Chapter 2: Rationale, Motivation and Welfare Implications
1. THE RATIONALE BEHIND REGIONALISM Committed free traders among economists turn up their noses at the regional integration agreement (RIA) phenomenon. Whatever the trade expansion properties of RIAs, they can lead to substantial trade diversion, which in turn implies distortion of efficient global allocation of resources, resulting in welfare losses. Preferential reduction in tariffs under an RIA induces purchasers to switch demand towards the RIA partners. This happens at the expense of both domestic producers and imports from non-member countries and the rest of the world. The former is trade creation, while the latter is trade diversion. It needs to be clarified that trade is created only when cheaper and more competitive products from the RIA member economies substitute for more expensive and less competitive domestic products. When intra-bloc imports substitute for cheaper and more competitive imports from the nonRIA-member economies, when both faced tariffs, it is a case of trade diversion. To be sure, the former is beneficial, but the latter can be detrimental. The detrimental effects include loss of tariff revenue. However, the overall effect on national income may well be positive, depending upon the cost of alternative sources of supply and on trade policy towards the non-RIAmember countries. RIAs can potentially result in the reduction of global trade and welfare. Even if it is not correct, one must know the counterfactual, or more correctly the anti-monde. Generally, that is left for one’s imagination. Meaning thereby, if an RIA is reducing global welfare, it is doing so in...
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