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.
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