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It is well known to readers of this forum that Article XXIV of the World Trade Organization (WTO) allows countries to form customs unions (CUs) or free trade agreements (FTAs) under two conditions: First, members should eliminate (substantially) all internal barriers to trade inside the union; second, external trade barriers should not be increased on average. Intuition might suggest that, compared to a world where bloc formation is allowed without any constraints, Article XXIV must increase world welfare, since it precludes (average) tariff increases on non-members by countries that form preferential trade agreements while requiring tariff removal between members. According to this intuition, aggregate world trade distortions through the formation of trade agreements should be reduced compared to a world in which trade agreements are not constrained by Article XXIV, and world welfare should be enhanced. Yet there has been considerable debate in policy circles as to whether Article XXIV is in fact so benign. In our paper, which is among a small but growing number of papers to analyze the implications of Article XXIV formally, we show that the simple intuition outlined above ignores the effect that Article XXIV has on the manner in which countries endogenously organize themselves into the CUs that form. We will refer to this as the ‘composition effect’ of Article XXIV. By taking account of this composition effect of CU formation we are able to show that Article XXIV may actually be bad for world welfare.
In our study of the effects of Article XXIV we focus on CUs (as opposed to FTAs), because the restriction imposed by Article XXIV is more likely to bind on CUs. CU members coordinate on setting external barriers and so they are more likely to leverage the power on world markets that this coordination gives them in raising external tariffs. On the other hand, prior research has indicated that FTAs do not suffer from this problem because members continue to set external tariffs independently and so FTA proliferation tends to compete external tariffs downwards. Although FTAs outnumber CUs in the world by a considerable margin, some of the world’s most influential preferential trade agreements are CUs such as the European Union (EU) and Mercado Comum do Sul (Mercosur). So the implications of CU formation under Article XXIV for world welfare do seem to warrant our attention.
To analyze Article XXIV, we adopt as a benchmark a model developed by Sang-Seung Yi of Seoul National University. This model is the simplest framework where we can identify the composition effect of Article XXIV. It has two key features. First, there can be any number (greater than or equal to three) of countries in the model. Most research on CU formation is carried out on a ‘standard model’ in which there are just three countries. Second, the number of CUs and the country membership of each are determined endogenously through a coalition formation game: governments decide on CU membership to maximize their country’s welfare. In the standard model, CU formation is imposed exogenously on two of the countries with the third remaining outside to capture the effects of CU formation on a nonmember. Therefore, the composition effect of Article XXIV that we indentify cannot be observed in the standard model.
In our benchmark model, each country has a single firm that produces a (single) different variety of a (horizontally differentiated) product, and firms compete internationally for a segment of each other’s markets. The substitutability between varieties can vary all the way from one end of the spectrum where each variety enters preferences ‘independently’ to the other end where varieties are perfect substitutes for another. Governments set a tariff on imports to maximize welfare of their country. When allowed to form CUs, governments choose the size of the CU and set a common external tariff (CET) to maximize joint welfare of all members. The CET varies with the size of the CU and with the substitutability between goods. As a CU becomes larger, it wants to exploit its bigger market power by raising its CET. On the other hand, the removal of internal barriers in the CU diverts trade away from the rest of the world towards CU members. As consumers prefer more variety, this trade-diversion effect tends to decrease the CET. When goods are independent, CU expansion does not divert trade much, the market-power effect dominates and the CET increases with the size of the union. When goods are made more substitutable, the trade-diversion effect starts to dominate when the CU reaches a certain critical size and a sufficiently large CU will impose a lower CET than a smaller CU.
In our paper we formally introduce into the benchmark model an ‘Article XXIV constraint,’ that trade barriers cannot be raised on average when a CU forms or expands. This is a formalization of the second condition of Article XXIV introduced above; the first condition that all internal barriers be removed is a feature of the standard model and of our benchmark model as well. Because of how the CET of the CU varies with the substitutability between products, the effects of Article XXIV also depend on the degree of substitutability between products.
To reveal the importance of the composition effect of Article XXIV, we first study the effects of Article XXIV ignoring the composition effect. That is, we treat CU membership as exogenously given and we show that Article XXIV increases world welfare. Thus, if we ignore the composition effect the simple intuition outlined above does hold. Note that because in the standard three-country model CU formation is exogenously imposed on two countries, the simple intuition would apply there too.
Then, we allow countries to endogenously form CUs both with and without the Article XXIV constraint. For what we call a ‘practical’ number of countries, by which we mean a number lower than in the hundreds of thousands, there will be at most two CUs in equilibrium (both with and without Article XXIV). When goods are independent, the gains from free trade outweigh the gains from market-power exploitation through tariffs and so the equilibrium CU structure is one single bloc, which is of course equivalent to world free trade. Put differently, when goods are independent, outsiders can inflict a large welfare loss on any CU and so all countries agree to form one single bloc. When goods are more substitutable, countries that start the CU formation process are better off if they leave some other countries outside their bloc and are thereby able to exploit their market power over them. The equilibrium CU structure thus comprises two blocs, one larger and one smaller. Members of the larger bloc have higher welfare than members of the smaller bloc.
Article XXIV has two opposite effects on the equilibrium CU structure depending on whether it binds on the larger or the smaller bloc. When the larger bloc is constrained by Article XXIV, it would want to accept more members, because Article XXIV sets a bound on foreign rent extraction and thus makes the benefits from freer trade relatively larger. On the other hand, when the smaller bloc is constrained by Article XXIV, the larger bloc would want to accept fewer members because the welfare loss that the smaller bloc can inflict on the larger bloc is smaller. Which of these two effects dominates depends on which bloc is more constrained by Article XXIV, which in turn depends on the substitutability between goods. For independent goods, the larger bloc is more constrained and so the composition effect of Article XXIV tends to make the equilibrium CU structure more asymmetric. A corollary of this is that free trade arises for a larger range of substitution elasticities. By increasing the asymmetry between the blocs, Article XXIV is actually good for world welfare. More asymmetry between the blocs implies a larger number of goods are traded within the larger bloc and so a smaller number of goods are subject to welfare-reducing tariff distortions (the most extreme possible asymmetry is world welfare maximizing free trade). When goods are relatively substitutable, the smaller bloc is more constrained and so the composition effect of Article XXIV tends to make the equilibrium CU structure less asymmetric. By reducing the asymmetry between the blocs through its composition effect, Article XXIV may be bad for world welfare, because more goods are traded between the blocs and subject to welfare-reducing tariff distortions. Another interpretation of the composition effect is that, when blocs are less asymmetric, there are fewer ‘rich countries’ and more ‘poor countries’ in the world since members of the larger bloc have higher welfare than members of the smaller bloc.
Yi, S.-S. (1996): “Endogenous Formation of Customs Unions under Imperfect Competition: Open Regionalism is Good,” Journal of International Economics, 41(1), 153–177.
Monika Mrazova is currently an ESRC Postdoctoral Research Fellow in the Managerial Economics and Strategy Group at the London School of Economics. She is also a Research Associate of the Globalisation Programme at LSE's Centre for Economic Performance. Monika received her PhD from the University of Oxford. Her main research interests lie in the field of International Trade with particular focus on international trade agreements. Her PhD thesis considered various aspects of the multilateral trading system as well as questions surrounding the formation of regional trade blocs. She continues to work on these topics as well as on broader issues of globalisation and economic integration.
David Vines is Professor of Economics, and a Fellow of Balliol College, at Oxford University. He is also Adjunct Professor of Economics in the Centre for Applied Macroeconomic Analysis at the Australian National University, and a Research Fellow of the Centre for Economic Policy Research. Since June 2008 he has been the Research Director of the European Union’s Framework Seven PEGGED Research Program, which is analysing the Politics and Economics of Global Governance: the European Dimension. David’s research is on macroeconomics and international economics. Recently he has worked on the macroeconomics of the global financial crisis, and on the reform of the international financial system. He is also interested in issues of trade agreements and has written on the future of the WTO and the World Bank, and on the reform of global economic governance.
Ben Zissimos is an Assistant Professor of Economics at Vanderbilt University, USA, and holds a Ph.D. in Economics from the University of Warwick, UK. His research on international trade policy focuses on preferential and multilateral trade agreements, agreements over the protection of intellectual property rights and protection of the global environment. He has also explored issues of international tax competition, international trade and its effects on employment, and the links between international trade and economic development. His research has been published in leading field journals in international economics and public economics.