be seen
in the comparison between

in all studies except in three of the Hinjosa-Robinson (HR) experiments. Since RRS hold
national capital stocks constant, their results are the easiest to interpret. NAFTA stimulates
production of traded goods throughout the region and since these are capital intense, the
derived demand for capital and R rise.
Finally, two of the studies allow us to see that the removal of NTBs (which are
nonDRC barriers in these papers), have much larger welfare effects than the removal tariffs



26
(DRC barriers). RRS find that Mexico's gain from the latter are negligible 0.13%, while
removal of both creates very large gains, viz. 2.27%. HR finds removing NTBs in addition to
tariffs triples the welfare gains due to allocation effects. This result suggests that the trade
cost effect in (2) is quite large compared to the trade volume effect.
IN THEORY SECTION ??? Analytically the reason for this is simple. The trade
volume effect depends upon the change in imports, while the trade rent effect depends upon
the initial level of imports. Evidence in 5.?.?, and the detailed results of studies in Table 6-1
(not shown in table), indicate that the changes in bilateral import volumes is quite small
compared to the initial levels of imports. showed that the trade volume effect is typically
quite small. The loss in trade rents that occurs when DRC barriers are removed almost
entirely offsets this small gains. However for the removal of pure nonDRC barriers, the trade
volume disappears but the trade rents effects remains. This is approximately equal to the
change in the tariff-equivalent of the nonDRC barriers times the entire volume of imports.
NAFTA's impact on US and Mexican income distributions (especially wages of
skilled versus unskilled workers) has been a major focus of NAFTA evaluations. We omit
this debate since the effects emphasised have nothing particular to do with regional
integration. They depend upon liberalization between countries with very different factor
endowments. Interested readers can consult the surveys cited above.

5.3.2 Evaluations of EC92

PARA OR TWO ON DETAILS OF VARIOUS MODELS AND EXPERIMENTS
Table 6-2 presents five computable equilibrium evaluations of EC92. EC92 originally
excluded EFTA. The EEA agreement, signed in 1992, essentially extends EC92 to EFTA.
Two of the studies consider this extension. EC92 is estimated to produce gains to the EC12
ranging from 0.25% to 2.6% of base year expenditure and reduce EFTA real income by
between -0.07% and -0.24%. If EC92 is extended to the EFTA nations, EFTAns gain
between 0.43% and 1.54% and the EC12's gain is boosted marginally. All studies report a
negligible impact on the rest of the world.
The median estimate of the EC12's gain from EC92 is five times larger than the US's
median estimated gain from NAFTA. Part of the explanation is that EC92 involves a much
deeper level of integration than NAFTA (NAFTA-style integration has existed in the EC
since 1968). Another part reflects the fact that EC12 nations are much more open than the
US (the EC12 import-to-GDP ratio is almost three times the US's) and EC92 affects much
more of the EC12's trade than NAFTA does of the US's trade (the EC12 account for two-
thirds of EC12 imports while Mexico and Canada account for one-quarter of US imports).
Notice also that when EFTA nations and EC12 nations participate in EC92, the smaller
region (EFTA) gains substantially more than EC, according to the Haaland and Norman
(1992) and Baldwin, Forslid and Haaland (1994); Henceforth these are referred to as HN and
BFH.
One set of important findings in Gasoirek, Venables and Smith (1992), Mercenier and
Akitoby (1993), and Harrison, Rutherford and Tarr (1994) - abbreviated as GVS, MA and
HRT - is that the gains from EC12 are very uneven among the EC member states. The
distributional effects are largest in HRT; All members gain but the estimates range from
1.49% for the UK to 6.39% for Belgium, in the endogenous-capital/scale-economies version
of their model. Most of this variance is explained by the variance in the importance of intra-
EC trade among members. Interestingly, imposing constant returns and fixed capital stocks



27
seems to exaggerate distributional effects. All versions of the HRT model find that Belgium
and the UK are the highest and lowest gainers respectively. The ratio of gains is 5.28 in their
CRS-exogenous capital version, 4.21 in their IRS-exogenous capital model, and 4.29 in their
IRS-endogenous capital version.
The findings in Table 6-2 systematically show that market integration greatly boosts
the welfare impact of lowering real trade costs. GVS model market integration as a shift in
the pricing strategies of firms from the segmented markets case to the integrated market case.
HRT model market integration as an equalization of price elasticities (the justification is
based on product standardization). They assume that the elasticity of substitution is 15
between domestically produced-varieties, 10 between imported varieties and 5 between the
import composite and the domestic composite. Their market integration experiment assumes
all EC-produced goods are treated as domestically-produced goods by consumers after EC92.
GVS find that moving from segmented market pricing strategies to integrated market
strategies triples the welfare effects (0.399% versus 1.267%) for the EC when free entry is
assumed. In the increasing-returns version of their model, HRT find that equalization of price
elasticities raises the gain by 2.3 times (0.52% versus 1.18%) when capital is exogenous and
1.5 times (1.79% versus 2.6%) when capital is endogenous.
The possibility of investment creation and investment diversion appear in Table 6-2
for the market integration case. HN do not endogenize capital stocks, however they find
changes in the real return to capital the would provide the price signals that would trigger
investment creation in the EC and diversion in EFTA, if EFTA is excluded from EC92. In
the market integration cases, the real return to EC capital (see the R column under the EC in
Table 6-1) rises by 0.57% while the EFTA R falls by -0.04%. This would trigger a rise in the
EC capital stock and a fall in the EFTA capital stock. This conjecture is confirmed in the
BFH model, which is almost identical to the HN model except that all capital stocks are
endogenous. The induced changes in steady-state capital stocks, multiplies EC real income
gains by 1.68 times (0.475% versus 0.8%) and multiplies the EFTA real income losses by
2.67 times (-0.09 versus -0.24).

5.3.3 Why the Estimates Vary So Widely

The finding of studies listed in Table 6-1 and 6-2 studies vary widely. Inspection
of Table 6-1 and 6-2 results reveals that the successive generations of models typically yield
successively higher estimates of the impact of regional integrations. The sources of errors
framework (6-3) helps us understand this. Second generation models 'estimate' - using
strong priors - the elements of Γ that corresponding to the capital stock to be zero. Thus if
policy changes do alter the capital stock, the results of second generation models contain
errors of the mis-estimated coefficients type. To sign the direction of the error, note virtually
all of the studies showed that NAFTA and EC92 would raise R in the integrating region.
Since investment responds positively to R (see evidence in Section 5) the findings of second
generation models are probably biased downwards. Most of these models are so complex that
analytic results are impossible to derive. Numerical simulation are necessary to confirm this
conjecture in each specific models .
The necessary theory-with-numbers experiments on the impact of ruling out capital
endogeneity are performed by HRT and BFH. Considering HRT's trade-cost-reduction
experiment, we see that ruling out capital endogeneity reduces the estimates of EC92's impact
on EC aggregate welfare by 72% (line ?? versus ??). BFH, which is the third generation



28
version of HN, finds that assuming fixed capital stocks reduces the estimates of EC gains by
48% and 40% for the trade-cost reduction and market integration experiments (line ?? versus
?? and line ?? versus ?? respectively). Notice also the fixing capital stocks leads to an
underestimate of the losses that EFTA would have experienced had it not participated in
EC92 (line ?? versus ??).
The fact that the finding of first generation models are typical an order of magnitude
small than those of second generation models also reflects a mis-estimated parameter bias.
As the theory section showed, regional integration may reduce the average mark-up charged
by firms, lowering average cost (assuming free entry) and thereby producing a large welfare
effect. The size of this effect limits to zero as economies of scale parameters used limit to
zero.
xxx

In models that are complicated enough to resemble the real world, such conjectures
cannot be confirmed analytically. RRS and HRT have undertaken the necessary numerical
simulation to confirm this conjecture for their models. RRS find the imposing zero scale
economies instead of using estimates reduces the simulated impact of NAFTA on Mexico by
11.7% (2.27% versus 2.57%). HRT find a very similar number for the EC92's impact on the
EC in their trade-cost-reduction experiment (line ?? versus ??). The number is 57.6% for
their equal-price-elasticities experiment (line ?? versus ??).
The pro-competitive effect of integration can be illustrated with the findings of the
various experiments in the tables. GVS report estimates with and without free for both of
their experiments. Their detailed results (not reported) show that integration expands output
and depresses profits in the imperfectly competitive trade goods sector. These losses are not
enough to offset other gains, so EC compensating variation is positive. When entry is
allowed, the number of firms falls, average firm size rises and a substantial scale effect boosts
the total welfare gain. This is especially true for their market integration case.
In all of the second and third generation models listed in the tables, profit effects
contribute nothing to welfare changes since zero profits are equilibrium conditions in all,
except the no-entry version of GVS. Their detailed results (not reported) show that even in
this case the welfare contribution, negative in both experiments, is small. The reason is that
zero profit are assumed in the base case. Inspection of (2) shows that under such
circumstance, output changes have second-order and lower effects on profits and welfare.
Both Bachrach and Mizrahi (1992) (BM) and RRS perform the hybrid experiments of
allowing capital endogeneity in a perfectly competitive economy. Their findings suggest that
scale economies are not critical to understanding why accumulation effects lead to large
output. BM finds accumulation effects boost the allocation effects by 14.5 times (0.32%
versus 4.64%). RRS find the multiplier between accumulation and allocation effects is 3.39
(0.46% versus 1.56%). Other studies that assume NAFTA boosts the Mexican capital stock
also find a significant output increase, although these experiments comes quite close to
assuming their results.

Baldwin (1989) was the first to calculate accumulation multipliers of for regional integration.
The accumulation multipliers (i.e., ratio of total gains to 'static' gains) produced by HRT,
BFH, and BM make the central estimate multiplier suggested by Baldwin (viz. 1.67) look
modest. The highest multiplier is 14.5 from BM; The lowest is 1.68 from BFH and the
median is 2.2. The likely explanation for this fact is that Baldwin worked with average
capital-output elasticities and average allocation (i.e. static) gains, while the allocation effects
of both NAFTA and EC92 were concentrated in traded-goods sectors. These sectors are more



29
capital intense than average, implying greater induced capital formation than estimates based
on averages figures.
Studies that assume NAFTA alters Mexican capital market conditions find very large
effects (see Young and Romero 1992 and McCleery 1992). Although these studies provide
no microfoundations for their assumptions, their results suggest that the impact of regional
integration schemes on national and regional capital markets may be an important source of
welfare effects that has hereto been ignored. This is particular relevant to European
integration since complete capital market liberalization was an important element of EC92.
Also the promised move to a single currency will undoubtedly affect the EC capital market
and risk premiums.

References

Baldwin R. (1992) "Measurable Dynamic Gains from Trade", Journal of Political Economy,
vol 100, no. 1, pp162-174.

Baldwin, R. (1992) "On the Growth Effects of Import Competiton," NBER Working Paper
No. 4045.

Ben-Zvi,? and E. Helpman,

Brander, J. and P.R. Krugman, .. Journal of International Economics

Brander, J. and B. Spencer,.. Review of Economic Studies

Brown, D. (1992), "The impact of a NAFTA: applied general equilibrium models," Brookings
Papers on Economic Activity.

Dixit, A.K and J.E. Stiglitz, (1977) 'Monopolistic competition and optimum
product diversity' American Economic Review.

Dixit, A.K. and V. Norman,

Ethier, W., and H. Horn (1984), 'A new look at economic integration', in Monopolistic
Competition and International Trade, ed H. Kierszkowski, Oxford.

Haaland, J. and I. Wooton,

Flam, H. (1992) "Product markets and 1992: full integration, large gains?" Journal of
Economic Perspectives, 6, 4, pp7-30.

Gasiorek, Smith, A., and Venables, T., (1992) "Competing the internal market in the EC:
factor demands and comparative advantage," in European Integration: trade and industry,
Cambridge University Press.

Grossman, G. and Helpman, E. (1991), Innovation and Growth in the World Economy, MIT



30
Press, Cambridge USA.

Haaland, J. and Norman V. (1992) "Global Production Effects of European Integration", in
European Integration: trade and industry, Cambridge University Press.

Kowalczyk, C. (1992) "Integration in Goods and Factors: The Role of Flows and Revenue,"
Dartmouth mimeo.

Kowalczyk, C., R.Wonnacott (1992) "Hubs and Spokes, and Free Trade in the Americas,"
Darmouth Working Paper No. 92-14.

Kemp, M. and H.Y. Wan (1976), 'An elementary proposition concerning the formation of
customs unions', Journal of International Economics, 6, 95-8.

Krugman, P.R., (1980) 'Scale economies, product differentiation and the pattern of trade'
American Economic Review.

(1991a) 'Increasing returns and economic geography' Journal of Political Economy.

(1991b) Geography and Trade, MIT.

Krugman, P.R. and A. J. Venables, (1990), 'Integration and the competitiveness of peripheral
industry' in Unity with Diversity in the European Community, ed C. Bliss and J. de Macedo,
CEPR/CUP, 1990.

Krugman, P.R. and A. J. Venables, (1993), 'Integration, specialization and adjustment', NBER
discussion paper no 4559.

Lipsey, R. (1960) "The Theory of Customs Unions: A General Survey", The Economic
Journal, 70, pp 496-513.

Lloyd, P.J. (1982), '3x3 Theory of Customs Unions', Journal of International Economics 12,
41-63.
McMillan, J. and E. McCann, (1981), 'Welfare effects in customs unions' Economic Journal,
91, 697-703.

Mankiw, G., Romer, D. and Weil, P, "A contribution to the empirics of economic growth,"
Quarterly Journal of Economics.

Maddison, A. (1987), "Growth and slowdown in advanced capitalist economies: techniques
of quantitative assessment," Journal of Economic Literature.

Meade, J.E., (1955), The Theory of Customs Unions, North-Holland, Amsterdam

Nerb, G. (1988) "The Completion of the Internal Market: A survey of Europe's industry
perception of the likely effects". Research on the Costs of Non-Europe, Basic Findings
Vol.3, Commission of the European Community.



31

Norman, V.D. and A.J. Venables, (1994),

Ohyama, M. (1972), 'Trade and welfare in general equilibrium', Keio Economic Studies, 9,
37-73.

Pelkman, J, Wallace, H and Winters, A. (1988), The European Domestic Market, Chatham
House, London.

Romer, P. (1983) "Dynamic competitive equilibria with externalities, increasing returns and
unbounded growth," PhD Thesis, University of Chicago.
Romer, P. (1986) "Increasing returns and long run growth," Journal of Political Economy.

Romer, P. (1987) "Crazy Explanations for the Productivity Slowdown," NBER
Macroeconomic Annual.

Romer, P. (1990) "Endogenous Technological Change" Journal of Political Economy, 98.

Sapir, A. (1992), "Regional integration in Europe," Economic Journal, Policy Forum.

Smith, MAM, Venables, A.J. and Gasiorek, M, (1992) "1992: Trade and Welfare - A general
equilibrium model", in Winters, L A (ed.)(1992).

Solow, R. (1956) "A contribution to the theory of economic growth," Quarterly Journal of
Economics.

Venables, A.J. and Smith M.A.M. (1988) "Completing the Internal Market in the European
Community: Some Industry Simulations," European Economic Reveiw, 32, pp 1501-1525.

Venables, A.J.

Viner, J., (1950), The Customs Union Issue, New York.

Winters, L.A. (1992) Trade flows and trade policies after '1992', Cambridge University Press,
Cambridge.

Wooton, I., (1986), 'Preferential trading agreements; an investigation', Journal of
International Economics 21, 81-97.



32
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40

Appendix A:
1) Equation 2:
Differentiating the indirect utility function gives:
Defining output per firm, x, X=Nx, and assuming that costs are separable between industries
and homogenous of degree 1 in NX means that B(X,N,w,θ) = N.b(x,w,θ) where b is the
vector of firm level total cost functions in each industry; b' is marginal cost. Differentiating
(1) with this gives:
Normalizing V
Y
= 1, using Roy's identity, Sheppards lemma, assuming full employment and
defining m = c - x enables this to be rewritten as (2) of the text.


Appendix B:
Denoting perceived elasticity of demand ε, the equality of marginal revenue to marginal cost
takes the usual form,
hence λ = 1/(ε-1).
To find the perceived elasticity of demand suppose that there is an equiproportionate
change in consumer prices of a subset I of products. Defines
j
as the share in market j of
products whose prices have changed. Differentiating demand system () and () gives:
If a single product changes price then, ε = σ~-~s
j
(σ-η) this giving the mark up for price
competition. For quantity competition use the primal not the dual.

@
i. Another frequently used term is preferential trading arrangement, sometimes used

.dY
V
+
dN
.
V
+ dt] + .[dp
V
- = dV
Y
*
N p
23

dI. - w.dk + ) w, N, (X,
B
-

)]dx w, (x, b - t + N[p + )]dN w, b(x, - t)x + [(p +

.m.dt + .m.dt + .t.m d + dt] + X[dp + ].dw
B
- [k = dY
w
θ
θ θ
α α α
θ
′ 24

b
= ) 1/ - (1 p
j
i
jk
ε 25

I. i 0, > ) - (
s
=
c
p
.
) p (
c

I i 0, < ) - (
s
+ - =
c
p
.
) p (
c
j
i
kj
kj
i
kj
kj
i
kj
i
kj
j
i
kj
kj
i
kj
kj
i
kj
i
kj






η σ
τ
τ
η σ σ
τ
τ
~
~
26




synonymously with RIA, and some times to denote a region with reduced, but not necessarily
zero, tariffs.
ii. More than 80 preferential trade agreements have been notified to the GATT as required by
Article 24. Some of these are components of European and North American RIAs. De Torre
and Kelly (1993) lists 17 nonNAFTA RIAs in the Western Hemisphere, eight in Africa and
eight in Asia-Pacific and the Middle East.
iii. De Torre and Kelly (1992) and Schott (1989) study the reasons for this.
iv. See De Melo and Panagariya (1993), Anderson and Blackhurst (1993) and De Torre and
Kelly (1993) for details on other RIAs.
v. See Hufbauer and Schott (1992) on North American integration.
vi. See Baldwin (1994) and Molle (1990) for a brief history of European integration and details
of the various arrangements and institutions.
vii. The EC changed its name from EEC to EC to EU. We stick with EC in this chapter.
viii. See Roessler (1993) and Finger (1993) for further details and analysis.
ix. This sort of framework was first used by Meade. For an early, and less general, application
to trade liberalization see Rodrik (1988).
x. Of course, one special case of this is when goods produced in different nations are perfect
substitutes.
xi. For example, t
i
may represent real trade costs or a foreign VER in which foreigners capture
the quota rents
xii. It also spawned the original Lipsey and Lancaster (1956) piece on second-best reasoning.
xiii.See Kowalczyk (1992) for summaries of this 'what Viner really meant' literature.
xiv. See OBrien (1976) for a review of pre-Vinerian literature.
xv. See Kowalczyk (1992) for the many other definitions of trade creation and diversion.
xvi. This ignores export barriers.
xvii. Ethier and Horn (1984) is an exception, however it deals with a limited number of cases.
Haaland and Wooton (1992) present some analytic results and some numerical simulation
results. See Baldwin and Venables (1994) for a complete survey, including the early work by
Cordon (1972).
xviii. One sector can be assumed to be untaxed, without loss of generality. Assuming that it is

41




42
the Z sector focuses all the effects of integration on the imperfectly competitive sector.
xix. See Helpman and Krugman (1985) for a more complete treatment of CES demand
functions and trade models using them.
xx. For instance, η and E
j
X
are both constant with Cobb-Douglas preferences between Z and
CES composite of X goods.
xxi. If the λ are independent of market shares, as in the large group case, the cov term is zero
and firm scale is independent of market shares.
xxii. Recall that the mark ups here are on physical units sold not on the value of sales.
xxiii. This is clearly true for a mean preserving reduction in the spead. It will also be true for
other reductions although the analysis is more complicated.
xxiv. Asymmetries in country size mean that initial cov[x
jk
, λ(s
jk
)] need not be positive; if a
firm has small shares where it sells the most (as mmight be the case for a small country located
near a large country) covariance may be negative, and integration will raise the covariance
towards zero. This creates the perverse effect found in a study of Norway by Orvedal (1992).
xxv. The quantity competition analogue is choice of a single level of output, with this
distributed across markets such that producer prices are the same in all markets.
xxvi. Feldstein and Horioki (198?), Bayoumi and Rose, and Balasubramanian (????) argue that
international capital flows are not large enough to have macro-economic effects.
xxvii. Constructed with the assumption that the X industry accounts for 1/3 of national income.
xxviii. This assumes that the price index for intermediates can be constructed in exactly the
same way as the price index for consumption.
xxix. According to the data in Anderson and Norheim (1993).
xxx. Firm size is indeterminant in first generation models, so formally we must treat perfect
competition and constant returns as the limiting case.

1. Introduction
1.1 Definitions
Geographically discriminatory trade policy is the defining characteristic of a regional integration agreement (RIA). Traditionally three types of RIAs are distinguished. A free trade area (FTA) is an RIA formed by removing tariffs on trade among nations that are FTA members without changing tariffs on imports from non-members. A customs union (CU) is an FTA where members' tariff structures on the extra-CU trade are equalized. A common market (CM) permits free movement of factors as well as goods and services between states.i At present some 35 RIA's exist with a range and variety far richer than the traditional distinctions.ii Some have very limited product coverage (eg??), and others function poorly or have not been fully implemented.iii There is increasing awareness of the fact that non-tariff barriers (NTBs) mean that duty free trade is not the same as free trade. Restrictions on merchandise trade stem from contingent protection, government support of industries (especially nationalized industries), health, safety and environmental standards, and discriminatory government procurement. Trade in services is hindered by discriminatory regulations (particularly the right to establish an enterprise and professional accreditation) and government monopolies in the communications and energy sectors. Barriers to trade in productive factors - labour, capital and technology - may be harmful in their own right, but they also may distort merchandise and services trade. To deal with this range of barriers, modern RIAs often involve thousands of pages of text and are accompanied by administrative, political and judicial institutions. Space limitations allow us to briefly describe only the two largest RIAs viz. those in North America and Europe.iv Europe and North America account for two-thirds of world trade; 60% of this trade is directly governed by RIAs, and RIAs' discriminatory tariff structures indirectly affect the rest. Post war integration in North America began with a 1965 US-Canada agreement that provided free trade in the automobile sector.v In 1988 the Canada-US FTA (CUSFTA) extended this to trade in most industrial goods and added some investment guarantees. It did not forbid contingent protection measures but it did establish a separate adjudication procedure for bilateral dumping and subsidies cases. In 1993 CUSFTA became the North American FTA (NAFTA), incorporating Mexico. This provides for free trade in most industrial goods with long phase out periods for certain 'sensitive' sectors. It also includes guarantees for direct investment and intellectual property rights. NAFTA does not rule out contingent protection and the special CUSFTA procedure were not extended to US-Mexico trade cases. European integration started much earlier and has gone much deeper than North American integration.vi The European Community (EC) completed its CU in 1968. By that date, contingent protection measures on intra-EC trade were forbidden and free labour mobility was instituted.vii In addition to covering industrial products, this so-called Common Market removed duties and quotas on intra-EC food trade, replacing them with a complex system of subsidies, price supports and external trade barriers known as the Common Agricultural Policy (CAP). A separate group of West European nations formed the European Free Trade Area (EFTA), which is an FTA for industrial goods that was completed in 1968.

1

The EEC and all EFTAns signed bilateral FTAs in 1974, implicitly forming an a duty-free zone for industrial goods covering most of West Europe. The membership of the EC was enlarged in 1972 and ???. The EC's 1986 Single European Act promised to establish the 'Single Market' by removing all intra-EC barriers to the moment of goods, services, people and capital by 1992. We refer to this as programme as EC92 and note that it is still not fully implemented. Importantly, EC92 promised mutual recognition of product, health and safety regulations and standard, unrestricted rights of establishment of EC firms, financial institutions and other service providers. The Single European Act also centralized economic decision making on matters concerning the Single Market and doubled EC funds available for intra-regional transfers. The 1992 European Economic Area (EEA) agreement extended EC92 to the EFTAns with the exception of food trade. EEA members account for about half of world trade and a third of world GDP. The EC has recently, or soon will, sign agreements with 10 Central and Eastern European countries (CEECs). These 'Europe Agreements' are FTA in industrial goods (with longer phase out of barriers for certain 'sensitive' sectors). They include evolutionary clauses leading to deeper integration including eventual EC membership. RIAs are inconsistent with the GATT's MFN principle. However, the GATT Article 24 specifically allows RIAs unless they violate certain conditions. FTAs are allowed unless they are shown to not promise to completely eliminate barriers on 'substantially all the trade' among members. For a CU there is the additional requirement that external tariffs "shall not on the whole be higher or more restrictive" than prior to the CU. Judgement on whether a particular RIA violates these conditions requires a unanimous conclusion of a GATT 'working party'. None of the 50 or so such parties formed over the last three decades have reached unanimity, so no RIA has been ruled inconsistent with the GATT.viii

1.2 Outline
The formation of most RIAs appears to be driven primarily by concerns unrelated to simple economic factors. Nevertheless, RIAs have important economic implications for participating and non-participating nations. We categorize the economic effects of PTAs into three types: allocation, accumulation and location. The first includes a RIA's impact on the static allocation of resources. The second encompasses a RIA's impact on the accumulation of productive factors. We define factors broadly enough to included knowledge capital (i.e. the level of technological progress), so our accumulation effects have growth effects. The third covers an RIA's impact on the spatial allocation of resources and draws on the recent 'economic geography' literature. These effects are the principal topics of Sections 2 through 6. To organize presentation, Section 2 introduces a core model. This permits us to illustrate the various welfare effects in a coherent manner and with a consistent notation throughout the chapter. Section 2 also deals with allocation effects in models which do and do not allow for scale economies and imperfect competition. Section 3 covers medium-term and long-term accumulation effects that are particular to preferential, as opposed to unilateral or multilateral, liberalizations. Section 4 deals with location effects. Empirical evidence and discussion of evaluations two real-world RIA (NAFTA and

2

EC92) are the subjects of Section 5. Section 6 deals with further issues. These include types of regionalism (Section 6.1), regionalism and the world trading system (Section 6.2) and the political economy of RIAs (Section 6.3).

1.3 A framework for welfare analysis
To introduce notation and organize our discussion of theoretical and empirical results, we present a simple framework.ix Welfare of the representative consumer in country j at a moment in time is given by an indirect utility function Vj(p+t,n*,E), where p is the vector of border prices (the border of the country in which the good is produced), t reflects trade costs and the specific-tariff equivalent of import barriers, n* is a vector of number of varieties available domestically and the scalar E is total consumption expenditure. Without loss of generality, each good from every country enters V separately.x E is the sum of factor income, profits and rent from trade barriers that accrues domestic agents (including the government) minus investment expenditure. Namely: E = wL + rK + αtm + X[(p + t) - a(w, r, β , x)] - (K + δK) 1

Total factor income is wL+rK, where L and K are country j's supply of labour and capital, and w and r are factor prices. Domestically-accruing trade rents equal αtm, where m is the net import vector (positive elements indicates imports) and α is a diagonal matrix that measures the proportion the wedge t that creates income for domestic agents (including the government). αi = 1 for a tariff or other domestic rent creating barrier (DRC); αi = 0 for a barrier where no trade rent is captured domestically (non-DRC).xi The third term is total profit. It is the inner product of the economy's production vector X and the gap between consumer prices and average cost. Firms are assumed to be symmetric by sector, so elements of the vector a(w,r,β,x) give the sectoral average cost functions. Average cost in a typical sector j depends on factor prices, the scale of firm-level production xj and a sector-specific efficiency parameter βj (more on this below). The final term in (1) is gross investment equal to the change in K and depreciation δK. Totally differentiating Vj(p+t,n*,E) and dividing through by the marginal utility of expenditure yields (see appendix A):

dV/ V E = α tdm - m d[(I - α )t] - m dp + [p + t - a]dX - X a x dx + ( V n / V E ) dn* - X a β dβ + (r - δ )dK - dK
We refer back to the terms in this expression throughout the chapter. The three terms in the first row represent welfare effects that appear in models with perfect competition. We refer to these as the 'trade volume', 'trade cost' and 'terms of trade' effects respectively. The three terms in the second row are relevant only in models that allow for increasing returns to scale and imperfect competition. We call them the 'output', 'scale' and 'variety' effects respectively. The last two terms in the third row depend upon the accumulation of factors. A change in 2

3

2 deal with the allocation effects of PTAs under assumptions of constant returns and perfect competition and increasing returns and imperfect competition respectively.1) went further by ignoring export barriers and assuming all elements of t were equal.xii Most of these assumed perfect competition and constant returns. This yields an even simpler rule. the 4 . Meade (1955 p. Krauss (1972) and Kowalczyk (1992)).xiv 2. these terms form a weighted average (the diagonal elements of α are the weights) of the trade volume change times t and the change in t times the initial trade volume.investment is instantaneously costly. human or knowledge). tdm. The two polar cases are when α equals the identity matrix and the zero matrix.that the welfare impact of customs union formation is ambiguous . This abstracts from changes in α. Capital stock changes only have first-order welfare effects if there is a wedge between the private and social return capital. His most famous result . from (2) remains. Lipsey (1960). if there are spillovers due to the creation of new capital (physical. We devote relatively little space to this literature since econometric and simulation studies (see Sections 5 and 6) have shown these effects to be small and good surveys already exist (see Pomfret (1986). Many merely contribute to the a debate about what Viner real meant. 2. 2. For each good i. β would be a function of the stock of capital. Thus. A nation gains if and only if the PTA formation raises its aggregate import volume. Allocation Effects The first two row of (2) list ways in which regional integration can affect welfare via changes in the allocation of resources. In this case. so only the first two terms in (2) are relevant. then β would be a function of X. Sections 2. The early CU literature assumed that α was the identity matrix since it was concerned only with discriminatory tariff reductions. The first term in the third row reflects this possibility. If ther are economies of scale that are external to the firm. and so dealt only with welfare effects listed in the first row of (2). but augments the capital stock with net return r-δ.triggered a flood of paper. His lucid.35) pointed out that the tariff weighted change in a nation's trade volume is a sufficient statistic for the total welfare effect. only the trade volume effect.xiii The most useful of these illuminated interesting special cases where total welfare effect can be signed despite the fundamental second-best nature of PTAs.1 National Welfare for a Small Country Border prices are fixed in a small country. as is assumed in much new growth theory. The empirical literature (see Section 5.1.1 Perfect Competition and Constant Returns Modern regional integration theory began life with Viner (1950) under the name of customs union theory. reasoning is full of insights and anticipates many of the post-war theoretical and policy debates. but informally. Traditionally.1 and 2.

1) show that the welfare effects of removing NTB regionally are much larger than those of removing tariffs regionally. trade creation/diversion terminology generated a substantial literature. There are two fairly general results. only the term '-mdt' is relevant. Fortunately it is trivial to deal with.i to be around 2 (Leamer and Stern (1970)). the FTA partners initially account for large shares of each others imports. Notice that the amount of trade creation and trade diversion are entirely irrelevant in this case. so it must be addressed directly. Since most NTBs are nonDRC barriers.1. trade diversion does not occur in this good. Moreover. NTB liberalization is also an important part of NAFTA and many other PTAs.2. Of course.2 Large Country and Regional Welfare Results The analysis for the large-country and multi-country cases rapidly increases the complexity of the problem. This motivation assumes that relative cost is an important determinant of import shares. if the bilateral tariffs are reduced on only on imports from countries that already were the lowest-cost supplier.i [ t i /( pi + t i )] 1 and [( t i mi )( . so all recent RIAs involve only NTB removals. tariff changes.xv The confusing but enduring. then a CU must increase the sum of the economic welfare of member nations. Formation of the CU will have no impact on external trade. so unless τi is very large.is particularly relevant in the modern world. When tariffs on intra-PTA imports. we compare approximations of the gains from liberalization in the two polar cases of α. Since m is a function of p+t. Evaluations of NAFTA (Section 6. if the quantitative restrictions (QRs) remain binding.aggregate import volume change is decomposed into trade creation (the sum of extra imports from PTA and nonPTA nations) and trade diversion (reduced imports from nonFTA nations). To motive the relative magnitudes of these effects.dt i / t i )] ε m. Another special case in which welfare effects can be easily signed is presented by Ethier and Horn (1984). Removing internal QRs. the change in tariff revenues on external trade is a sufficient statistic for welfare gains. tdm and -mdt can be re-written as the sum over all goods i of [( t i mi )( . a nation gains from any PTA that lowers its average (trade-weighted) t's. Econometric studies typically estimates εm. this case was largely ignored in the early CU literature. Meade (1955 p. the welfare impact of reducing DRC barriers will be much smaller than that of reducing nonDRC barriers. Trade diversion occurs when discriminatory tariff liberalization leads a private agent to import from a supplier that is not the lowest cost supplier. Ohyama (19??). The ratio of the former to the later is εm.i is the import demand elasticity. When α is the zero matrix. yielding another simple rule. however. but not MFN. This tends to reduce home welfare since it raises the nation's cost of consuming such goods. Most DRC barriers restricting intra-West European trade were eliminated by 1975. When α is the zero matrix.98) showed that if all barrier are "fixed and unchanging" quantitative restrictions. and Kemp and Wan 5 .iτi/(1+τi) where τi is the ad valorem equivalent of ti. The first is the MeadeOhyama-Kemp-Wan Theorem.dt i / t i )] 2 respectively. Clearly trade diversion can arises from discriminatory. or rest-of-world welfare. This observation motivates the claim by Lipsey (1975) that FTA are likely to be beneficial if.xvi Here εm. allows a more efficient allocation of CU resources and transfers among CU partners can ensure a pareto improvement. are in the neighbourhood of zero initially. the other polar case where α is the zero matrix . 2. but not extra-PTA imports.

~ 32 ) dm32 ] t t 4 The PTA's welfare is maximized when this expression equals zero.there may well be complementarities between them. A related point is that most 6 . misses out a consideration pursued in one branch of the literature. When the home country imports a single good. if extra-PTA trade is optimally taxed in all members.~ 31 ) dm31 + ( t 32 . the sum of the first-row terms in (2) t can be written as: α [( t . Suppose initially the home country (country 1) exports good A and imports good B from both country 2 and country 3. Additionally. altered firm scale and price-cost margins. Focusing on two-good models. for which scale economies are especially important. Moreover. however. Basically their assumption of initially zero intra-regional tariffs allows one to treat CU members as a single nation. scale economies and imperfect competition Much of recent literature on RIAs has focused on environments that are imperfectly competitive. Supposing that α is the identity matrix. Moreover.~ )dm ] + (I .2) suggest that the assumption of constant returns and perfect competition is false. A sufficient condition for the optimality of internal free trade (t21=t12=0) is that external trade is optimally taxed. A more general analysis by McMillan and McCann (1981) shows that complementarity between imports from the partner country and from the rest of the world is sufficient to ensure gains from integration for a small country with no export barriers. 2. many existing and proposed RIAs are explicitly limited to trade in industrial products. then any internal liberalization that increases tariff-weighted trade volume is beneficial to the members. Econometric studies (see Section 5.2 Market structure. More generally. Country 1's terms of trade effect depends on its import volume change. Consider a PTA consisting of a marginal reduction of tjk defined as the specific tariff applicable to goods exported from j to k. at least in Europe. Terms of trade considerations render the analysis much more complicated. A framework with three large countries trading two goods is sufficient to motivate the basic findings. t We first consider when internal free trade is optimal. the welfare change of countries 1 and 2 added together is: dV 1 / V E1 + dV 2 / V E 2 = t 21 dm21 + t 12 dm12 + [( t 31 . so that standard gains from trade arguments can be used to demonstrate the result.α ) [m dt] t 3 where ~ 4is the vector of optimal tariffs and we assume α to be invariant. A literature using three-good three-country frameworks have explored this in depth (see Lloyd (1982) survey). (???) and that RIAs have. home welfare depends only on tdm and all elements in this sum are positive. this need not be so -.(1976) rediscovered and extended Meade's result by showing that a sufficiently intricate change in the CU's external tariffs could also freeze external trade. internal and external trade are necessarily substitutes.3. Using the standard inverse-elasticity formula for optimal tariffs ~ i1 dmi1 = mi1 dpi1 3 for i=2. In this case. The Ethier-Horn result is also valid when considering the sum of FTA partners welfare. simulation studies of NAFTA and EC92 suggest that the 'second-row' effects of (2) are quantitatively the most important.

Z sector firms are perfectly competitive. The representative consumer in country j has indirect utility function Vj(Pj. Free trade in Z makes wages invariant to X-sector trade policy changes..denoted as 1-η . The X sector in has imperfectly competitive firms producing differentiated goods with increasing returns to scale technology. although it has been widely applied in numerical simulations. E j ) Pσj -1 pikj τ kj j i ∂Pj ∂( p kj τ kj ) ( ) -σ 6 where E is country j total expenditure on X industry goods which is a function of the price index and total expenditure. Variants and extensions of this are employed throughout the rest of the chapter. The core model of trade and imperfect competition has N economies each with an X and Z sector. and that the τkj's represent 'iceberg' trade costs. and units are chosen such that all wages are unity. labor.RIAs cover two-way trade in similar products. k=1 N 7 where we assume technology has fixed cost fj and constant marginal cost bj. E j ) ∂ P j = E X ( P j .xvii In order to develop land build intuition for these results. and τkj reflect the ad valorem trade costs of selling products from k in j.xx That is.xviii Country j is endowed with Lj units of the only productive factor. To further simplify the discussion. face constant returns to scale and produces a homogeneous product that we assume to be costlessly tradeable and use as numeraire. k =1 N x j ≡ ∑ x jk . so output exceeds consumption according to: xkj = τ kj c kj 5. we start this section by developing an 'algebraic core'. we often assume that the price elasticity of EXj . If firms play a segmented market game then standard first order conditions (see Helpman and Krugman 1985) are: p jk = (1 + λ ( s jk )) b j 8 7 . a proportion τkj-1 of the goods 'melt' in transit.x j b j . That is: P 1-σ j N  nk = ∑ ∑ pikj τ kj k=1  i=1 ( ) 1-σ    σ >1 5 where nk (k=1.1. Trade model that are consist with this involve scale economies. As in Section 1.. The theoretical literature on trade and imperfection competition does not contain a systematic. The profit of a typical country j firm in the Z sector is: π j = ∑ p jk x jk . Ej is consumption expenditure as in (1).xix Namely: c kj = i ∂ V j ( P j . so superscripts are dropped. This wedge between consumer and producer prices is due to trade barriers or transport costs.f j ..is constant. pj is the producer price of the ith variety produced in k and sold in j. and Pj is the standard CES consumer price index of varieties supplied to market j. firms are assumed to be symmetric by country and by sector.Ej) where 1 is the price of Z sector output. formal treatment of discriminatory trade liberalization.N) is the number of varieties produced in country k.1. Consumption demand cj is found by Roy's identity.

accumulation and location of productive facts and thereby welfare. One special case of the core model . the value of sales of a firm from country j in market i can be expressed as 8 .1 Variety effects and production shifting in the 'large group case' The formation of an RIA tends to shift production of the liberalized good into the liberalizing region. Assuming iceberg trade costs. We assume that the ratio of fixed to marginal cost is the same in all countries.which we call the large group case . producer prices. For Nash equilibrium in prices we have: λ( s jk ) = 1/ (σ . This 'production shifting' effect has welfare implications. The nk are treated as continuous variables. with no change in barriers between these two and country 3. the pattern of entry and exit necessary to re-establish zero profits. second. so when allowing free entry and exit implies that equilibrium nk are such that all firms earn zero profits. Note that λ is an increasing and strictly convex function of a firm's own market share in the relevant market.2.s jk ( σ .1 . it is apparent from (8) and (10) that equilibrium firm scale depends only on parameters. firms that are larger or smaller thanx earn positive or negative profits respectively. country 1 and 2. and its exact form depends on the nature of strategic interaction between firms. If η is constant. sjk. so country-j firms charge producer prices equal to bjσ/(1-σ) in all markets.where λ(sjk)is the price-marginal-cost mark up and sjk is the value share of a country-j firm's sales in country k's market. Moreover. We are now in a position to see how formation of an RIA affects firms' sales. Using (7) and (8) the zero profit condition is: ∑ λ( s k=1 N jk ) x jk = f j / bj 10 2. so it is worthwhile to point out its essential properties.η )) 9 (Derivation and the case of quantity competition are in appendix B). We want to establish first the impact on firms' sales without entry or exit. We use the special case in here and in Sections 3 and 4. and third. Inspection of (9) shows that under this assumption all λjk equal (σ-1)-1. and denote equilibrium firm scale x = (σ-1)fj/bj. mark ups and the free-entry equilibrium firm scale are unaffected by trade policy. and hence the location of the industry. profits.is particular useful for illustrating the impact of integration the allocation. λjk depends only upon sjk and parameters. the welfare effects. Furthermore. To explore it we consider a three-country world where the PTA formation consists of lowering X industry trade barriers only between the member countries. The large group case abstracts from game theoretic interactions by assuming that market shares of individual X firms. as well as having important positive effects on accumulation and industry location. are negligible.

coming as changes in firms' production affects average costs. Point A is the initial equilibrium. ik  pτ  =  i ij  θ ij ≡ p j x jj  p j    pixij 1-σ 11 θij is defined as the ratio of an i firm's sales in j to a j firm's sales in j. producer prices and the terms of trade are unchanged.1). This arises as each variety brings consumer surplus. can then be written as: X X X * E1 E2 θ E3 θ + + * * * * n1 + n2 θ + θ n3 θ n1 + n 2 + θ n3 θ n1 + θ n2 + n3 X * X * X E1 θ E2 θ E3 + + * p 3 x3 = * * * n1 + θ n 2 + θ n3 θ n1 + n 2 + θ n3 θ n1 + θ n 2 + n3 p 1 x1 = 12 13 We illustrate these relationships in figure *. The welfare effects of this experiment can be found by refering to the framework given in equation (2). If the experiment is around a point of zero profits (so producer prices equal average cost). a number of country 3 firms exit. . shifting the curves to positions illustrated by the finer curves. and θi3 = θ3i = θ*. and is a convenient way of summarizing the effects of trade barriers and differences in marginal costs and hence prices. The heavy-lined curve labelled x1 =x is the loci of n1=n2 and n3 at which country 1 and 2 firms would sellx units. 2. there is 'production shifting'. If they do. Axes are n3 and n1=n2. Since expenditure on each home produced variety exceeds expenditure on an imported variety (if θ* 9 . i ≠ j. clearly θjj = 1 and infinite trade costs mean θij = 0. The curve x3=x depicts the similar loci for country 3 firms. then the only second row effect is the scale effect. To the southwest firms have positive profits. i = 1. and firms enter in countries 1 and 2. The only second row effect is therefore a variety effect arising as the location of firms changes. Total sales of a firm located in 1 or 2 and those of a firm in country 3. Trade liberalization between i and j increases θij. The RIA increases θ. or trade volume effects (if barriers are DRC). as we shall assume. Allowing entry and exit to occur restores all profits to zero and moves the new equilibrium to A' in figure 1. then a sufficient condition for them to intersect in the direction illustrated is that θ* ∈ (0. The only effects in the first-row of (2) are trade cost effects -mdt (if barriers are non-DRC). aj = bj+fj/xj. into the RIA. At equilibrium price equals average cost. This illustrates the production shifting aspect of RIAs. To the northeast of each curve. and firm scale is unchanged by the experiment. Holding numbers of firms constant. we see that firms in the union now have expanded production and make positive profits (A is below the new x1 =x ) while firms in country 3 have contracted and make negative profits (A above the new x3 =x ). If the two countries in the union are symmetric.p j x jk = E k θ jk X ∑n θ i i=1 N . the relevant firms are operating at scales that imply negative profits. If not some country will be specialized in the Z industry. This is a source of gain for countries in the RIA and loss for country 3. Once again. These changes generate long run welfare effects quite different from the short run. The curves need not intersect in the positive quadrant. with the further assumption that expenditures are constant. In our example. then we can write θ12 = θ21 = θ. this being equal to 1/(σ-1) times expenditure on the product.

It has also been important in some empirical work on the effects of NAFTA (Brown et al). Loss of profits on domestic sales is associated with higher profits on export sales. Both these factors mean that equilibrium firm scale must increase. this being achieved through increased firm scale. its simplifying assumption of constant mark ups rules out scale effects in the long run.that plays a role in understand the allocation.production shifting . consider first a symmetric experiment in which similar economies all engage in trade liberalisation. so that policy may change the profits earned per unit sale. firms' average profit margins are affected in a very complex manner and the analytics have not been worked out in the literature. maintaining zero profits may then necessitate changes in firm scale. accumulation and location effects of regional integration. some care needs to be taken in developing it. cov[xjk.xxi Expression (1) illustrates the two channels by which integration alters equilibrium firm scale: the average mark up and the covariance of sales and mark ups. (as firms gain exports and lose home market sales) and. 10 . and consequent reduction in average costs of production. To develop the argument we note that the zero profit condition (equation (**)) can be rearranged to give an explicit expression for firm scale: ∑ x jk = k=1 N (f j / b . sjk. In general. Put very informally the argument is that integration will lead to erosion of firms' dominant positions in their home markets. This will reduce the dispersion of market shares. The mechanism through which RIA will change price cost margins is often referred to as the pro-competitive effect of integration. since λ is strictly convex.2 The pro-competitive effect: Scale and variety implications Allowing for oligopolistic interaction between firms in the industry makes price cost mark-ups endogenous.xxiii Furthermore. Although the argument is intuitive. Simulation studies reported in Section 6 typically show that these effects are quantitatively significant and in this section we use our core model to investigate the forces at work. For example.λ( s )] ) _ λ( s ) j jk jk jk 14 where cov and _ 6 are operators that denote the sample covariance and the unweighted average over all markets. a reduction in dispersion lowers the mean _ 7λ(sjk). this reducing their profitability. However. since market shares are high where sales are high there is positive covariance.xxii To see how this operates. This 'large group case' has the merits of simplicity and helped us identifying an important mechanism . we turn next to a less restrictive version of the core model in which scale effects may occur even in the long run.cov [x . Since scale effects have proved to be important in studies on NAFTA and EC92. 2. Maintenance of zero profits is then possible only with lower average costs. a lowering of the average mark-up requires that there is an increase in long run equilibrium firm scale.< 1) the production shifting increases consumer surplus in RIA countries and reduces it in country 3. which will also decline as dispersion falls. λ(sjk)].2.

it seems then that firms have retained an ability to segment markets -. and move towards a single 'integrated' market in Europe. for instance. as we shall see. and now also terms of trade effects as price change. Suppose alternatively that national boundaries are of no significance for competition between firms which instead choose a single value of their strategic variable.2. and the price cost mark up.3 Market segmentation and integration So far. That is. Flam et al (1994). Despite the removal of tariffs. the experiment we have studied is the removal of tariffs or other trade barriers between union countries. are typically procompetitive. Comparison of trade and welfare levels in a variety of games provides a way of assessing the costs and benefits of more or less 'integrated' outcomes. union wide.that is to price discriminate between different countries. the equilibrium characterized in equations (*) and (*) has firms competing in each national market separately. 2. these turn out to be quantitatively important. and their covariance. However. The essence of segmentation is that firms have discretion to exercise market power in each segment of the market independently. and decrease in import prices from the rest of the world. One way to explore the distinction between segmented and integrated markets is to investigate different representations of the game between firms. this again reducing the overall dispersion of market shares and of sales. tending to raise equilibrium firm scale. and thereby retain dominant positions in their domestic markets. each firm chooses a value of its strategic variable in each market. If marginal costs are constant then we would expect to see some increase in producer prices charged on intra-union imports. An increase in the number of firms in the RIA (due to the production shifting effect of the preceding section) will further reduce the home market shares of firms in RIA countries. but European experience suggests that the removal of tariffs is not sufficient to achieve a 'single market'. and illustrate how different games support different volumes of trade and levels of welfare. as expansion of firms in RIA countries reduces average production costs. although simulation studies suggest that net effects of regional integration. The EC92 policy measures can be viewed as an attempt to reduce the extent of segmentation. demonstrate this for automobile prices. There is extensive evidence of wide price differentials between European countries even for goods that can be traded at low cost. these effects could easily be swamped by scale induced cost and price changes. In the second row we add scale effects. Thus. sjk.Regional as opposed to global integration will usually amplify these effects. However. The possibility that a RIA will have pro-competitive effects on price cost mark-ups means that two additional welfare effects come into play in equation (2). λ.xxiv The net effect is these asymmetric cases is difficult to characterise analytically. in the case of price competition. depends only on the firms share in that market. which we assume to be the producer price 11 . merely comparing the outcomes of different games leaves analysis incomplete. In the first row of equation (2) we have trade volume and trade cost effects as before. Nash equilibria are found market by market. a single price is chosen. as market shares change. if marginal costs depend on scale. For example. and in the first part of this section we make such comparisons. and in the second part of this section we discuss the more difficult question of how different degrees of market segmentation or integration could be endogenised within a more general model.

Accumulation Effects 12 . then games played in each market are completely separate from each other. capacity (Ben-Zvi and Helpman (). A more satisfactory approach is to recognise that some variables are set at the national level (perhaps price. In the case of a two-stage game with world capacity choice followed by national price competition. It seems implausible that two firms compete in a number of markets yet recognise no interaction between markets. The price cost mark up is given by λ( _ 9[sjk]). Firms have lower prices in markets where they were formerly dominant. This reasoning suggests that substantial welfare gains might be achieved by the equilibrium 'switching' from segmented to integrated market behaviour.λ(sjk)] is positive and λ(sjk) is convex this brings an unambiguous increase in firm scale and hence fall in average costs and welfare gain. The general point here is that it is possible to characterise international competition in a variety of different ways. The first is. 3. If marginal cost curves are flat. and the difference between this and segmentation is immediate. but is far from compelling. Empirical estimates of these effects are reported in section 6. λ. reducing trade volumes. _ 8[sjk]. think of the second stage decisions of firms (when capacity constraints are binding) and suppose that a home firm is considering a reallocation of sales between markets. becomes the share of the firm in the union as a whole. We shall refer to this as an 'integrated' outcome. thereby giving outcomes where changes in one market have no influence on outcomes in another. paradoxically.(the 'mill pricing' assumption of location theory)xxv. are either of these appropriate equilibrium concepts to use for modelling multi-market interaction between firms? Segmented market equilibrium has become the benchmark in the theory of trade under imperfect competition (from the early work on 'reciprocal dumping' (Brander and Krugman (19??)) onwards). If cov[xjk. achieved by an increase in its home price and reduction in its export price. This can be seen from (*). but the comparison raises several other issues. and fall in its export market. with different degrees of cross market interaction. This erodes its home market power and gives an outcome with more (although not completely) uniform price cost margins across markets. If it does this it knows (given rival's prices) that there will be an increase in rival's sales in its home market. This is typically a reduction in price in home markets and increase in export markets. it seems implausible that firms should not have at least some country specific instruments. Venables ()). the integrated market hypothesis outlined above has firms choosing a single decision variable at the union wide level. The implication of this is that the relevant market share in the mark up relationship. At the other extreme. and hence increases equilibrium firm scale. Accepting that it is possible to write down games with more or less integrated outcomes. To see this. and no longer varies across markets. and higher prices in markets where they have small market shares. equilibrium has trade and welfare levels intermediate between the segmented and the integrated outcomes. for countries k in the union. or sales volume) and others set at a world or union wide level (R&D in Brander and Spencer (). and the covariance between λ and xjk goes to zero. this. The loss of market power associated with integration reduces firms' profits. the second issue is how might policy cause a movement to a 'more integrated' equilibrium? This remains an area for future research.

the final output change is 1/(1-ε) times the allocation effect. However. For example. Welfare effects arise if the social return on capital is different from the private. 3. or knowledge capital -. human or knowledge) does not run into diminishing returns. An RIA will affect growth if it changes the returns to investment -. and have the imperfectly competitive X sector (the sector directly affected by the RIA) be the more capital intensive. or medium run growth implications of an RIA. There will be capital flow into the RIA countries from the rest of the world. but this extra GNP is not. or may be permanent if. Capital demand generated by production shifting will raise the rate of return leading to increased saving and investment and faster growth of GNP (and GDP). Important in Scandinavian debate. If capital is perfectly internationally mobile then this will show up as 'investment diversion'. Such effects often seem to be uppermost in the minds of policy makers and in popular debate. human. the additional capital will give permanent changes in the level of output and income. as accumulation will drive the rate of return down to its previous level.1 Medium-term effects: Investment creation and diversion. including the rate of return in participating and non-participating nations.Viner denoted x-fraction of his 'Theory of Customs Union' to the dynamic effects of RIA. Baldwin (1989) has referred to these as the output multipliers effects.. These changes may be transient -. or long run effects. If at the other extreme. For the simplest case in which technology is Cobb-Douglas (between capital and labor) and in which allocation effects can be summarised by a efficiency parameter in the production function. a source of welfare gain. yet they have received relatively little attention in recent academic literature. RIA's will usually effect factor prices. Baldwin (1991) evaluates these effects (???). and then turn to the permanent. as in new growth theory. The production shifting effect identified in the preceding section will now require additional capital in RIA countries. If there are diminishing returns to accumulation then this process will be transient. Extra income and consumption in the future is purchased with present consumption foregone. this raising GDP. The magnitude of these effects depends on the precise form of the production function.as will be the case if increased accumulation reduces return to the accumulated stock..ref. diminishing returns to accumulation are not encountered. 3. where ε is the elasticity of output with respect to capital. in the RIA. suppose that in the 'core model' of section 2 we let both sectors use capital as well as labour. (IF very short. why not put it here). This may take the form of direct investment flows (see Motta () for an analysis of multlinationals' decisions). over and above allocation effects.and hence leads to increased accumulation. so that 13 . of itself.. then adjustment will occur through domestic accumulationxxvi. In this section we first discuss the transient.in physical. We discuss evidence on the magnitude of this in section 6. The output multiplier tells us that GNP growth will exceed allocation effects. capital is internationally immobile. although not GNP.2 Long run growth effects The new growth theory investigates circumstances under which accumulation of capital (physical.

continuing growth is possible. US Canada). Geographers have been concerned with cumulative causation leading to vicious and virtuous circles of development for different locations. The strongest statement of this is contained in the factor price equalization theorem. if there are initial inequalities between countries. Capital market integration may have similar effects.Rivera-Batiz and Romer????). increasing the 'likelihood' that the each countries' endowment vector is inside the cone. Location Effects There has been long standing concern in that regional integration may be associated with increased inequality between regions. then it will lead to faster growth. Under such circumstances a change which increases the return to accumulation may raise the rate of growth permanently. then integration may have long run growth effects as showed by Baldwin (1993). Grossman and Helpman (1991 chapt. concluding that. check Blackburn and Hung??). For example. In Europe there has been worry that there might be agglomeration of economic activity in 'central' locations at the expense of the periphery. Romer & Rivera-Batiz?? consider cases in which the range of spillovers is influence by boundaries between countries. if the knowledge-creation sector is imperfectly competitive and integration has a pro-competitive effect.. (ref. If each country's endowment lies inside its cone of diversification then integration. We merely mention some mechanisms through which regional integration may feed into the rate of growth. In this framework it is clearly the case that if formation of an RIA changes the domain of spillovers from national to RIA wide. Bertola. Whether RIAs can achieve this is a moot point (evidence??). following recent work by Krugman (eg Krugman (book)). An alternative mechanism is that an RIA may directly affect the efficiency sectors producing accumulated facator stocks. The strong suggestion then is that integration should lead to 14 . also Wonnacott and Wonnacott. then large economies will grow faster than small (am I correct on any of this??). Similarly in the capital goods sector (someone must have done this -. will equalize factor prices. 4. will these be amplified or diminished by formation of an RIA? The second is. even if initial differences are small. what are these) from accumulated factors serve to hold constant the rate of return of the factors.. Continuing growth is possible if spillovers (fn something . Analytically there are two separate issues here. by equalizing goods prices. Endogenous growth in an open economy has been considered extensively in an absolutely brilliant masterpiece seminal work by Grossman and Helpman (1991). might integration cause economic activity to agglomerate in particular locations. Application of these ideas to RIAs remain to be fully developed. This will not occur if endowments lie outside cones of diversification..). thereby creating inequality? In a perfectly competitive world the expectation is that regional integration will reduce intra-RIA income differences.. but if integration increases the number of internationally traded goods or factors then it may increase the size (and possibly dimension) of the cones of diversification. if spillovers are national. if it services to decrease the wedge between returns to borrowers and lenders or improve the efficieny of the capital market in other ways (eg monitoring . The first is. These ideas have received renewed attention from economists.

At autarky n1 and n2 must be such that nipix = E. 4. If firms operate under increasing returns to scale then they have to make discrete location decisions -. This can be illustrated using the large group model of section 2. and hence change labor demand and relative incomes? We can see that there is a potential ambiguity here. Using this in (18) gives: X X X X (1 . because a lot of their output is exported. according as expenditure is in country 1 is greater or less than expenditure in 2. then sales per firm in the small economy must be a U-shaped function of trade costs. with easy access to a large market. what happens to the sales of firms in each country as trade barriers are reduced? The total sales of a country 1 firm are. The idea is that the country with the large market is a 'central' region. However. giving zero profits.θ )θ E 2 ( E 1 . θ = 0. having relatively few local consumers. The U-shape arises because as we have seen. On the one hand firms in the small country benefit more from trade cost reduction than do firms in the large.they will not locate some productive capacity in every country or region. not reduce. and increases with integration. from (12?): p 1 x1 = θ E E1 + 12 2 + θ 21 n2 n2 + θ 12 n1 n1 X X 15 As before. In the remainder of this section we investigate these possibilities. each of which increases exports to the small. relative to home sales per country j firm. at all intermediate values of θ x1 is greater or less than its equilibrium value.x .E 2 ) θ EX x1 E = X 1 X + X 2 X = 1+ X X X X ( E 1 +θ E 2 )( E 2 +θ E 1 ) x E1 +θ E 2 E 2 +θ E1 16 We see from this that the autarky number of firms is an equilibrium not only at autarky. falling then rising during a process of integration. Suppose that p1 = p2. the other country is 'peripheral'. but also at free trade. θ = 1. How does integration change the location of industry between these two regions.1. θij is imports per country i firm to market j. wherex is the equilibrium firm scale.2. so firms in the small economy suffer more from import growth. factor price differences between different countries in an integrating region and thereby lead to divergence in income levels. expenditures are constant and start from a position of autarky. this environment of increasing returns integration may widen.equalization of factor returns within the union. It turns out. A different story holds in an environment characterised by imperfect competition and increasing returns to scale. so that θ21 = θ12 = θ. But on the other hand there are relatively many firms in the large economy. In order to highlight intra-union issues we shall set external trade barriers prohibitively high (θ* = 0) and concentrate on the two economies in the RIA. The first question is.1 Location of firms The possibility that a RIA may amplify inequalities between regions can be seen by considering integration between two countries with different market sizes. there are two forces at 15 . This implies that if numbers of firms were held constant. so gain from a reduction in trade barriers.

4.2 Linkages and agglomeration A second possibility is that an RIA might not just amplify existing income differences. and the vertical gives wages. then it will lead to divergence of relative wages up to a point. τ. the supply of which is proportional to market size. real wage reductions occur as trade costs are moved from high to intermediate levels. The horizontal axis in the figure is the iceberg trade cost. assumed to be the only element of costs. It follows that the larger economy is net exporter of this industry's products.work. n1/n2 = E/E. Having good market access becomes more not less important as costs of market access go down. during a process of integration. but may actually create differences by facilitating agglomeration of activity at particular locations. This relocation of industry will be offset if factor supply considerations cause changes in relative factor prices in the two economies. however. and convergence thereafter. be drawn towards 'central' areas of the region. reducing trade barriers causes movement of firms from the small economy to the large. Reducing barriers makes the large market the more attractive location. They can be held at zero by letting numbers of firms adjust to keep x1 =x . The wage rate will change in order to ensure that this is an equilibrium. and are given by curves v1 and v2xxvii. The figure is constructed with E > E. Curves w1 and w2 give wages in terms of the numeraire. If changing industrial employment impacts on wages. At low enough trade barriers smaller wage differences are required to hold industry in the small economy and. at which point location is indeterminate. However. so in order to hold firms in each location there has to be a wage fall in location 1 and increase in location 2. Which side of the turning point actual economies are on is an empirical matter. The small economy gains relatively more from complete integration -. 16 . We can see this most starkly if we suppose that labor used in the X industry is a specific factor. Firms in the small economy benefit more from trade cost reduction. In the preceding thought experiment profits were non-zero. motivate. as trade barriers fall so location becomes increasingly sensitive to production cost differences. As would be expected in view of the preceding discussion. (see Krugman AER). as we have seen. Figure 2 was constructed under extreme assumptions about labour supply to the industry under study. Real wages must be adjusted to allow for changes in price indices in each country. in the limit. factor price equalisation takes over. At high trade barriers wages are similar in the two countries.it gets access to many more varieties without bearing trade costs. giving zero profits in each economy. Full employment means that the relative number of firm in each economy will be equal to relative endowments of labor. Firms in an imperfectly competitive industry will. but they suffer as their are many firms in the large economy. Equilibrium wages are given in figure 2. this continuing until θ = 1. because a lot of their output is exported. each of which increases exports to the small. and the curves w1 and w2 plot the wage (=cost) levels which hold number of firms proportional to expenditure in each country. and hence relative expenditures at all levels of trade barriers. but nevertheless is indicative of more general conclusions (see Krugman and Venables ()). about which little is known. except at autarky and free trade. If wages change little (the rest of the economy releases or absorbs labour with little change in the wage) this will lead to divergence of industrial structure.

A demand or backwards linkage occurs if increasing demand at a location makes that location more attractive to firms. Agglomeration requires that these forces be overturned by positive 'linkages' between the activities of agents at the same location. The experiment is a marginal reallocation of firms from 2 to 1. There are two economies and the number of firms in each are determined by the zero profit conditions (equation (20) with x1 =x . for example. with accompanying changes in endogenous variables dEX ≡ dE = -dE. and unstable if it increases x1. or could be 'pecuniary externalities' which. and there may also be other equilibria with asymmetric industrial location.directly. preferences and endowments. We can find the symmetry breaking point by looking at the stability of the symmetric equilibrium.Agglomeration will occur if increasing the number of economic agents (eg firms or workers) at a particular location raises the return to other agents in the location.4.3 and 4. this reducing the profitability of other firms. this also making the location more attractive to firms. The issues can be explored in the two country model of industrial location set out in the preceding section. dx ≡ dx1 = dx2. The remainder of this sub-section discusses some of the analytical issues raised by these questions. A cost (or forward) linkage occurs if costs depend on n1 and n2. when do they dominate centrifugal forces? To answer this question suppose that the two economies are identical in technology. To develop the ideas we ignore technological externalities and focus on the pecuniary externalities going through firms' input and output markets. dn ≡ dn1 = -dn2. These linkages could be technological externalities with a limited spatial range. A demand (or backwards) linkage occurs if expenditure depends on n1 and n2. We want to find regions of parameters within which symmetry is broken. and the system 'self organizes' into an asymmetric equilibrium with firms concentrated in one location. If we hypothesise that numbers of firms at each location adjust in response to profits and losses then the symmetric equilibrium is stable if relocation of a firm from 2 to 1 reduces the total sales and therefore profits of a firm in 1. dp ≡ dp1 = -dp2. Cost or forwards linkages occur if increasing activity in a location reduces costs of other firms at the location.n1 and n2 -. can operate in an imperfectly competitive industry. Denoting the right hand side of (26) by R and totally differentiating gives: p dx ∂R ∂R dE X  ∂R ∂θ  dp -x + + = dn ∂n ∂ E X dn  ∂θ ∂p  dn   17 and hence (evaluating the partials at the symmetric equilibrium and choosing units such that p = 1 at this equilibrium). and the country 2 analogue). putting more firms in a location will tend to reduce output price and increase input prices. hence the relevance of the topic for RIA. These linkages create centripetal forces. E and E and relative costs. as we shall see. x1. There will then be a symmetric equilibrium in which industry is equally dispersed between the two countries. denoted dn. 17 . Evidently the right hand side of these equations depends on the location of industry -. Applications are discussed in sections 4. these determining prices and hence θ12 and θ21 (equation (14)). In a standard neo-classical model this will not occur. It turns out the relative strengths of these forces depend critically on levels of trade barriers. It also depends on expenditures. In the neighbourhood of the symmetric equilibrium calculus is fairly straightforward.

with regions with a larger market having higher wages.θ    1+θ  n dE X  4θσ  = -   .3 Labour Mobility Integration may change both the barriers to. Workers move from the small economy to the large. Labour migration is now. raising wages in the source economy and reducing them in the host. a destabilizing force. potentially. and hence the sign of the change in profits. once again. this encouraging further migration and possibly leading to an outcome in which all mobile factors concentrate in a few locations (Krugman (1991a)). Symmetry is broken and agglomeration occurs if the right hand side of (25) is positive. if dp/dn < 0 (a linkage saying that having more firms reduces costs) then the effect is positive.1 we saw how goods market integration and firms' location decisions could cause divergence of wage levels between regions.2  dp  n dx  1 . Economy 1 has L sector Z workers and n1 manufacturing workers. In a perfectly competitive environment the story is.1+   X  (1 . destabilizing an equilibrium with dispersed activity and hence leading to an asymmetric equilibrium. The first is the direct effect of changes in n. again tending to destabilize the equilibrium. then this is a positive effect tending to destabilize the symmetric equilibrium. so may push it through the point of symmetry breaking. And if migration does occur. We turn to examples of this in the next two sections. The coefficients on the linkage terms in square brackets in (29) are strictly increasing in θ. The right hand side of these equations contain three distinct terms. a force for stability. labour migration. provided by factor price equalization. if dEX/dn > 0. consider the following simple model. Each worker spends amount γ on manufacturing. In section 4. then it promotes convergence of income levels. so increasing the difference between market sizes. The third term is a price effect. so X Z E 1 = γ ( L + n1 ) 19 If a firm relocates from 2 to 1 then it takes its worker with it. Combining labour mobility with the location decisions of firms in imperfectly competitive industries creates the possibility of a very different outcome. 4. The role of trade barriers is immediate. as expected this is negative. and 18 . The expectation is that trade liberalization reduces the incentives for labour to move. and the incentives for. Migration may therefore increase the wage gap between locations. The second is the demand linkage.θ  E dn      18 The left hand side of these equations give the change in output. To see how this may break symmetry between regions which are initially identical.θ )2 + 1 n dn  x dn  1 +θ    1 . and as they move they take their expenditure with them. This clearly creates a demand linkage. Integration raises θ.

labour mobility may not be a force for convergence. in the symmetry breaking condition. labour mobility between sectors and migration between countries is needed. and these elements are contained in Krugman (). where Pj is the price index for products of the industry. and access to intermediate inputs. there are other forces for agglomeration of activity -.xj). we see that the symmetric equilibrium is unstable if n1 > 1 . and hence increases the relative importance of these considerations in location decisions. Formally. Using the demand linkage. encouraging other firms to move. All of these interact with trade liberalization in the sense that liberalization reduces the tie between firms and their final market. the argument illustrates how. (29).xxviii This modification generates both cost and demand linkages. We have already seen that the price index depends on the location of firms (equation (8)). this is relevant to regional economic integration only if migration within the union is likely to occur on a significant scale. which are now used as a composite input. labour market pooling effects. The demand linkage arises as demand for output now comes both from consumers and from other firms. However. but not a cost linkage. with the modification that industry now uses its own output as an input in production. As an example of what can happen. expenditure in location i on the industry is given by: X X E j = E j (c) + n j x j ∂a( w j . given imperfectly competitive industry and a demand linkage. Firms in the industry therefore have average cost function a(wj.n dE X n = Z 1 X dn E L + n1 20 We abstract from cost linkages by assuming that nominal wages change in neither country. The story given here is incomplete. This is the cost linkage.such as externalities between firms. To give a complete description a fully developed general equilibrium model specifying employment in both sectors. P j . Moving a firm and associated employment and consumer demand to a location makes that location more profitable. Nevertheless. consider our core model of location of an imperfectly competitive industry. and that the more firms there are in a location the lower is the location's price index. this generating a demand linkage. (25). x j ) ∂ Pj 22 19 . (the worker is happy to move since the price index is lower in the location with more firms).θ L + n1 1 + θ Z 21 This condition is evidently more likely to be met the larger is the share of mobile workers in the population (manufacturing workers compared to Z sector) and the lower are trade costs. 4. Evidently.Pj.4 Integration and industrial agglomeration In the preceding section agglomeration of activity was based on a positive feedback between industrial location and migration.

and employment in other locations can only be maintained by these locations having substantially lower wages. linkages could be important at an industry wide level. Outcomes are illustrated on figures 3a-3c. Figure 3b gives the picture at low trade costs. Linkages attract industry to a single location. Agglomeration occurs -although there is nothing in the theory to say in which location.3). the equilibrium at A is stable. and consequent agglomeration of activity. adjustment costs and political frictions may be high. and it is useful to start by setting out a general framework to illustrate the relationships between these approaches.1) before turning to econometric evaluations (5. but now have numbers of firms in each of the union countries on the vertical axes. and the theory suggests that integration could be associated with substantial widening of wage differences between countries. or at the level of particular tightly linked groups of industries.integration permits the benefits from agglomeration to be achieved.1 Sources of errors in empirical evaluations The literature evaluating RIAs has followed several approaches. 5. @filename:\hb5. In the former case agglomeration forces effect industry as a whole. relatively large -. in between the stable equilibria are unstable equilibria at points labelled U. Its application depends. and the different sources of errors in the approaches. Thus. Empirics Theory tells us that RIAs have ambiguous welfare implications. This example illustrates how trade liberalization may be associated with symmetry breaking. so each must be evaluated seperately. and there are two stable equilibria at points labelled B. This section discusses several generic problems (5. in this case. as there is substantial relocation of activities between countries in the union. in the European context. 20 . The symmetric equilibrium at A is stable.2) and computable equilibrium evaluations (5. However.where E(c) is consumer expenditure. As is clear.emp 14 August 2004 (September 7 Draft) 5. each country may give up a presence in some industries. Figure 3a describes the case when trade costs are high. Zero profits in each country are given by the lines x1x1 and x2x2. even in the absence of labour mobility. with production divided equally between the two economies. and the second term is the value of intermediate demand. as in the US. and the equilibrium is at point A. or of any externalities. The crucial difference is that the direction of intersection of the zero profit contours is reversed. on the structure of the input-output matrix. These figures are similar to figure 1. but with concentration of particular industries in particular locations (Krugman and Venables (1993)). Figure 3c gives the case of intermediate trade costs. as are asymmetric equilibria at B. amongst other things. In the latter case integration would be associated not with aggregate wage differences. Arrows indicate a hypothetical out-of-equilibrium adjustment process in which entry (exit) occurs in each country in response to positive (negative) profits. The equilibrium at A is unstable. and the economic geography of Europe might become more regionally specialised. Depending on this structure. The gains from integration are.

To follow the residual imputation approach needs to know values of exogenous and endogenous variables in the period after the policy change. Whalley and Wooton (1993). The analytical method can be used for ex post as well as ex ante evaluations. Residual imputation does not require knowledge of the exact policy change (a considerable advantage given the scope and complexity of many RIAs). (Clavaux 1969. Both analytical and residual imputation methods have been used. policy and exogenous variables.1 Trade creation and diversion Most studies of trade creation and diversion have dealt with the European Community and we limit ourselves to a subset of these. To follow the analytical approach the researcher has to know both P1 the policy change. that is it looks at the difference between the actual outcomes Y1. and the relationship between them. P and X are vectors of endogenous. with a wide range of different exogenous variable used to construct the counterfactual. Some were extremely simple -. Since it is unknown they give rise to very different methodologies. The 'residual imputation' approach learns δY from the equation δY = Y1 . and δY is a coefficient of a dummy variable or variables for the policy. EFTA 1972). The 'analytical approach' (using terminology from Winters ()) is to learn δY from the obvious relationship δY = αP1. The change in endogenous variables due to the RIA is denoted δY. and the 'counterfactual' or 'anti-monde'. and P0 = 0 (so policies other than the RIA are contained in X). constant shares in apparent consumption (Truman 1969) and 21 . the set of parameters (or more generally functional relationships) through which policy affects endogenous variables. giving values of endogenous variables that woul have occured given pre RIA policy and post RIA exogenous variables.Levinson et al??). Two approaches have been followed to learn δY.3 below -. and α and β are matrices of coefficients.time trends for import growth from partner and non-partner nations. and then inserted actual tariff changes to give estimates of trade creation and diversion. Neither will be any better than the researchers' estimates of the relationships represented here by the parameters α and β. Both these approaches have strenghts and weaknesses. Surveys of this literature already exist (see Srinivasan. Results are given in table?? Residual imputation has been more commonly used. We look at these two subjects in turn.2.Suppose that the true model of the economy is Y = αP + βX where Y. the world is linear. If the true model is known (and linear??) then the two approaches are evidently identical. An example of the analytical approach is XX who estimated price elasticities of imports from various sources. Superscripts 0 and 1 respectively refer to observations before and after formation of the RIA.2 Econometric Evaluations Existing econometric studies have focused on the effects of RIAs on trade flows and growth (anything on pc margins -. 5.and in some econometric work. and Winters (1978)) and we comment on it only briefly. βX1. and α. Mayes (1978). (expand ??) 5. This is the approach followed in computable equilibrium modelling -discussed in section 5. This approach lends itself to time series econometrics in which parameters β are estimated over a period including the policy change.βX1.

(1985)). at least in Europe. Winters (1987). and it is only under very special circumstances that trade volume effects alone (let alone their sum) give an accurate measure of the welfare effects of an RIA. 0. i. Using EU time-series data. which we turn to next. (how uniform: analytical different from ri?? table ??)Some studies. The method followed is that of residual imputation. Some studies draw implications from the sign and significance of the RIA proxy. typically estimating a single equation growth model that includes several macroeconomic aggregates and a proxy for regional integration.. Winters (1984). for instance. This is similar to the analytic approximation of Baldwin (1989) and the Italianer regression results. Others quantify the growth effect by using an approach like (??). Thus EEC nations must already have been each others' lowest-cost suppliers for many goods. the scope for trade diversion is limited.xxix In such cases. and regional and general openness proxies. e. Assessment ?? 5. Those studies that did compute the welfare effects of trade volume changes found the effects to be extremely small. trade creation exceeded trade diversion.e. labour. To understand the low degree of trade diversion. date?? not one of ones listed above??). This literature is far from mature and new conclusions may emerge. Coe and Moghadam (1993) use multi-equation cointegration techniques on French time-series data to estimate a linear relationship among the levels of GDP. even found that the UK's EEC accession actually increased its imports from non-EEC members. especially regional trade in Europe. In sharp constrast to the low level of trade diversion in manufactures. and demand systems of increasing degrees of sophistication (Resnik and Truman (1973). we note that much of Europe's trade was with itself even prior to the Common Market.constant income elasticities of demand (Balassa 1974). Aitken and Lowry (1973).2 Growth regressions A more recent type of econometric evaluation focuses on the growth effects of RIAs. but the existing studies tentatively suggest that some RIAs have had a postive impact on growth. Beissen (1991)). capital. cumulated R&D spending and intraEU trade as a share of EU GDP.3 percentage points of the French growth rate from 1984-1991 was due to EU integration. These proxies are. focusing on a nation's bilateral imports and exports and using the gravity model (Aitken (1973).. The parameters are estimated with ordinary least squares (OLS) on cross-country data or time-series data for a single nation. Italianer (1994) regresses changes in EC founding members GDP on changes in physical capital and the labour force. Most of these studies were not concerned with the welfare implications of their findings.g.11% of UK GDP. According to their results. The general conclusion of these studies was that the EEC increased members' imports from each other more than it decreased their imports from non-members.2. respectively. Thus the fact that both proxies turn out significantly positive is very much in line with the idea that trade. The coefficients on Italianer's openness proxies can be thought of as having been estimated in a regression on Solow residuals. Others were more sophisticated. Winters (1987. fosters knowledge 22 . intraEC trade as a share of total EC trade and the trade/GDP ratio. Thorbecke (1975) shows trade diversion in food was quite important mainly due to tariff increases on external trade necessary to establish the common external tariff. found that the UK accession implied a welfare gain from the trade volume effect of 0.

but doubts surround the selection of independent variables. Neither limitation is particularly severe for the theory-with-numbers interpretations since it is understood that results are model dependent. A CES index of goods prices is also included to reflect the cost of intermediate inputs.e. should be kept in mind when the results are intended for policy makers. CE evaluations also have two serious limitations.3. Results from this literature are suggestive (!!!). 5.creation. then it is uninformative to learn that the RIA dummies are insigificant in a growth regression that includes investment ratios. it is hard to know how much credence to place in the final results. growth is too complex a phenomenon to be captured by a simple linear model that includes a handful of variables. Despite these limitations. They can be used for policy evaluation and they can be used as theory-with-numbers.3 Computable equilibrium evaluations CE evaluations have two distinct uses. A typical third generation model has 10 to 20 sector in each of 4 to 10 countries or regions. Costs are usually given by a nested CES function which display output-invariant marginal and fixed costs. First. Unfortunately there is no perfect solution to this. One solution is to make the model availble to other academics for inspection and experimentation. There are no standard errors for the results and the models are often very nontransparent. They find that only one RIA dummy (for the South African Customs Union) is significant. however. they estimated a linear growth regression that includes dummies for dozens (HOW MANY?) of RIAs as well as investment/GDP ratios and other strandard growth correlates. general equilibrium considerations and the complicated interplay of effects should not be ignored. 5. for example. Most of the traded sectors have increasing returns and imperfect competition (usually monopolistic competition). Typically three factors (skilled labour. unskilled labour and capital) are present and their prices enter sector-specific cost function via a CES price index. The details of each model matter. the CE approach is the only way of performing an overall evaluation.1 Description of three generations of CE models CE models and their results vary widely. Nontransparency is by far the most serious of the two. As we shall see in more detail below. Panagariya and Rodrik (1992) find that RIAs have no growth effects. if integration effects growth via investment. Using OLS on cross-country data. included variables need to be exogenous. In contrast. The lack of standard errors prevents us from judging the statistical significance the results. Both limitations. De Melo. The nontrade sector is perfectly competitive producing a homogenous good under constant returns. Since it is impossible to explain all the choices and their implications. Looking at individual effects econometrically is incomplete. to build intuition on how important various effects are in models that are too complicated to study analytically. but this is not always done. Moreover for large policy changes. i. but much of the variance in results can be understood by looking at broad differences. Demands are homogeneous and generated 23 . We distinguish three generations of CE models. many CE models are enormous and their implementation involves many arbitrary choices that can affect the results. And second. The only way to do this is with a CE model of the whole economy.

this the signs of affects tend to be correlated in all the published CE evaluations of actual RIAs. yet it is important in the data.) are simply set according to the researcher's beliefs. To use our sources-of-errors analysis.g.3 Evaluations of NAFTA Excellent surveys of the results of NAFTA evaluations exist (ITC (1992). cost shares. It is important to note that allowing for scale economies and endogenous capital does not a priori imply that welfare results will be magnified.from a nested utility function with an top-level Cobb-Douglas function determining expenditure per sector and bottom-level CES functions dividing demand among differentiated varieties in a sector. National aggregate capital stocks are endogenous with the steady-state level determined by the equality of rates of returns with national discount rates. but imperfect substitutes if they are produced in different nations. and an unvarying capital stock is a special case of capital endogeneity. 5. Econometric evidence shows that scale economies and imperfect competition are important. The next two generations additionally captured the second and third row effects respectively. These usually assume a home market bias. earlier generations are special cases of subsequent generations. 5. etc. which are assumed to be fixed exogenously. First generation models capture only the first row effects in (2). Here we limit ourselves to the aggregate income effects of representative sample of studies. trade barriers. The remaining parameters (cost and demand function intercepts. etc.3. Others (discount rates. First generation models typically have only labour and capital. etc. trade and income data for a base year. This so-called Armingtion assumption is that goods in each sector are perfect substitutes if they produced in the same nations. Thus in an abstract sense. An ad hoc assumption on preferences is made to allow for such trade. Second generation models differ from third generation models mainly in their treatment of capital as exogenous. wage and trade effects. Francois (1993) and Francois and Shields (1994)). Of course. These give a flavor of major conclusions 24 .) are taken from econometric studies. expenditure shares.) are chosen so to make the model fit exactly with production. there are systematically fewer incorrect parameter errors in the successive generations.2 Comparing the generations Constant returns and perfect competition are special cases of imperfect competition and increasing returns.3. These models are often very large. transport costs. this general statement is subject to the sensibility of each model. In the same abstract sense. Each sector produces a homogenous good under perfection competion and constant returns. These review results on many interesting policy issues such as employment. it could be the case that scale effects or accumulation effects would reverse gains due to the trade volume effect. since each effect in each row in independently ambiguous. and that capital stocks are endogenous and influenced by real rates of return. Intrasectoral trade cannot arise under such assumptions. the Michigan model (Deardorff and Stern 199?) has 25 sectors and 18 regions. third generation models are preferable to second generation models and these are preferable to first generation models. Thus in a very concrete sense we should give more credences the results of each successive generation. To implement these models some parameters (scale economies. e. However. As we shall see. but this need not be the case.

This result reflects two facts. but high NTBs still exist. even though its economy is bigger. Finally. Table 1 presents the aggregate results of two individual studies and the medium estimates from the studies surveyed in ITC (1992).and allow us to illustrate the policy-with-numbers interpretation. For instance. this tendency can be and often is reversed by other considerations. This suggests that NAFTA would not lead to investment diversion inside North America. Of course. all economies show positive gains. results from one first generation model (column 1) with two second generation model (columns 3 and 6). It is also interesting to note that almost all of the NAFTA studies surveyed by the ITC project that NAFTA would raises the return to capital in all three countries. Intuition for this common finding is simple. North American trade. The median aggregate welfare gain is 2.6% for Mexico. Section 2. Removing NTB and tariffs produces gains that are at least an order of magnitude large than tariff removal alone. Comparing columns 1 and 2. NAFTA stimulates production of traded goods throughout the region and since these are capital intense. the small countries (Mexico and Canada) gain much more as a percent of GDP than the large country (US). The notion that nonDRC barriers have more important welfare implications than DRC barriers can be seen by comparing columns 4 and 5. RIA evaluations frequently find that small countries gains more. Table 1 allows us to compare the effects of allowing for increasing returns and constant returns to scale. Bachrach and Mizharhi (1992) endogenize capital in an otherwise first generation model and focus only on USMexico trade. have much larger welfare effects than the removal tariffs 25 . Roughly speaking. is now subject to fairly low tariffs. The third point is that the gains Canada and Mexico are quite sizeable. yet the economic gains for the US are negligible. their results are the easiest to interpret. When large and small countries integrate. the derived demand for capital and R rise. but they certainly illustrate the theory-with-numbers point that accumulation effects can be big. the opportunity set facing small-nation agents expands proportionally more than that of large-nation agents. Recall from Section 3 that accumulation-induced output gains cannot be interpreted diretly as welfare gains. Unfortunately. two of the studies allow us to see that the removal of NTBs (which are nonDRC barriers in these papers). amounting something like one year's worth of growth. xy% for the US and xy% for Canada. Since RRS hold national capital stocks constant. Finally. liberalizations raise welfare by expanded the opportunity set facing private agents. no full-fledged third generation studies has been done on NAFTA. there are three important points. Column 4 shows the impact of removing only tariffs while column 5 shows the effects of removing tariffs and NTBs (which are modelled as nonDRC barriers by the authors). Although each study is less important from a welfare point of view Another theory-with-number point can be seen in the comparison between in all studies except in three of the Hinjosa-Robinson (HR) experiments. like most of world trade.1 showed that removing NTBs that create no domestic rents have much large welfare effects than the removal of DRC barriers such as tariffs. Roland-Holst et al (1992) find that Canada gains more from NAFTA than Mexico. Second. we see that they find capital endogeneity doubles the projected US gains and multiplies those of Mexico by 15 times. As far as the policy interpretation is concerned. First. The accumulation effects in Bachrach-Mizharhi findings maybe too extreme.

viz. IN THEORY SECTION ??? Analytically the reason for this is simple. Rutherford and Tarr (1994) . while the trade rent effect depends upon the initial level of imports. Henceforth these are referred to as HN and BFH. the smaller region (EFTA) gains substantially more than EC. Venables and Smith (1992). imposing constant returns and fixed capital stocks 26 . The median estimate of the EC12's gain from EC92 is five times larger than the US's median estimated gain from NAFTA.24%. the trade volume disappears but the trade rents effects remains. 5.abbreviated as GVS.54% and the EC12's gain is boosted marginally. EC92 originally excluded EFTA. signed in 1992. RRS find that Mexico's gain from the latter are negligible 0. NAFTA's impact on US and Mexican income distributions (especially wages of skilled versus unskilled workers) has been a major focus of NAFTA evaluations. in the endogenous-capital/scale-economies version of their model.is that the gains from EC12 are very uneven among the EC member states. according to the Haaland and Norman (1992) and Baldwin. MA and HRT .39% for Belgium. All studies report a negligible impact on the rest of the world. HR finds removing NTBs in addition to tariffs triples the welfare gains due to allocation effects. essentially extends EC92 to EFTA. The loss in trade rents that occurs when DRC barriers are removed almost entirely offsets this small gains.27%.49% for the UK to 6. and the detailed results of studies in Table 6-1 (not shown in table). EC92 is estimated to produce gains to the EC12 ranging from 0. Most of this variance is explained by the variance in the importance of intraEC trade among members. showed that the trade volume effect is typically quite small. The trade volume effect depends upon the change in imports.?.3.(DRC barriers).43% and 1.07% and -0.6% of base year expenditure and reduce EFTA real income by between -0.2 Evaluations of EC92 PARA OR TWO ON DETAILS OF VARIOUS MODELS AND EXPERIMENTS Table 6-2 presents five computable equilibrium evaluations of EC92. However for the removal of pure nonDRC barriers. Mercenier and Akitoby (1993). and Harrison. Notice also that when EFTA nations and EC12 nations participate in EC92. Two of the studies consider this extension. They depend upon liberalization between countries with very different factor endowments. Another part reflects the fact that EC12 nations are much more open than the US (the EC12 import-to-GDP ratio is almost three times the US's) and EC92 affects much more of the EC12's trade than NAFTA does of the US's trade (the EC12 account for twothirds of EC12 imports while Mexico and Canada account for one-quarter of US imports). If EC92 is extended to the EFTA nations. while removal of both creates very large gains. The distributional effects are largest in HRT. Interested readers can consult the surveys cited above.25% to 2.13%.?. Part of the explanation is that EC92 involves a much deeper level of integration than NAFTA (NAFTA-style integration has existed in the EC since 1968). We omit this debate since the effects emphasised have nothing particular to do with regional integration. EFTAns gain between 0. Evidence in 5. Interestingly. The EEA agreement. One set of important findings in Gasoirek. 2. indicate that the changes in bilateral import volumes is quite small compared to the initial levels of imports. All members gain but the estimates range from 1. This is approximately equal to the change in the tariff-equivalent of the nonDRC barriers times the entire volume of imports. This result suggests that the trade cost effect in (2) is quite large compared to the trade volume effect. Forslid and Haaland (1994).

5. To sign the direction of the error.04%.67 times (-0.267%) for the EC when free entry is assumed.29 in their IRS-endogenous capital version. Second generation models 'estimate' .3 times (0. HRT find that equalization of price elasticities raises the gain by 2. This would trigger a rise in the EC capital stock and a fall in the EFTA capital stock. The induced changes in steady-state capital stocks. In the increasing-returns version of their model. the results of second generation models contain errors of the mis-estimated coefficients type.seems to exaggerate distributional effects. we see that ruling out capital endogeneity reduces the estimates of EC92's impact on EC aggregate welfare by 72% (line ?? versus ??).68 times (0. The necessary theory-with-numbers experiments on the impact of ruling out capital endogeneity are performed by HRT and BFH.8%) and multiplies the EFTA real income losses by 2. The ratio of gains is 5.5 times (1.28 in their CRS-exogenous capital version. which is the third generation 27 . the real return to EC capital (see the R column under the EC in Table 6-1) rises by 0. This conjecture is confirmed in the BFH model.21 in their IRS-exogenous capital model. BFH. GVS find that moving from segmented market pricing strategies to integrated market strategies triples the welfare effects (0. and 4.24). note virtually all of the studies showed that NAFTA and EC92 would raise R in the integrating region. HN do not endogenize capital stocks. 10 between imported varieties and 5 between the import composite and the domestic composite. The findings in Table 6-2 systematically show that market integration greatly boosts the welfare impact of lowering real trade costs. In the market integration cases.3 Why the Estimates Vary So Widely The finding of studies listed in Table 6-1 and 6-2 studies vary widely.09 versus -0. Inspection of Table 6-1 and 6-2 results reveals that the successive generations of models typically yield successively higher estimates of the impact of regional integrations.6%) when capital is endogenous. They assume that the elasticity of substitution is 15 between domestically produced-varieties. Since investment responds positively to R (see evidence in Section 5) the findings of second generation models are probably biased downwards. Most of these models are so complex that analytic results are impossible to derive. Numerical simulation are necessary to confirm this conjecture in each specific models . The sources of errors framework (6-3) helps us understand this.using strong priors . Considering HRT's trade-cost-reduction experiment. Their market integration experiment assumes all EC-produced goods are treated as domestically-produced goods by consumers after EC92. HRT model market integration as an equalization of price elasticities (the justification is based on product standardization). The possibility of investment creation and investment diversion appear in Table 6-2 for the market integration case.52% versus 1. however they find changes in the real return to capital the would provide the price signals that would trigger investment creation in the EC and diversion in EFTA.the elements of Γ that corresponding to the capital stock to be zero. 4.57% while the EFTA R falls by -0. Thus if policy changes do alter the capital stock.475% versus 0. All versions of the HRT model find that Belgium and the UK are the highest and lowest gainers respectively.79% versus 2.3. multiplies EC real income gains by 1. if EFTA is excluded from EC92.399% versus 1.18%) when capital is exogenous and 1. GVS model market integration as a shift in the pricing strategies of firms from the segmented markets case to the integrated market case. which is almost identical to the HN model except that all capital stocks are endogenous.

67) look modest. is small. so EC compensating variation is positive. and BM make the central estimate multiplier suggested by Baldwin (viz. although these experiments comes quite close to assuming their results. The accumulation multipliers (i.32% versus 4. Their findings suggest that scale economies are not critical to understanding why accumulation effects lead to large output. BFH.56%).e. GVS report estimates with and without free for both of their experiments. except the no-entry version of GVS. ratio of total gains to 'static' gains) produced by HRT.39 (0.27% versus 2. lowering average cost (assuming free entry) and thereby producing a large welfare effect. Notice also the fixing capital stocks leads to an underestimate of the losses that EFTA would have experienced had it not participated in EC92 (line ?? versus ??). regional integration may reduce the average mark-up charged by firms. RRS find the multiplier between accumulation and allocation effects is 3. As the theory section showed. These sectors are more 28 . Baldwin (1989) was the first to calculate accumulation multipliers of for regional integration. The likely explanation for this fact is that Baldwin worked with average capital-output elasticities and average allocation (i. RRS find the imposing zero scale economies instead of using estimates reduces the simulated impact of NAFTA on Mexico by 11. The lowest is 1. output changes have second-order and lower effects on profits and welfare. BM finds accumulation effects boost the allocation effects by 14. RRS and HRT have undertaken the necessary numerical simulation to confirm this conjecture for their models. In all of the second and third generation models listed in the tables.57%).6% for their equal-price-elasticities experiment (line ?? versus ??).46% versus 1. These losses are not enough to offset other gains. Both Bachrach and Mizrahi (1992) (BM) and RRS perform the hybrid experiments of allowing capital endogeneity in a perfectly competitive economy. negative in both experiments. finds that assuming fixed capital stocks reduces the estimates of EC gains by 48% and 40% for the trade-cost reduction and market integration experiments (line ?? versus ?? and line ?? versus ?? respectively). HRT find a very similar number for the EC92's impact on the EC in their trade-cost-reduction experiment (line ?? versus ??). static) gains. such conjectures cannot be confirmed analytically. The pro-competitive effect of integration can be illustrated with the findings of the various experiments in the tables. Their detailed results (not reported) show that even in this case the welfare contribution.5 times (0. the number of firms falls. The highest multiplier is 14.xxx In models that are complicated enough to resemble the real world. 1. The fact that the finding of first generation models are typical an order of magnitude small than those of second generation models also reflects a mis-estimated parameter bias.5 from BM. while the allocation effects of both NAFTA and EC92 were concentrated in traded-goods sectors. Inspection of (2) shows that under such circumstance.version of HN. The size of this effect limits to zero as economies of scale parameters used limit to zero.e.68 from BFH and the median is 2. The reason is that zero profit are assumed in the base case. Their detailed results (not reported) show that integration expands output and depresses profits in the imperfectly competitive trade goods sector..2. When entry is allowed. The number is 57.7% (2. This is especially true for their market integration case. Other studies that assume NAFTA boosts the Mexican capital stock also find a significant output increase. average firm size rises and a substantial scale effect boosts the total welfare gain. profit effects contribute nothing to welfare changes since zero profits are equilibrium conditions in all.64%).

This is particular relevant to European integration since complete capital market liberalization was an important element of EC92. Stiglitz. 6. Studies that assume NAFTA alters Mexican capital market conditions find very large effects (see Young and Romero 1992 and McCleery 1992). Ben-Zvi. Innovation and Growth in the World Economy. (1992) "Competing the internal market in the EC: factor demands and comparative advantage. Smith. J. Ethier. Cambridge University Press. 1. J.. Also the promised move to a single currency will undoubtedly affect the EC capital market and risk premiums. and P. (1992). Haaland.capital intense than average." NBER Working Paper No.K and J. Krugman. "The impact of a NAFTA: applied general equilibrium models. W. Baldwin. and I. D. 'A new look at economic integration'. E. A. (1977) 'Monopolistic competition and optimum product diversity' American Economic Review. J. R.. Flam.? and E.. pp162-174. Wooton.R. MIT 29 ." in European Integration: trade and industry. and Venables. and V. Although these studies provide no microfoundations for their assumptions. in Monopolistic Competition and International Trade. Dixit. (1992) "Measurable Dynamic Gains from Trade". Gasiorek. T. (1991). A.. (1992) "Product markets and 1992: full integration. A. vol 100. References Baldwin R. G. their results suggest that the impact of regional integration schemes on national and regional capital markets may be an important source of welfare effects that has hereto been ignored.. pp7-30. and B. H. Brander. Spencer. Kierszkowski. and Helpman. (1992) "On the Growth Effects of Import Competiton. Grossman. implying greater induced capital formation than estimates based on averages figures. Norman. Journal of International Economics Brander. large gains?" Journal of Economic Perspectives. ed H." Brookings Papers on Economic Activity. and H. 4045. . Dixit. Journal of Political Economy.K. no.E. Review of Economic Studies Brown. 4. Horn (1984). Oxford.. Helpman.

" Darmouth Working Paper No. C. product differentiation and the pattern of trade' American Economic Review. Meade. 697-703. 'Welfare effects in customs unions' Economic Journal.. (1992) "Integration in Goods and Factors: The Role of Flows and Revenue. (1988) "The Completion of the Internal Market: A survey of Europe's industry perception of the likely effects"." Quarterly Journal of Economics. J. J. (1982). North-Holland. M.Press. Cambridge USA. 'An elementary proposition concerning the formation of customs unions'. Research on the Costs of Non-Europe. Journal of International Economics. "A contribution to the empirics of economic growth. Basic Findings Vol. Maddison. MIT. Amsterdam Nerb.J.R. CEPR/CUP. R. 30 . and A. Journal of International Economics 12.E. '3x3 Theory of Customs Unions'. (1990).R. A. C. (1991b) Geography and Trade. The Economic Journal. R. P. Venables.Wonnacott (1992) "Hubs and Spokes. J. in European Integration: trade and industry. Wan (1976). P. J. McMillan. P. Krugman. NBER discussion paper no 4559. 92-14. and H. P. 95-8. (1960) "The Theory of Customs Unions: A General Survey". (1991a) 'Increasing returns and economic geography' Journal of Political Economy. Lloyd. Mankiw. Kemp. and Weil. de Macedo. and A. and Norman V. The Theory of Customs Unions. Haaland...Y. Cambridge University Press. 'Integration. ed C. specialization and adjustment'. P. Commission of the European Community. 'Integration and the competitiveness of peripheral industry' in Unity with Diversity in the European Community. Kowalczyk. (1987). 41-63. McCann. pp 496-513. (1992) "Global Production Effects of European Integration". Venables. 1990.. D. (1980) 'Scale economies. (1955). 6. (1993).R. G. Krugman. 91. "Growth and slowdown in advanced capitalist economies: techniques of quantitative assessment. Lipsey. Romer. and Free Trade in the Americas. Kowalczyk." Journal of Economic Literature. (1981). Bliss and J. G. J. Krugman. 70. and E." Dartmouth mimeo.3.

A. Pelkman. (1972). 98. A. (1983) "Dynamic competitive equilibria with externalities. Romer. P. Wooton. J. (1992) Trade flows and trade policies after '1992'.A general equilibrium model". P. Solow. in Winters. Romer. Smith. Romer. (1956) "A contribution to the theory of economic growth. Policy Forum. A.A. P.J.A.J. (1988) "Completing the Internal Market in the European Community: Some Industry Simulations. and A. Keio Economic Studies. Sapir. (1950). and Smith M. A." Economic Journal. Romer. Chatham House. 'Trade and welfare in general equilibrium'.J. (1990) "Endogenous Technological Change" Journal of Political Economy.Norman.M.." Quarterly Journal of Economics. Venables. Viner. J." Journal of Political Economy.D. New York. Venables. (1992) "1992: Trade and Welfare . 37-73. M.. Ohyama. (1986) "Increasing returns and long run growth. Journal of International Economics 21. I. "Regional integration in Europe. Venables. The Customs Union Issue. and Gasiorek. P. H and Winters. R. Wallace.)(1992). pp 1501-1525. M. Winters. (1992). Cambridge University Press. Venables. (1994)." PhD Thesis. 81-97.J. MAM. an investigation'. (1988). L A (ed. University of Chicago. V. (1986). (1987) "Crazy Explanations for the Productivity Slowdown. 'Preferential trading agreements. 9." NBER Macroeconomic Annual. L. increasing returns and unbounded growth. 31 . London." European Economic Reveiw. Cambridge. The European Domestic Market. 32. A.

Figure 1 Figure 2 32 .

Figure 3a Figure 3b 33 .

Figure 3c @@ 34 .

Contestable mkts.45 5.K 0.6 0* 0.34 1.74 Bachrach & Mizrahi 7.PC.2 0. exog. ditto ditto IRS.82 13.02 0.Arm.27 2.57 3. tariffs and NTBs 2.38 0.Integ.endog.PC.1 0.olig.94 2.Free entry. tariffs only 4.6 5 0. No entry..7 0.exog.38 0.3 R Structure Results (% change) USA Income Canada R Income R 0.PC.K flow into Mexico ditto IRS. mkts.32 4.06 1. US-Mexico FTA 8.57 20.K IRS.K 1. exog.43 7.5 2.1 0.77 6. tariffs and NTBs 5.6 3.07 0.04 0.exog.22 14.Arm. ditto 6.Cour.4 10.K CRS.13 2.7 0.64 0. K CRS.3 0.Mexican K 0.Free entry.07 Hinjosa & Robinson 35 ..5 Roland-Holst et al 3.18 5.3 2.4 0.MC. ditto CRS. ditto + exog.57 3.03 0.57 0.2 0.49 5.TABLE 6-1: NAFTA EVALUATIONS Study and Experiments Mexico Income Brown et al 1. exog.

K flow 6.a. ditto ditto + endog.09 11.a.1 0 1.exog.2 1.productivity ditto CRS.lower Mex.1 -1.a. ditto 12.2 -0.interest rate ditto CRS. MEDIAN 2. tariffs only 10.K 2.growth.3 CRS. n. Young & Romero 16. n. migration ditto + exog.26 36 .a. 0.a.1 0 -25* 18.4 6.1 McCleery 13. endog.1 0. tariffs only 17.1 0 0.6 0.pop.4 1.K 0.6 8.pop.9 0.1 -0. risk prem. tariffs and NTBs 14.22 0. ditto + exog.PC.Mex.1 0.39 n. n.PC.32 0.8 ditto 0.9.exog.51 n. lower Mex. 15. ditto + exog.1 3.a.PC.endog.growth. n. ditto ditto + endog.K 0.01 3. tariffs and NTBs 11.exog.

lower real trade cost.360 -0.275 0. ditto 7. endog. lower real trade cost.250 0. Haaland & Norman 5. lower real trade cost.250 0.48 0.K w/ Segmented Mkts w/ Integrated Mkts 0.MC. No entry IRS.010 -0. Free entry w/ Integrated Mkts.a.090 0.01 Baldwin.570 0. n. intra-EC 6.K via int'l K mobility 0. ditto + EC92 extended to EFTA 8.a. n.24 0* -0.267 0* 0* 0* 0* R Structure Results (% change) EFTA Income ROW R R n.02 0* 37 .endog. No entry w/ Segmented Mkts.MC. intra-EC 10.500 0.312 0.070 -0.475 0.399 0. n.a.004 0. Forslid & Haaland 9. Free entry. Venables & Smith 1.050 -0. exog. ditto 3.512 1.008 -0.430 0. n.01 1.a.MC.a. ditto w/ Integrated Mkts.010 -0.690 0.01 0* 0* -0.110 -0.040 -0. Free entry. n. Free entry w/ Segmented Mkts.a.010 0.a.TABLE 6-2: EC 1992 EVALUATIONS Study and Experiments EC Welfare* Gasiorek.K w/ Segmented Mkts w/ Integrated Mkts w/ Segmented Mkts w/ Integrated Mkts 0.310 0.11 -0.a. ditto 4. ditto IRS. n. n. ditto IRS. intra-EC 2.006 0.8 0* 0* -0.610 -0.

a. K w/ endog. K w/ exog. K w/ endog. K w/ endog.54 0* 0* 0* 0* Mercenier & Akitoby 13.MC. K w/ exog.6 n. all EC gds 17.46 1.a.MC. 0* 22. intra-EC 15. K w/ exog.05 0* 0. all EC gds w/ endog. ditto 20.18 0 38 .79 1.a.56 0. ditto + EC92 extended to EFTA 12.11. ditto w/ Integrated Mkts 0. n. intra-EC 19. ditto w/ exog.1 n.PC 18.7 0* Harrison. 0* n.52 0.a. 0* n. 0 0.54 0* 0* 1. lower real trade cost.a. all EC gds 21. ditto + equal price elas. ditto CRS.84 w/ Segmented Mkts 0. Free entry 0. Free entry 0.a.Segmented Mkts.18 2.a. Rutherford & Tarr 14. K w/ endog. K IRS.a.5 1.3 0. n.52 1. ditto + equal price elas.a. MEDIAN 0. 0* n. lower real trade cost. equal price elas. K IRS. 0 0. ditto 16.1 n.Segmented Mkts. 0* n.03 1.

@@Appendices: 39 .

using Roy's identity.Appendix A: 1) Equation 2: Differentiating the indirect utility function gives: dV = .m. Appendix B: Denoting perceived elasticity of demand ε.θ) where b is the vector of firm level total cost functions in each industry. For quantity competition use the primal not the dual. b' is marginal cost. Another frequently used term is preferential trading arrangement. s i ∉ I.b(x. dN * + V Y .dw + X[dp + dt] + dα .dk .dY 23 Defining output per firm.η ) < 0.w.V p . p jk (1 . and assuming that costs are separable between industries and homogenous of degree 1 in NX means that B(X.dI. p τ kj c kj i = ~ j ( σ . p kj τ kj ckj i kj i i = . @ i.θ) = N.m.b′(x.η ) > 0.θ )]dN + N[p + t . 24 Normalizing VY = 1.N.x enables this to be rewritten as (2) of the text. i ∈ I s 26 ∂( p τ kj ) .t. x. Sheppards lemma. N.[dp + dt] + V N .w. To find the perceived elasticity of demand suppose that there is an equiproportionate change in consumer prices of a subset I of products. assuming full employment and defining m = c .dt + [(p + t)x .1/ε ) = b j i 25 hence λ = 1/(ε-1). X=Nx.dt + α . If a single product changes price then. Differentiating (1) with this gives: dY = [k . w.b(x. Defines j as the share in market j of products whose prices have changed.θ )]dx .θ ) + w. w. sometimes used 40 . w.B w ]. ε = σ~-~sj(σ-η) this giving the mark up for price competition.σ + ~ j ( σ .m + α . Differentiating demand system () and () gives: ∂ cikj ∂( p kj τ kj ) ∂c i kj i kj i .Bθ (X. the equality of marginal revenue to marginal cost takes the usual form.

See Hufbauer and Schott (1992) on North American integration. See Kowalczyk (1992) for the many other definitions of trade creation and diversion. v. ii. Assuming that it is 41 . We stick with EC in this chapter. For an early. and some times to denote a region with reduced. eight in Africa and eight in Asia-Pacific and the Middle East. xv. It also spawned the original Lipsey and Lancaster (1956) piece on second-best reasoning. For example. xiv. x. iii. De Torre and Kelly (1992) and Schott (1989) study the reasons for this. Ethier and Horn (1984) is an exception. application to trade liberalization see Rodrik (1988). vi. Some of these are components of European and North American RIAs. including the early work by Cordon (1972). ix. viii. Of course. tariffs. See Roessler (1993) and Finger (1993) for further details and analysis. ti may represent real trade costs or a foreign VER in which foreigners capture the quota rents xii. See De Melo and Panagariya (1993). but not necessarily zero. See OBrien (1976) for a review of pre-Vinerian literature. More than 80 preferential trade agreements have been notified to the GATT as required by Article 24. xiii.See Kowalczyk (1992) for summaries of this 'what Viner really meant' literature.synonymously with RIA. xvii. See Baldwin and Venables (1994) for a complete survey. and less general. Haaland and Wooton (1992) present some analytic results and some numerical simulation results. xvi. iv. one special case of this is when goods produced in different nations are perfect substitutes. See Baldwin (1994) and Molle (1990) for a brief history of European integration and details of the various arrangements and institutions. The EC changed its name from EEC to EC to EU. Anderson and Blackhurst (1993) and De Torre and Kelly (1993) for details on other RIAs. however it deals with a limited number of cases. De Torre and Kelly (1993) lists 17 nonNAFTA RIAs in the Western Hemisphere. xviii. This ignores export barriers. This sort of framework was first used by Meade. without loss of generality. xi. One sector can be assumed to be untaxed. vii.

xxvii. as in the large group case. xxx. For instance. If the λ are independent of market shares. xx. xxix. the cov term is zero and firm scale is independent of market shares. This is clearly true for a mean preserving reduction in the spead. 42 . Firm size is indeterminant in first generation models. xxv. η and EjX are both constant with Cobb-Douglas preferences between Z and CES composite of X goods. This creates the perverse effect found in a study of Norway by Orvedal (1992). Bayoumi and Rose. xxii. xxiv. so formally we must treat perfect competition and constant returns as the limiting case. According to the data in Anderson and Norheim (1993). This assumes that the price index for intermediates can be constructed in exactly the same way as the price index for consumption. Recall that the mark ups here are on physical units sold not on the value of sales. See Helpman and Krugman (1985) for a more complete treatment of CES demand functions and trade models using them. The quantity competition analogue is choice of a single level of output. xix. It will also be true for other reductions although the analysis is more complicated. Feldstein and Horioki (198?). and Balasubramanian (????) argue that international capital flows are not large enough to have macro-economic effects. xxvi. if a firm has small shares where it sells the most (as mmight be the case for a small country located near a large country) covariance may be negative. λ(sjk)] need not be positive. and integration will raise the covariance towards zero. Asymmetries in country size mean that initial cov[xjk. Constructed with the assumption that the X industry accounts for 1/3 of national income. xxiii.the Z sector focuses all the effects of integration on the imperfectly competitive sector. xxi. with this distributed across markets such that producer prices are the same in all markets. xxviii.

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