DIFFERENT PATHS TO FREE TRADE: THE GAINS ...

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DIFFERENT PATHS TO FREE TRADE: THE GAINS FROM REGIONALISM* CAROLINE FREUND

We compare free trade reached through expanding regional trading blocs to free trade accomplished by multilateral negotiation. With sunk costs, the outcomes are different. Trade in an imperfectly competitive good flows disproportionately more between the original members of a regional agreement even after free trade is reached. They secure a higher welfare level from regionalism than from free trade achieved multilaterally; nonmembers, however, reach a lower welfare level. A surprising result is that world welfare during free trade is greater when it is achieved by the regional path. We conclude with some empirical evidence from the European Union that is consistent with the model.

1.

INTRODUCTION

The current proliferation of preferential trade agreements (PTAs) has led to renewed interest in the economics of regionalism. The recent literature has focused on how preferential trade agreements affect welfare and on how they influence the scope for further multilateral trade liberalization.! Krugman [1992], Bond and Syropoulos [1996], and Bagwell and Staiger [1997] examine trade policy and welfare in the presence of exogenously formed customs unions. Their findings suggest that welfare and external tariffs may depend on transport costs, endowments, and the ability of countries to commit to tariff reduction. A related literature analyzes the incentives for preferential and multilateral trade liberalization, under the assumption that governments care relatively more about certain sectors of the economy. While Baldwin [1995] and Richardson [1993] conclude that regionalism

* I am very grateful to Jagdish Bhagwati, Kyle Bagwell, and John McLaren for many useful discussions. I also benefited from comments from Alberto Alesina, Richard Baldwin, Olivier Blanchard, Alessandra Casella, Simeon Djankov, Simon Evenett, Philip Lane, Catherine Mann, Usha Nair, Seamus O'Cleireacain, Francisco Rivera-Batiz, Dani Rodrik, John Rogers, Maurice Schiff, Neeraja Sivaramayya, Kei-Mu Yi, an anonymous referee, and seminar participants at Clemson University, Columbia University, the Federal Reserve Board, Pennsylvania State University, Texas A & M College of Business, the World Bank, and The Empirical Investigations in International Trade Conference. An earlier version ofthis paper, titled "Regionalism and Permanent Diversion," was Chapter 1 of my Ph.D. thesis. The views presented in this paper are solely the responsibility of the author and should not be interpreted as reflecting the views of the Board of Governors of the Federal Reserve System or any other person associated with the Federal Reserve System. Correspondence: email: [email protected], phone: 202-452-2762, Fax: 202-452-6424. 1. See Bhagwati and Panagariya [1996] for a detailed discussion of the economics of regionalism. © 2000 by the President and Fellows of Harvard College and the Massachusetts Institute of Technology. The Quarterly Journal of Economics, November 2000

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QUARTERLY JOURNAL OF ECONOMICS

can speed up the liberalization process, Grossman and Helpman [1995], Findlay and Panagariya [1996], Levy [1997], and Krishna [1998] find that political support for free trade is likely to decline after a PTA is formed. In these models, welfare and optimal trade policy are affected because preferential treatment induces a redistribution of consumption and production among countries and among constituencies within countries. 2 However, what these models fail to take into account is that altering the structure of production and trade is costly. 3 This has implications for the sequencing of trade liberalization, and in particular, suggests that free trade achieved through regional expansion may look quite different, in terms of the trade flows between countries and the welfare of each country, from free trade achieved via multilateral tariff reduction. In addition, countries may be able to strategically order their liberalizations to influence trade orientation and improve welfare. This paper examines alternative liberalization strategies to determine how they influence trade flows and welfare. We compare free trade reached through expanding preferential trade agreements with free trade reached via multilateral liberalization. In a three-country two-period model with quantity competition and sunk costs, we find that a regional agreement in the first period, followed by free trade in the second period, leads to permanently greater trade among the member nations. Permanent effects arise because firms undertake irreversible investment before free trade is achieved. 4 Specifically, we assume that each firm incurs a distribution network cost that is based on quantity, and that the cost of the distribution network inherited in the second period is sunk. An existing firm's marginal cost will therefore be lower in the second period since it is only the production cost. Thus, whenever an incumbent firm competes 2. Regional agreement, bilateral trade agreement, preferential trade agreement, and regionalism are used interchangeably in this paper. 3. Significant hysteresis has been observed in bilateral trade flows and is found to be associated with sunk costs involved in exporting. The theoretical contributions linking observed trade patterns to sunk costs are Baldwin [1988], Baldwin and Krugman [1989], and Dixit [1989]. Roberts and Tybout [1997] find empirical evidence that sunk costs associated with exporting playa significant role in determining exports at the firm level. 4. McLaren [1997] also examines the interaction of sunk costs and regional agreements. He shows that a small country can be made worse off as a result of forming a PTA with a large country if there is a possibility of future trade negotiations. The small country loses bargaining power once sunk costs to expand the export sector have been expended.


DIFFERENT PATHS TO FREE TRADE

1319

with a new-entrant firm, it has a cost advantage, and its Cournot exports will be relatively greater. The irreversibility of investment in the distribution network also implies that firms in the original PTA member nations will effectively gain first-mover advantages in exporting to each other. There is a strategic incentive for them to commit to high bilateral exports in the first period in order to limit second-period exports by firms from the new member. As a result, second-period world output is greater, and the member nations earn higher profits abroad from the regional path than from the multilateral path. Comparing the welfare associated with free trade achieved via regionalism with that of free trade achieved via multilateral negotiation, we find that the primary members of a trade bloc attain a higher level of welfare from the regionalism path, while late entrants fall to a lower level of welfare. Moreover, world welfare in the second period is greater from the regional path. The gains to the original members are greater than the loss to the entrant, implying that there is no compensation the entrant can offer the initial members to be permitted at the start. One testable implication of this model is that order of entry into a trade bloc will affect future market shares among members. To evaluate the importance of first-mover advantage in trade empirically, we examine trade data for the European Union. The European Union serves as a unique natural experiment because it expanded from six members in 1958, to nine in 1973, and reached twelve by 1986. The model implies that the original members will be able to establish trade links that persist after other countries enter the union, and thus that the founding members will trade more with one another from 1958 onward. The gravity equation is used as a basis by which to test the importance of the date of entry. We find that in 1962 the original members of the European Union traded over 65 percent more with each other, by 1970 the founders traded more than twice as much with each other as with the nonmembers, and in 1990 the six still traded over 75 percent more with each other than with the late entrants. The empirical evidence is thus broadly consistent with the market share results predicted by the model. Alternatively, the relatively high trade intensity among the original members might be natural, a result of comparative advantage, tastes, or technology. There is, however, little evidence that the original members traded more with each other than was predicted by the gravity equation before the common market is


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created. In addition, after controlling for initial (preunion) trade flows, the original members still trade relatively more with each other fonowing the establishment of the European Economic Community. Finally, a comparison of trade between the original members and two countries that were similar in terms of trade, tariffs, and size in the 1950s, but joined at different times, also suggests that date of entry affects current trade intensity. The evidence is therefore inconsistent with the view that the original members trade more with each other entirely as a result of comparative advantage, tastes, or technology. This paper is divided into four sections. The next section develops the model, the third section examines its predictions on market share empirically, and the last section concludes.

n.

THE MODEL

We consider three identical countries, A, B, and C, each with n firms producing a homogeneous good. Competition is Cournot, and welfare gains are a result of the increase in competition that trade introduces (as in Brander and Krugman [1983] and Brander and Spencer [1985]). We further assume that market-specific investments are required to sen the good in a particular market. Indeed, most traded goods, aside from commodities, must be adapted to the country's tastes and marketed effectively in order to be sold abroad. Many of these investments are specific to the foreign country and are not likely to be recouped if the firm exits. While we focus on distribution costs in order to simplify the model, many other types of costs are important and would generate similar effects. Some examples include examining foreign competition, adapting the product, learning the legal and institutional infrastructure, developing an advertising campaign, acquiring clientele, and establishing contacts with local bankers, trade associations, and transport providers [Axtell 1989] .5 The game has two periods, and there is perfect information. Within each period there are two stages. In the first stage, 5. In addition, survey results from the National Federation of Independent Businesses indicate that costly investments in distribution, information, and marketing are the primary reasons that firms do not enter the export market [Axtell 1989]. Distribution costs in key industries are especially important. In the automobile industry, for example, distribution costs make up nearly 30 percent of sale prices in the industrialized countries. In Europe almost all dealers carry only one brand so getting a distributor is particular to the country and to the firm. Also in the high-tech industries, where marginal production costs are close to zero, large investments in marketing and distribution make up the bulk ofthe costs.



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governments set policy. In the second stage, output is produced and traded. Policy consists of (i) forming a regional agreement, (m allowing free trade, or (iii) autarky. We assume that only two of the countries, A and B, have the option to form a regional agreement, perhaps because of proximity. In this case, they have zero bilateral tariffs, but do not allow imports of the imperfectly competitive good from the third country C. Meanwhile, the government in country C chooses between total free trade and autarky. Once trade policy is set, each firm decides on exports. In the second period, the game repeats itself. The governments first choose policy, and then firms choose sales at home and abroad. In the first period, we assume that domestic firms have the opportunity to set up domestic distribution networks before trade policy is set. This is optimal because it improves home country profits, leads to expanded output, and allows countries to achieve a higher welfare level. This assumption also generates a "home bias" in consumption-domestic absorption is biased toward domestic production-which is consistent with empirical evidence. Finally, it eliminates the possibility that countries benefit in their own market as a result of trade policy. If a firm could not set up its domestic distribution network first, then its position in the home market would (by symmetry) be identical to its position in the partner's market, implying that trade policy would affect the firm's domestic production in the same way as it affects exports to the other member country. A Market Structure

Demand for the imperfectly competitive good in each country is defined by (1)

P =K- Q,

where P is price, K is a constant, and Q is total output. The markets here are assumed to be segmented; that is, it is prohibitively costly to cross-haul output. 6 In a given market, costs for each firm without a distribution network in place are

(2)

c = wq

+ xq,

6. Widely observed deviations from the law of one price are consistent with segmented markets and pricing to market. Moreover, Engel and Rogers [1996] find that the law of one price holds more closely within regions-they speculate that this may be the result of integrated marketing and distribution systems.


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q* FIGURE I The Reaction Function of a Firm

where x is the variable cost of the distribution network, q is quantity, and w is the variable cost of production. A firm that has already set up a distribution network faces the fonowing cost function:

(3)

c = wq + xq* + x max (q - q*,O),

where q* is the quantity chosen in the first period. This implies that the cost of the distribution network in the second period is fixed at xq*, provided that output is less than or equal to first-period output; therefore, the firm's second-period marginal cost is lower than its first-period marginal cost, for q :s q*. 7 Building a distribution network for q* in the first period allows the firm to shift out its second-period reaction function. Figure I shows the reaction function of a firm with a marginal cost of w + x (AA) and the reaction function of a firm with a marginal cost of w (AA'). Since a firm with an established distribution network has a marginal cost ofw for output below q* and w + x for output above q*, it presents the bold reaction function to other firms. The key feature of this reaction function is the vertical segment. No matter how much the competitors produce within this range, it remains optimal for the firm to produce q*. Hence, 7. For a complete description of this type of cost function and its effect on a two-firm market, see Dixit [1980].



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within a given range, a firm can effectively precommit to maintaining sales in a particular market. 8

B. Solution There are several strategies that need to be examined, but some can be ruled out immediately. A welfare-maximizing government will always prefer some trade to no trade. In addition, no country will ever choose to go from free trade to regionalism. If free trade is optimal in the first period, then it will be in the second period as well. The same is not true of regionalism to free trade since regionalism affects the free trade outcome. The main question becomes will countries A and B choose regionalism followed by free trade or free trade in both periods? The government knows how firms will behave under each policy scenario and will choose the path that maximizes welfare. We start by evaluating the outcome if regionalism is followed by free trade and then examine free trade in both periods. We solve for the equilibrium output levels in marketA, assuming that A and B choose to exclude C in the first period and have complete free trade in the second period. The problem is solved backwards. First, we solve for second-period Cournot quantities, and then we solve for first period output. We assume that each firm from country A and country B is on the vertical part of its reaction function in the second period and therefore produces the same amount in both periods. Next, we provide the conditions under which full commitment is feasible and optimal. The objective of each firm from country C is to maximize profits with respect to exports to country A, max zdP(n~ 2 + ncrl2 + (n - 1)£Jt; 2 + zc) - w - x], zc

"

,

where qj,k is the quantity for sale in country i, by a firm from countryj, in the kth period, Zi is the output of a representative firm 8. It is not crucial that the distribution cost is paid in both periods. For example, if the sunk cost were paid entirely in the first period, then the incumbent's second-period cost function would bee = wq +xmax (q - q*,O), which yields an identical reaction function to the one shown. However, if the entrant in the second period were required to make the same investment, then the entrant would have higher average costs (since it makes sales in only one period), giving the incumbent firm a real cost advantage. The chosen cost function implies that all firms have identical average costs. Thus, the advantage to being first is entirely because the investment is sunk.


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from country i, and Zi = q12 in equilibrium. The solution to this problem defines q~ 2 as a fu~ction of qi and q~. In the first period, each firm in B maximizes profits taking into account the effect of today's output choice on next period's profits. Since the quantities do not change between periods, the time subscript is dropped. The optimization problem, for a firm fromB, is maxzB[P(nqi

+ (n

- 1)tfs

+ ZB)

xl

- w -

ZB

+

I3zB[P(nqi

+ m/c(nqi,(n

- l)tfs,zB)

+ (n

- l)tfs

+ ZB)

-

w - x],

where 13 is the rate of time preference. 9 The solution to this problem defines q~ as a function of qi and q~. Each firm in country A chooses its distribution network before each firm from B, so we have max ZA [P«n - 1)qi + ZA + ntfs«n - 1)qi,ZA)) - w - xl ZA

+ I3zA[P«n

- 1)qi

+ n~2«n

+ ZA + ntfs«n

- 1)qi,ZA)

- 1)qi,zA,ntfs«n - 1)qi,ZA))) - w -

xl.

The solution to this problem defines qi as a function of q~ and q~. As noted above, a first-mover advantage is guaranteed to all domestic firms in their home market relative to foreign firms. If firms from A and B enter both markets simultaneously (no home market advantage), then the PTA would also generate a first-mover advantage for firms in their domestic market. In that case, the quantity and welfare effects that result from having a regional agreement before free trade would be magnified because there would be an additional positive effect on home market profits. Under the chosen setup, the regional agreement exclusively improves market share in the partner country. 10 Solving the firms' problems above, yields the equilibrium 9. 13 is not restricted to being less than one; 13 will be greater than one if governments care more about the future. 10. An alternative would be to assume that firms did not pay distribution costs in their home market. In this case, domestic firms would sell at least as much as under the present assumptions, and the following results would survive. There


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quantities, (4)

~AA =

!fA

K-w-x n

+

1

K-w-x

~B = - - -

,!fn

(n

+

1)2 ' and~·

lJC,2

K-w-x =----

(n

+

1)3

The quantity of each firm from A is the Stackelberg leadership quantity with respect to a firm from B or C, and the Cournot quantity with respect to another firm from A. The quantity of a firm from B is the Stackelberg leadership quantity with respect to a firm from C, and a Stackelberg follower quantity with respect to a firm from A. The quantities, q~ and q~ above, are credible in the second period only if each incumbent firm would not wish to reduce its quantity once firms from C have entered. If the Cournot quantity in the second period, with a marginal cost ofw, is greater than or equal to the quantity chosen in the first period, then a firm is on the vertical portion of its reaction function and can maintain sales. The condition that must be satisfied for each firm in country A, in the second period, is

qi : :; (K -

w - nCJ1 - n(/r)/(n

+

1).

The left-hand side of the equation above is the optimal quantity (from (4» that a firm from A produces. The right-hand side is the Com'not quantity that the firm would produce if its marginal cost was w. Using the quantities from equation (4) and simplifying, we have

(5)

distribution cost/markup

2::

n 2 + 2n.

There is a corresponding condition for the credible commitment of each firm from B in A's market. It is less stringent than the condition on a firm from A, since each firm from B produces less than each firm fromA. The condition for a firm from B reduces to

(6)

distribution cost/markup :::= n.

Provided that the distribution cost x is large enough, firms from A would, however, be a welfare loss from trade as a result of wasted distribution payments.


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and B can effectively precommit to their Stackelberg leadership quantities. 11 1. If the sunk part of the distribution cost is large enough, firms from the PTA member countries can commit to their leadership quantities in each other's markets before firms from the third country enter.

PROPOSITION

Next we examine output in C's market, assuming that firms from A and Benter C's market simultaneously. Each firm solves the following maximization in the period when it enters C's market: maxZAB(P(nqg

+ (2n

- 1)q~

+ ZAB)

- w - x),

ZAB

where ZAB is the output that a representative firm in A or B exports to C. The solution to this problem defines q~ (and by symmetry q~) as a function of qg. Iffirms from A and B enter in the second period, the problem that each firm from C will solve is max zc(P«n - 1)qg + zc) - w - x) + [3zC is the same in both periods: W~ = U(~c) - (w

+ x)(~c),

which simplifies to (13)

:A

W

FT

=

13n 2 + 6n + 4n 4 + 12n 3 (K - w - X)2 - - - - - - - - 2(n + 1)2(2n + 1)2

From equations (11) and (13), first-period welfare from regionalism is greater than first-period welfare from immediate free trade (W~ > W~). Welfare from free trade achieved after regionalism is also greater than welfare from immediate free trade (W~,FT > W~T). Therefore, the original members of a bilateral agreement are at a higher welfare level in both periods as a result of having a regional agreement before free trade, relative to choosing free trade in both periods. PROPOSITION 4. Welfare in the original members of the PTA is greater if free trade is achieved after a regional agreement than if it is achieved immediately. Welfare is greater because ofthe effect of sequential entry on quantity and profits. In the first period, profits accruing to firms from A and B are higher than they would be under free trade since firms from C are excluded. This gain in profits exceeds the corresponding loss in consumer surplus as a result of excluding C.13 In the second period, profits abroad remain relatively larger because of the first-mover advantage. Moreover, the total quantity consumed in country A is greater than the total quantity from multilateralism. Thus, in the bloc countries, consumer surplus in free trade subsequent to a regional agreement is larger than consumer surplus from immediate free trade. Welfare in country C, in the first period, is ~ = U(Q~c) - (w

+ x)(Qg)

- PQ~.

Plugging in from the quantities solved for above, yields me

(14)

vv" R

= (K-

(n + 1)2(2n + 1)2 - (4n + 1) W -X)2----------2(n + 1)2(2n + 1)2

13. If C does not allow imports in the first period under regionalism, then first-period welfare inA and B is lower relative to free trade welfare. Second-period welfare is still greater. In that case, provided that 13 is greater than 0.95, the present discounted value of welfare is still greater from regionalism.


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In the second period after a regional agreement, welfare in country Cis ~,FT

= U(Q;uw)

- (w

+ x)(Qg) - PQJw + rr~.

Using the quantities solved for above, this simplifies to (15)

~,FT = (K -

w -

X)2

(n [

+

1)2(2n 2(n

+

+

1)2 - (4n

1)2(2n

+

1)2

+

1)

2n]

+. (n

+

1)6

In both periods, country C is worse off from the regional path to free trade. 5. Welfare in the nonmember country is greater if free trade is achieved multilaterally than if it is achieved subsequent to a regional agreement.

PROPOSITION

Firms in country C lose on two accounts if free trade is achieved via regionalism: (i) they are excluded from the foreign market in the first period; and (ii) in the second period they have less scope for expansion abroad because output offirms inA and B is greater. Thus, the late entrant to a regional agreement obtains a higher welfare level from immediate free trade than from entering a regional agreement previously signed by the other nations. Next, we turn to world welfare, defined as the sum of the three countries'welfare levels. World welfare in the period offree trade after regionalism, WWR,FT, is higher than world welfare in free trade not subsequent to a regional agreement, WWFT,FT. (16)

WWR,FT -

WWFT,FT =

(K - w -

+ 4n + n 2) > O. + n)6(1 + 2n)2

[3n 2(2 X)2

(1

The intuition is that world output is greater after regionalism than if there was free trade in both periods. The amount the early entrants gain from free trade reached through a regional agreement is thus greater than the amount the late entrant loses. This implies that even if side payments are feasible, if the members care relatively more about second-period gains, then the nonmember cannot bribe the regional bloc countries to allow free trade in the first period because the members' gains are greater than what the nonmember would be willing to pay.14 14. World welfare in the first period is lower in regionalism than in free trade.



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6. World welfare in the period of free trade after regionalism is higher than world welfare in free trade.

PROPOSITION

In this section we have seen that a regional agreement has persistent effects on trade flows in the presence of sunk costs. This implies that countries may sign regional agreements, not only to attain preferential market access now, but also because they can retain their market share even if free trade is achieved. Moreover, a regional agreement before free trade brings a member country closer to the efficient outcome. Thus, ifthe world is moving toward free trade, foreign market share gains, and domestic consumption improvements provide a reason why countries may prefer the regional path.

III.

EMPIRICAL EVIDENCE

The model relies on the assumption that first-mover advantages are an important determinant of future sales. Empirical evidence at the industry level supports this claim. Order of entry has a significant impact on firms' market shares, and the advantages associated with market tenure persist over time. I5 Robinson and Fornell [1985], for example, find that pioneering firms tend to have an average market share of 29 percent, early followers 17 percent, and late entrants 12 percent, and that order of entry explains 18 percent of the variation in market share in a cross-sectional study of consumer goods in the United States. I6 Results for industrial goods are similar although not quite so strong [Robinson 1988]. In addition, while Brown and Lattin [1994] find that first-mover advantage in consumer-goods sales gradually declines as time passes, their results also suggest that the advantage will never disappear. In this section we examine the European Union (EU) for evidence of first-mover advantages in trade among its founders. Entry into the Union was staggered, the original membersFrance, Germany, Italy, Belgium, Luxembourg, and the Nether15. For a survey of the literature see Robinson, Kalyanaram, and Urban [1994]. 16. Within specific industries, evidence of the importance of first-mover advantages is striking. Numerous studies of the pharmaceutical and cigarette industries find that order of entry is the single most important determinant of market share [Robinson, Kalyanaram, and Urban 1994]. Hurwitz and Caves [1988], for example, find that average pioneer market share in the pharmaceutical industry, at a varying number of years after patent expiration, is 63 percent. They also find that greater market share associated with early entry is not a result of lower prices or higher quality.


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lands-formed the European Economic Community (EEC) in 1958. The United Kingdom, Ireland, and Denmark were the next to join in 1973; they were fonowed by Greece in 1981, Portugal and Spain in 1986; and more recently, Austria, Finland, and Sweden became members in 1995.17 Using the gravity model to adjust for "normal" trade flows, this section examines data from the ED countries to determine how the formation of the Union affected trade flows among members. The main results are consistent with the hypothesis that early entry into a union allows countries to establish trade links that persist over time. A. The Gravity Equation The basic gravity equation postulates that bilateral trade flows are a function of the size of the trading partners and the distance between them. The hypothesis is that trade is increasing in income and decreasing in distance, or XPij

= Yi~/DISij,

whereXPij is trade flows from country i to country j, Yi(J) is i's (j's) income, and DISij is the distance between the countries. IS Other studies have found that trade flows fit this simple model surprisingly well. 19 By including a dummy variable that represents countries in a PTA, the gravity equation is often used to explain deviations from "normal" trade as a result of preferential trade agreements. Frankel, Stein, and Wei [1995] employ this approach to determine regional bias in trade. They find that regional groupings have significantly altered trade flows. The European Community members, for example, traded 63 percent more with each other in 1990 than the gravity model predicts. Eichengreen and Irwin [1998] look at the effect of PTAs on trade flows using historical data from 1949 to 1964. They also analyze the effect of history on trade flows, using lagged trade in the gravity model. To test the effect of order of entry on trade flows, we use an 17. We do not include Austria, Finland, and Sweden in the sample because they were members of the competing trade bloc, the European Free Trade Association, throughout the period examined. 18. Note that the gravity model is broadly consistent with the model of trade presented earlier. The relevant equation is (10). The number of firms (n) will be increasing with the size of a country and the partner's demand (K·- Q) will also increase with its size. Distance raises costs (w), implying that exports are decreasing in distance. 19. Chapter 4 in Frankel [1997] surveys the literature.



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approach similar to that of Frankel, Stein, and Wei [1995] and Eichengreen and Irwin [1998]. The hypothesis is that trade between the original six members is larger than the otherwise natural trade flow as predicted by the gravity model, after other countries joined the union (and thus also relative to the other members). We also suspect that trade between the late entrants and the incumbent members will be below the natural trade flows predicted by the gravity model. We examine bilateral trade flows between EU member nations for 1954, 1962, 1970, 1980, and 1990. The countries included are Belgium-Luxembourg, the United Kingdom, Denmark, France, Germany, Greece, Ireland, Italy, the Netherlands, Portugal, and Spain.2o Since we are looking at exports from one country to another there are 110 data points (11 * 10). The model we fit is the following:

where Yi is per capita income in country i, ADJ is a dummy variable that is one if the countries share a border, DIFPC is the natural logarithm of the difference in the partners' per capita incomes, and ORG is a dummy variable that equals one if both countries are original members and is zero otherwise. The hypothesis above implies that the coefficient on ORG will be positive and increasing in the years since the formation of the union and before other members join. We also expect the coefficient to decrease as new members accede, but to remain positive and significant throughout the sample period. The first five columns in Table I report the results. The variable ORG is positive and significant in all four years after the customs union was formed. The gradual tariff reductions prescribed under the Treaty of Rome were completed in 1969, so it is not surprising that the coefficient on ORG is greatest in 1970. The members traded more than twice as much with each other than predicted by the gravity model (exp 0.88 = 2.41) in 1970. In 1980 20. The trade data are from the IMF Direction of Trade Statistics database. The GNP and GNP per capita data are from the World Bank CD STARS, except for 1954, which is calculated from the IMF International Financial Statistics. The distance data are from the world distance tables and represent the direct air distance between economic centers.


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QUARTERLY JOURNAL OF ECONOMICS TABLE I GRAVITY EQUATION BY YEAR

1954 0.61** (0.07) PCGNP 0.17 (0.24) -0.65* DIS (0.30) ADJ 0.07 (0,31) DIFPC 0.17 (0.13) ORG 0.36 (0,24) COL

GNP

1962

1970

1980

1990

1954

1962

1970

1980

1990

0.66** (0.06) 0.47** (0.18) -0.41* (0.20) 0.37 (0,24) 0.15 (0.08) 0,51* (0,20)

0.75** (0.06) 0.22 (0.19) -0.54** (0.21) 0.23 (0,22) 0,15 (0.13) 0.88** (0,16)

0.71** (0.04) 0.05 (0.17) -0.78** (0.18) 0,09 (0.18) 0.13** (0.04) 0,62** (0,13)

0.75** (0.04) -0.48** (0.14) -0.87** (0.12) 0.17 (0,16) 0.17** (0,05) 0.58** (0,15)

0.67** (0.07) -0.29 0.30 -0.66* (0.31) 0.24 (0,28) 0,23 (0,15) 0.10 (0,26) 1.51** (0,36) -0.91 ** (0.29)

0.71** (0.06) 0.09 (0.25) -0.37 (0.20) 0.49* (0,23) 0.15* (0,08) 0,39 (0.21) 1.52** (0,26) -0.63* (0.26)

0.79** (0.06) -0.14 (0.25) -0.46* (0.19) 0,42 (0.22) 0.18 (0.11) 0.82** (0.16) 1.71** (0,28) -0,62* (0.26)

0.78** (0.04) -0.36* (0.18) --0.64** (0,16) 0.34* (0,16) 0,12** (0,04) 0.44** (0,13) 1.07** (0.22) -0.91** (0.17)

0.80** (0.04) -0.70** (0.15) -0.75** (0.11) 0,34* (0.14) 0.16** (0,04) 0.42** (0,14) 0,80** (0,13) -0,56** (0,15)

107 0,78

110 0,82

110 0,85

110 0.88

106 0,68

107 0.79

110 0,83

110 0.88

110 0.90

LATE No. of obs, 106 AdjR2 0.65

Regressions were run with a constant term; values for the constants are not reported. Heteroskedasticit,yconsistent standard errors are in parentheses. **Significant at the 1 percent level. *Significant at the 5 percent level.

and 1990 we see a decline in the coefficient; however, it remains positive and significant in both years. In 1990 the founders still traded over 75 percent more with each other than is predicted by the gravity model. Since Spain and Portugal were the last countries to join the Union, we also include a dummy variable called LATE that is one when either of these countries participates in trade. The theory above suggests that the coefficient on LATE should remain negative in 1980 and 1990, since Spain and Portugal had less access to foreign markets and foreign countries had less of an incentive to expand exports to Spain and Portugal. In addition, owing to past colonial links, we include a dummy variable to represent trade between Ireland and the United Kingdom, titled COL. The coefficient on COL is likely to be positive. The results are recorded in columns 6-10 of Table I. In 1990 Spain and Portugal traded about 45 percent less with the other members of the Union than is predicted by the gravity model. However, Spain and Portugal trade significantly less throughout the years, suggest-



1335

ing that this may be the result of other factors.21 The United Kingdom and Ireland still traded more than twice as much with each other than with the other members in 1990. Not surprisingly, the coefficient on ORG declines when LATE is included in the regression equation; part ofthe relatively higher trade among the original members is a result of their trading less with Spain and Portugal. Of greater interest, the coefficient on ORG is small and insignificant in 1954, increasing through 1970, decreasing after, and remains positive and significant in 1990. This suggests that, after accounting for relatively less trade with Spain and Portugal, the original members traded more with each other than the model predicts only after the union was created. B. An Alternative Explanation An alternative is that the union was formed endogenously, by countries that were and still are natural trading partners, perhaps because of comparative advantage, tastes, or technology. Stated differently, this suggests that there would be a bias toward trade with original members even if all members had joined simultaneously. To examine this competing hypothesis, we first look at trade flows before the union was formed for evidence of a preexisting bias. Second, we include trade flows from 1950 in the basic regression equation to adjust for initial conditions. Third, we compare trade adjustment between two initially similar countries, France and the United Kingdom, over time. 22 If the original members are natural trade partners, then they would likely trade more with each other before the union was formed. The positive coefficient in 1954 suggests that we cannot rule out the possibility that the union was formed along natural trade lines. However, in 1954 Belgium, Luxembourg, and the Netherlands had already been in a customs union for six years, and the founding six had already begun the process of forming a free trade arrangement-they created the European Coal and Steel Community (ECSC) in 1951, which formed a customs union in these products. Ideally, we would like to explore the gravity model before 1948. Eichengreen and Irwin [1998] have gone some way toward this. In a sample of 38 countries they find that in 1949 21. The magnitude of the coefficient in 1954 is due primarily to autarkic policies in Spain before their Stabilization Plan of 1959. 22. We also test whether the original members trade more with each other because they are the main exporters in the region. Including a dummy variable that is one whenever an original member is an exporter is never significant (not reported).


1336


the founding six did not trade more with each other. Using the gravity equation, they find that the coefficient on EEC, which is a dummy variable that represents the original members, is negative although not significant. In addition, they find that the coefficient on the EEC grows over the years. Their results for the coefficient on EEC in 1954 and 1964 of 0.18 and 0.63, respectively, are consistent with those presented here. Their results suggest that the original members did not trade more with each other before the union was formed. A second way to distinguish the hysteresis hypothesis from the natural trade partners hypothesis is to use past trade as a proxy for initial conditions. That is, we want to see whether the agreement affected trade, after accounting for relative trade positions when the agreement was signed-the hope is that initial conditions control for persistent comparative advantage positions or other missing variables that might affect trade. We include past values of the dependent variable from 1950 in the regression equation. The results are recorded in Table II. After accounting for initial conditions, the coefficient on ORG is still highly significant in 1962, 1970, 1980, and 1990. 23 Moreover, the magnitude of the coefficient does not change (as compared with the results in Table I), suggesting that ORG is picking up mainly the effects of unification. In contrast, all ofthe other coefficients decline in both magnitude and significance. For example, the coefficient on distance falls close to zero in 1962 and 1970, indicating that distance affects trade in roughly the same way in the two periods. Not surprisingly, the importance ofthe initial conditions declines over time. However, trade patterns in 1950 are still highly significant in determining trade in 1990. Still, even if trade had been liberalized among all members at one time, trade might not have increased uniformly. Countries had different average tariff levels in 1958, and tariffs differed across industries. The high tariff countries would likely experience the most increased trade as a result of unification. Therefore, it may be that the initial members did not trade significantly more in the 1950s because of the tariffs that prevailed. In an attempt to control for this, we compare trade between the original members 23. The regression including past trade was also run on 1954 trade values. In addition, it was tried in trade levels, as opposed to log levels. In both cases the results still hold. When it was run in levels, while ORG was still highly significant in each year, COL was never significant, and LATE was not significant in 1962 and 1970.



1337

TABLE II GRAVITY EQUATION WITH INITIAL CONDITIONS

GNP PCGNP DIS ADJ EXP50 DIFPC ORG COL

1962

1970

1980

1990

0.37** (0.06)

0.42** (0.06)

0.55** (0.05) -0.36* (0.16)

0.67** (0.05) --0.71** (0.16)

~O.O8

~0.30

(0.15)

(0.18) - 0.11 (0.13) 0.30 (0.16) 0.51 ** (0.08) 0.15 (0.12) 0.91 ** (0.20) 0.53** (0.20)

~0.06

(0.11) 0.24 (0.16) 0.64** (0.06) 0.10 (0.05) 0.35* (0.14) 0.38** (0.14)

~0.41**

~0.58**

(0.14) 0.30 (0.13) 0.33** (0.06) 0.12* (0.04) 0.47** (0.11) 0.36 (0.19)

(0.11)

0.33** (0.12) 0.19** (0.06) 0.15** (0.05) 0.44** (0.12) 0.46** (0.14)

LATE

~0.34*

~0.44*

~0.72**

~0.42**

No.ofobs. AdjR2

(0.16) 100 0.91

(0.06) 100 0.90

( ~0.16) 100 0.90

(0.15) 100 0.90

Regressions were run with a constant term; values for the constants are not reported. Heteroskedasticityconsistent standard errors are in parentheses. **Significant at the 1 percent level. *Significant at the 5 percent leveL

and the United Kingdom, with trade between the original members and France, a founding member. Evidence suggests that in 1958, the United Kingdom was as much of a natural member as France was. The United Kingdom decided not to join the EEC because of political reasons; she wanted to form a free trade agreement, while the others were inclined toward a customs union. Moreover, France and the United Kingdom were similar in many respects. In the 1950s the unweighted-average ad valorem tariff level in France was 0.17, and in the United Kingdom it was 0.165 [Truman 1975, p. 63]. Both countries had high tariffs relative to the rest of the EEC, and tariffs in the two were very similar by industry, so there is no reason to believe tariff cuts in one country would be more beneficial [Political and Economic Planning 1959]. Total trade with the other EEC countries was $1626 for France and $1711 for the United Kingdom. Their national incomes were similar as well, France's GDP was over 90 percent ofU. K. GDP in 1954.


1338


To test for a difference in the bias among the original members with respect to France and the United Kingdom, we create the following three dummy variables: ORGUK is a dummy for trade between the original members and the United Kingdom; ORGFR is a dummy for trade between the original members and France; and ORG2 is a dummy for trade among the original members, excluding France. Hence, ORGUK represents how much more or less the United Kingdom trades with the original members relative to what the model predicts, and similarly for France. If the bias in trade among the original members in 1990 is the result of natural forces, then we expect the coefficients on ORGUK and on ORGFR to be similar to each other in both 1954 and 1990. Alternatively, if the bias with respect to France and the United Kingdom is a result of history, we expect the coefficients on ORGUK and ORGFR to be similar in 1954, to diverge over time, and to remain significantly different from each other in 1990. The results are reported in Table III. We test the hypothesis that the coefficient on ORGUK in each year is equal to the coefficient on ORGFR, reporting the significance level of the Chi-square statistic in the last line of Table III. The coefficients are not significantly different from each other in 1954, and the magnitude of the coefficients suggests that if anything France traded less with the original members than the United Kingdom did. Over the years they diverge as discriminatory policy comes into effect. However, even after the United Kingdom joined the union in 1973, trade between France and the other original members remained significantly greater than trade between the United Kingdom and the bloc members. The hypothesis that the coefficients are the same is rejected at the 1 percent level in 1970, and at the 5 percent level, in 1980 and 1990. Hence, the evidence suggests that France has gained an advantage in trading with the other original members, relative to the United Kingdom, as a result of joining the Union in 1958. The empirical results from this section are consistent with the hypothesis that the founding members of the European Union have retained a relatively greater share of each others' markets as a result of past discriminatory policy. The original members ofthe EU trade more with each other than is predicted by the gravity model in all of the years since its formation. There is little evidence that the original members were natural trading partners relative to all of the other members. This suggests that, in


1339

DIFFERENT PATHS TO FREE TRADE TABLE III

TRADE WITH THE ORIGINAL MEMBERS: FRANCE AND THE UNITED KINGDOM

GNP PCGNP DIS ADJ DIFPC ORG2 ORGFR ORGUK LATE COL No.ofobs. AdjR2 Chi-square (1) Significance

1954

1962

1970

1980

1990

0.72** (0.09) -0.24 (0.32) -0.65* (0.33) 0.30 (0.30) 0.22 (0.14) 0.28 (0.39) -0.55 (0.39) -0.27 (0.46) -0.90** (0.32) 1.46** (0.44) 110 0.68 0.93 0.34

0.76** (0.07) 0.07** (0.24) -0.42 (0.22) 0.50* (0.24) 0.14 (0.07) 0.51 (0.31) -0.21 (0.33) -0.32 (0.38) --0.66* (0.27) 1.44** (0.34) 110 0.80 0.24 0.62

0.88** (0.08) -0.24 (0.27) -0.60** (0.21) 0.31 (0.23) 0.15 (0.11) 0.78** (0.25) 0.11 (0.26) -0.68 (0.36) -0.73** (0.27) 1.48** (0.34) 110 0.84 10.11 ** 0.001

0.84** (0.06) -0.46 (0.20) -0.76** (0.19) 0.26 (0.17) 0.11 ** (0.04) 0.40* (0.20) -0.04 (0.21) -0.49 (0.28) --1.00** (0.19) 0.86** (0.28) 110 0.89 5.80* 0.02

0.86** (0.05) -0.80** (0.17) -0.85** (0.12) 0.29* (0.14) 0.14** (0.04) 0.42* (0.17) -0.11 (0.19) -0.44* (0.23) -0.65** (0.17) 0.64** (0.18) 110 0.91 4.43* 0.04

Regressions were run with a constant term; values for the constants are not reported. Heteroskedasticityconsistent standard errors are in parentheses. **Significant at the 1 percent 1evel. *Significant at the 5 percent level.

addition to the standard determinants of trade, current trade patterns are a result of past trade policy.

IV.

CONCLUSION

This paper has shown that the equilibrium free trade outcome arising from a regional agreement followed by free trade may be different from the outcome attained through multilateral negotiations. This is because firms can effectively pre commit to exports if there are large sunk costs involved in setting up a distribution network. As a result, regionalism provides firms in the early entrant nations with first-mover advantages. This leads


1340


to higher welfare in the member nations than without the regional agreement. Welfare expands because of the effect of the regional agreement on competition. With imperfect competition, output is too low. Trade helps alleviate this distortion. The initiation of a regional agreement before allowing free trade reduces the distortion further by introducing a strategic incentive to expand output. Sunk costs allow firms from a member nation to commit to exporting more to their partner than they would if they enter simultaneously with firms from a third country. Because of this expansion in output, consumer surplus in the free trade period after a regional agreement and profits from exports are greater than ifthere had been two periods offree trade. The allotment of benefits from the regional path is skewed. While the initial members achieve a higher welfare level from the regional path than they would from free trade reached multilaterally, the late entrant attains a lower welfare level from the regional path than from immediate free trade. Surprisingly, world welfare during the period offree trade is higher from the regional path. We go on to examine some of the implications of the model for the European Union, adjusting for the natural determinants of trade using the gravity equation. The main results are consistent with the hypothesis that early entry into a trade union allows countries to establish trade links that persist over time. There is little support for the hypothesis that the countries were natural trading partners. BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM

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