The Implications of a South-South Customs Union on Tariffs, Welfare, and the Prospect of Global Free Trade

Following the failure of multilateral trade negotiations at the Cancun meeting and the Doha Round, developing countries have pursued an alternative in so-called "south-south" trade agreements. Since these agreements lead to trade diversion from efficient north (developed) countries to less efficient south (developing) partners, there have been widespread concerns regarding their welfare implications. Using a three country oligopoly model of trade, we first examine statically the implications of a south-south customs union (CU) on the pattern of tariffs and welfare. We find that south countries always have incentives to form a CU that reduces the welfare of the north country. Moreover, when south firms are sufficiently inefficient relative to north firms, a south-south CU leads to a large trade diversion effect and reduces world welfare. We further show that, in a repeated interaction model, free trade is less likely to be sustainable under the south-south CU relative to no agreement.