Regional Trading Blocs
Regional trading blocs have become common in recent decades. They remove trade borders between neighboring countries to expand local markets and bolster trade by streamlining regulations, tariffs, and economic policies. These blocs can also come in the form of customs unions, which essentially create one shared market between several countries and dictate trade policies between countries in the union and those outside it.
Chauffour and Maur discuss in detail the economic, societal, and political-economy motives for signing preferential trade agreements. A central issue is whether to opt for an FTA or a CU. By definition, both are preferential in nature and discriminate against third-party (nonmember) suppliers. The primary effect of a customs union, as with an FTA, is the expansion of trade flows among member countries, often at the expense of trade with nonmembers. This expansion, a consequence of the removal of the intraunion tariff barriers, can be decomposed into trade creation (more efficient suppliers in CU partners replace domestic suppliers of a given good) and trade diversion (more efficient third-party suppliers are displaced by less efficient suppliers located in partner countries, as a result of the discriminatory liberalization). As is well established in the literature, when trade diversion dominates trade creation, CUs and FTAs tend to be welfare reducing. The likelihood of significant trade diversion is closely related to the degree of discrimination associated with the agreement.