Small Countries and Regionalism

The number of regional trade agreements has nearly doubled in the last four years. Interestingly, relatively small countries have put enormous effort into joining regional agreements with larger countries during this period. In this paper, we address the following question: why are small countries so eager to be a part of these agreements? We construct a general equilibrium model of a natural trading block to answer this question. Using this model, we examine the welfare implications of a variety of regional trade agreements between large and small countries. We simulate the model and calculate consumption allocations, prices, trade volume, and tariffs under three different equilibria: Free Trade, Free Trade Association, and Customs Union. The results of this investigation indicate that a relatively small nonmember country might face significant welfare loses if a large regional trading block uses its monopoly power to manipulate external tariffs charged on the exports of the small country. In other words, our findings suggest that being an innocent bystander might be extremely costly for a small economy in a natural trading region. JEL Classification: F02, F13, F15