Theoretical Studies on the Effects of Regional Integration

Theoretical Studies on the Effects of Regional Integration

As it is stated, theory on the welfare effects of regional economic integration stems from
Viner’s (1950) “The Customs Union Issue”. Prior to  this study, the customs union was
seen as a movement toward free trade and as a way to increase world welfare. As the father
of the concepts of trade creation and trade diversion, Viner had showed that the formation
of customs union was not necessarily a welfare improving process. While trade creation
effect arises in the case of “one of the members of the customs union will now newly
import from the other but which it formerly did not import at all because the price of the
protected domestic product was lower than the price at any foreign source plus the duty”,
trade diversion effect arises in the case of “one of the members of the customs union will
now newly import from the other whereas before the customs union it imported them from
a third country, because that was the cheapest possible source of supply even after payment
of duty” (Viner, 1950, p.43). Accordingly, net welfare effect of customs union will depend
on the extent of these two effects. For a customs union to operate in the free trade
direction, Viner (1950, p.51) suggests the larger economic area, the lower average tariff
level on post integration imports from non members, the less degree of complementarity of
the member countries with respect to protected industries, etc.

The analysis presented in Viner (1950) had been critized from several points, and resulted
in extensions on the issue.  For example, Lancaster and Lipsey (1956 57) take the Vinerian
analysis as “The General Theory of the Second Best”. In this theory, if it is impossible to
satisfy all of the optimum conditions, then a change in some of these conditions could
cause better or worse outcomes (cited in Lipsey, 1960, p.498). In addition to this, they
criticize the Vinerian analysis further due to its focus on the trade shifts from one country
to another and its ignorance on the effect of the substitution between commodities that
derived from the changes in relative prices (ibid., p.499).  

The substitution effect in consumption entered into the customs union theory through the
works of Meade (1956), Gehrel (1956 57), and Lipsey (1957) (cited in Lipsey, 1960,
p.501). Gehrel’s conclusion in favor of the gains rather than the losses of the customs
union is criticized by Lipsey (1960) because of taking into account two commodity case.   15
Lipsey (1960) states that in order to derive the valid conclusions on the customs union
theory it is necessary to consider at least three types of commodities (domestic commodity,
imports from partners, imports from the outside world). Additionally, Lipsey (1960)
proposes the distinction of inter country substitution that would embody trade creation and
trade diversion effects of Viner (1950), and inter commodity substitution that would derive
from the changes in relative prices.  His analysis  together with the analysis of Meade
(1956) lead Lipsey to conclude that “when only some tariffs are to be changed, welfare is
more likely to be raised if these tariffs are merely reduced than if they are completely
removed” (ibid., p.507). Lipsey also makes another  generalization1
 that relates the gains
from inter commodity substitution to the size of expenditure on previously mentioned
three classes of goods. From these generalizations, Lipsey (1960, p.508) concludes that
“the sort of countries who ought to form customs unions are those doing a high proportion
of their foreign trade with their union partner, and making a high proportion of their total
expenditure on domestic trade”.

Another extension on the Vinerian analysis came from the study of Dam (1963). Dam
(1963) interpretes the Viner’s trade diversion and  trade creation effects as the model of
production side and includes consumption effects to measure the overall impact of RIAs
together with the production effects. Accordingly,  the ratio of prices paid for domestic
goods to that for partner goods and the ratio of prices paid for partner goods to that for
non member goods will be changed by the formation of FTA, and “consumers will tend to
find prices of member goods cheaper, relative to the pre free trade area situation, than
either local goods or nonmember goods” (ibid., p.626). Hence, this will result in favorable
(substitution of member goods for local goods) and  unfavorable consumption effects
(substitution of member goods for nonmember goods). Dam (1963, p.628) concludes as
“… the smaller the range of goods imported from nonmember countries relative to the
range of goods imported from member countries, the  smaller the unfavorable and the
greater the favorable consumption effects”.

The study of Cooper and Massell (1965), on the other hand, derives the pure theory of the
customs union theory which is based on the Lipsey’s extension of the Vinerian trade
                                                
1
 This generalization derives from Lipsey’s doctoral thesis: Lipsey, R.G., 1958, “The theory of customs
unions: A general equilibrium analysis”, Unpublished Ph.D. thesis,  University of London.   16
creation and trade diversion analysis. The study rules out the effects like terms of trade and
economies of scale from the pure theory. By splitting the welfare effects of a CU into two
as “tariff reduction component” and “pure trade diversion component” (ibid., p.743),
authors states that the former component is the only source of any gain in consumers’
welfare in the integrated union. Accordingly, this component accounts for the consumption
effect introduced by Lipsey (1960) and the trade creation effect of Viner (1950). The
overall effect of the union will depend on the relative magnitudes of the two components in
which tariff reduction component represents the gain side, pure trade diversion represents
the welfare loss side of a CU. In the welfare analysis, the study concludes that since a CU
necessarily causes in trade diversion, as a result welfare loss, appropriate policy of non
preferential protection would result in better welfare effects relative to the customs union
option. The authors further criticizes the Viner’s  analysis taking into account customs
union as an acceptable policy option but not taking into account a tariff reduction policy. 

The study of Arndt (1968) starts from the ‘inferiority of the customs union relative to the
non preferential protection’ assertion suggested by Cooper and Massell (1965) and argues
that the argument is not valid due to not taking into account the effect of integration on the
terms of trade. With three country two goods model, the study concludes that two
countries acting together may gain in economic terms, relative to the case where one
country acts alone, due to the terms of trade effect of the union which result in a “net
improvement in welfare over any non preferential tariff situation” (ibid., p.976).  Kemp
and Wan (1976), on other hand, emphasizes the importance of the design of RIAs on the
expected outcomes. The study shows that the optimal tariff constructed so as to leave non
members’ trade unaffected would improve the welfare of member countries as well as the
welfare of world. The argument raised in Cooper and Massell (1965) is also critized by
Wonnacott and Wonnacott (1981). The study suggests  that small countries can gain from
the formation of regional integration in the presence of transport costs.  

With the advance of the new trade theory, the concepts of imperfect competition,
economies of scale and product differentiation has  become important determinants of
international trade. In this vein, Krugman (1991) studies the model consisting B identical
blocs and N identical countries, each producing one differentiated product. While transport   17
costs are not taken into account, the model is further based on the concept of natural
trading partners which states two countries as natural partners in case of high initial
volumes of bilateral trade and low distance between them. According to this setting, as the
number of blocs declines through further integration, each bloc starts to consume from the
share of the other blocs. The study finds the maximum number of blocs as three.

The extension of Krugman (1991) model comes from Frankel, Stein and Wei (1996). The
study emphasizes the role of transportation costs on determining the desirability of RIAs
and includes transport costs to the model of Krugman (1991). Accordingly, the magnitude
of these costs will determine the optimal level for the extent of regional integration. 

On the other hand, Panagariya (1998) offers an example in which the formation of a PTA
with a distant partner is superior relative to the  one with proximate partner. The author
states that the studies like Wonnacott and Wonnacott (1981) and Frankel et al. (1996) that
emphasize the importance of proximity or transport  costs on the formation of PTAs are
misleading due to their highly specific assumptions and/or selected variables of the
simulations.  Accordingly, all sources of cost (transportation costs, costs arising from
differences in technology/factor endowments) have equal significance for the trade flows. 

Goto and Hamada (1999) study the effects of regional integration under the assumptions of
constant tariffs and asymmetric bloc formation as an extension of the Krugman (1991)
framework which assumes symmetric blocs. The study  states that welfare first increases
with the expansion of the bloc, but when approximatley half of the world is participated
into this bloc, welfare starts to decrease with new members.