A Theory of Exclusive Trading Blocs

Over the last decade the world trading system has seen a proliferation in regional trade agreements and a spate of requests for membership of the European Community. The purpose of this paper is to analyse the formation of trade blocs and what leads to their expansion. In the context of a general equilibrium model featuring imperfect competition, we show that both firms and consumers in new member countries unambiguously gain through trade bloc membership. For firms in existing trade bloc member countries however, the change in equilibrium operating profits initially increases with trade bloc size and then decreases as the bloc expands. Hence there exists an optimal trade bloc size for firms in existing member countries; the size at which the change in operating profits following the admission of a new member equals zero. Clearly trade bloc consumers prefer uninhibited expansion of the bloc, which places firms and consumers in conflict over the ideal size of the bloc. To overcome this opposition we consider ways in which existing firms might be compensated by those who gain from the enlargement. Where compensation is possible, the formation of a trading bloc combined with a system oflump-sum transfers might be considered a movement in the direction of free trade.