the quarterly journal of economics 2000 freund 1317 41

DIFFERENT PATHS TO FREE TRADE:THE GAINS FROM REGIONALISM*

CAROLINE FREUND

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

I. INTRODUCTION

The current proliferation of preferential trade agreements(PTAs) has led to renewed interest in the economics of regional-ism. The recent literature has focused on how preferential tradeagreements affect welfare and on how they influence the scope forfurther multilateral trade liberalization.1 Krugman [1992], Bondand Syropoulos [1996], and Bagwell and Staiger [1997] examinetrade policy and welfare in the presence of exogenously formedcustoms unions. Their findings suggest that welfare and externaltariffs may depend on transport costs, endowments, and theability of countries to commit to tariff reduction. A relatedliterature analyzes the incentives for preferential and multilat-eral trade liberalization, under the assumption that governmentscare relatively more about certain sectors of the economy. WhileBaldwin [1995] and Richardson [1993] conclude that regionalism

* I am very grateful to Jagdish Bhagwati, Kyle Bagwell, and John McLarenfor many useful discussions. I also benefited from comments from Alberto Alesina,Richard Baldwin, Olivier Blanchard, Alessandra Casella, Simeon Djankov, SimonEvenett, Philip Lane, Catherine Mann, Usha Nair, Seamus O’Cleireacain, Fran-cisco Rivera-Batiz, Dani Rodrik, John Rogers, Maurice Schiff, Neeraja Sivara-mayya, Kei-Mu Yi, an anonymous referee, and seminar participants at ClemsonUniversity, Columbia University, the Federal Reserve Board, Pennsylvania StateUniversity, Texas A & M College of Business, the World Bank, and The EmpiricalInvestigations in International Trade Conference. An earlier version of this paper,titled ‘‘Regionalism and Permanent Diversion,’’ was Chapter 1 of my Ph.D. thesis.The views presented in this paper are solely the responsibility of the author andshould not be interpreted as reflecting the views of the Board of Governors of theFederal Reserve System or any other person associated with the Federal ReserveSystem. Correspondence: email: [email protected], phone: 202-452-2762,Fax: 202-452-6424.

1. See Bhagwati and Panagariya [1996] for a detailed discussion of theeconomics of regionalism.

r 2000 by the President and Fellows of Harvard College and the Massachusetts Institute ofTechnology.The Quarterly Journal of Economics, November 2000

1317

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can speed up the liberalization process, Grossman and Helpman[1995], Findlay and Panagariya [1996], Levy [1997], and Krishna[1998] find that political support for free trade is likely to declineafter a PTA is formed.

In these models, welfare and optimal trade policy are affectedbecause preferential treatment induces a redistribution of con-sumption and production among countries and among constituen-cies within countries.2 However, what these models fail to takeinto account is that altering the structure of production and tradeis costly.3 This has implications for the sequencing of tradeliberalization, and in particular, suggests that free trade achievedthrough regional expansion may look quite different, in terms ofthe trade flows between countries and the welfare of each country,from free trade achieved via multilateral tariff reduction. Inaddition, countries may be able to strategically order theirliberalizations to influence trade orientation and improve welfare.

This paper examines alternative liberalization strategies todetermine how they influence trade flows and welfare. We com-pare free trade reached through expanding preferential tradeagreements with free trade reached via multilateral liberaliza-tion. In a three-country two-period model with quantity competi-tion and sunk costs, we find that a regional agreement in the firstperiod, followed by free trade in the second period, leads topermanently greater trade among the member nations. Perma-nent effects arise because firms undertake irreversible invest-ment before free trade is achieved.4 Specifically, we assume thateach firm incurs a distribution network cost that is based onquantity, and that the cost of the distribution network inherited inthe second period is sunk. An existing firm’s marginal cost willtherefore be lower in the second period since it is only theproduction cost. Thus, whenever an incumbent firm competes

2. Regional agreement, bilateral trade agreement, preferential trade agree-ment, and regionalism are used interchangeably in this paper.

3. Significant hysteresis has been observed in bilateral trade flows and isfound to be associated with sunk costs involved in exporting. The theoreticalcontributions linking observed trade patterns to sunk costs are Baldwin [1988],Baldwin and Krugman [1989], and Dixit [1989]. Roberts and Tybout [1997] findempirical evidence that sunk costs associated with exporting play a significant rolein determining exports at the firm level.

4. McLaren [1997] also examines the interaction of sunk costs and regionalagreements. He shows that a small country can be made worse off as a result offorming a PTA with a large country if there is a possibility of future tradenegotiations. The small country loses bargaining power once sunk costs to expandthe export sector have been expended.

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with a new-entrant firm, it has a cost advantage, and its Cournotexports will be relatively greater.

The irreversibility of investment in the distribution networkalso implies that firms in the original PTA member nations willeffectively gain first-mover advantages in exporting to each other.There is a strategic incentive for them to commit to high bilateralexports in the first period in order to limit second-period exportsby firms from the new member. As a result, second-period worldoutput is greater, and the member nations earn higher profitsabroad from the regional path than from the multilateral path.Comparing the welfare associated with free trade achieved viaregionalism with that of free trade achieved via multilateralnegotiation, we find that the primary members of a trade blocattain a higher level of welfare from the regionalism path, whilelate entrants fall to a lower level of welfare. Moreover, worldwelfare in the second period is greater from the regional path. Thegains to the original members are greater than the loss to theentrant, implying that there is no compensation the entrant canoffer the initial members to be permitted at the start.

One testable implication of this model is that order of entryinto a trade bloc will affect future market shares among members.To evaluate the importance of first-mover advantage in tradeempirically, we examine trade data for the European Union. TheEuropean Union serves as a unique natural experiment because itexpanded from six members in 1958, to nine in 1973, and reachedtwelve by 1986. The model implies that the original members willbe able to establish trade links that persist after other countriesenter the union, and thus that the founding members will trademore with one another from 1958 onward. The gravity equation isused as a basis by which to test the importance of the date of entry.We find that in 1962 the original members of the European Uniontraded over 65 percent more with each other, by 1970 the founderstraded more than twice as much with each other as with thenonmembers, and in 1990 the six still traded over 75 percent morewith each other than with the late entrants. The empiricalevidence is thus broadly consistent with the market share resultspredicted by the model.

Alternatively, the relatively high trade intensity among theoriginal members might be natural, a result of comparativeadvantage, tastes, or technology. There is, however, little evidencethat the original members traded more with each other than waspredicted by the gravity equation before the common market is

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created. In addition, after controlling for initial (preunion) tradeflows, the original members still trade relatively more with eachother following the establishment of the European EconomicCommunity. Finally, a comparison of trade between the originalmembers and two countries that were similar in terms of trade,tariffs, and size in the 1950s, but joined at different times, alsosuggests that date of entry affects current trade intensity. Theevidence is therefore inconsistent with the view that the originalmembers trade more with each other entirely as a result ofcomparative advantage, tastes, or technology.

This paper is divided into four sections. The next sectiondevelops the model, the third section examines its predictions onmarket share empirically, and the last section concludes.

II. THE MODEL

We consider three identical countries, A, B, and C, each withn firms producing a homogeneous good. Competition is Cournot,and welfare gains are a result of the increase in competition thattrade introduces (as in Brander and Krugman [1983] and Branderand Spencer [1985]). We further assume that market-specificinvestments are required to sell the good in a particular market.Indeed, most traded goods, aside from commodities, must beadapted to the country’s tastes and marketed effectively in orderto be sold abroad. Many of these investments are specific to theforeign country and are not likely to be recouped if the firm exits.While we focus on distribution costs in order to simplify the model,many other types of costs are important and would generatesimilar effects. Some examples include examining foreign compe-tition, adapting the product, learning the legal and institutionalinfrastructure, developing an advertising campaign, acquiringclientele, and establishing contacts with local bankers, tradeassociations, and transport providers [Axtell 1989].5

The game has two periods, and there is perfect information.Within each period there are two stages. In the first stage,

5. In addition, survey results from the National Federation of IndependentBusinesses indicate that costly investments in distribution, information, andmarketing are the primary reasons that firms do not enter the export market[Axtell 1989]. Distribution costs in key industries are especially important. In theautomobile industry, for example, distribution costs make up nearly 30 percent ofsale prices in the industrialized countries. In Europe almost all dealers carry onlyone brand so getting a distributor is particular to the country and to the firm. Alsoin the high-tech industries, where marginal production costs are close to zero,large investments in marketing and distribution make up the bulk of the costs.






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governments set policy. In the second stage, output is producedand traded. Policy consists of (i) forming a regional agreement, (ii)allowing free trade, or (iii) autarky. We assume that only two ofthe countries, A and B, have the option to form a regionalagreement, perhaps because of proximity. In this case, they havezero bilateral tariffs, but do not allow imports of the imperfectlycompetitive good from the third country C. Meanwhile, thegovernment in country C chooses between total free trade andautarky. Once trade policy is set, each firm decides on exports. Inthe second period, the game repeats itself. The governments firstchoose policy, and then firms choose sales at home and abroad.

In the first period, we assume that domestic firms have theopportunity to set up domestic distribution networks before tradepolicy is set. This is optimal because it improves home countryprofits, leads to expanded output, and allows countries to achievea higher welfare level. This assumption also generates a ‘‘homebias’’ in consumption—domestic absorption is biased towarddomestic production—which is consistent with empirical evi-dence. Finally, it eliminates the possibility that countries benefitin their own market as a result of trade policy. If a firm could notset up its domestic distribution network first, then its position inthe home market would (by symmetry) be identical to its positionin the partner’s market, implying that trade policy would affectthe firm’s domestic production in the same way as it affectsexports to the other member country.

A. Market Structure

Demand for the imperfectly competitive good in each countryis defined by

(1) P 5 K 2 Q,

where P is price, K is a constant, and Q is total output. Themarkets here are assumed to be segmented; that is, it is prohibi-tively costly to cross-haul output.6

In a given market, costs for each firm without a distributionnetwork in place are

(2) c 5 wq 1 xq,

6. Widely observed deviations from the law of one price are consistent withsegmented markets and pricing to market. Moreover, Engel and Rogers [1996] findthat the law of one price holds more closely within regions—they speculate thatthis may be the result of integrated marketing and distribution systems.






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where x is the variable cost of the distribution network, q isquantity, and w is the variable cost of production. A firm that hasalready set up a distribution network faces the following costfunction:

(3) c 5 wq 1 xq* 1 x max (q 2 q*,0),

where q* is the quantity chosen in the first period. This impliesthat the cost of the distribution network in the second period isfixed at xq*, provided that output is less than or equal tofirst-period output; therefore, the firm’s second-period marginalcost is lower than its first-period marginal cost, for q # q*.7

Building a distribution network for q* in the first periodallows the firm to shift out its second-period reaction function.Figure I shows the reaction function of a firm with a marginal costof w 1 x (AA) and the reaction function of a firm with a marginalcost of w (AA8). Since a firm with an established distributionnetwork has a marginal cost of w for output below q* and w 1 x foroutput above q*, it presents the bold reaction function to otherfirms. The key feature of this reaction function is the verticalsegment. No matter how much the competitors produce withinthis range, it remains optimal for the firm to produce q*. Hence,

7. For a complete description of this type of cost function and its effect on atwo-firm market, see Dixit [1980].

FIGURE IThe Reaction Function of a Firm






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

B. Solution

There are several strategies that need to be examined, butsome can be ruled out immediately. A welfare-maximizing govern-ment will always prefer some trade to no trade. In addition, nocountry will ever choose to go from free trade to regionalism. Iffree trade is optimal in the first period, then it will be in the secondperiod as well. The same is not true of regionalism to free tradesince regionalism affects the free trade outcome. The mainquestion becomes will countries A and B choose regionalismfollowed by free trade or free trade in both periods? The govern-ment knows how firms will behave under each policy scenario andwill choose the path that maximizes welfare.

We start by evaluating the outcome if regionalism is followedby free trade and then examine free trade in both periods. Wesolve for the equilibrium output levels in market A, assuming thatA and B choose to exclude C in the first period and have completefree trade in the second period. The problem is solved backwards.First, we solve for second-period Cournot quantities, and then wesolve for first period output. We assume that each firm fromcountry A and country B is on the vertical part of its reactionfunction in the second period and therefore produces the sameamount in both periods. Next, we provide the conditions underwhich full commitment is feasible and optimal.

The objective of each firm from country C is to maximizeprofits with respect to exports to country A,

maxzC

zC[P(nqB,2A 1 nqA,2

A 1 (n 2 1)qC,2A 1 zC) 2 w 2 x],

where qj,ki is the quantity for sale in country i, by a firm from

country j, in the kth period, zi is the output of a representative firm

8. It is not crucial that the distribution cost is paid in both periods. Forexample, if the sunk cost were paid entirely in the first period, then theincumbent’s second-period cost function would be c 5 wq 1 x max (q 2 q*,0), whichyields an identical reaction function to the one shown. However, if the entrant inthe second period were required to make the same investment, then the entrantwould have higher average costs (since it makes sales in only one period), givingthe incumbent firm a real cost advantage. The chosen cost function implies that allfirms have identical average costs. Thus, the advantage to being first is entirelybecause the investment is sunk.






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from country i, and zi 5 qi,2A in equilibrium. The solution to this

problem defines qC,2A as a function of qA

A and qBA.

In the first period, each firm in B maximizes profits takinginto account the effect of today’s output choice on next period’sprofits. Since the quantities do not change between periods, thetime subscript is dropped. The optimization problem, for a firmfrom B, is

maxzB

zB[P(nqAA 1 (n 2 1)qB

A 1 zB) 2 w 2 x]

1 bzB[P(nqAA 1 nqC

A(nqAA,(n 2 1)qB

A,zB)

1 (n 2 1)qBA 1 zB) 2 w 2 x],

where b is the rate of time preference.9 The solution to thisproblem defines qB

A as a function of qAA and qC

A.Each firm in country A chooses its distribution network

before each firm from B, so we have

maxzA

zA[P((n 2 1)qAA 1 zA 1 nqB

A((n 2 1)qAA,zA)) 2 w 2 x]

1 bzA[P((n 2 1)qAA 1 zA 1 nqB

A((n 2 1)qAA,zA)

1 nqC,2A ((n 2 1)qA

A,zA,nqBA((n 2 1)qA

A,zA))) 2 w 2 x].

The solution to this problem defines qAA as a function of qB

A and qCA.

As noted above, a first-mover advantage is guaranteed toall domestic firms in their home market relative to foreignfirms. If firms from A and B enter both markets simulta-neously (no home market advantage), then the PTA would alsogenerate a first-mover advantage for firms in their domesticmarket. In that case, the quantity and welfare effects that resultfrom having a regional agreement before free trade would bemagnified because there would be an additional positive effect onhome market profits. Under the chosen setup, the regionalagreement exclusively improves market share in the partnercountry.10

Solving the firms’ problems above, yields the equilibrium

9. b is not restricted to being less than one; b will be greater than one ifgovernments care more about the future.

10. An alternative would be to assume that firms did not pay distributioncosts in their home market. In this case, domestic firms would sell at least as muchas under the present assumptions, and the following results would survive. There






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quantities,

(4) qAA 5

K 2 w 2 x

n 1 1, qB

A 5K 2 w 2 x

(n 1 1)2,

and qC,2A 5

K 2 w 2 x

(n 1 1)3.

The quantity of each firm from A is the Stackelberg leadershipquantity with respect to a firm from B or C, and the Cournotquantity with respect to another firm from A. The quantity of afirm from B is the Stackelberg leadership quantity with respect toa firm from C, and a Stackelberg follower quantity with respect toa firm from A.

The quantities, qAA and qB

A above, are credible in the secondperiod only if each incumbent firm would not wish to reduce itsquantity once firms from C have entered. If the Cournot quantityin the second period, with a marginal cost of w, is greater than orequal to the quantity chosen in the first period, then a firm is onthe vertical portion of its reaction function and can maintainsales. The condition that must be satisfied for each firm in countryA, in the second period, is

qAA # (K 2 w 2 nqB

A 2 nqCA)/(n 1 1).

The left-hand side of the equation above is the optimal quantity(from (4)) that a firm from A produces. The right-hand side is theCournot quantity that the firm would produce if its marginal costwas w. Using the quantities from equation (4) and simplifying, wehave

(5) distribution cost/markup $ n2 1 2n.

There is a corresponding condition for the credible commit-ment of each firm from B in A’s market. It is less stringent thanthe condition on a firm from A, since each firm from B producesless than each firm from A. The condition for a firm from B reducesto

(6) distribution cost/markup $ n.

Provided that the distribution cost x is large enough, firms from A

would, however, be a welfare loss from trade as a result of wasted distributionpayments.






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and B can effectively precommit to their Stackelberg leadershipquantities.11

PROPOSITION 1. If the sunk part of the distribution cost is largeenough, firms from the PTA member countries can commit totheir leadership quantities in each other’s markets beforefirms from the third country enter.

Next we examine output in C’s market, assuming that firmsfrom A and B enter C’s market simultaneously. Each firm solvesthe following maximization in the period when it enters C’smarket:

maxzAB

zAB(P(nqCC 1 (2n 2 1)qAB

C 1 zAB) 2 w 2 x),

where zAB is the output that a representative firm in A or Bexports to C. The solution to this problem defines qA

C (and bysymmetry qB

C) as a function of qCC.

If firms from A and B enter in the second period, the problemthat each firm from C will solve is

maxzC

zC(P((n 2 1)qCC 1 zC) 2 w 2 x) 1 bzC(P((n 2 1)qC

C

1 zC 1 2nqABC ((n 2 1)qC

C,zC)) 2 w 2 x).

The solution to this problem defines qCC as a function of qA


C), given that C chooses autarky in the first period. Iffirms from A and B enter in the first period, the correspondingproblem is

maxzC

zC(P((n 2 1)qCC 1 zC 1 2nqAB

C ((n 2 1)qCC,zC)) 2 w 2 x)(1 1 b).

The solution to this problem defines qCC as a function of qA


C), given that C imports from A and B in both periods.Solving, in both cases, yields equilibrium quantities:

(7) qCC 5

K 2 w 2 x

n 1 1, qAB

C 5K 2 w 2 x

(n 1 1)(2n 1 1).

Note that since the countries are symmetric, if firms in A cancommit to their leadership quantity at home, then firms in C must

11. If the distribution cost is zero, firms have no commitment capability, andthe outcome will be symmetric. If it is greater than zero, but permits less than fullcommitment, a firm will produce its maximum credible commitment.






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be able to as well. Firms from C face less intense competition fromtheir rivals in the domestic market, so the comparable feasibilityconstraint (to equation (7)) is less likely to bind.

Finally, we examine the outcome if there is free trade in bothperiods. The multilateral path implies that firms from bothtrading partners enter each country simultaneously. The problemwill look identical to the problem above for country C—in terms ofimports and domestic sales—except that all countries will beidentical; i.e., trade flows will be symmetric. Home sales for eachfirm in each country (i) will be qi

i 5 (K 2 w 2 x)/(n 1 1) andexports to each other country ( j) will be qi

j 5 (K 2 w 2 x)/((n 1 1)(2n 1 1)). In addition, trade and output in both periodswill be the same.

C. Export Quantities

If free trade is achieved in the second period following abilateral agreement in the first period, trade between foundingmembers will be greater than trade between an initial memberand a new member. From equation (4), A’s imports from B(nqB

A)and from C(nqC

A) are

(8) nqBA 5

n(K 2 w 2 x)

(n 1 1)2$

n(K 2 w 2 x)

(n 1 1)35 nqC

A.

From equations (4) and (5), A’s exports to B(nqAB) and to C(nqA

C) are

(9) nqAB 5

n(K 2 w 2 x)

(n 1 1)2$

n(K 2 w 2 x)

(n 1 1)(2n 1 1)5 nqA

C.

Thus, A trades more with B than with C.

PROPOSITION 2. With sunk costs in distribution, if a regionalagreement is in place before free trade, then the regionalmembers trade more with each other than with the thirdcountry even after free trade is achieved.

Alternatively, if there is free trade in both periods, then alltrade flows from i to j are identical and are

(10) nqij 5 n(K 2 w 2 x)/((n 1 1)(2n 1 1)).

From equations (8), (9), and (10) it is straightforward to show thattotal trade is greater if free trade is achieved after regionalismthan if free trade is achieved directly.






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PROPOSITION 3. Total trade is greater if free trade is achievedafter a regional agreement than if free trade is achievedimmediately.

Proposition 2 provides a specific prediction about trade flowsamong trade bloc members that can be evaluated empirically. InSection III we use intraregional trade data from the EuropeanUnion to determine whether the original members of the Euro-pean Union trade more with each other than with other membersthat joined at a later date.

D. Welfare Effects

In this section we examine the implications for welfare fromthe regional path to free trade versus the multilateral liberaliza-tion path. First, we examine welfare in country A, which bysymmetry is identical to welfare in B, and then we turn tocountry C.

If the regional path to free trade is taken, then welfare incountry A(WR

A), in the regional period is

WRA 5 U(QAB

A ) 2 (w 1 x)(QABA ) 1 PA

C,

where U(Q) is the utility from consuming quantity Q, QABA is the

total quantity produced for market A by firms from countries Aand B, and PA

C is the producer surplus accruing to firms in A fromsales in market C.12 Plugging in the quantities solved for above,we have

(11) WRA 5 (K 2 w 2 x)23(n 1 1)4 2 1

2(n 1 1)41

n

(n 1 1)2(2n 1 1)24 .

Welfare in the free trade period following the regional period(WR,FT

A ) is

WR,FTA 5 U(QABC

A ) 2 (w 1 x)(QABA ) 2 PQC

A 1 PAC.

Plugging in the quantities solved for above yields

(12) WR,FTA

5 (K 2 w 2 x)23(n 1 1)6 2 (2n 1 1)

2(n 1 1)61

n

(n 1 1)2(2n 1 1)24 .

12. We assume that C allows imports from A and B, as this is the welfare-maximizing strategy, although the results are qualitatively similar if C does notallow imports in the first period.






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Alternatively, under immediate free trade, welfare, WFTA , is

the same in both periods:

WFTA 5 U(QABC

A ) 2 (w 1 x)(QABCA ),

which simplifies to

(13) WFTA 5 (K 2 w 2 x)2

13n2 1 6n 1 4n4 1 12n3

2(n 1 1)2(2n 1 1)2.

From equations (11) and (13), first-period welfare from regional-ism is greater than first-period welfare from immediate free trade(WR

A . WFTA ). Welfare from free trade achieved after regionalism

is also greater than welfare from immediate free trade (WR,FTA .

WFTA ). Therefore, the original members of a bilateral agreement

are at a higher welfare level in both periods as a result of having aregional agreement before free trade, relative to choosing freetrade in both periods.

PROPOSITION 4. Welfare in the original members of the PTA isgreater if free trade is achieved after a regional agreementthan if it is achieved immediately.

Welfare is greater because of the effect of sequential entry onquantity and profits. In the first period, profits accruing to firmsfrom A and B are higher than they would be under free trade sincefirms from C are excluded. This gain in profits exceeds thecorresponding loss in consumer surplus as a result of excludingC.13 In the second period, profits abroad remain relatively largerbecause of the first-mover advantage. Moreover, the total quantityconsumed in country A is greater than the total quantity frommultilateralism. Thus, in the bloc countries, consumer surplus infree trade subsequent to a regional agreement is larger thanconsumer surplus from immediate free trade.

Welfare in country C, in the first period, is

WRC 5 U(QABC

C ) 2 (w 1 x)(QCC) 2 PQAB

C .

Plugging in from the quantities solved for above, yields

(14) WRC 5 (K 2 w 2 x)2

(n 1 1)2(2n 1 1)2 2 (4n 1 1)

2(n 1 1)2(2n 1 1)2.

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


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In the second period after a regional agreement, welfare incountry C is

WR,FTC 5 U(QABC

C ) 2 (w 1 x)(QCC) 2 PQAB

C 1 PCAB.

Using the quantities solved for above, this simplifies to

(15) WR,FTC

5 (K 2 w 2 x)2 3(n 1 1)2(2n 1 1)2 2 (4n 1 1)

2(n 1 1)2(2n 1 1)21

2n

(n 1 1)64.In both periods, country C is worse off from the regional path tofree trade.

PROPOSITION 5. Welfare in the nonmember country is greater iffree trade is achieved multilaterally than if it is achievedsubsequent to a regional agreement.

Firms in country C lose on two accounts if free trade isachieved via regionalism: (i) they are excluded from the foreignmarket in the first period; and (ii) in the second period they haveless scope for expansion abroad because output of firms in A and Bis greater. Thus, the late entrant to a regional agreement obtainsa higher welfare level from immediate free trade than fromentering a regional agreement previously signed by the othernations.

Next, we turn to world welfare, defined as the sum of thethree countries’ welfare levels. World welfare in the period of freetrade after regionalism, WWR,FT, is higher than world welfare infree trade not subsequent to a regional agreement, WWFT,FT.

(16) WWR,FT 2 WWFT,FT 5 (K 2 w 2 x)2bn2(2 1 4n 1 n2)

(1 1 n)6(1 1 2n)2. 0.

The intuition is that world output is greater after regionalismthan if there was free trade in both periods. The amount the earlyentrants gain from free trade reached through a regional agree-ment is thus greater than the amount the late entrant loses. Thisimplies that even if side payments are feasible, if the memberscare relatively more about second-period gains, then the nonmem-ber cannot bribe the regional bloc countries to allow free trade inthe first period because the members’ gains are greater than whatthe nonmember would be willing to pay.14

14. World welfare in the first period is lower in regionalism than in free trade.






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PROPOSITION 6. World welfare in the period of free trade afterregionalism is higher than world welfare in free trade.

In this section we have seen that a regional agreement haspersistent effects on trade flows in the presence of sunk costs. Thisimplies that countries may sign regional agreements, not only toattain preferential market access now, but also because they canretain their market share even if free trade is achieved. Moreover,a regional agreement before free trade brings a member countrycloser to the efficient outcome. Thus, if the world is moving towardfree trade, foreign market share gains, and domestic consumptionimprovements provide a reason why countries may prefer theregional path.

III. EMPIRICAL EVIDENCE

The model relies on the assumption that first-mover advan-tages are an important determinant of future sales. Empiricalevidence at the industry level supports this claim. Order of entryhas a significant impact on firms’ market shares, and the advan-tages associated with market tenure persist over time.15 Robinsonand Fornell [1985], for example, find that pioneering firms tend tohave an average market share of 29 percent, early followers 17percent, and late entrants 12 percent, and that order of entryexplains 18 percent of the variation in market share in across-sectional study of consumer goods in the United States.16

Results for industrial goods are similar although not quite sostrong [Robinson 1988]. In addition, while Brown and Lattin[1994] find that first-mover advantage in consumer-goods salesgradually declines as time passes, their results also suggest thatthe advantage will never disappear.

In this section we examine the European Union (EU) forevidence of first-mover advantages in trade among its founders.Entry into the Union was staggered, the original members—France, Germany, Italy, Belgium, Luxembourg, and the Nether-

15. For a survey of the literature see Robinson, Kalyanaram, and Urban[1994].

16. Within specific industries, evidence of the importance of first-moveradvantages is striking. Numerous studies of the pharmaceutical and cigaretteindustries find that order of entry is the single most important determinant ofmarket share [Robinson, Kalyanaram, and Urban 1994]. Hurwitz and Caves[1988], for example, find that average pioneer market share in the pharmaceuticalindustry, at a varying number of years after patent expiration, is 63 percent. Theyalso find that greater market share associated with early entry is not a result oflower prices or higher quality.






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lands—formed the European Economic Community (EEC) in1958. The United Kingdom, Ireland, and Denmark were the nextto join in 1973; they were followed by Greece in 1981, Portugal andSpain in 1986; and more recently, Austria, Finland, and Swedenbecame members in 1995.17

Using the gravity model to adjust for ‘‘normal’’ trade flows,this section examines data from the EU countries to determinehow the formation of the Union affected trade flows amongmembers. The main results are consistent with the hypothesisthat early entry into a union allows countries to establish tradelinks that persist over time.

A. The Gravity Equation

The basic gravity equation postulates that bilateral tradeflows are a function of the size of the trading partners and thedistance between them. The hypothesis is that trade is increasingin income and decreasing in distance, or

XPij 5 YiYj /DISij,

where XPij is trade flows from country i to country j, Yi( j) is i’s ( j’s)income, and DISij is the distance between the countries.18 Otherstudies have found that trade flows fit this simple model surpris-ingly well.19

By including a dummy variable that represents countries in aPTA, the gravity equation is often used to explain deviations from‘‘normal’’ trade as a result of preferential trade agreements.Frankel, Stein, and Wei [1995] employ this approach to determineregional bias in trade. They find that regional groupings havesignificantly altered trade flows. The European Community mem-bers, for example, traded 63 percent more with each other in 1990than the gravity model predicts. Eichengreen and Irwin [1998]look at the effect of PTAs on trade flows using historical data from1949 to 1964. They also analyze the effect of history on trade flows,using lagged trade in the gravity model.

To test the effect of order of entry on trade flows, we use an

17. We do not include Austria, Finland, and Sweden in the sample becausethey were members of the competing trade bloc, the European Free TradeAssociation, throughout the period examined.

18. Note that the gravity model is broadly consistent with the model of tradepresented earlier. The relevant equation is (10). The number of firms (n) will beincreasing with the size of a country and the partner’s demand (K 2 Q) will alsoincrease with its size. Distance raises costs (w), implying that exports aredecreasing in distance.

19. Chapter 4 in Frankel [1997] surveys the literature.






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approach similar to that of Frankel, Stein, and Wei [1995] andEichengreen and Irwin [1998]. The hypothesis is that tradebetween the original six members is larger than the otherwisenatural trade flow as predicted by the gravity model, after othercountries joined the union (and thus also relative to the othermembers). We also suspect that trade between the late entrantsand the incumbent members will be below the natural trade flowspredicted by the gravity model.

We examine bilateral trade flows between EU member na-tions for 1954, 1962, 1970, 1980, and 1990. The countries includedare Belgium-Luxembourg, the United Kingdom, Denmark, France,Germany, Greece, Ireland, Italy, the Netherlands, Portugal, andSpain.20 Since we are looking at exports from one country toanother there are 110 data points (11 * 10). The model we fit is thefollowing:

(17) log XPij 5 b0 1 b1 log (YiYj) 1 b2 log ( yiyj)

1 b3 log DIS 1 b4ADJ 1 b5DIFPC 1 b6ORG,

where yi is per capita income in country i, ADJ is a dummyvariable that is one if the countries share a border, DIFPC is thenatural logarithm of the difference in the partners’ per capitaincomes, and ORG is a dummy variable that equals one if bothcountries are original members and is zero otherwise. The hypothe-sis above implies that the coefficient on ORG will be positive andincreasing in the years since the formation of the union and beforeother members join. We also expect the coefficient to decrease asnew members accede, but to remain positive and significantthroughout the sample period.

The first five columns in Table I report the results. Thevariable ORG is positive and significant in all four years after thecustoms union was formed. The gradual tariff reductions pre-scribed under the Treaty of Rome were completed in 1969, so it isnot surprising that the coefficient on ORG is greatest in 1970. Themembers traded more than twice as much with each other thanpredicted by the gravity model (exp 0.88 5 2.41) in 1970. In 1980

20. The trade data are from the IMF Direction of Trade Statistics database.The GNP and GNP per capita data are from the World Bank CD STARS, except for1954, which is calculated from the IMF International Financial Statistics. Thedistance data are from the world distance tables and represent the direct airdistance between economic centers.






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and 1990 we see a decline in the coefficient; however, it remainspositive and significant in both years. In 1990 the founders stilltraded over 75 percent more with each other than is predicted bythe gravity model.

Since Spain and Portugal were the last countries to join theUnion, we also include a dummy variable called LATE that is onewhen either of these countries participates in trade. The theoryabove suggests that the coefficient on LATE should remainnegative in 1980 and 1990, since Spain and Portugal had lessaccess to foreign markets and foreign countries had less of anincentive to expand exports to Spain and Portugal. In addition,owing to past colonial links, we include a dummy variable torepresent trade between Ireland and the United Kingdom, titledCOL. The coefficient on COL is likely to be positive. The resultsare recorded in columns 6–10 of Table I. In 1990 Spain andPortugal traded about 45 percent less with the other members ofthe Union than is predicted by the gravity model. However, Spainand Portugal trade significantly less throughout the years, suggest-

TABLE IGRAVITY EQUATION BY YEAR

1954 1962 1970 1980 1990 1954 1962 1970 1980 1990

GNP 0.61** 0.66** 0.75** 0.71** 0.75** 0.67** 0.71** 0.79** 0.78** 0.80**(0.07) (0.06) (0.06) (0.04) (0.04) (0.07) (0.06) (0.06) (0.04) (0.04)

PCGNP 0.17 0.47** 0.22 0.05 20.48** 20.29 0.09 20.14 20.36* 20.70**(0.24) (0.18) (0.19) (0.17) (0.14) 0.30 (0.25) (0.25) (0.18) (0.15)

DIS 20.65* 20.41* 20.54** 20.78** 20.87** 20.66* 20.37 20.46* 20.64** 20.75**(0.30) (0.20) (0.21) (0.18) (0.12) (0.31) (0.20) (0.19) (0.16) (0.11)

ADJ 0.07 0.37 0.23 0.09 0.17 0.24 0.49* 0.42 0.34* 0.34*(0.31) (0.24) (0.22) (0.18) (0.16) (0.28) (0.23) (0.22) (0.16) (0.14)

DIFPC 0.17 0.15 0.15 0.13** 0.17** 0.23 0.15* 0.18 0.12** 0.16**(0.13) (0.08) (0.13) (0.04) (0.05) (0.15) (0.08) (0.11) (0.04) (0.04)

ORG 0.36 0.51* 0.88** 0.62** 0.58** 0.10 0.39 0.82** 0.44** 0.42**(0.24) (0.20) (0.16) (0.13) (0.15) (0.26) (0.21) (0.16) (0.13) (0.14)

COL 1.51** 1.52** 1.71** 1.07** 0.80**(0.36) (0.26) (0.28) (0.22) (0.13)

LATE 20.91** 20.63* 20.62* 20.91** 20.56**(0.29) (0.26) (0.26) (0.17) (0.15)

No. ofobs. 106 107 110 110 110 106 107 110 110 110

Adj R2 0.65 0.78 0.82 0.85 0.88 0.68 0.79 0.83 0.88 0.90

Regressions were run with a constant term; values for the constants are not reported. Heteroskedasticity-consistent standard errors are in parentheses.

**Significant at the 1 percent level.*Significant at the 5 percent level.






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ing that this may be the result of other factors.21 The UnitedKingdom and Ireland still traded more than twice as much witheach other than with the other members in 1990.

Not surprisingly, the coefficient on ORG declines when LATEis included in the regression equation; part of the relatively highertrade among the original members is a result of their trading lesswith Spain and Portugal. Of greater interest, the coefficient onORG is small and insignificant in 1954, increasing through 1970,decreasing after, and remains positive and significant in 1990.This suggests that, after accounting for relatively less trade withSpain and Portugal, the original members traded more with eachother than the model predicts only after the union was created.

B. An Alternative Explanation

An alternative is that the union was formed endogenously, bycountries that were and still are natural trading partners, per-haps because of comparative advantage, tastes, or technology.Stated differently, this suggests that there would be a bias towardtrade with original members even if all members had joinedsimultaneously. To examine this competing hypothesis, we firstlook at trade flows before the union was formed for evidence of apreexisting bias. Second, we include trade flows from 1950 in thebasic regression equation to adjust for initial conditions. Third, wecompare trade adjustment between two initially similar coun-tries, France and the United Kingdom, over time.22

If the original members are natural trade partners, then theywould likely trade more with each other before the union wasformed. The positive coefficient in 1954 suggests that we cannotrule out the possibility that the union was formed along naturaltrade lines. However, in 1954 Belgium, Luxembourg, and theNetherlands had already been in a customs union for six years,and the founding six had already begun the process of forming afree trade arrangement—they created the European Coal andSteel Community (ECSC) in 1951, which formed a customs unionin these products. Ideally, we would like to explore the gravitymodel before 1948. Eichengreen and Irwin [1998] have gone someway toward this. In a sample of 38 countries they find that in 1949

21. The magnitude of the coefficient in 1954 is due primarily to autarkicpolicies in Spain before their Stabilization Plan of 1959.

22. We also test whether the original members trade more with each otherbecause they are the main exporters in the region. Including a dummy variablethat is one whenever an original member is an exporter is never significant (notreported).






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the founding six did not trade more with each other. Using thegravity equation, they find that the coefficient on EEC, which is adummy variable that represents the original members, is nega-tive although not significant. In addition, they find that thecoefficient on the EEC grows over the years. Their results for thecoefficient on EEC in 1954 and 1964 of 0.18 and 0.63, respectively,are consistent with those presented here. Their results suggestthat the original members did not trade more with each otherbefore the union was formed.

A second way to distinguish the hysteresis hypothesis fromthe natural trade partners hypothesis is to use past trade as aproxy for initial conditions. That is, we want to see whether theagreement affected trade, after accounting for relative tradepositions when the agreement was signed—the hope is that initialconditions control for persistent comparative advantage positionsor other missing variables that might affect trade. We include pastvalues of the dependent variable from 1950 in the regressionequation. The results are recorded in Table II. After accounting forinitial conditions, the coefficient on ORG is still highly significantin 1962, 1970, 1980, and 1990.23 Moreover, the magnitude of thecoefficient does not change (as compared with the results in TableI), suggesting that ORG is picking up mainly the effects ofunification. In contrast, all of the other coefficients decline in bothmagnitude and significance. For example, the coefficient ondistance falls close to zero in 1962 and 1970, indicating thatdistance affects trade in roughly the same way in the two periods.Not surprisingly, the importance of the initial conditions declinesover time. However, trade patterns in 1950 are still highlysignificant in determining trade in 1990.

Still, even if trade had been liberalized among all members atone time, trade might not have increased uniformly. Countrieshad different average tariff levels in 1958, and tariffs differedacross industries. The high tariff countries would likely experi-ence the most increased trade as a result of unification. Therefore,it may be that the initial members did not trade significantly morein the 1950s because of the tariffs that prevailed. In an attempt tocontrol for this, we compare trade between the original members

23. The regression including past trade was also run on 1954 trade values. Inaddition, it was tried in trade levels, as opposed to log levels. In both cases theresults still hold. When it was run in levels, while ORG was still highly significantin each year, COL was never significant, and LATE was not significant in 1962 and1970.






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and the United Kingdom, with trade between the original mem-bers and France, a founding member. Evidence suggests that in1958, the United Kingdom was as much of a natural member asFrance was. The United Kingdom decided not to join the EECbecause of political reasons; she wanted to form a free tradeagreement, while the others were inclined toward a customsunion. Moreover, France and the United Kingdom were similar inmany respects. In the 1950s the unweighted-average ad valoremtariff level in France was 0.17, and in the United Kingdom it was0.165 [Truman 1975, p. 63]. Both countries had high tariffsrelative to the rest of the EEC, and tariffs in the two were verysimilar by industry, so there is no reason to believe tariff cuts inone country would be more beneficial [Political and EconomicPlanning 1959]. Total trade with the other EEC countries was$1626 for France and $1711 for the United Kingdom. Theirnational incomes were similar as well, France’s GDP was over 90percent of U. K. GDP in 1954.

TABLE IIGRAVITY EQUATION WITH INITIAL CONDITIONS

1962 1970 1980 1990

GNP 0.37** 0.42** 0.55** 0.67**(0.06) (0.06) (0.05) (0.05)

PCGNP 20.08 20.30 20.36* 20.71**(0.15) (0.18) (0.16) (0.16)

DIS 20.06 20.11 20.41** 20.58**(0.11) (0.13) (0.14) (0.11)

ADJ 0.24 0.30 0.30 0.33**(0.16) (0.16) (0.13) (0.12)

EXP50 0.64** 0.51** 0.33** 0.19**(0.06) (0.08) (0.06) (0.06)

DIFPC 0.10 0.15 0.12* 0.15**(0.05) (0.12) (0.04) (0.05)

ORG 0.35* 0.91** 0.47** 0.44**(0.14) (0.20) (0.11) (0.12)

COL 0.38** 0.53** 0.36 0.46**(0.14) (0.20) (0.19) (0.14)

LATE 20.34* 20.44* 20.72** 20.42**(0.16) (0.06) (20.16) (0.15)

No. of obs. 100 100 100 100Adj R2 0.91 0.90 0.90 0.90








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To test for a difference in the bias among the originalmembers with respect to France and the United Kingdom, wecreate the following three dummy variables: ORGUK is a dummyfor trade between the original members and the United Kingdom;ORGFR is a dummy for trade between the original members andFrance; and ORG2 is a dummy for trade among the originalmembers, excluding France. Hence, ORGUK represents howmuch more or less the United Kingdom trades with the originalmembers relative to what the model predicts, and similarly forFrance. If the bias in trade among the original members in 1990 isthe result of natural forces, then we expect the coefficients onORGUK and on ORGFR to be similar to each other in both 1954and 1990. Alternatively, if the bias with respect to France and theUnited Kingdom is a result of history, we expect the coefficients onORGUK and ORGFR to be similar in 1954, to diverge over time,and to remain significantly different from each other in 1990.

The results are reported in Table III. We test the hypothesisthat the coefficient on ORGUK in each year is equal to thecoefficient on ORGFR, reporting the significance level of theChi-square statistic in the last line of Table III. The coefficientsare not significantly different from each other in 1954, and themagnitude of the coefficients suggests that if anything Francetraded less with the original members than the United Kingdomdid. Over the years they diverge as discriminatory policy comesinto effect. However, even after the United Kingdom joined theunion in 1973, trade between France and the other originalmembers remained significantly greater than trade between theUnited Kingdom and the bloc members. The hypothesis that thecoefficients are the same is rejected at the 1 percent level in 1970,and at the 5 percent level, in 1980 and 1990. Hence, the evidencesuggests that France has gained an advantage in trading with theother original members, relative to the United Kingdom, as aresult of joining the Union in 1958.

The empirical results from this section are consistent withthe hypothesis that the founding members of the European Unionhave retained a relatively greater share of each others’ markets asa result of past discriminatory policy. The original members of theEU trade more with each other than is predicted by the gravitymodel in all of the years since its formation. There is littleevidence that the original members were natural trading partnersrelative to all of the other members. This suggests that, in






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

IV. CONCLUSION

This paper has shown that the equilibrium free trade out-come arising from a regional agreement followed by free trademay be different from the outcome attained through multilateralnegotiations. This is because firms can effectively precommit toexports if there are large sunk costs involved in setting up adistribution network. As a result, regionalism provides firms inthe early entrant nations with first-mover advantages. This leads

TABLE IIITRADE WITH THE ORIGINAL MEMBERS: FRANCE AND THE UNITED KINGDOM

1954 1962 1970 1980 1990

GNP 0.72** 0.76** 0.88** 0.84** 0.86**(0.09) (0.07) (0.08) (0.06) (0.05)

PCGNP 20.24 0.07** 20.24 20.46 20.80**(0.32) (0.24) (0.27) (0.20) (0.17)

DIS 20.65* 20.42 20.60** 20.76** 20.85**(0.33) (0.22) (0.21) (0.19) (0.12)

ADJ 0.30 0.50* 0.31 0.26 0.29*(0.30) (0.24) (0.23) (0.17) (0.14)

DIFPC 0.22 0.14 0.15 0.11** 0.14**(0.14) (0.07) (0.11) (0.04) (0.04)

ORG2 0.28 0.51 0.78** 0.40* 0.42*(0.39) (0.31) (0.25) (0.20) (0.17)

ORGFR 20.55 20.21 0.11 20.04 20.11(0.39) (0.33) (0.26) (0.21) (0.19)

ORGUK 20.27 20.32 20.68 20.49 20.44*(0.46) (0.38) (0.36) (0.28) (0.23)

LATE 20.90** 20.66* 20.73** 21.00** 20.65**(0.32) (0.27) (0.27) (0.19) (0.17)

COL 1.46** 1.44** 1.48** 0.86** 0.64**(0.44) (0.34) (0.34) (0.28) (0.18)

No. of obs. 110 110 110 110 110Adj R2 0.68 0.80 0.84 0.89 0.91Chi-square (1) 0.93 0.24 10.11** 5.80* 4.43*Significance 0.34 0.62 0.001 0.02 0.04








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to higher welfare in the member nations than without theregional agreement.

Welfare expands because of the effect of the regional agree-ment on competition. With imperfect competition, output is toolow. Trade helps alleviate this distortion. The initiation of aregional agreement before allowing free trade reduces the distor-tion further by introducing a strategic incentive to expand output.Sunk costs allow firms from a member nation to commit toexporting more to their partner than they would if they entersimultaneously with firms from a third country. Because of thisexpansion in output, consumer surplus in the free trade periodafter a regional agreement and profits from exports are greaterthan if there had been two periods of free trade.

The allotment of benefits from the regional path is skewed.While the initial members achieve a higher welfare level from theregional path than they would from free trade reached multilater-ally, the late entrant attains a lower welfare level from theregional path than from immediate free trade. Surprisingly, worldwelfare during the period of free trade is higher from the regionalpath.

We go on to examine some of the implications of the model forthe European Union, adjusting for the natural determinants oftrade using the gravity equation. The main results are consistentwith the hypothesis that early entry into a trade union allowscountries to establish trade links that persist over time. There islittle support for the hypothesis that the countries were naturaltrading partners.

BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM

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