impacts of the formation of an RIA could be a smaller numberof large industrial agglomerations, which could deindustrialize some of theconstituent members of an RIA and mark them as less-favored regions. If this
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happens, some of the members of the RIA may grow and industrialize at thecost of others. Such an outcome is more plausible if manufacturing andservices sectors are relatively small, that is, they account for a smaller share ofGDP. If the manufacturing sector is spatially limited to only a few locations,it is less likely to press against the supply constraints. It is also less likely tolead to rising prices of immobile factors like land. This is likely to take placeat early stages of economic growth in a group of economies.195.1 Industrial and Sectoral Specialization in an RIAAs an RIA is created, inter- and intra-industry trade flows expand and withthat, it is logical to expect that, each member country’s production structurewould be reorganized to exploit comparative advantage and possible benefitsfrom spatial clustering of sectors. However, evidence from the EU reveals thatregional integration only resulted in modest increase in manufacturingspecialization. Midelfart-Knarvik et al. (1999) computed measures of thedifference between the industrial structures of the EU economies at the levelof 36 different industrial sectors. They concluded that since 1970, all the EUeconomies except the Netherlands saw their industrial structures become moredissimilar to the other EU economies. That is, industrial structures of the EUeconomies were not becoming harmonized, if anything they were becomingdis-harmonized and specialized.The measures computed by Midelfart-Knarvik et al. (1999) were averagedover groups of countries according to the date of their accession to the EU. Forthe new entrants, it was observed that there was a more or less steady increasein the measures, which indicated that the industrial structure was becomingmore dissimilar. Econometric analysis of these changing patterns of industrialand sectoral specialization indicated that it was largely in line with intra-EUcomparative advantage. That is, labor-intensive and skilled-labor-intensiveindustries and sectors tended to relocate towards labor and skilled-laborabundant countries, and knowledge-intensive and R&D-intensive activitiestended to relocate towards scientist abundant countries (Midelfart-Knarvikand Overman 2002). It should however be noted that reallocations in line withintra-EU comparative advantage are not necessarily salutary or welfareincreasing, as they could result in trade diversion.However, Venables and Winters (2003) contended that analysis at the levelof countries, taking 36 industrial sectors, is likely to understate the degree ofspecialization that is taking place in the EU economies. At the level of narrowsectors, they believe that there is ‘evidence of increasing clustering of activity,and specialization is increasing at the sub-national as well as the nationallevel’. Despite this evidence of progress in clustering and specialization, it hasbeen observed that the EU economies and regions remain very much less
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specialized than comparable size geographical units in the US. Thus far,integration has not caused ‘specialization and clustering of activity to go as faras the US experience suggests would be expected in a single country’.5.2 Foreign Direct Investment and RIAsThe FDI flows between countries are presently regulated by bilateralinvestment treaties (BITs). Approaching two thousand of them are in force,linking countries in all continents and at varying levels of development andstages of industrialization.20 Typically, BITs are agreements with a ‘narrow’and specific purpose. Their objective is to remove barriers and uncertainty inthe area of foreign investment. They are not made to encourage mutualinvestment between the two partners. In general, these bilateral treaties coverstipulations regarding admission and general treatment of investment, disputesettlement issues and other specific provisions. BITs defer to the domestic lawof the home country and the governments of the recipient country holddiscretion to manage the sectors in which FDI is made. However, the US hasbeen more progressive than other investing countries in this regard and in mostof its BITs insists on MFN and national treatment on the admission ofinvestment (subject to explicit specific exceptions). Moreover, during the1990s, when FDI assumed a much more prominent role in developmentthinking, this approach began to find favor in other investing countries as well.The BITs essentially call for fair and equitable treatment of FDI, security ofownership, and freedom from unreasonable or discriminatory restrictions onthe operation of investments. The MFN treatment in BITs implies that foreigninvestors should not be treated more favorably than are the partner country’sresidents, although, as in case of trade, this is subject to exceptions. In thecontext of RIAs, FDI from the RIA member countries is often treated morefavorably. Dispute settlement provisions vary in BITs. However, most definearbitration procedures based on international standards laid down by theorganization established by the World Bank Group. It is called theInternational Center for Settlement of Investment Disputes (ICSID).For the purpose of RIAs, the BITS have also been made into freestandingmulti-country regional treaties. Agreement on Investment and Free Movementof Arab Capital among Arab Countries (of 1970) and the Colonia Protocol onthe Promotion and Reciprocal Protection of Investment within MERCOSUR(of 1994) are two such treaties. A BIT can also form a part of an RIA. Forexample, the Andean Community, the EU, LAIA, NAFTA and CommonMarket for Eastern and Southern Africa (COMESA) all have elements of aBIT. Of these, the most far-reaching investment provisions are those of theEU. They had to be far-reaching because the EU was aimed at creating aSingle Market, which includes movements of factors of production.
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The US also took the initiative in the area of making the BIT conceptregional, which is reflected in the NAFTA agreement. It contains a wellresearched and innovative chapter on investment in NAFTA, notwithstandingthe fact that it is only an FTA not a CU. This chapter has been admired andflatteringly imitated by other RIAs, particularly by the APEC and the Groupof-Three. Some of the important features of NAFTA include (1) nationaltreatment in establishment, (2) MFN treatment in establishment andoperations, (3) a ban on new performance requirements, (4) phasing out of oldperformance requirements, and (5) a ban on expropriations except for publicpolicy reasons on a non-discriminatory basis and with full compensation. Thisis a long list of provisions. Another innovation of NAFTA was to haveextensive dispute settlement provisions, which include private action againstrecalcitrant host governments. Taking their cue from NAFTA, members ofAPEC agreed on a more extensive set of principles on intra-regionalinvestment in 1994. However, these principles presently exist only on a nonbinding basis.Economies that suffer from low credibility of their policy regimes faceaversion by foreign investors. If investors have noticed sudden policy shifts,frequent changes in tariff rates, variations in tax incentives, a history ofilliberal trade policy, or instances of nationalization in the past, it is reasonablethat they would avoid investing in such an economy. Interest-group-drivengovernments and kleptocratic regimes also lead to a low image in the globalinvestment markets. In the backdrop of low credibility, when policy reformsare undertaken, their benefits may be slow to arrive because changing animage in the global investment markets is a slow process. In such cases, RIAscan help improve the policy credibility of an economy. For policy reforms andchanges to have a positive impact on investment, they must either raiseexpected returns or lower costs. By anchoring such reforms through a bindingcommitment to an RIA the economy in question may improve its policycredibility in the global investment marketplace. In this regard, RIAs can setthe norms. They can reward a good policy regime and reform measures in aconstituent member economy. Conversely, they can punish the bad policyregimes and policy vicissitudes. If the latter target has to be achieved, the RIApartners must have the power, interest and commitment to enforce thenecessary reforms. The partners need to be large enough, stable enough andhave a sufficiently strong interest in the RIA to make it worth their while todiscipline the target country (Fernandez, 1998).Mexico’s membership of NAFTA provided a considerable impetus to itspolicy reforms, tariff reduction and investment regulation liberalization. Itsmembership also seriously restrained the ability to raise tariffs and dismantletrade policy and investment reforms. That there was a sea change in itsintellectual policy climate became obvious from the manner in which the 1994
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financial crisis was handled. Its credibility in the global investment marketwas enhanced considerably. With southern enlargement of the EU, riskpremium on investment in the newly acceding economies declined markedly.Policy commitments by the EU governments reduced future uncertainty andinduced additional investment and growth in the newly acceding economies.The same effect is likely to continue in the eight CEECs, Cyprus and Maltathat signed the Accession Treaty with the EU in April 2003.21
6. WELFARE IMPLICATIONSThe economics of RIAs has been extensively researched, starting with theseminal contribution of Jacob Viner. The welfare impact of RIA is an issue,which has been the subject of on-going debate since Viner’s early analysesover a half century ago. Regional integration, when tariffs are prohibitivelyhigh so that economies are autarkic or nearly autarkic, raises the level ofwelfare of the regional trading blocs because trade diversion cannot take place.The other extreme is when the tariffs are zero or trade with non-partnercountries is free. Under these circumstances as well, regional integrationamong small economies would raise the welfare of the regional trading bloc.However, for any tariffs level between autarkic and zero, regional integrationseems to have an ambiguous effect on welfare.22Early research on the welfare impact of RIA was stimulated by theintegration experiment taking place in Europe. In the Vinerian analysis, tradecreation and trade diversion were the two traditional tools for RIA analysisand were considered marvelous heuristic devises for illustrating thefundamental effects of RIAs. The age-old and well-known static Vinerianconcept is that the trade creation effect benefits the partners of the RIA, whilethere is an unambiguous loss from trade diversion (Viner, 1950). These twoseminal Vinerian concepts have proved to be central to the subsequentthinking and policy debate on regionalism. Viner’s conclusions were thatRIAs might predominantly be trade diverting and therefore welfare-reducingfor the members. Therefore, the static theory essentially failed to yielduniversally applicable guidelines for policy application.The welfare implications of regionalism or preferential trade policies instatic economic theory are dependent upon the circumstances surrounding anindividual RIA and the member economies. They are consistent with thetheory of second-best in which the movements in the direction of Paretooptimality are not always welfare-improving. Notwithstanding the longlasting Vinerian concepts, some current researchers (see Winters, 1999)believe that except for the very simple case explored by Viner, the mappingfrom trade creation and trade diversion to economic welfare is treacherous.
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For example, à la Winters (1999) ‘pure trade diversion can be beneficial if itseffect of lowering consumer prices is sufficiently important to welfare. Thebenefit of trade creation for a single country can be outweighed by the lossesof tariff revenues on the pre-RIA volume of imports from the partnercountries’. Thus, the results based on the trade creation and trade diversionconcepts should be taken as indicative, not definitive. Trade creation for theRIA members indirectly affects the non-members or the rest of the world.Higher income inside the RIA would lead to greater consumption, parts ofwhich will indeed be of goods and services produced outside the RIA. Thisbenefits the non-members.According to the maxims of the classical trade theory, welfare in the globaleconomy is maximized if the number of RIAs is one, or if the global economyis one large RIA. This amounts to free global trade. By the same token globalwelfare is also maximized if the membership of RIAs is large. This wouldstand for zero or near zero optimal tariffs, so that the effect is close to freetrade. With the increase in the number of RIAs, economic welfare must firstdecline, reach a minimum, and then rise again. De Melo and Panagariya(1992) posited that if one starts from one RIA in the world or from a free tradescenario, and divides the world into two RIAs, there is trade diversion due toa positive tariff on extra-bloc imports. This should lead to a decline in globalwelfare. Next, if the world is divided into three RIAs, the optimal tariffdeclines, however each bloc becomes smaller. The former leads to tradecreation, while the latter to trade diversion. Thus, the net welfare effect wouldremain somewhat unclear.Measured static welfare effects of regional integration tend to be ambiguousin sign and small in size. This led many proponents of regional integration tobring in refinement and switch attention from the old stylized static approachto dynamic effects of RIA. They believed that the latter were likely to bepositive and large (Hoekman et al., 1998; Cernat, 2001). In the earlierexposition we have seen that RIAs can lead to dynamic benefits througheconomies of scale for small economies with small markets and also throughthe effect of enhanced competition. These effects can enhance welfare only ifmarket forces determine which firms expand and which contract and arephased out.Another source of dynamic benefit in an RIA is the incentive for knowledgeand transfer of technology, which may favorably affect the rate of GDPgrowth. This kind of dynamic benefit may be large in an RIA betweendeveloping and industrial economies, and may not exist in one betweendeveloping economies. The probabilities of RIAs generating economies ofscale and competitive gains under imperfectly competitive market structuresare high. This would be another beneficial effect, leading to welfare gains.However, these benefits would potentially double if RIAs also stimulate
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investment. RIAs can potentially increase FDI flows, both from the moredeveloped members of the RIA and from the rest of the world. In addition,locating (or relocating) of industry among member countries would belogically affected in a manner that enhances growth, and eventually welfare(Hoekman et al., 1998).RIAs and trade liberalization on a preferential basis does not necessarilyhave to be benign in itself. Membership of an RIA does not suspend theordinary laws of economics. That mere membership of an RIA does notnecessarily ensure welfare gains is obvious from the EU membership ofGreece and Ireland. The latter became a part of the then EEC in 1973, with aper capita GDP level of 62 percent of the EU average, measured in purchasingpower parity terms. In 2002, Ireland’s per capital GDP was 21 percent abovethe EU average. In contrast, Greece joined the then EEC in 1981. Betweenthen and 2002, the ratio of per capital GDP to the EU average has risen little.Welfare implications of EU membership for Greece were virtually zero (EIU,2003).Numerous studies have empirically examined the welfare effects of RIAs(Laird, 1997; Schiff, 1999; Rutherford and Martinez, 2000). Their conclusionsconvincingly demonstrated that RIAs could be welfare enhancing but onlyunder certain conditions. When they are welfare enhancing, welfare gains aregreater (1) the higher the trade barriers being reduced, (2) the higher the shareof pre-existing trade between the partners, (3) the larger the trade partner, (4)the more diversified the partner countries’ economies are, and (5) the moreclosely the partners’ domestic prices resemble world prices. Riezman (1999)analysed the strategic interactions between trading blocs in a computablegeneral equilibrium model, and concluded that when RIAs are of more or lessequal size they are welfare enhancing. If the RIAs are of unequal size, theirimpact is the opposite.There are not many studies that provide a comprehensive generalequilibrium examination of similarities and dissimilarities across differentkinds of RIAs, like customs unions (CUs) and free trade areas (FTAs). Koseand Riezman (1999) tried to fill this gap by constructing a simple model forstudying various types of preferential trade agreements. Along with othervariables, they analysed the welfare implications of two kinds of RIAs,namely CUs and FTAs. Their results indicated that on welfare grounds, FTAsare better than CUs for the global economy as a whole. However, membereconomies benefit more in a CU than in an FTA. Decomposition of welfareeffects indicated that a major proportion of the welfare gains in both memberand non-member countries are explained by the volume of trade effect for theCUs and FTAs. This implies that having free market access is the mostsignificant benefit of participating in RIAs. In the CUs, the terms of tradeeffects generate relatively large welfare gains because members of a CU
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determine their common external tariff (CET) rates. Conversely, members ofan FTA do not coordinate their trade policies, which diminishes their marketpower, which in turn results in welfare losses. These losses are also associatedwith the terms of trade effect in the FTA.As stated in section 2, the principal objective of an RIA is wider marketaccess. The welfare gains to the members of RIAs also result from the sameimproved market access. The above-cited empirical studies show that thesewelfare gains would be greater, the larger the partners’ share is in home trade.These studies also concluded that home price effect (the sum of consumersurplus and producer surplus) would also be larger, the greater the marketaccess of the RIA partners. Effect on non-members’ welfare is a function ofthe level of CET of the RIA. At the overall level, taking the rest of the worldas a single region, the CET that reflects the minimum tariffs of the RIA wouldnot harm non-members’ welfare. However, at the country level the RIAformation with a CET of minimum tariffs would benefit some countries, whileharming others. Which effect will be greater for an RIA, trade creation or tradediversion, will depend upon the sizes of the economies (as proxied by theirGDPs) forming the RIA and the relative similarities and competitivenessamong them. There can be no categorical answer in this regard. These effectswill necessarily vary for each RIA (Laird, 1997; Schiff, 1999; Rutherford andMartinez, 2000).The constituent members of an RIA are the mutual trading partners. Thesize of the trading partner, generally takes on a great deal of significance in anRIA. A large partner economy, for a given tariff rate, can be a source ofseveral benefits. Foremost, a large partner is more likely to satisfy the homecountry’s import demand at the world prices. Second, the home country islikely to gain more on its exports to the large partner because a large partnerwould continue to import from the rest of the world even after the formationof the RIA. Since the partner has a tariff on imports from the rest of the world,the home country is more likely to obtain an improvement in its terms of tradeby selling to the partner at the higher tariff-inclusive price (Michaely, 1998;Schiff, 1999). Structural complementarity in trade is another important factoraffecting welfare. An RIA as an entity would be better off in welfare terms ifeach country imports what the other exports. This, indeed, is a hypotheticalsituation. What is feasible is that a large proportion of the imports of onepartner are also a large proportion of the exports of the other partner, in turnleading to large welfare gains for both the constituent members.Which member incurs welfare losses and which one gains from an RIA hasbeen a debatable point. The comparative advantage of member countries,relative to the rest of the world, provides a basis for predicting who gains andwho loses. Using two-by-two Ricardian model, Venables (2002) concludedthat typically the country in the RIA that has comparative advantage most
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different from the world average is the most at risk from trade diversion. Thus,if a group of low-income countries form an RIA, there will be a tendency forthe lowest income members to suffer real income loss due to trade diversion.As opposed to this, if an RIA includes a high-income country, then lowerincome members are likely to converge with the high-income partner.23 ThatRIAs with higher income countries are likely to lead to convergence of incomelevel is a valuable inference for the policy mandarins.Following Harris and Cox (1986) and Smith and Venables (1988), a sizableliterature has emerged in which the RIAs are treated as operating in animperfectly competitive world. These empirical studies delved into thechanges in the nature of competition due to the creation of RIA. As aneconomy becomes a member of an RIA, the immediate effect on the domesticfirms is that their market enlarges and the special privileges provided by thedomestic government decline or disappear. Competition from firms from themember countries reduces the hold of the domestic firms on the domesticmarket. This generates both gains and losses. The new, post-RIA situationwould redistribute rents in the larger market.There is a distinct possibility of beneficial dynamic effects of an RIA. Agood illustration of which is the well-known and widely cited Cecchini Report(1998), which calculated that by 2000 the GDP in the EU economies wouldrise on the order of 2.5 percent to 6.5 percent as a result of the Single EuropeanMarket initiative. Higher real income in the EU would raise imports from alltrading partners. Assuming elasticity of import demand to be about 2, exportsfrom Asia to EU would go up by at least 5 percent. This positive effect shouldbe netted against the negative effects of trade diversion. However, thedynamic estimates are usually considered uncertain. Yet, it is widely believedin the business community that the 2004 enlargement of the EU will result inspreading financial and macroeconomic ‘stability and prosperity across a largeswathe of Europe’s heartland’.24At the turn of the century, a large number of RIAs and multilateral tradingsystems coexist. With regard to how RIAs affect the global trading system, itis a difficult proposition to assess. Serious efforts to study this have been madein the past. Opinions on this issue vary widely and researchers and policymakers need to continue examining this issue. One such effort was made bySchill (1996). After synthesizing the conflicting viewpoints, he concluded thatthe effect on the multilateral system would depend on the structure of the RIA.Whether an RIA facilitates or impedes global free trade essentially dependsupon whether procedures for joining it are liberal, whether it satisfies WTOregulations and whether it is accompanied by some degree of tradeliberalization of the members’ trade regimes. In short, the effect of an RIA onthe global trading system would depend upon the terms of the agreement.Clear policy guidelines in this regard are not available because the terms of
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every RIA and the rationale behind establishing them have differed throughouthistory (Sager, 1997). RIAs established for different reasons would havevaried effects on global trade flows.Similarly, using both gravity model and simulation using computablegeneral equilibrium model to make welfare estimates, Gilbert et al. (2001)examined the potential welfare effects of RIAs in the Asia-Pacific region.Although both the techniques are quite different, they can offer insight intoareas where the other is commonly used. Thus, the CGE model can be used toconsider the effect of existing arrangements through backcasting the models.Similarly, the gravity models are often used for predicting the consequencesof the proposed agreements by searching for pre-existing trends that mightpoint toward ‘natural’ trading partners. Gilbert et al. (2001) concluded thatboth the techniques suggested that there might be ‘significant welfare gains’from the RIA proposed in the Asia-Pacific region. The welfare gains werefound to be the largest (1) when the RIA had diverse members, and (2) whenthe RIA is large, having many members. Interestingly, welfare benefits ofliberalization within the Asia-Pacific region on an MFN basis were found tobe substantially greater than on a preferential basis. The simulation resultsindicated that even when RIAs had substantial net benefits for the membereconomies, they managed to impose a substantial cost on non-members, bothwithin the Asia-Pacific region and to the rest of the world.
7. INCOME CONVERGENCE AND DIVERGENCEA closely related query to welfare gains is, whether RIAs are a force forincome convergence among the member economies or for income divergence.The answer is that it is conditional upon the level of economic developmentand per capita income of the member economies of the RIA in question. RIAformation can lead to both income convergence and income divergence,although neither can be taken for granted. For instance, labor-intensiveproduction and exports move to those members of the RIA where wagesare low. This raises wage levels in that member country. By the sametoken, RIA formation can lead to income divergence. A good example ofthis is high technology industries, which may be pulled towards thosemembers of an RIA that have succeeded in making a head start in thoseindustries and have a superior physical and technological infrastructure. Theother members of the RIA may be forced to be contented with lowertechnology industries.RIA members can be high-income industrial economies, developingeconomies and both. As seen in section 4.1, there is evidence that industrialcountries that trade heavily with each other in an RTA converge – upward –
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in terms of per capital income. An RIA between higher-income, industrialeconomies is likely to benefit the lower-income members of the RIA, that is,it is likely to lead to convergence in income levels. Lower-income here implieslower than the other members and vis-à-vis the rest of the world. Theexperiences of the EU are important and enlightening in this regard.There are economic reasons to believe that RIAs between developingeconomies may lead to divergence in their income levels, with better-offdeveloping economies benefiting at the expense of the worse-off (refer tosection 4.2). An RIA between developing and industrial economies benefitsthe former by way of transfer of capital, technology as well as creation of tradebetween the constituent members. In the medium-term, this could result inincome convergence. Therefore, there is a case for developing economiesforging preferential trade links with industrial economies (WB, 2000;Venables, 2003).There is a marked contrast between RIAs between developing economiesand those between advanced industrial economies having matured institutions.The European economies have historically shown that an RIA led toconsiderable convergence in per capita income levels of the membereconomies. One early example in this regard is that of the Benelux union.Created in 1947, it comprised Belgium, Netherlands and Luxembourg. BenDavid (1993) found that per capita income narrowed steadily in this RIA. Thesame was found for the EEC after it was created in 1957. Tariffs wereeliminated between the Benelux members in 1968. Per capita incomedifferences narrowed steadily between the three member economies. They fellby a third between 1957 and 1968, and again by a third between 1968 and1980 (Ben-David, 1993). A more recent and conspicuous observation is thatfor Ireland, Portugal and Spain, which have narrowed the income gap with thericher members after joining the EU. In 1985, Ireland, Spain and Portugal hadper capita income levels of 61 percent, 49 percent and 27 percent, respectively,of the average income levels of the four large EU economies, namely, France,Germany, Italy and the UK. However, by the end of the 1990s, correspondingnumbers had risen to 91 percent, 67 percent and 38 percent, respectively. Thisincome convergence for the lower-income members was nothing short ofstriking (Venables, 2002).RIAs between developing economies not only did not demonstrate incomeconvergence tendencies but also provided strong evidence of incomedivergence among the constituent members. In some cases it became the causeof collapse of RIAs. Several instances of integration, which promoteddivergence in per capita income, were identified by Venables (2002). Forinstance, in the East African Common Market (EACM) two of the partners(Tanzania and Uganda) contended that the benefits from the EACM werebeing reaped by Kenya because it had succeeded in developing a better
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industrial infrastructure than the other two members and had a relativelystronger industrial base. Since the 1960s, Kenya had steadily strengthened itsposition as the industrial center of the EACM. It accounted for 70 percent ofthe manufactured production of the EACM, which it exported to the relativelyless-developed partners. The poorer members were convinced that the EACMwas benefiting one member at the expense of the other two. Consequently, theEACM collapsed in 1977. Comparable more recent examples were that ofGuatemala City and San Salvador in the Central American Common Market(CACM) where there was a large concentration of industry, commerce andservices. These two centers of manufacturing activity in the CACM accountedfor 80 percent of the manufacturing value added (MVA) in the CACM in1997, up from 68 percent in 1980. Abidjan (Côte d’Ivoire) and Dakar(Senegal) in the Economic Community of West African States (ECOWAS)were the two exact parallels of Guatemala City and San Salvador, with thesame kind of concentration of industrial activity leading to income divergenceamong the RIA members. In the ECOWAS, Abidjan and Dakar jointlyaccounted for 55 percent of MVA in 1972. This proportion soared to 71percent in 1997. Many more cases exist of this kind of income divergencecreated by RIAs.7.1 The Dilemma of ‘the Innocent Bystander’Krugman (1991b) was the first to analyse the problem of ‘the innocentbystander’, that is, the welfare implications of a developing country thatdecides not to join an RIA that is being created around it. He concluded thatthe innocent bystander could suffer from significant welfare losses. Thisapplies all the more if the RIA turns into an inward-looking one, or a closedRIA. Such RIAs while ‘doing little damage to themselves or each other, caneasily inflict much more harm on economically smaller players that for onereason or another are not part of any big blocs’.One of the major influences on the welfare of any trading economy isthrough its terms of trade. Therefore, questions surrounding trade policyshould be essentially concerned with this variable. In a seminal paper Mundell(1964) had postulated that in a three-country model in which goods aresubstitutes, for a single tariff change by one member, the preferred exportingpartner’s terms of trade unambiguously improve, while the non-membercountry’s terms of trade deteriorate. The net effect of the terms of tradedeterioration for the innocent bystander, therefore, leaves it worse off.However, can this response be so categorical?Formation of an RIA affects traded goods prices of the innocent bystander.Chang and Winters (2000) examined the effect of