American Business Review
January, 2002
Vol. 20, No. 1; Pg. 91-99; ISSN: 07432348

Dr. James Reardon is Wells Fargo Professor of Marketing, University of Northern Colorado, CO. Besides his numerous articles, he is the co-author of a management book.

Dr. Nathan D. Kling is Associate Professor of Marketing, University of Northern Colorado, CO. His publications have appeared in such journals as Journal of Marketing.

Dr. Denny E. McCorkle is Professor of Marketing, Southwest Missouri State University, MO. Recent publications are found in such journals as Journal of Marketing Education and Journal of Education for Business.

Dr. Chip Miller is Associate Professor of Marketing, Pacific Lutheran University, Tacoma, WA. His research has appeared in such journals as Journal of Marketing and Journal of Applied Business Research.

Governmental trade restrictions have the greatest impact on the success or failure of international business. The purpose of this paper is to: 1. develop a conceptual model to recognize the existence of regional trade blocs, 2. explain the manner in which they can exist, and 3. examine the conditions under which they may be formed successfully. A multidisciplinary approach is taken that first examines the effects and formation of regional trade blocs from the business, international economics, and political economics literature.

Perhaps second only to culture, governmental trade restrictions have the greatest impact on the success or failure of international business. While the effects of culture have been studied extensively (e.g., Terpstra and David 1991; Barkema and Vermeulen 1997), there is minimal research on the theoretical underpinnings of trade barriers.

One of the more interesting developments since World War II has been the formation of regional trade regimes. In essence, these trade blocs are designed to create less restrictive trade between members, while also increasing or standardizing trade restrictions with non-members. However, there is little research on why and how regional trade blocs form at all. With 32 regional economic groupings believed in existence today (Czinkota, Ronkainen, and Moffett 1999), an unusual diversion of trade is created unlike what is expected from international trade models such as Porter's Diamond (Porter 1990), Eclectic Theory (Dunnig 1977, 1979, 1988), Internationalization Theory (Johanson and Vahlne 1977), and Internalization Theory (Buckley 1988). More specifically, these trade blocs impose additional constraints on these theories. Although in reality we know that regional trade blocs are prevalent, there are some that argue that, for theoretical reasons, they should not exist at all (Grieco 1990).

The purpose of this paper is to: (a) develop a conceptual model to recognize the existence of regional trade blocs; (b) explain the manner in which they can exist, and (c) examine the conditions under which they may be formed successfully. A multidisciplinary approach is taken that first examines the effects and formation of regional trade blocs from the business, international economics, and political economics literature. In order to develop a comprehensive model, it is first incumbent to examine a short history of what has actually occurred in the area of regional trade bloc formation.

For years the champion of multilateralism was the United States. However, multilateral trade negotiations in the 1980s were slow and tedious, thus leading the U.S. to move away from its policy of supporting only multilateral trade negotiations as a mechanism for encouraging free trade. This new U.S. policy fosters the development of both multilateral liberalization trade and preferential trade agreements.

Since the mid-1980s there has been a profound change in the structure of the international economy due to the widespread growth and internalenhancement of regional trading blocs in all parts of the globe. The World Trade Organization (WTO), for example, notes that almost all of its 134 members are signatories to regional trade agreements with other countries. As of February 1999 the GATT/WTO has been notified of 184 regional trade agreements of which 109 are currently in effect (see WTO 1999 web page).' These regional trade groups, according to Fred Bergsten of the Institute for International Economics, account for approximately 60 percent of world trade (Anon. 1999).

Among the most notable and impactful of these trade arrangements include the North American Free Trade Agreement (NAFTA) and the European Union (EU). The plan to establish the Asian-Pacific Economic Cooperation Group by 2020 (2010 for developed economies; 2020 for developing ones) should be an equally important development (APEC Secretariat 1999).

The United States, Mexico, and Canada created a free-trade area that became effective in January 1994. The members of NAFTA have declared their aspiration of incorporating much of Latin America and the Caribbean, thus ultimately establishing a Free Trade Area of the Americas (FTAA). Efforts are underway to make the FTAA a reality by 2005 (Office of NAFTA & Inter-American Affairs 2000). This area collectively will have a gross domestic product (GDP) of $2 trillion with a population of almost 500 million by the year 2000. According to the President of Pakistan's Institute for Development Research, 87 percent of world trade is currently accounted for by three blocs of 33 countries; namely NAFTA, the EU, and APEC (Anon. 2000).

The European Union's intensification of its program with its membership now totaling 15 members and a new common currency for 11 of its 15 members currently results in the establishment of the world's largest single market. Further expansion is anticipated, particularly into Central Europe, with the addition of up to ten new members over the next few years. It is estimated that the EU generates 31 percent of total world output and commands more than 20 percent of world trade (Weindenfeld 1999).

The Asia-Pacific Economic Cooperation (APEC), in spite of the financial problems the area experienced in 1997 and 1998, is still one of the fastest-growing regions in the world. By 1998, APEC's 21 member economies produced a Gross Domestic Product of more than US$16 trillion; this represents approximately 42 percent of global trade (Asia-Pacific Cooperation 2000). In contrast to other regional integrations, APEC, an open regional organization, represents an approach to integration that is concordant with the multilateralism of the WTO (Kim and Koo 1997).

While the history of trade is replete with regional trade bloc formation, we know little as to why or how these blocs form. At first, it was implicitly assumed that the trade blocs formed because there were some inherent benefits to the participants. However, a review of the existing knowledge of this area calls that proposition into question.

Regional trade blocs were first thought to form due to beneficial economic welfare for the countries involved. In fact as early as 1950, this suggestion was questioned. Jacob Viner (1950) pioneered the analysis of the immediate effects (static) of preferential trade agreements (PTAs). In contrast to multilateral, nondiscriminatory trade liberalization, Viner's argument is that PTAs could lead to a reduction of trade barriers and reduce world welfare of member nations if inefficient trade patterns emerge. His argument is that PTAs could act as trade creating or trade diverting entities. While the more obvious trade diversion can impose a cost on the non-member countries, the less obvious welfare costs are endured by consumers of member countries due to low-cost import substitutes coming in from member countries.

The evolution of the theory of economic integration went through two distinct phases until the mid-1960s (Krauss 1972). The first phase of research focuses on the effect of custom unions on production (Viner 1950), trade flows, and consumption (Meade 1955; Lipsey 1957). With the second phase from the 1960s and beyond, particularly in view of the emergence of the second-best theory, researchers began to seek understanding of the true aims of members of a regional economic integration grouping. By that time economists had come to the judgment that regional liberalization of trade did not necessarily increase the welfare of even the members of the grouping. Notable contributions in this phase include those by Johnston (1965), Cooper and Messell (1965), and Berglas (1979).

Contradictory to Viner's analysis, Lipsey (1957) argues that in certain instances trade-diversion in customs unions could be welfare improving for its members. Kemp and Wan (1996) later show that a welfare-improving customs union could be developed leaving the welfare of non-members in their initial state. Srinivasan (1993) compares the KempWan tariff to the provisions of GATT's Article XXIV (sanctioning free trade areas and custom unions) that state that, on the average, the common external tariff of a customs union should not change. In contrast to Viner's static analysis, Bhagwati and Panagariya (1996a, p. 83) have analyzed "... whether the (dynamic time-path) effect of the PTA is to accelerate or decelerate the continued reduction of trade barriers toward the goal of reducing them worldwide." They dismiss Kemp-Wan's (1976) and Krugman's (1991b) static arguments as not meaningful to the context of dynamic path analysis. They conclude that the United States' simultaneous use of PTAs in conjunction with a policy of multilateralism can be explained in terms of a selfish hegemon (Bhagwati 1994). Bhagwati and Panagariya (1996a, 1996b) further make the point that "free trade areas" and "free trade" are not synonymous.

In contrast to Bhagwati and Panagariya (1996a), Krugman (1991a), and Frankel, Stein, and Wei's (1995) arguments that preferential trade areas have a negative welfare effect, Wonnacott (1996) counters that free trade agreements (FTA) may be better than previously thought. He argues that, even under trade diversion, welfare may increase for both the diverting country and the world due to economies of scale. Mexico, for example, lost trade to higher cost Canada when the Canada-U.S. FTA was formed, but regained trade when the FTA was expanded with NAFTA. Wei and Frankel (1998) more recently note that the negative impact of PTAs on the welfare of nonmember nations may be moderated by two concepts: "open regionalism" and the "McMillan criterion." Open regionalism, a notion formally proposed at the Asia Pacific Economic Cooperation (APEC) discussion, argues that trade blocs will liberalize external trade with nonmembers when members liberalize trade with each other. Trade liberalization with nonmembers does not require the same degree as with members. The McMillan criterion refers to McMillan's (1993) proposal to change GATT XXIV to mandate that trade volume remain the same between members and nonmembers after formation of a preferential trade area.

In a simulation that extends the work of Frankel, Stein, and Wei (1995), Wei and Frankel (1998) examine the effects of forming continental trade blocs on trade volume and overall world welfare. They find that both trade volume with nonmembers and world welfare increases monotonically, but that applying the McMillan criterion is the equivalent of requiring trade blocs to reduce external barriers by 40 percent (a politically unacceptable solution). Further, in their simulations they find that in counterpoint to the McMillan proposal, a Pareto improvement could be obtained by increasing the degree of external liberalization by only four percent. Additionally, by setting within-bloc liberalization at 50 percent (noting that in the EC in 1990 within bloc liberalization was estimated only to be approximately 50-60 percent) that trade diversion can be tolerated to a certain level. In this simulation, continental trade blocs were found to be overall welfare improving as long as imports were not reduced by more than 15 percent from nonmembers.

Unfortunately, there is no answer whether trade blocs increase or decrease the welfare of the world. In fact, even the question as to whether there is a positive impact on the member countries is called into question. Thus without the simplistic answer that countries form trade blocs because it is in their best interest to do so, we must examine the issue from a more complex and integrative approach. This leads us to examining trade blocs from a more theoretical and macro perspective.

The three major schools of thought regarding the possibilities of cooperation under anarchy are realism, neoliberalism, and Marxism (Gilpin 1987). However, Marxism has lost much of its relevance due to the decline of the Soviet bloc and Cuba and the transition of China from traditional communism to a more market based economy. The remaining two schools of thought disagree over the possibilities for cooperation in the world economy.

Neoliberals, such as Keohane (1984), argue that cooperation is both possible and likely, even without an acting hegemon. Using a prisoners' dilemma, Keohane argues that countries have the incentive to cooperate due to the absolute gains that can be obtained. Collective action problems arise and deter cooperation under a single play prisoners' dilemma. However, as both Keohane (1984) and Oye (1986) argue, international trade is an iterated game in which participants are unlikely to perceive the end of the game as near. This iterative character of the game leads to a stable, cooperative solution.

Realists, such as Grieco (1990), disagree with Keohane's assessment. Grieco argues that states are concerned with relative, not absolute gains. He convincingly shows that under given conditions, cooperation is unlikely to happen. He specifies the payoff function of a state as:

Thus if k > (V - W) / ((Delta)W-(Delta) AV) there will be no cooperation because the game becomes one of deadlock (Grieco 1990).

Recent empirical studies and new models attempt to predict and quantify the effects of increasingly numerous regional trade blocs. This work supports the contention that regionalism is a major force in world trade and that its characteristics may not be as detrimental as previously predicted.

Frankel, Stein, and Wei (1995) developed a model that shows evidence of increases in regional trading blocs beyond what is expected by natural determinants. Syropoulos (1996) looks at the behavior of these blocs, making the point that regional trade blocs are more inclined to be restrictive in their dealings with non-members, leading to some potential reduction in trade globally. Bond and Syropoulos (1996) show further that while the relationship between the absolute size of trading blocs and their market power is ambiguous, larger bloc size leads to a welfare level for its members greater than that obtained through free trade.

Nitsch (1996) also argues that regional trading blocs do not result in a decline in world welfare. He contends that previous models were not sufficiently robust and offers a revised model to show that regional blocs are beneficial. The change in results achieved is due to more realistic assumptions than previously used. The call for careful modeling is echoed by Matyas (1998), as he states that careful use of econometrics is in order if accurate results are to be achieved.

The authors of this paper argue that limited regional cooperation will exist if the decision country considers all states simultaneously. This cooperation will take the form of a regional or cultural regime. Aggarwal (1985), who refers to it as "liberal protectionism," recognizes the phenomenon of increasing regional or sectoral regimes. Gilpin (1987) also suggests that the pattern of trade is strongly characterized by regional constellations. That this trend has not abated is supported by the findings of Czinkota and Ronkainen (1993) and Perroni and Whalley (1996).

Logic suggests that if countries can be excluded from a regime, other countries are more likely to form them. International organizations will be formed with the specific intent of protecting members' interests against encroachment from nonmembers. In a military sense, this would include organizations such as the North American Treaty Organization (NATO) and the Warsaw Pact. However, interests in economic activities also need protecting. This has historically been accomplished through regional and global organizations such as the Association of Southeast Asian Nations (ASEAN) and the General Agreement on Tariffs and Trade (GATT). Intuitively, one would expect cooperation not because of the direct benefits, but instead as a defensive measure against third parties. This agrees with Grieco's assessment of the state as a defensive measure against third parties. For instance, NATO was originally implemented because of the perceived threat to European countries by the Soviet Union. Even when there is a high incentive to pool resources, military and economic alliances are often not formed without an accompanying threat from third parties.

This paper examines the probability of cooperation using an expansion of Grieco's (1990) analysis of the prisoners' dilemma. Removing some restrictive assumptions underlying the realist position allow this. Specifically, the assumption that countries make decisions with regard to only one other player will be removed. The game will be expanded to include all of the countries in the world. This can easily be accomplished by respecifying the utility function of a country as shown in TABLE 1.

This model divides the world into two segments, those who join a regime (1 = participant countries) and those who are either voluntarily or involuntarily excluded from the regime (j = non-participant countries). The assumptions for this model are the same as Grieco's model. However, it needs to be stated that this model explicitly includes a degree of excludability. In other words, countries not participating in regimes will not receive any residual benefits of the regime's existence. Very few goods produced by regimes are public goods in a strict definitional sense. There remains a degree of excludability in nearly all regimes. Even in GATT agreements, non-signatories have been excluded from automatically receiving all of the benefits of the agreements. More common are bilateral and multilateral trade agreements and organizations, such as NAFTA, ASEAN, and the EU. Also, included in this model is the assumption that the game is iterated over a period of time. This model reduces to an equivalent of Grieco's model when all countries choose to form a regime (j = 0) and the discount rate approaches infinity.

Adopting Grieco's notation, a state faces the payoff matrix shown in TABLE 2. An example of this type of behavior is evident with OPEC (Organization of Petroleum Exporting Countries). While all countries cooperated, each received relatively high gains (R) due to limited supply. When a country defects (i.e., produces over quota), that country receives a premium (T) due to higher production as long as other countries continue to cooperate. In this instance, the countries that cooperate gain only marginally (S) because of the lower prices due to oversupply by the defecting country. However, if all countries defect, all will receive a deflated price for oil (P).

Thus countries will cooperate in regional trade blocs for two specific reasons, one is to gain welfare over time for their own citizens. The second is to retard the welfare gains from trade for those states that they consider 'unfriendly.' As the model shows, this dual effect leads to considerable relative gains to countries involved in regional trade blocs - both political and economic in nature. This leads to a stable solution of regional trade blocs being formed under two mentalities: (a) the friend of my friend is a friend and (b) a common enemy creates friends. It is when both of these mentalities exist together that the greatest potential for cooperation exists. An obvious example of this is the formation of the Warsaw Pact and NATO.

Grieco (1990) shows that cooperation is unlikely to exist with asymmetric payoffs, even in an iterated prisoners dilemma. The authors of this paper believe that this relationship is mediated by the ratio of the degree of sensitivity to gains of those within the regime compared to the sensitivity for those excluded from the regime (%ksub c). Even when the absolute gains from the states are significantly greater than that of the first, cooperation is possible if %ksub c is low enough. This signifies that countries that are relatively ambivalent to each other's gains will cooperate. Also, countries that have a common competitor will cooperate because ksub j will approach infinity for these countries. Therefore, %ksub c will approach zero regardless of the size of ksub i between the cooperating countries. To some extent, this explains the adage "common enemies create strong friends."

The question of whether regional regimes are good or bad necessarily includes normative analysis. Two distinct possibilities for future cooperation include a global network of regimes or several mutually exclusive, oligopolistic regimes.

The possibility of cooperation on a global level is more likely to happen through an interconnected network of regional regimes than through global cooperation. Patrick (as cited in Gilpin 1987) indicates that interregional trade is shifting from a series of bilateral relationships to a more truly multilateral trading network. As indicated in the above analysis, cooperation is likely to decrease as the weighted number of participants increase. However, if countries do not have bilateral coefficients of sensitivity that are equal, then the possibility for interlocking regimes exists. For instance, while the United States and Japan may have relatively high k's for each other, a third country such as Singapore could cooperate with both, thus creating an indirect channel for trade. This would create interdependencies for all three countries.

In the second scenario, regional cooperation may exacerbate animosities in world trade by polarizing countries into mutually exclusive regimes. Gilpin (1987) argues that the world is coalescing along three axes and that the changing environment will pull the regions of the world economy further apart. However, he also indicates that it is unlikely there will be a complete break. As explained by Oye (1986), regional regimes tend to impose a substantial cost on third parties through externalities. If these costs are imposed on countries that have mediocre relations to begin with, the result could be the development of permanent enemies. If the regimes are mutually exclusive, a problem of polarization of the world could easily occur. In the worst-case scenario, this could lead to military conflict between regional trade oligopolies. However, a more likely scenario (in the authors' opinion) is competition between regimes for world trade. If a few liberal assumptions regarding competition are adapted, this could lead to a great deal

The prisoner's dilemma model allows for both macro economic and micro (i.e., business) implications. In essence, the model implies that the macro effects to the participants can be positive in both a political and economic sense. For business, the model can be used to estimate, with judgment, whether a trade bloc will form or an existing trade bloc will succeed.

Regional trade blocs have the effect of lessening trade restrictions between members, while increasing or standardizing trade restrictions for non-members. In terms of worldwide trade, the net effect is arguable.

The obvious, and often encouraged, way around the external barriers is for businesses to commit to foreign direct investment (FDI) within a member country. Thus, the member nations often increase capital availability and gross national product within the country while decreasing trade deficits, or alternatively increasing trade surpluses. Often member countries that have the least restrictive domestic and tax policies obtain these increases in FDI. In some cases, countries will offer incentives to firms to commit FDI to their country. "One country in a group may have more liberal currency repatriation policies than others, while maquiladoras offer less stringent environmental requirements and significantly lower wages to manufacturers (Czinkota and Ronkainen 1998, p. 121)." If all countries within a bloc commit to increasing FDI, this could potentially lead to competition and the offering of very high incentives by member countries. However, with or without the incentives, these artificial trade barriers could create a situation where companies begin to ignore comparative and competitive advantages of countries in favor of entering areas where the differential cost of production may be less than the cost of encountering a trade barrier. In short, regional trade regimes may shift production from the most efficient countries to the less efficient countries. This causes a potential decrease in world production due to inefficiencies, lower economies of scale and scope for businesses, and ultimately higher prices for the consumer. In essence, member countries gain production, ultimately at the expense of the consumers in member nations.

The effect of regional trade blocs on business is dramatic on everything from entry mode decisions, pricing, marketing, administration, financial, accounting, and distribution decisions. By the very nature and purpose of trade blocs, companies that attempt to gain access to member nations from non-member nations will encounter trade barriers, both tariff and nontariff. As examples, Germany's strict rules on what is allowed in beer and sausage (Cateora 1990), and ISO 9000 rules allowing engine certification before importation by the EU, are perceived by many as nontariff barriers to non-members (Czinkota and Ronkainen 1998). Additionally, grain producers face variable levies in the EU, giving EU producers an assurance that "no product from abroad will be admitted at a price lower than domestically produced goods (Ball and McCulloch 1996, p. 89)." The net effect of these barriers is to increase the cost of production for the business, thus encountering price escalation problems above what is normal under free market conditions.

The implications of trade blocs on business strategy are diverse and significant. Companies may decide to enter a less than favorable nation merely because it has the opportunity for later admission to a favorable trade bloc, allowing that firm entry to a market otherwise too difficult to penetrate. Manufacturing sites and jobs may shift to other areas within a trade bloc to take advantage of better wages and gain a competitive edge in the market (e.g., manufacturing in Portugal to reach the EU or in Mexico for NAFTA). Trade blocs may also permit indigenous businesses to form a sufficiently strong organization for excluding foreign products from entry, the so-called "Fortress Europe" prediction. A similar negative outcome occurs if a company is forced to choose a local partner in order to gain access to a desirable market, thus losing potential profits and dissipating authority for business decisions.

The bloc may make a region look appealing enough to finally attract foreign sales and investment, especially if the bloc consists of less developed countries that, alone, have insufficient demand to warrant attention as an export market. Instead of studying individual countries, marketing research units can assess the rules of the bloc, perhaps simplifying the decision for entry. For situations such as the EU, currency risks reduce with the use of a single currency for the entire trade bloc. Also, labeling and product features may be designed for the bloc's standard rather than for each individual country, thus simplifying product decisions and allowing greater price flexibility.

A host of other responses are likely if international firms are to successfully exploit trade blocs. Forming partnerships with companies within the trade blocs may demand mergers of disparate corporate or national cultures. Some countries may restrict the degree of foreign ownership, thus dictating the mode of entry a foreign competitor may adopt. Permitting such partnerships, others may allow multinational corporations (MNC) access to capital resources not otherwise available until considered a "domestic" firm. Transfer pricing and repatriation of profits can present challenges, as well as determining whether or not products can be sold to a country that is under embargo by the parent firm but not by the subsidiary. Promotion decisions must be a blend of centralized decisions (e.g. on expenditures and general theme) and local creativity to adapt to regional tastes, while production costs may be spread over several countries with common needs instead of individualized ads. Trade bloc needs may allow manufacturing economies by reducing the number of models or diverse packaging types needed for the group as opposed to individual countries.

What the authors have offered is a more complete and less restrictive explanatory model as to why regional trade blocs exist. Some underlying assumptions still exist, however, as the model solves the longstanding argument between the political science realists and neoliberals. Regional trade blocs do exist, obviously, but the proposed reasoning by previous authors in this area requires some excessively restrictive assumptions to acknowledge regional blocs. While our model offers a creative addition to the literature, more work must be done to explain how this theoretical process parallels reality. In essence, it is important to empirically test this model.

Another avenue for further research is examining the depth and precursors to the 'relative sensitivity to gains' by differing countries. Since this variable is a central linchpin to the model, added information here would allow practitioners to adjust various characteristics, or at least appearances of these precursors, to appear more favorable for other countries to join them in a regional trade bloc.

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