1. Estimating the Effects of Regional Integration
Nigel Grimwade (LSBU)

2. Regional economic integration
Definition: the process whereby separate national economies are combined into larger economic regions
Two basic conditions:-
Free movement of goods and factors of production (labour and capital)
Absence of discrimination
Brought about in 2 ways:-
Negative integration – removal of discrimination (e.g. tariffs) and restrictions on movement
Positive integration – creation of common policies and institutions

3. Forms of regional economic integration
Types of regional economic integration:-
Preferential trading agreements (e.g. EU’s Lomé and Cotonou Agreements)
Free trade agreements – elimination of tariffs on all trade between the member states (e.g. EFTA, NAFTA, AFTA)
Customs unions – internal free trade plus a common external tariff (e.g. EC/EU, Mercosur)
Common Markets – free trade in goods and services and free movement of capital and labour (e.g. SEM)
Monetary unions – adoption of a common currency, single central bank and common monetary policy (e.g. Euro zone)

4. Economic effects of regional integration
Static effects - short-run, once-and-for all increase/decrease economic welfare due to:-
Reallocation of resources due to trade-creation and trade-diversion
Terms of trade effects – change in the ratio of average export prices to average import prices
Dynamic effects – long run, on-going increase in national income due to:-
Economies of scale (static and dynamic)
Increased competition
Increased investment (domestic and foreign)
More rapid rate of technological innovation

5. Problems in estimating the effects of regional integration
Which effects to measure – effects on trade, national income, rate of economic growth
What time period to consider – short- or long-run
What types of integration to cover – tariffs, NTBs, services, factor mobility, monetary integration
How to estimate the counterfactual – what would have happened if integration had not taken place

6. Simple extrapolation
Most early studies were concerned with the static effects – trade-creation and trade-diversion
Focused on trade (exports and imports) between the members (intra-area trade) and trade with non-members (extra-area trade)
Made the simple assumption that intra- and extra-area exports/imports would have continued growing at the same rate had integration not happened (anti-monde)
Difference between actual trade and the anti-monde (the residual) is the integration effect
One major problem – this assumes that conditions in the post-integration period were the same as in the pre- integration

7. Intra- and extra-area trade share
A better approach is to extrapolate intra-area and extra- area exports/imports as shares of total imports (see diagram) e.g. Xij/Xi, Mij/Mi
Increase in actual intra-area export/import share compared with the anti-monde is evidence for an integration effect
But we have no way of knowing whether this is due to trade-creation or trade-diversion
Is greatly affected by (a) the number of countries involved and (b) the region’s share in total trade
Share may also be affected by an increase in the number of members over time

8. Residual imputation
Intra- Regional Export Actual Share % Trend 0 T1 Time

9. Problems with simple residual models
Different factors may have affected intra- and extra area exports/imports in the pre- and post-integration periods, such as:-
Rate of economic growth – import demand
Phases of the business cycle
Changes in relative prices
Changes in the exchange rate
Structural changes
Reductions in multilaterally negotiated tariffs
So, we cannot assume that what happened in the pre- integration period would have happened in the post- integration period had integration not happened

10. Shares of intra- and extra-area trade in national income/consumption
Extrapolate share of extra- and intra-area imports in GNP/GDP or….
Extrapolate share of extra- and intra-area imports in apparent consumption (domestic production less exports plus imports)
An increase in share of AC coming from domestic sources is evidence for gross trade-creation
An increase in share of AC coming from partner countries is evidence for net trade-creation
A decrease in share of AC coming from rest of the world is evidence for trade-diversion

11. Balassa’s income elasticity of demand for imports approach
Income elasticity of demand for imports (∆M/∆Y) is calculated for pre- and post-integration period
Rise in income elasticity of demand for imports for intra- area imports is defined as gross trade-creation
Increase in income elasticity of demand for imports from member states is net trade-creation
Decrease in demand for imports from non-member states is trade-diversion
Found evidence for net trade-creation following the formation of the EC – but some trade diversion in agricultural goods

12. Use of a control group
An alternative approach was to use a third country as a normaliser or control group
Assumption was that intra- and extra-area imports would have grown at the same rate as imports of the normaliser country
Necessary that normaliser country was a similar country not affected by any special factors
But such an approach is heavily dependent on the country chosen

13. Intensity of Trade Approach
Based on the idea that there exists some “natural” amount of trade that will take place between any two countries
If actual trade exceeds this natural amount, this suggests trade is biased by other factors
Such factors include membership of a regional integration scheme
Then, any increase in the degree of bias over time provides a measure of the effects of integration
Several studies have used an intra-regional trade intensity index or trade concentration ratio:-
Iij = Xij /Mj ÷ Mj /M
Where I is greater than one, this implies geographical bias in trade due to natural and institutional factors

14. Intensity of trade approach
Increase in the index over time measures the trade integration effect
But trend over time gives a confusing picture (see Table 2):-
No change in some cases e.g. EU, EFTA
Upward trend in others e.g. Mercosur and Andean Pact
Downward trend in others
Major weakness – lacks any proper measure of natural trade and fails to take account of possible changes in factors affecting natural trade

15. Gravity Models
Draws on Newton’s law of gravity in physics and the idea that there is some “natural” amount of trade taking place between any two countries, i and j (intensity of trade)
In the original gravity model, bilateral trade flows are affected by two forces or masses - trade potential and trade resistance
Trade potential is shaped by size of each country’s GDP/GNP and population – and thus by per capita GDP/GNP
Trade resistance is negatively related to distance between two countries
But newer versions of the gravity models have added other variables to increase the explanatory power of the model

16. Gravity Models
Newer versions of the gravity model have added other variables:-
Geographical size – negative relationship
Adjacency
Common language (or cultural affinity)
RTA membership
Landlocked or island economies
Common currency
Former colonies
using a dummy variable for 2-7
A simple form of the gravity equation might be:-
log Xij = log A + β log Yi + β log Yj + μ log Hi + μ log Hj + γ log Ni + γ log Nj + α log Dij + log εij

17. Gravity estimation
Simple approaches is to use the gravity equation to estimate the amount of trade expected had integration not occurred
Actual trade is then compared with predicted trade – the residual measures the integration effect,
But this approach cannot distinguish between trade- creation and trade-diversion
Better approach is to estimate trade flows for integration period only, using dummy variables for membership/non- membership of the same trading bloc
Coefficient of the dummy variable will measure how much extra trade was trade-creation and trade-diversion

18. An example: Frankel, 1997
Estimated the integration effects of 6 trading blocs between 1965 to 1994
Found positive integration effect for all cases, with strongest effects for ASEAN and ANZCERTA
Strong effects were also found for Mercosur and the Andean Community
But there was no statistically significant effect for the EU until after 1985
The EC bloc effect was stronger for the EC, but not significant until after 1980
But the two EC enlargements of 1973 and 1985 had major effects

19. Computable General Equilibrium Models
Involve construction of complex computer models covering all the sectors in a country’s economy – including goods, services, firms, households, government, labour, etc.
Shows all the interconnections between different parts of the economy using a series of equations
Model is then calibrated for a particular year and the model is then subject to a shock to estimate the effects
Models may be single-country models (e.g. PRCGEM) or multi-regional (e.g. GTAP)
Models can be used to study the effects of regional integration

20. Uses of CGE Modelling
Were first used to analyse the effects of NAFTA and its enlargement to Central and Southern America
Were also used extensively to study the effects of APEC liberalisation
More recently, several models have been used to simulate the effects of the EU and its eastern enlargement
CGE models have also been used extensively to estimate the effects of multilateral trade liberalisation e.g. effects of the Uruguay Round
Can be used to predict what will happen (ex ante) as well as estimate what has happened (ex post)

21. Conclusions
Important to have some idea of the size of the effects from regional integration
Wide variety of different approaches have been used, but they give wildly different results
Methodology used in this research has progressed from the early days
No studies can tell us exactly what has happened or will happen because of the counterfactual problem
But the use of econometric methods can give us a fair estimate of the broad magnitude of these effects
CGE models are especially useful for estimating the long run effects on economic growth