Regional Agreements and Welfare in the South: When Scale Economies in Transport Matter

This paper focuses on two issues that challenge the accepted pessimistic view that regional trade agreements (RTAs) between developing countries in welfare terms by taking into account scale economies in transport. First, how is the standard welfare analysis of an RTA affected by the endogeneity of transport costs (i.e. by the joint determination of trade quantities and transport costs)? Second, what are the long-run consequences of endogenous transport costs for welfare if worldwide free trade is achieved through RTAs? A standard model of inter and intra-industry trade is augmented by a “hub-and-spoke” transport network structure, where the standard “iceberg” transport cost model is contrasted with one in which transport costs depend on the distance between trade partners, the volume of trade, and the level of development. Under a plausible parameterization for scale economies in transport, regional liberalization will have persistent effect on trade flows through an irreversible effect on regional transport costs that improves welfare. Free trade achieved under an RTA leads to permanently higher welfare than under multilateral liberalization.