Regional Integration as Diplomacy

Regional integration agreements (RIAs) are examples of second best and have an ambiguous impact on welfare. This paper builds a model where RIAs unambiguously raise welfare by correcting for externalities. It assumes that trade between neighboring countries raises trust between them and reduce the likelihood of conflict. The optimum intervention in that case is a subsidy on imports from the neighbor. The paper shows that an equivalent solution is for the neighboring countries to tax imports from the rest of the world, i.e., to form a RIA, together with some domestic taxes. In fact, security threats have moved neighboring countries to form RIAs. Examples include the creation of the European Coal and Steel Community (ECSC, 1951) and the European Economic Community (EEC, 1957) to reduce the threat of war in Europe, as well as various RIAs among developing countries. The paper shows: i) that the optimum tariffs on imports from the rest of the world are likely to decline over time; ii) deep integration implies lower optimum external tariffs if deep integration is exogenous; iii) on the other hand, deep integration implies higher optimum external tariffs before deep integration and lower ones thereafter if deep integration is endogenous; iv) enlargement of bloc size (in terms of symmetric countries) has an ambiguous impact on external tariffs but raises welfare, and some form of domino effect exists in the sense that, starting from a two-member RIA, both the outside country and the RIA members want to enlarge the RIA.