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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. 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* 2

- 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

3
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

4
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 i mi )( - dt i / t i )] ε m,i [ t i /( pi + t i )] 1 and
[( t i mi )( - dt i / t i )] 2 respectively.xvi Here εm,i is the import demand elasticity. The ratio of the
former to the later is εm,iτi/(1+τi) where τi is the ad valorem equivalent of ti. Econometric
studies typically estimates εm,i to be around 2 (Leamer and Stern (1970)), so unless τi 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

5
(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 tjk
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 ~ t i1 dmi1 = mi1 dpi1 3 for i=2,3, the sum of the first-row terms in (2)
can be written as:

α [( t - ~t )dm ] + (I - α ) [m dt] 3

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:

dV 1 / V E1 + dV 2 / V E 2 = t 21 dm21 + t 12 dm12 + [( t 31 - ~ ~
t 31 ) dm31 + ( t 32 - t 32 ) dm32 ] 4

The PTA's welfare is maximized when this expression equals zero. A sufficient condition for
the optimality of internal free trade (t21=t12=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

6
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 Lj 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 Vj(Pj,1,Ej) where
1 is the price of Z sector output, Ej is consumption expenditure as in (1), and Pj is the standard
CES consumer price index of varieties supplied to market j. That is:

 nk 
( )
N

P
1-σ
j = ∑ ∑ pikj τ kj
1-σ
 σ >1 5
k=1  i=1 

where nk (k=1,...N) is the number of varieties produced in country k, pj is the producer price
of the ith variety produced in k and sold in j, and τkj 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 cj is found by Roy's identity.xix
Namely:
∂ V j ( P j ,1, E j ) ∂ P j
i
c kj = -
∂Pj i
∂( p kj τ kj )
(
= E Xj ( P j , E j ) Pσj -1 pikj 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. 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 EXj - denoted as 1-η - is constant, and that the τkj's
represent 'iceberg' trade costs.xx That is, a proportion τkj-1 of the goods 'melt' in transit, so
output exceeds consumption according to: xkj = τ kj c kj 5.
The profit of a typical country j firm in the Z sector is:
N N
π j = ∑ p jk x jk - x j b j - f j , x j ≡ ∑ x jk . 7
k =1 k=1

where we assume technology has fixed cost fj and constant marginal cost bj. 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
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. If η is constant, λjk depends only upon sjk and parameters, and its
exact form depends on the nature of strategic interaction between firms. For Nash
equilibrium in prices we have:
λ( s jk ) = 1/ (σ - 1 - s jk ( σ - η )) 9

(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 nk are treated as continuous variables, so when allowing free entry and exit
implies that equilibrium nk are such that all firms earn zero profits. Using (7) and (8) the zero
profit condition is:
N

∑ λ( s
k=1
jk ) x jk = f j / bj 10

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, sjk, are
negligible. Inspection of (9) shows that under this assumption all λjk equal (σ-1)-1, so
country-j firms charge producer prices equal to bjσ/(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)fj/bj; 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

8
 1-σ
X
E k θ jk pixij  pτ 
p j x jk = , θ ij ≡ =  i ij  11
N
p j x jj  p j 
∑n θ
i=1
i ik

θij 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 θij; clearly θjj = 1 and infinite trade
costs mean θij = 0, i ≠ j. .
If the two countries in the union are symmetric, then we can write θ12 = θ21 = θ, and
θi3 = θ3i = 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:

E2 θ
X X X *
E1 E3 θ 12
p 1 x1 = + +
n1 + n2 θ + θ n3 θ n1 + n 2 + θ n3 θ n1 + θ n2 + n3
* * * *

X * X * X
E1 θ E2 θ E3 13
p 3 x3 = + +
n1 + θ n 2 + θ n3 θ n1 + n 2 + θ n3 θ n1 + θ n 2 + n3
* * * *

We illustrate these relationships in figure *, with the further assumption that expenditures are
constant. Axes are n3 and n1=n2. 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. The curve x3=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 x1
=x ) while firms in country 3 have contracted and make negative profits (A above the new x3
=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, aj = bj+fj/xj. 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*

9
< 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:

N (f / b - cov [x ,λ( s )] )
∑ x jk =
j j jk jk
14
k=1 _ λ( s )
jk

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, sjk, (as firms gain
exports and lose home market sales) and, since λ is strictly convex, a reduction in dispersion
lowers the mean _ 7λ(sjk).xxiii Furthermore, since market shares are high where sales are high
there is positive covariance, cov[xjk, λ(sjk)], which will also decline as dispersion falls. Both
these factors mean that equilibrium firm scale must increase.

10
 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, sjk.
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

11
(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[sjk], 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[sjk]), and no
longer varies across markets, and the covariance between λ and xjk goes to zero. If
cov[xjk,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. 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

12
 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 accumulationxxvi. 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

13
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

14
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?):
X X
E1 θ E
+ 12 2 15
p 1 x1 =
+
n1 θ 21 n2 n2 + θ 12 n1

As before, θij is imports per country i firm to market j, relative to home sales per country j
firm, and increases with integration. Suppose that p1 = p2, so that θ21 = θ12 = θ, expenditures
are constant and start from a position of autarky. At autarky n1 and n2 must be such that nipix
= E, wherex is the equilibrium firm scale, giving zero profits. Using this in (18) gives:

x1 E
X
θ EX (1 - θ )θ E 2X ( E 1X - E 2X )
= X 1 X + X 2 X = 1+ X 16
x E1 +θ E 2 E 2 +θ E1 ( E 1 +θ E 2X )( E 2X +θ E 1X )

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 x1 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

15
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 x1 =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,
n1/n2 = 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 w1 and w2 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 w1 and w2 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 v1 and v2xxvii. 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.

16
 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 x1 =x , and
the country 2 analogue). Evidently the right hand side of these equations depends on the
location of industry -- n1 and n2 -- directly. It also depends on expenditures, E and E and
relative costs, these determining prices and hence θ12 and θ21 (equation (14)). A demand (or
backwards) linkage occurs if expenditure depends on n1 and n2. A cost (or forward) linkage
occurs if costs depend on n1 and n2.
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, x1, and unstable if it increases x1.
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 ≡ dn1 = -dn2, with
accompanying changes in endogenous variables dEX ≡ dE = -dE, dp ≡ dp1 = -dp2, dx ≡ dx1 = -
dx2. Denoting the right hand side of (26) by R and totally differentiating gives:

dx ∂R ∂R dE X  ∂R ∂θ  dp
p = + + -x 17
dn ∂n ∂ E X dn  ∂θ ∂p  dn

and hence (evaluating the partials at the symmetric equilibrium and choosing units such that p
= 1 at this equilibrium),

17
 n dx  1 - θ    dp 
2
 1+θ  n dE X  4θσ
=   - 1+   X - + 1 n  18
x dn  1 +θ    1 - θ  E dn  (1 - θ )
2
 dn 

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 dEX/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 n1
manufacturing workers. Each worker spends amount γ on manufacturing, so

E 1 = γ ( L + n1 )
X Z
19

If a firm relocates from 2 to 1 then it takes its worker with it. This clearly creates a demand
linkage, and

18
 n dE X n
X
= Z 1 20
E dn L + n1

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

n1 > 1 - θ 21
L + n1 1 + θ
Z

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(wj,Pj,xj), where Pj 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:

X X
∂a( w j , P j , x j )
E j = E j (c) + n j x j 22
∂ Pj

19
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 x1x1 and x2x2, 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.

20
 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 P0 = 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 = αP1. The 'residual imputation' approach
learns δY from the equation δY = Y1 - βX1; that is it looks at the difference between the
actual outcomes Y1, and the 'counterfactual' or 'anti-monde', βX1, 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 P1 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

21
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

22
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

23
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

24
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

25
(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

26
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

27
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

28
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.

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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.

31
Figure 1

Figure 2

32
Figure 3a

Figure 3b

33
Figure 3c

@@

34
TABLE 6-1: NAFTA EVALUATIONS
Study and Experiments Structure Results (% change)
Mexico USA Canada
Income R Income R Income R
Brown et al
1. tariffs and NTBs IRS,MC,Integ. mkts,Free entry, exog.K 1.6 0.6 0.1 0.2 0.7 0.4
2. ditto + exog.K flow into Mexico ditto 5 3.3 0.3 0.2 0.7 0.5
Roland-Holst et al
3. tariffs only CRS,PC,exog.K 0.13 0.45 0.06 0.1 0.38 0.94
4. tariffs and NTBs ditto 2.27 5.18 1.34 2.43 7.22 14.5
5. ditto IRS,Arm.,Cour.olig,Free entry, exog.K 2.57 5.77 1.3 2.49 5.82 13.57
6. ditto IRS,Arm.,Contestable mkts, No entry, exog. K 3.38 6.57 2.07 3.4 10.57 20.74
Bachrach & Mizrahi
7. US-Mexico FTA CRS,PC,exog.K 0.32 0.6 0.02 0.03
8. ditto CRS,PC,endog.Mexican K 4.64 0* 0.04 0.07
Hinjosa & Robinson
35
9. tariffs only CRS,PC,exog.K 0.1 -0.4 0.1 0
10. tariffs and NTBs ditto 0.3 1.1 0 1.2
11. ditto ditto + exog.K flow 6.4 -1.2 0.1 1.1
12. ditto ditto + endog. migration 6.8 -0.9 0.1 0.1
McCleery
13. tariffs and NTBs CRS,PC,exog.pop.growth, endog.K 0.01 n.a. 0.22 n.a.
14. ditto + exog. lower Mex. risk prem. ditto 3.09 n.a. 0.32 n.a.
15. ditto ditto + endog.productivity 11.39 n.a. 0.51 n.a.
Young & Romero
16. tariffs only CRS,PC,exog.pop.growth,endog.Mex.K 2.6 0
17. ditto + exog.lower Mex.interest rate ditto 8.1 -25*
18. MEDIAN 2.6 0.1 3.26
36
TABLE 6-2: EC 1992 EVALUATIONS
Study and Experiments Structure Results (% change)
EC EFTA ROW
Welfare* R Income R R
Gasiorek, Venables & Smith IRS,MC,endog.K via int'l K mobility
1. lower real trade cost, intra-EC w/ Segmented Mkts, No entry 0.312 0* n.a. n.a.
2. ditto w/ Segmented Mkts, Free entry 0.399 0* n.a. n.a.
3. ditto w/ Integrated Mkts, No entry 0.512 0* n.a. n.a.
4. ditto w/ Integrated Mkts, Free entry 1.267 0* n.a. n.a.
Haaland & Norman IRS,MC, Free entry, exog.K
5. lower real trade cost, intra-EC w/ Segmented Mkts 0.250 0.250 -0.070 0.110 -0.004 0.010
6. ditto w/ Integrated Mkts 0.475 0.570 -0.090 -0.040 -0.008 -0.010
7. ditto + EC92 extended to EFTA w/ Segmented Mkts 0.275 0.310 0.430 0.360 -0.006 0.01
8. ditto w/ Integrated Mkts 0.500 0.610 0.690 1.050 -0.010 -0.01
Baldwin, Forslid & Haaland IRS,MC, Free entry, endog.K
9. lower real trade cost, intra-EC w/ Segmented Mkts 0.48 0* -0.11 0* -0.01 0*
10. ditto w/ Integrated Mkts 0.8 0* -0.24 0* -0.02 0*
37
11. ditto + EC92 extended to EFTA w/ Segmented Mkts 0.54 0* 1.03 0* 0*
12. ditto w/ Integrated Mkts 0.84 0* 1.54 0* 0*
Mercenier & Akitoby IRS,MC,Segmented Mkts, Free entry
13. equal price elas. all EC gds w/ endog. K 0.7 0*
Harrison, Rutherford & Tarr IRS,MC,Segmented Mkts, Free entry
14. lower real trade cost, intra-EC w/ exog. K 0.52 n.a. n.a.
15. ditto w/ endog. K 1.79 0* n.a.
16. ditto + equal price elas. all EC gds w/ exog. K 1.18 n.a. 0 0.3
17. ditto w/ endog. K 2.6 0* 0.05 0*
CRS,PC
18. lower real trade cost, intra-EC w/ exog. K 0.46 n.a. n.a.
19. ditto w/ endog. K 1.56 0* n.a.
20. ditto + equal price elas. all EC gds w/ exog. K 0.5 n.a. 0 0.1
21. ditto w/ endog. K 1.1 0* n.a. 0*
22. MEDIAN 0.52 0.18 0
38
@@Appendices:
39
Appendix A:
1) Equation 2:
Differentiating the indirect utility function gives:

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

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:
dY = [k - B w ].dw + X[dp + dt] + dα .t.m + α .m.dt + α .m.dt

+ [(p + t)x - b(x, w,θ )]dN + N[p + t - b′(x, w,θ )]dx 24

- Bθ (X, N, w,θ ) + w.dk - dI.

Normalizing VY = 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,
i
p jk (1 - 1/ε ) = b j 25

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:
i
∂ cikj p kj τ kj
i
. i
= -σ + ~
s j ( σ - η ) < 0, i ∈ I
∂( p kj τ kj ) ckj
26
i
∂c i
p τ kj
=~
kj kj
i
. i s j ( σ - η ) > 0, i ∉ I.
∂( p τ kj )
kj c kj

If a single product changes price then, ε = σ~-~sj(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

40
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, ti 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
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 EjX 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[xjk, λ(sjk)] 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.

42