Abstract
Following the failure of multilateral trade negotiations at the
Cancun meeting and the Doha Round, developing countries have pursued an
alternative in so-called "south-south" trade agreements. Since
these agreements lead to trade diversion from efficient north
(developed) countries to less efficient south (developing) partners,
there have been widespread concerns regarding their welfare
implications. Using a three country oligopoly model of trade, we first
examine statically the implications of a south-south customs union (CU)
on the pattern of tariffs and welfare. We find that south countries
always have incentives to form a CU that reduces the welfare of the
north country. Moreover, when south firms are sufficiently inefficient
relative to north firms, a south-south CU leads to a large trade
diversion effect and reduces world welfare. We further show that, in a
repeated interaction model, free trade is less likely to be sustainable
under the south-south CU relative to no agreement.
Introduction
By permitting a group of member countries of the World Trade
Organization (WTO) to form a preferential trade agreement (PTA) wherein
these countries extend tariff concessions to each other but not to other
WTO member countries, Article XXIV of the General Agreement on Tariffs
and Trade (GATT) provides an important exception to the
most-favored-nation (MFN) clause (contained in Article I of GATT). (1)
Since the notion of non-discrimination as specified by the MFN clause is
at the heart of the WTO system, the existence of Article XXIV has not
been without controversy. (2) PTAs are so widespread today that MFN
treatment appears to be more of an exception rather than a norm and,
thus, far from playing a pivotal role in multilateral trade
liberalization. According to the WTO (2009), there are over 200 PTAs in
force today and almost all major countries participate in one or more
PTAs of various types.
Prominent examples of PTAs include the North American Free Trade
Agreement (NAFTA), the South American Common Market (MERCOSUR), the
Association of South East Asian Nations (ASEAN) Free Trade Area, the
Andean Pact, and numerous agreements of the European Union with other
countries.
The failure of multilateral trade negotiations at the Cancun
meeting and the Doha Round led the developing countries to look for an
alternative in so-called "south-south" PTAs. As Stiglitz
(2003) argues, even though there is more to gain from North-South trade
in theory, just as north-north trade agreements have intensified, there
is no question that south-south trade agreements can also flourish.
Bhagwati and Panagariya (1996), Ray (1998), and Das and Ghosh (2006)
contend that the majority of the PTAs have been formed between similar
countries (so-called north-north agreements between developed countries
and south-south agreements between developing countries) rather than
between developed and developing countries (north-south agreements).
This paper aims at addressing the following questions. What are the
implications of a south-south customs union (CU) on the pattern of
tariffs and the welfare of the member and non-member countries and the
world as a whole? Do these agreements facilitate multilateral trade
liberalization process? To address these questions, we develop a
three-country oligopoly trade model with one north (developed) and two
south (developing) countries. We begin with the premise that the north
firms have a superior production technology compared to that of south
firms. (3) That the above questions are important is evident from the
recent proliferation of PTAs between developing countries. As per WTO,
the number of PTAs between developing countries has increased
dramatically over the last two decades: 70 new such agreements have been
formed between 1990 and 2003 and they account for more than 50 percent
of all new trade agreements, including those not notified to the WTO.
Important examples include MERCOSUR in South America, South Asia Free
Trade Area (SAFTA), the Group of Three, and South Africa Customs Union
(SACU). Recently, three major south countries: India, Brazil, and South
Africa, have taken major steps leading to south-south cooperation.
In the literature, following Jacob Viner's (1950) classic
analysis, economists as well as policy-makers have extensively discussed
the static and dynamic distortions created by preferential trade
liberalization. It has been argued that PTAs can lead to trade creation
if member countries switch from inefficient domestic producers and
import from more efficient producers in other member countries of the
PTA. On the other hand, trade diversion takes place when member
countries substitute efficient, low-cost imports from non-member
countries with less efficient imports from member countries. The net
welfare effect of a PTA depends upon which of these two effects
dominate. Since south member countries substitute efficient imports from
non-member north countries with less efficient imports from south
partners, there has been widespread concern regarding the welfare
implications of southsouth CU. Grossman and Helpman (1995) claim that
the formation of trade diverting PTAs is the most likely case. Further,
Schiff and Winters (2003) argue that a PTA between two small developing
countries is likely to generate only trade diversion and no trade
creation. The rationale for this argument is that the increased export
profits in such a PTA stem mainly from trade diversion via an
inefficient transfer of tariff revenue to the bloc's exporters.
This argument is contested by Ornelas (2005) who shows that the
exporting rents generated by exchanging preferential market access and
coordinating external tariffs under a CU can offset trade diversion
losses. It is important to note that Ornelas (2005) uses the same
oligopoly set-up as here but assume that countries are completely
symmetric with respect to production technology, but asymmetric with
respect to market size. Unlike Ornelas (2005), we examine the dynamic
implications of CUs on the multilateral tariff cooperation.
In order to tie our results with those in the existing literature,
we first consider a two-stage static game. In the first stage, given the
agreement in place, countries choose their optimal tariffs. Then, firms
compete in a Cournot fashion. We find that, even when the external
tariff of the member countries fall under CU relative to no agreement
(tariff complementarity effect as required by Article XXIV of the GATT),
the formation of a south-south CU reduces the welfare of the north
country. Moreover, when south countries are sufficiently inefficient
relative to the north, south- south agreement leads to a large trade
diversion effect and thus reduces world welfare. By adding an initial
stage to the above game where south countries decide whether to form a
CU or not, we can show that south countries always have incentives to
form a CU since they benefit from exchanging market access at the
outsider's expense.
We then analyze infinite repetition of the above two-stage static
game to allow countries to cooperate multilaterally over free trade and
show that multilateral cooperation over flee trade is less likely to be
sustainable when south-south CU is formed relative to no agreement.
These results suggest that, when the cost asymmetry across regions is
sufficiently high, the concerns over the negative impact of a
south-south CU on the world welfare and the prospect of global free
trade are legitimate.
Basic Model
We develop a simple oligopoly model of trade in which each country
has a unilateral incentive to impose rent extracting tariffs on those
trading partners with whom it does not have any trade agreement. There
are three countries: one is a north country (n) and the other two are
south countries (s and [??]). Two goods are produced in each country: x
and y. Good x is produced by a single profit-maximizing firm in each
country at a constant marginal cost in terms of the numeraire good y
that is produced under perfect competition with constant returns to
scale technology. The gains from trade stem from reduced market power in
the domestic industry. To this end, the monopoly assumption is not
crucial but is the simplest way to represent market power. Note that,
for notational simplicity, whenever we say firm i, it refers to country
i's firm. The north and south countries are asymmetric with respect
to their marginal costs of production. For simplicity, we assume that
[c.sub.s] = [c.sub.[??]]= c > [c.sub.n] = 0. The assumption that
marginal cost is constant implies that there is no advantage in
establishing more than one plant. If marginal costs were rising, firms
have the incentive to build several plants to serve the foreign markets.
In order to exclude prohibitive cost levels and guarantee market access
of south firms, we assume that c [less than or equal to] [alpha]/4 holds
hereafter. Preferences over the two goods are quasilinear:
[U.sub.i] ([x.sub.i], [y.sub.i]) = u([x.sub.i]) + [y.sub.i] (l)
Furthermore, u([x.sub.i]) is assumed to be quadratic so that the
demand curve for good x is linear in country i:
[p.sub.i]([x.sub.i]) = [alpha] - [[summation].sub.j][x.sub.ji]. (2)
where [x.sub.ji] denotes the output sold by country j's firm
in country i, while [x.sub.i] is the total output sold in country i :
[x.sub.i] [equivalent to] [[summation].sub.j][x.sub.ji]. Note that
[alpha] represents the reservation price for a representative consumer
above which there is no demand for the non-numeraire good.
Next, we consider a two-stage static game that compares no
agreement and a south-south CU with respect to external tariffs and
welfare levels.
Static Game
We examine a two-stage game under two distinct trade regimes: no
agreement ({[PHI]}) and south-south CU ({S}). The game proceeds as
follows. In the first stage, given the trade agreements, countries
simultaneously choose their tariff schedules. Then, firms compete in a
Cournot fashion in the product markets. We solve the above game
backwards in order to obtain subgame perfect Nash equilibrium (SPNE).
No Agreement ({[PHI]})
Since Article I of the GATT (the MFN Clause) forbids tariff
discrimination, we restrict our attention to symmetric external tariffs
by each country. Let [t.sup.[phi].sub.i]be the tariff imposed by
countries where i = n, s, [??]. Firms' effective marginal costs of
exporting equal:
[c.sub.ij] = [c.sub.i] + t[t.sup.[phi].sub.i]be for all i [not
equal to] j. (3)
Then, export profit functions can be written as:
[[pi].sub.ij] = [[p.sub.j](x.sub.j]) - [c.sub.ij]][x.sub.ij], for
all i [not equal to] j, (4)
where [[pi].sub.ij] denotes firm i's export profits in country
j.
First order conditions (FOCs) for profit maximization for exporters
are:
[p.sub.j] + [p'.sub.j][x.sub.ij] = [c.sub.ij], for all i [not
equal to] j. (5)
The above FOCs, together with an analogous condition for the local
firm, can be easily solved for equilibrium output levels and profits:
(4)
[[pi].sub.ij] = [[chi square].sub.ii], ([pi].sub.ij]) = [[chi
square].sub.ij], for all i [not equal to] j. (6)
Due to the symmetric nature of south firms, we denote a typical
south country (firm) by s from hereon. The following comparative static
results are standard:
[dx.sub.zi]/[dt.sup.[phi].sub.i] < 0 <
[dx.sub.ii]/[dt.sup.[phi].sub.i]; and [dx.sub.i]/[dt.sup.[phi].sub.i]
< 0 where z [not equal to] i. (7)
In other words, a country's tariff lowers imports from other
countries to its domestic market, increases the sales of its local firm,
and lowers the total output sold in its market.
Welfare of country i is defined as the sum of its domestic surplus
and total export profits:
[w.sub.i] [equivalent to] [S.sub.i] + [[summation].sub.j[not equal
to]i][[pi].sub.ij], (8)
where
[S.sub.i] [equivalent to] u([x.sub.i]) - [p.sub.i][x.sub.i] +
[[pi].sub.ii] + [t.sub.i][[summation].sub.j[not equal to]i] [x.sub.ji].
(9)
Since markets are segmented, strategic independence of trade
policies is obtained. Thus, country i's tariff choice problem
reduces to:
[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] (10)
The optimal tariffs are given by
[t.sup.[phi].sub.i] = 3[alpha]-2c/10. (11)
South-South CU ({S})
Due to market segmentation, the north country solves the same
problem as in (10) and thus imposes the same optimal tariff as under
({[PHI]}) : [t.sup.S.sub.n] = [t.sup.[phi].sub.n]. When south countries
form a CU with each other, they abolish tariffs on each other and impose
a common external tariff ([t.sup.S.sub.s] on north firm's export.
Therefore, under ({S}), the problem in (10) is modified as follows:
[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] (12)
The following optimal tariff levels solve the above problem:
[t.sup.S.sub.s] = 5[alpha]+2c/19. (13)
Under complete symmetry (c = 0), when south countries form a CU,
export of the south member country increases while that of north
non-member decreases. As a result, compared to ({[PHI]}), south
members' incentive to impose a tariff on the north non-member
decreases since the north non-member country becomes a less important
source for rent-extraction. This result is known as the tariff
complementarity effect in the literature (see Bagwell & Staiger,
1997, 1998). However, when cost of production is sufficiently asymmetric
across regions, the tariff complementarity effect does not necessarily
hold:
[t.sup.S.sub.s] - [t.sup.[phi].sub.s] [greater than or equal to] 0
iff c [greater than or equal to] 7[alpha]/58. (14)
It is important to note that in order to minimize the potential
harmful effects of PTAs, Article XXIV requires that member countries
should not raise tariffs on non-members relative to tariffs under no
agreement. (5) To this end, hereafter we assume that [t.sup.S.sub.s] =
3[alpha] - 2c/10 when c > 7[alpha]/58 holds. Based on these optimal
tariffs, the comparison of welfare yields the following result: (6)
Proposition 1: Suppose that c [less than or equal to] [alpha]/4
holds. Then, the following results are obtained: (i) south countries
always have an incentive to form a CU with each other: [w.sub.s](S) >
[w.sub.s]([PHI]) for all c; (ii) south-south CU always reduces the
welfare of north countries: [w.sub.n](S) < [w.sub.n]([PHI]) for all
c, and (iii) world welfare is lower under ({S}) relative to ({[PHI]}) if
the cost asymmetry is sufficiently large: ww (S) [less than or equal to]
ww ([PHI]) iff c [greater than or equal to] [c.sup.ww] = 29 [alpha]/126.
The first part of the above proposition provides a support to the
idea that, as north-north trade agreements have intensified, there is no
question that south- south trade agreements can also flourish. In other
words, south countries always have an incentive to form a CU excluding
the efficient north country. The second part of the above proposition
argues that the non-member country is worse off under ({S}) relative to
({[PHI]}) since while its domestic surplus stays unchanged, its firm is
discriminated in each of the south country markets against its rival
exporter. Finally, when the cost asymmetry across regions is
sufficiently high, the concerns over the negative impact of such
agreements on the world welfare are legitimate. The intuition behind the
last part of the proposition is as follows. Since south member countries
have free access in each other's market while the north
country's firm faces an external tariff, they substitute efficient
imports from the non-member north country with less efficient imports
from south partners. As a result, trade diversion effect arises and it
increases as the cost asymmetry rises. Thus, as represented in figure 1,
world welfare is lower under ({S}) relative to ({[PHI]}) when south
firms are sufficiently inefficient relative to the north firm.
Next, we employ infinite repetition of this one-shot game in order
to examine the implications of south-south CU on the prospect and
sustainability of global free trade.
[FIGURE 1 OMITTED]
Sustainability of Cooperation over Free Trade
In order to determine whether multilateral cooperation over free
trade under ({S}) is easier or harder to sustain relative to ({[PHI]}),
we analyze infinite repetition of the above one-shot game. As in Riezman
(1991), Bagwell and Staiger (1997a, 1997b, 1998), Bond, Syropoulos, and
Winters (2001), and Saggi (2006), such cooperation is required to be
self-enforcing: each country balances the current benefit of deviating
from the cooperative tariff against the future losses it suffers under
the permanent trade war that results from its defection. Similar to
Saggi (2006), we assume that CU is permanent by nature so that members
retain zero tariffs on each other, even if cooperation with the
non-member breaks down.
Tariff Cooperation over Free Trade under ({[PHI]})
Suppose each country employs a zero tariff until someone defects,
in which case cooperation breaks down with countries switching to their
MFN tariffs forever. In order to proceed, it is useful to discuss the
costs and benefits of multilateral cooperation for all countries. Under
free trade, the per period welfare of a country equals:
[w.sup.F.sub.i](t = 0) [equivalent to] [S.sub.i]([t.sub.i] = 0) +
[[summation].sub.z[not equal to]i][[pi].sub.iz]([t.sub.z] = 0). (15)
Let [w.sup.D.sub.i] ([t.sup.[phi].sub.i],[t.sub.z] = 0) denote the
welfare of a country that defects from free trade to its optimal tariff,
[t.sup.[phi].sub.i]:
[w.sup.D.sub.i]([t.sup.[phi].sub.i],[t.sub.z] = 0) [equivalent to]
[S.sub.i] ([t.sup.[phi].sub.i] + [[summation].sub.z[not equal
to]i][[pi].sub.iz]([t.sub.z] = 0). (16)
It is immediate from the above equations that defection from free
trade benefits the defecting country by increasing its domestic surplus
through the ability to impose optimal tariffs. One period benefit from
defection for south countries equals
[B.sub.s]([PHI]) = [w.sup.D.sub.s]([t.sup.[phi].sub.s],[t.sub.z] =
0) - [w.sup.F.sub.s](t = 0) = [S.sub.s] ([t.sup.[phi].sub.s] -
[S.sub.s]([t.sub.s] = 0) = [[3[alpha] - 2c].sup.2]/160 > 0, where z
[not equal to]s. (17)
Similarly, one period benefit from defection for the north country
equals
[B.sub.n]([PHI]) = [w.sup.D.sub.n]([t.sup.[phi].sub.n],[t.sub.z] =
0) - [w.sup.F.sub.n](t = 0) = [S.sub.n] ([t.sup.[phi].sub.n] -
[S.sub.n]([t.sub.n] = 0) = [[3[alpha] - 2c].sup.2]/160 > 0, where z
[not equal to] n. (18)
It is important to note that one period benefit from defection
falls as the degree of asymmetry between south and north firms rises:
[[partial derivative]B.sub.s]([PHI])/[partial derivative]c
=[[partial derivative]B.sub.n]([PHI])/[partial derivative]c < 0
Next, we consider the per period cost of defection. When
cooperation breaks down, from next period on, countries use their MFN
tariffs. The per period cost to a south country of the breakdown of
cooperation is given by:
[C.sub.s]([PHI]) = [w.sup.F.sub.s](t = 0) - [w.sub.s]([PHI])=
[-B.sub.s]([PHI]) + [summation] [[pi].sub.sz] ([t.sup.[phi].sub.z] = 0)
- [summation] [[pi].sub.sz]([t.sup.[phi].sub.z])] = [13[alpha] -
62c][3[alpha]-2c]/800, where z[not equal to]s. (19)
The lower the production cost of its trading partner, the smaller
is the increase in export profits enjoyed by a country due to the trade
liberalization undertaken by its partners, and the larger is the loss in
local profits suffered by the domestic firm due to its own trade
liberalization. As a result, cost of defection to a country depends
negatively (positively) on its own (rivals') cost:
[[partial derivative]C.sub.s]([PHI])/[partial derivative]c < 0
(20)
This result suggests that when south firms are sufficiently high
cost relative to north firm, cost of defection may even become negative:
[C.sub.s]([PHI]) [less than or equal to]0 iff c [greater than or
equal to] [c.sup.cr] = 13a/62 (21 )
Since benefit of defection is always positive for south countries,
it is immediate from (21) that, when c [greater than or equal to]
[c.sup.cr] holds, cooperation over free trade is never sustainable. That
is, there is always an incentive for south countries to defect in this
case.
On the other hand, cost of defection is always positive for the
north country and gets larger as the cost asymmetry between the two
regions increases:
[C.sub.n]([PHI]) = [w.sup.F.sub.n](t = 0) - [w.sub.n]([PHI])=
[-B.sub.n]([PHI]) + [summation] [[pi].sub.nz]([t.sub.z] = 0) -
[summation] [[pi].sub.nz]([t.sub.z])] = [t.sup.[phi].sub.z])] [13[alpha]
+ 98c][3[alpha]-2c]/800, where z[not equal to]n. (22)
and
[[partial derivative]C.sub.n]([PHI])/[partial derivative]c > 0
(23)
More importantly, the per period cost of the breakdown of
cooperation to a south country is lower than that to a north country:
[C.sub.s]([PHI]) [less than or equal to] [C.sub.n]([PHI]). (24)
For cooperation to be sustainable, the current benefit of defection
must be less than the discounted life-time cost of defection for each
country. In other words, the incentive compatibility (IC) constraint
must hold for each country as follows:
[B.sub.i]([PHI]) [less than or equal to] [delta]/1-[delta]
[C.sub.i]([PHI]) for all i (25)
where [partial derivative] denotes the discount factor and
[delta]/1-[delta] [C.sub.i]([PHI]) measures the trade war's cost to
each country under ({[PHI]}). For each country, the critical discount
factor, [[delta].sup.[phi].sub.i], above which cooperation over free
trade is self-enforcing is obtained when [B.sub.i]([PHI]) =
[C.sub.i]([PHI]) holds. From the expressions (17), (18), and (24), the
following is immediate (see figure 2):
Proposition 2: Under ({[PHI]}), the range of discount factors above
which north country is willing to cooperate over free trade is larger
than that above which south countries are willing to cooperate. It
implies that: [[delta].sup.[phi].sub.s]> [greater than or equal to]
[[delta].sup.[phi].sub.n]. Thus, multilateral cooperation over free
trade is sustainable if and only if [delta] [greater than or equal to]
[[delta].sup.[phi].sub.s].
[FIGURE 2 OMITTED]
The above proposition suggests that since the benefit of defection
is the same while the cost of defection is smaller for south countries
relative to the north country, the critical discount factor above which
south countries are willing to cooperate over free trade binds for the
sustainability of multilateral cooperation over free trade.
Tariff Cooperation over Free Trade under ({S})
Now, we consider how the formation of a south-south CU alters
incentives for multilateral tariff cooperation. To this end, we discuss
how the costs and benefits of multilateral cooperation for all countries
change. It is straightforward to argue that when countries cooperate
over free trade, the per period welfare of the north country stays the
same under ({S}) as in (15) under ({[PHI]}). Therefore, the benefit of
defection from cooperation for the north country remains the same under
({[PHI]}) and ({S}).
Next, consider the cost of the defection of the north country. When
cooperation breaks down, from the next period on, the north country
responds by raising its tariff on imports from south countries from zero
to [t.sup.[phi].sub.n] as under ({[PHI]}). In contrast, north country
faces [t.sup.S.sub.s](instead of t.sup.[phi].sub.s]) in the south
countries that abolish tariffs between each other. It follows
immediately from the second part of the proposition 1 that:
Lemma 1: The per period cost to a north country of the breakdown of
cooperation is higher under ({S}) than under ({[PHI]}), while the
benefit of defection stays the same under these two regimes.
The above lemma implies that a south-south CU makes north countries
more willing to cooperate multilaterally over free trade. Next, we
consider the incentives of south countries for multilateral tariff
cooperation. Note that, by the nature of the institution, defection from
cooperation by a CU involves defection by both members. In the following
discussion, the welfare per CU member is considered.
Let [w.sup.D.sub.s]([t.sup.S.sub.s], [t.sup.S.sub.z] = 0) denote
the welfare of a south country that defects from zero tariff to its
optimal tariff [t.sup.S.sub.s] under ({S}):
[w.sup.D.sub.s]([t.sup.S.sub.s], [t.sup.S.sub.z] = 0) [equivalent
to] [S.sub.s]([t.sup.S.sub.s] +[[pi.sub.s[??]][t.sup.S.sub.s] +
[[pi.sub.sn]([t.sup.S.sub.n] = 0). (26)
Thus, one period benefit from defection for south countries under
({S}) equals
Bs(S) = [w.sup.D.sub.s]([t.sup.S.sub.s], [t.sup.S.sub.z] = 0) -
[w.sup.F.sub.s](t = 0) = [S.sub.s]([t.sup.S.sub.s] -
[[S.sub.s]([t.sup.S.sub.s] = 0)] + [[pi.sub.s[??]][t.sup.S.sub.s] -
[[pi.sub.s[??]][t.sup.S.sub.s] = 0)] = [[5[alpha] + 2c].sup.2]/608 >
0, if c [greater than or equal to] 7[alpha]/58. (27)
On the other hand, one period cost of defection to south countries
under ({S}) is given by:
[C.sub.s](S) = [w.sup.F.sub.s](t = 0) - [w.sub.s](S) =
[-B.sub.s](S) + [summation] [[pi].sub.sn]([t.sup.S.sub.n] = 0) -
[summation] [[pi].sub.sn]([t.sup.S.sub.n])].
The first part of proposition 1 implies that the cost of defection
is unambiguously lower under ({S}) relative to ({[PHI]}) and gets
negative when south firms are sufficiently high cost (multilateral
cooperation is never sustainable). Similar to the analysis under
({[PHI]}), the incentive compatibility (IC) constraint must hold for
each country for multilateral cooperation to be sustainable:
[B.sub.i](S) [less than or equal to] [delta]/1 - [delta]
[C.sub.i](S) for all i. (29)
Let [[delta].sup.S.sub.i] denote the critical discount factor above
which cooperation is self-enforcing for country i under ({S}). The
following result is depicted in figure 3:
Proposition 3: Under ({S}), the range of discount factors above
which north country is willing to cooperate over free trade is larger
than that above which south countries are willing to cooperate. It
implies that: [[delta].sup.S.sub.s] [greater than or equal to]
[[delta].sup.S.sub.n]. Thus, multilateral cooperation over free trade is
sustainable if and only if: [delta] [greater than or equal to]
[[delta].sup.S.sub.n].
[FIGURE 3 OMITTED]
The above proposition has a similar implication as Proposition 2 in
the sense that south countries' choices are binding for the
sustainability of multilateral cooperation. Next, we ask whether
south-south CU makes multilateral cooperation over free trade easier to
sustain or not. To this end, figure 4 compares [[delta].sup.[phi].sub.s]
and [[delta].sup.S.sub.s]
[FIGURE 4 OMITTED]
The major implication of proposition 1 and proposition 4 is that
when south firms are sufficiently high cost relative to north firms, the
formation of a south-south CU not only reduces world welfare statically
via trade diversion but also makes multilateral cooperation over free
trade harder to sustain. These two results suggest that the concerns
regarding the impact of south-south agreements on world welfare and the
prospect of global free trade are legitimate.
Conclusion
Over the last few decades, the proliferation of PTAs has been the
visible trend in the international trading system. According to the WTO,
on an average, each country belongs to six PTAs and Mongolia is the only
country that does not belong to a PTA. Jagdish Bhagwati (1991) famously
raised concern about the potential adverse effects of the pursuit of
PTAs on the pattern of tariffs, welfare, and the prospect of
multilateral trade liberalization. His work led to a rich body of
research that has examined the implications of preferential trade
liberalization along several fronts. Since Jacob Viner's (1950)
classic analysis, the static and dynamic distortions created by
preferential trade liberalization have received substantial attention
from economists and policy-makers alike. The net welfare effect of a PTA
depends upon the relative dominance of the trade creation effects and
the trade diversion effects of the PTAs. Since south member countries
would substitute efficient imports from non-member north countries with
less efficient imports from south partners, there have been widespread
concerns over the welfare implications of south-south PTAs.
This paper addresses two interrelated questions: What are the
static implications of a south-south PTA on the pattern of tariffs and
the welfare of the PTA member countries and the world when PTA is in the
form of a customs union? Do these agreements facilitate multilateral
cooperation over free trade dynamically? These questions are important
since the number of PTAs among developing countries has increased
dramatically over the last two decades. We show that south countries
always have incentives to form a CU among themselves, under which the
north country is always worse off relative to no agreement. More
importantly, when the degree of cost asymmetry between developed and
developing countries is sufficiently high, the concerns regarding the
adverse impact of such agreements on the world welfare are legitimate.
We further show that the multilateral cooperation over free trade is
less likely to be sustainable under a south-south customs union relative
to no agreement.
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Hiranya K. Nath
Sam Houston State University * Huntsville, Texas
Halls Murat Yildiz
Ryerson University * Toronto, Ontario
Notes
(1.) The MFN clause states that: "Under the WTO agreements,
countries cannot normally discriminate between their trading partners.
Grant someone a special favour (such as a lower customs duty rate for
one of their products) and you have to do the same for all other WTO
members. This sounds like a contradiction. It suggests special
treatment, but in the WTO it actually means non-discrimination--treating
virtually everyone equally.... Each member treats all the other members
equally as "most-favoured" trading partners. If a country
improves the benefits that it gives to one trading partner, it has to
give the same "best" treatment to all the other WTO members so
that they all remain "most-favoured'"'(WTO webpage:
http://www.wto. org/english/thewto_e/whatis_e/tif_e/fact2_e.htm#seebox)
(2.) To minimize the potential harmful effects of PTAs, Article
XXIV requires that: (i) a PTA must cover almost all trade between its
members; (ii) PTA members must
fully eliminate tariffs and other trade restrictions on each other;
and (iii) they should not raise tariffs (or any other trade
restrictions) on non-members.
(3.) In a similar set-up, Das and Ghosh (2006) employ an endogenous
coalition formation model to provide a rationale for why trading blocs
among similar countries may arise as an equilibrium phenomenon.
(4.) Note that, in order to guarantee positive output levels for
the south firms in the north country is market, we assume that c [less
than or equal to] [alpha]/4 holds.
(5.) See Hoekman and Kosetcki (2001) for an extended discussion of
Article XXIV.
(6.) For detailed proof of the propositions, the readers may
contact the corresponding author.
Biographical Sketch of Authors
Hiranya K. Nath is an Associate Professor of Economics at Sam
Houston State University. He has published on inflation and relative
price behavior, the growth of transition economies of Central and
Eastern Europe, the growth of Bangladesh, and information economy in
refereed journals including Applied Economics, Applied Economics
Letters, Applied Financial Economics Letters, California Management
Review, Comparative Economic Studies, Economics Letters, Journal of
International Trade & Economic Development, Journal of
Macroeconomics, Journal of Money, Credit and Banking, and Review of
Development Economics. He earned his Ph.D. in Economics from Southern
Methodist University, Dallas (TX).
Halis M. Yildiz is an Associate Professor of Economics at Ryerson
University, Toronto, Canada. He has published on international trade
policy, foreign direct investment, trade and environmental policy in
reputed journals like Canadian Journal of Economics, Economics Letters,
Indian Growth and Development Review, International Economic Journal,
International Review of Economics and Finance, Journal of Environmental
Economics and Management, Journal of International Economics, Journal of
International Trade & Economic Development, and Review of
International Economics. He holds a Ph.D. in Economics from Southern
Methodist University, Dallas (TX).