Trading Blocs: States, Firms, and Regions in the World Economy

Kerry A. Chase
http://www.press.umich.edu/titleDetailDesc.do?id=133506
The University of Michigan Press

CHAPTER 1

Introduction
A World of Trading Blocs

Trading blocs have been dramatically expanding throughout the world econ-
omy. In 1992, the European Union (EU) completed the single-market program
and began a historic initiative for monetary union. The United States, Canada,
and Mexico launched the North American Free Trade Agreement (NAFTA) in
1994. Even Japan, for years the only industrial country that was not a member
of any regional arrangement, completed a trade agreement with Singapore in
2001. Overall, half of the regional trade agreements notified to the General
Agreement on Tariffs and Trade (GATT) were negotiated in the last decade—
133 in all since the creation of the World Trade Organization (WTO). At this
writing, several post-Soviet states and past members of the Eastern bloc have
lined up to enter the EU; thirty-four countries in the Americas envision free
trade “from Alaska to Tierra del Fuego”; the Association of Southeast Asian
Nations (ASEAN) is preparing to establish a free trade area; and Japan is ex-
ploring trade pacts with the Philippines, Thailand, Malaysia, and South Korea.
This book analyzes how domestic politics has driven the formation of trad-
ing blocs.1 Its central claim is that states construct trading blocs in response to
political pressures from organized interests in society. Understanding the for-
mation of trading blocs and their external effects, I argue, requires an exami-
nation of the domestic system and the process of national policy-making. To
accomplish this, the book develops an analytical framework that specifies the

1. The book uses the terms trading blocs and regional trading arrangements interchangeably. In
general, there are three types of trading blocs. In customs unions, countries eliminate all restrictions
on trade with one another and maintain common trade policies toward nonmembers. In free trade
areas, members eliminate all restrictions on their mutual trade but retain separate, autonomous
external trade policies. In preferential trading arrangements, members reduce barriers to trade
within the group but do not practice free trade with one another or establish common policies to-
ward nonmembers.
Trading Blocs: States, Firms, and Regions in the World Economy
Kerry A. Chase
http://www.press.umich.edu/titleDetailDesc.do?id=133506
The University of Michigan Press
2 Trading Blocs

trade preferences of domestic actors and tests this framework in a comparative

analysis of trading blocs from the 1920s through the 1990s.
The book’s principal contribution is to demonstrate the significance of
economies of scale in domestic pressure for trading blocs. Economic analyses,
press accounts, and government reports routinely highlight larger-scale pro-
duction as a benefit of regional integration, but its importance in motivating
group lobbying has not been systematically examined. This study, however,
finds the same actors repeatedly pushing for inclusion in a wider trading area:
from Imperial Japan and the British Commonwealth to the EU and NAFTA,
businesses in industries with large returns to scale have been key forces in the
emergence of trading blocs. In addition, the book shows how the growth of
multinational production sharing has spurred the creation of trading blocs. As
businesses move discrete stages of manufacturing to different countries, they
become interested in opening trade and harmonizing standards across the bor-
ders that link their investments. When groups that rely on scale economies or
production-sharing networks have political clout, the book argues, trading
blocs are likely to form.
Many previous studies of trading blocs treat states as unitary actors and ex-
amine the strategic incentives for participation in these arrangements. This
work usually reaches pessimistic conclusions about the global effects of re-
gional arrangements. Bhagwati (1998, 286) predicts that “divisions will be
sharpened and the world economy fragmented” because trading blocs, once
formed, “invite . . . defensive, if not retaliatory” reactions. Gilpin (2000, 8, 42)
warns of a regressive spiral if “each regional movement attempts to enhance its
own competitive position vis à vis other regions,” and he concludes that the
“unity and integration of the global economy are increasingly challenged by
the spread of regional economic arrangements.” Others (e.g., Thurow 1992;
Garten 1993; Hatch and Yamamura 1996; Pomfret 1997) emphasize the perils
of fortress Europe, a yen bloc, protectionism in NAFTA, and introverted, re-
strictive regional arrangements elsewhere. Some suggest that a three-bloc trad-
ing system is particularly volatile and dangerous (Krugman 1991; Froot and
Yoffie 1993; Bergsten 2001).
The experience of the 1930s offers a vivid backdrop for anxiety about the
recent drift toward regionalism. In this period, Britain and France established
preferential trade with their colonial territories; Japan and Germany sought ex-
panded empires of their own, first through trade, later through conquest. The
growth of imperial blocs coincided with rising and sometimes prohibitive bar-
riers against foreign goods: Japan increased import duties throughout the
1920s, the United States passed the Smoot-Hawley tariff in 1930, Britain’s Gen-
Trading Blocs: States, Firms, and Regions in the World Economy
Kerry A. Chase
http://www.press.umich.edu/titleDetailDesc.do?id=133506
The University of Michigan Press
Introduction 3

eral Tariff reversed its longstanding free trade policy in 1931, France tightened
import quotas that same year, and Germany imposed rigid exchange controls
under its New Plan of 1934. The collapse of the trading system, the Great De-
pression, and World War II ensued, each in succession contributing to the de-
struction of the integrated world economy that flourished before 1914.
Lessons drawn from the interwar period and its aftermath are central to de-
bates about how to interpret present trends. In the conventional wisdom, the
rise of imperial blocs was a primary factor in the outbreak of beggar-thy-
neighbor protectionism and mercantilist warfare. The belief that open, nondis-
criminatory trading systems tend to be peaceful while closed, compartmental-
ized economic relations create conflict is implicit in most discussions about
trading blocs, if not plainly stated in analogies to the 1930s. “Tariff discrimi-
nations,” wrote Jacob Viner (1951, 355), a pioneer in the economics of regional
integration, “poison international relations and . . . make more difficult the task
of maintaining international harmony.” Conversely, a world free of empires
and exclusions is widely viewed as more cooperative and tranquil.
The U.S. diplomats who designed the blueprints for a new world order
after World War II certainly thought so. Secretary of State Cordell Hull, who
designated Britain’s Imperial Preference “the greatest injury, in a commercial
way, inflicted on this country since I have been in public life,” regarded “trade
discrimination . . . as the handmaiden of armed aggression” (Gardner 1969,
19). In applying this conviction, the State Department pushed foreign gov-
ernments during the war to pledge to end unequal treatment and dissolve im-
perial trading links. The GATT codified these national commitments to
nondiscrimination and multilateral liberalization, as the most favored nation
(MFN) clause enabled members to share the benefits of significant tariff re-
ductions achieved in a series of trade rounds after 1947.2 Under the GATT, the
European Community (EC) was the only trading bloc to realize lasting suc-
cess; regional arrangements among developing nations in Latin America,
Africa, and Asia amounted to mere acronyms that failed to open regional
trade or collapsed amid acrimony—or both. As Hull and his cohorts had
hoped, trade was liberalized, regionalism was infrequent, and a repeat of the
interwar calamity was averted.
Recently, however, trading blocs have multiplied and flourished, as figure 1

2. GATT Article XXIV amended Article I to allow free trade agreements and customs unions
to deny MFN treatment to other countries provided that these arrangements liberalized “substan-
tially all” trade and did not “on the whole” increase “the general incidence of ” trade barriers against
nonmembers. An annex to Article I also permitted certain colonial and regional preferences to re-
main in force. On the origins of Article XXIV, see Chase 2005.
Trading Blocs: States, Firms, and Regions in the World Economy
Kerry A. Chase
http://www.press.umich.edu/titleDetailDesc.do?id=133506
The University of Michigan Press
4 Trading Blocs

200

180

160

140

120

100

80

60

40

20

0
1948 1952
1956 1960
1964 1968
1972 1976
Number per year 1980 1984
Year 1988 1992
Cumulative total 1996 2000
2004

Fig. 1. The proliferation of regional trade agreements, 1948–2004. (Data from WTO,
“Regional Trade Agreements Notified to the GATT/WTO and in Force,” http://www.wto
.org/english/tratop_e/region_e/eif_e.xls.)

demonstrates. While prior work tends to focus on particular regional arrange-

ments—usually the EU or NAFTA—this book places them in the context of
other integration efforts, including the more insidious imperial and regional
schemes of the interwar era. In doing so, the book finds that the forces driving
regionalism of late do not fully resemble those of the past. The case chapters
show that while similar actors pushed for trading blocs in both periods, propo-
nents of regionalism typically sought external protectionism in the 1930s but not
in the 1990s. The argument and evidence suggest that businesses in contempo-
rary regional arrangements have been more favorably inclined to external trade
openness because these trading blocs have created opportunities to restructure
production more efficiently. The book therefore rejects the 1930s analogy and
concludes that today’s regionalism is not a threat to the global trading system.

Analytical Puzzles and Proposed Solutions

The rise of trading blocs raises three fundamental questions for international eco-
nomic relations. First, why do governments form or join regional arrangements?
Second, what impact do trading blocs have on the multilateral integration of the
world economy—do their members tend to raise trade barriers against the out-
Trading Blocs: States, Firms, and Regions in the World Economy
Kerry A. Chase
http://www.press.umich.edu/titleDetailDesc.do?id=133506
The University of Michigan Press
Introduction 5

side world or reduce them? Third, how does the creation of trading blocs affect
economic, political, and military conflict and cooperation between regions?3
These questions are sequentially linked, yet many studies examine one in
isolation from the others. In international relations theory, realists and liberals
debate the third step, how regional arrangements affect outcomes at the sys-
temic level. To realists, trading blocs signal a failure of international coopera-
tion; to liberals, they are a method for successful collective action. The two ap-
proaches offer different conjectures about how trading blocs affect regional
relations with the rest of the world, but they do not address how external poli-
cies are determined endogenously in the political systems of the countries in-
volved. In economics and political economy, a large body of work examines
step two, whether members of trading blocs are likely to raise or reduce foreign
trade barriers. Yet much of this work presupposes a set of motives for regional
integration that are not validated empirically: proponents of the regional
arrangements as “building blocks” thesis often assume the dominance of pro-
trade interests, while adherents to the “stumbling blocks” line of argument
tend to emphasize incentives for protectionism.4
In short, we cannot understand step three without step two, or step two with-
out step one. Instead of cutting into the problem from the middle and taking
prior decisions as given, analytical work on trading blocs must start at the be-
ginning. The book’s theory proceeds from a set of analytical propositions about
the motives for organized groups—principally firms and trade associations—to
seek regional arrangements. The argument emphasizes two key factors in the po-
litical calculus of domestic actors that want to be part of a trading bloc. A pri-
mary consideration is the desire to gain scale economies. When small national
markets inhibit the concentration of production in a country (or a region), firms
that can capture unexploited scale economies in an enlarged market will push for
trading blocs. A second important motive in pressure for regional arrangements
is the ability to locate stages of production in different countries to take advan-
tage of factor price differences.5 If manufacturing can be divided and dispersed,
3. Economists are interested in a related set of questions but cast them differently. For example,
Frankel (1997) examines the effect of regional blocs on trade patterns between the bloc and the out-
side world, on the welfare of the members of the bloc, and on world welfare. The first question is em-
pirical; the latter two are normative. My objective in this book is to present explanations for the ques-
tions that I seek to answer and then to systematically evaluate these proposed explanations against
the available evidence. While this exercise has important implications for the welfare issues that econ-
omists such as Frankel investigate, the purpose is positive and analytical, not normative. It is this dif-
ference that distinguishes modern political economy from economics, as chapter 2 explains.
4. The terms building blocks and stumbling blocks first appeared in Bhagwati 1991 (77).
5. Factor prices are the cost of inputs or resources used in the production process, usually
labor, capital, and land.
Trading Blocs: States, Firms, and Regions in the World Economy
Kerry A. Chase
http://www.press.umich.edu/titleDetailDesc.do?id=133506
The University of Michigan Press
6 Trading Blocs

then firms that can integrate production tasks across borders will seek regional
arrangements. Thus, the formation of trading blocs reflects first and foremost
the aggregate number and political strength of businesses that rely on scale econ-
omies or production-sharing networks to survive and prosper in the world mar-
ket.
Building from this foundation, the book examines the conditions under
which domestic actors are likely to seek to increase or reduce trade barriers
against countries outside a regional arrangement. The key point is that re-
gional integration is a dynamic process that affects—and potentially alters—
the trade preferences of organized groups. If forming a trading bloc enables
businesses to gain scale economies or deepen production sharing, then they
will become more favorable to external liberalization. In this case, a protected
regional market provides temporary shelter while firms restructure. But if
firms cannot reorganize to expand product runs or outsource high-cost
processes, domestic support for external trade protection is likely to persist. To
the extent that regional trade liberalization increases import competition in
activities with high comparative costs, protectionist pressures from these in-
dustries will intensify.
Because the approach offers predictions about the circumstances under
which domestic groups are likely to support or oppose trading blocs, and the
conditions that cause them to favor external protectionism or further trade lib-
eralization, it provides insights into systemic outcomes such as the distribution
of regional arrangements over time, the openness or closure of the global trade
regime, or conflict and cooperation across trading blocs. However, the book
does not attempt to explain systemic outcomes. Such a theory would have to
include interstate bargaining and factors in the strategic environment that are
outside the argument’s scope. Rather, the approach confronts one aspect of
these larger puzzles—how domestic distributional pressures affect the forma-
tion and evolution of trading blocs. In doing so, it lays a foundation for unit-
ing theories of strategic interaction with domestic politics to develop more
refined expectations about systemic outcomes.

Other Explanations

The book’s explanatory framework draws from a large body of work in eco-
nomics and political science, but it is distinct from both. Economic approaches
provide useful first principles for understanding the distributional issues in re-
gional integration at the domestic level (between industries or factors of pro-
duction) and in interstate bargaining (between states). However, economic
Trading Blocs: States, Firms, and Regions in the World Economy
Kerry A. Chase
http://www.press.umich.edu/titleDetailDesc.do?id=133506
The University of Michigan Press
Introduction 7

theory cannot explain the formation of trading blocs because these arrange-
ments—like any policy other than total free trade—conflict with the national
welfare assumptions at the core of all trade models. Economic studies therefore
treat trading bloc formation as an exogenous decision and evaluate the static
impact of this event on national and world welfare. Realist and liberal theories
of international relations, in contrast, are sensitive to the political context in
which trading blocs form and the dynamics of policy responses at the interstate
level. Yet the exclusive focus on the geopolitical environment has led work in
political science to disregard, until recently, the importance of political forces
operating at the domestic level.

Customs Union Theory

Viner’s Customs Union Issue, published in 1950, is the starting point for the
economic analysis of trading blocs. In this seminal work, Viner did not offer a
positive theory of the formation of customs unions. Instead, his purpose was
to assess how shifts in the source of supply of goods after regional integration
affected national and world welfare. He found that customs unions could have
positive or negative welfare effects on members and nonmembers based on the
net of “trade creation” and “trade diversion.”6 Since his analysis treated the de-
cision to form a customs union and the level of the common external tariff as
exogenously given, the welfare gain or loss in any particular case depended on
factors outside the scope of his theory. Years later, Kemp and Wan showed that
a customs union could, in principle, adopt a “compensating common tariff ”
that left nonmembers no worse off. Yet the decision to establish such an
arrangement remains a puzzle for welfare-based trade models because the mo-
tives to stop partway along the road to free trade are unclear.7 Eliminating all
tariffs is always better for social welfare, so regional integration is a “second-
best” policy. Thus, economists (e.g., Johnson 1965) concluded long ago that the
motives must be “noneconomic.”
An exception to the “second-best” finding is the case in which regional in-
tegration enables members to exploit market power over states outside the
group. In this approach, a trading bloc can impose an optimal tariff that re-
6. Trade creation occurs when customs liberalization allows imports from one partner coun-
try (a more efficient source) to replace domestic production in another (a less efficient source);
trade diversion occurs when imports from a partner country (a less efficient source) supplant im-
ports from nonmembers (a more efficient source) due to the wedge between the intrabloc tariff
and the external tariff (Viner 1950).
7. As Kemp and Wan (1976, 96) explain, countries have “an incentive to form and enlarge cus-
toms unions . . . until the world is one big customs union, that is, until world free trade prevails.”
Trading Blocs: States, Firms, and Regions in the World Economy
Kerry A. Chase
http://www.press.umich.edu/titleDetailDesc.do?id=133506
The University of Michigan Press
8 Trading Blocs

duces the demand for foreign imports and shifts the terms of trade to its be-
nefit. Since the terms of trade improve with the height of the tariff and the
number (or size) of countries in the bloc, trading blocs have incentives to raise
tariffs and divert trade. This creates conflict in strategic interaction between re-
gions, as each bloc’s attempt to redistribute wealth reinforces a downward spi-
ral of protection and retaliation (Krugman 1991; Saxonhouse 1993; Srinivasan,
Whalley, and Wooton 1993). Yet even the authors of these models concede that
they provide a “grossly unrealistic . . . description of trade politics” (Krugman
1993, 61). Thus, normative trade theory provides rigorous models but no com-
pelling analytical scenario of the formation and evolution of trading blocs.
More plausible explanations lie in the realm of politics.

Realist and Liberal Approaches

International relations theories examine the organization of trade in the

geopolitical context of the international system. These approaches suggest that
open trade is difficult to achieve because countries in an anarchic interstate
system prefer to free ride by gaining access to others’ markets without opening
their own. Since states cannot credibly commit to liberalize without acting op-
portunistically and no central authority exists to monitor the fulfillment of na-
tional commitments, open trade requires costly contractual and enforcement
mechanisms to overcome incentives to defect under anarchy (Keohane 1984).
In realist thought, global trade liberalization occurs only when there is a dom-
inant or “hegemonic” power to supervise and enforce compliance with an open,
multilateral trade regime (Krasner 1976; Kindleberger 1973). When the distri-
bution of power is relatively equal, however, open trading systems break down.
In these conditions, states increase protectionist barriers and form trading blocs.8
Though there are cases of declining hegemonic powers seeking refuge in
trading blocs—a weakened Britain turned to Imperial Preference in 1931 and
the United States embraced regional initiatives in the 1980s after its postwar
preeminence had decayed—the proposition that open trade benefits the hege-
monic power, while large, nonhegemonic states gain from closure, rests on
shaky theoretical ground (Lake 1988; Stein 1984). Critics suggest that very
large countries have incentives to exploit market leverage or to “limit price” to
reap monopolistic advantages without encouraging potential challengers
(Conybeare 1987; Gowa 1989). Following this reasoning, other realist argu-

8. Krasner (1976, 324) links trading blocs with hegemonic decline and “[p]eriods of closure.”
Also see Gilpin 1971, 407–9.
Trading Blocs: States, Firms, and Regions in the World Economy
Kerry A. Chase
http://www.press.umich.edu/titleDetailDesc.do?id=133506
The University of Michigan Press
Introduction 9

ments contend that powerful countries seek to gain private advantages rather
than provide public goods. In one view, trading blocs are nested inside military
alliances to limit trade-related “security externalities” and maximize the rela-
tive power of alliances (Gowa 1994; Gowa and Mansfield 1993; Mansfield
1993). Studies supporting this view suggest that trading blocs have malignant
effects on global commerce because they are tied up with military disputes.9
Another approach casts trading blocs as a means through which the strong ex-
ploit the weak, as large states can extract concessions from small neighbors by
fostering close trade ties that would impose asymmetric costs if broken.10
Liberal approaches instead focus on how interdependence, market failures,
and coordination problems affect trade relations. One set of arguments explains
trading blocs as a response to conditions within a region. In these “functional-
ist” accounts, growing economic interactions have external consequences that
are beyond the capacity of any state to manage individually, so countries that
have reached a threshold level of market integration form regional arrange-
ments to provide supranational regulation. Cooperation in one policy area in
turn has “spillover” effects that motivate successively deeper levels of regional
integration, as it is difficult to maintain different regulatory, customs, and ad-
ministrative rules and procedures in the presence of intense intraindustry trade
and large-scale capital flows.11
A second set of arguments emphasizes conditions in the global trade regime
that promote regional cooperation.12 Liberal institutional theories argue that
transaction costs, incomplete contracts, and large numbers plague multilateral
negotiations.13 In this view, regionalism alleviates global collective action prob-
lems when international institutions are ineffective and hegemonic leadership
is absent. In particular, regional arrangements speed initiatives to liberalize
trade by reducing the number of participants and limiting monitoring and en-
forcement costs. Thus, small groups of countries with similar political, institu-
tional, and cultural backgrounds can achieve “deeper integration” (Lawrence
1996) than is feasible multilaterally.
In contrast to the realist view that trading blocs are designed to enhance

9. At the same time, members of the same preferential arrangement are less likely to engage
in military conflict with one another (Mansfield and Pevehouse 2000).
10. Hirschman (1945) outlines how Nazi Germany exploited the “influence effect” of trade to
gain leverage in central Europe. Also see Gruber 2000.
11. Haas 1958 is the seminal functionalist work. Moravcsik (1998) and Mattli (1999) critique
and modify elements of this approach.
12. Mansfield and Reinhardt (2003) empirically assess how conditions in the multilateral trad-
ing environment motivate the formation of regional arrangements.
13. See Yarbrough and Yarbrough 1992.
Trading Blocs: States, Firms, and Regions in the World Economy
Kerry A. Chase
http://www.press.umich.edu/titleDetailDesc.do?id=133506
The University of Michigan Press
10 Trading Blocs

relative power or political influence, liberal theories regard regional arrange-

ments as devices to exploit mutual gains from trade that are unrealized in
global negotiations. These approaches suggest that regional blocs are not likely
to raise new barriers to trade with outsiders; rather, they are useful halfway
houses along the road to free trade to wean governments of their dependence
on protection. For one, interregional interdependence constrains the develop-
ment of self-contained trading blocs as long as threats to punish defection are
credible and retaliation costly. Moreover, postwar regional arrangements have
been embedded in the multilateral GATT-WTO structure. Finally, large coun-
tries remain committed to the multilateral process and nondiscrimination in
international trade, even as they pursue regional initiatives (Haggard 1997;
Lawrence 1996; Fishlow and Haggard 1992).
While these approaches illuminate conditions in the strategic environment
that lead to alternative modes of organizing trade relations, both assume na-
tional preferences rather than explaining them. In realism, states prefer more
relative power to less, and closed trading blocs are a strategy to enhance na-
tional power or the strength of alliances. In liberalism, states seek to maximize
their gains from trade, and they pursue regional initiatives when transaction
costs and free riding at the global level frustrate multilateral trade liberaliza-
tion. These two strands of international relations theory yield opposing pre-
dictions: one is a theory of the 1930s calamity, when open trade and regional
blocs proved mutually exclusive; the other is a theory of the last decade’s ap-
parent success, when the emergence of trading blocs coincided with progress
(amid strain) at the multilateral level. Neither approach accounts for the range
of possible outcomes within a common analytical framework.
Moreover, because structural theories focus on systemic outcomes, they
miss important differences across countries in the same international structure
and across industries in the same country. This variation is understandable
only in the context of the policy process at the domestic level. Simply stated,
realist and liberal theories are too abstract to fully explain the development and
effects of trading blocs; systemic factors such as collective action, national
power, and strategic interaction are insufficient. As a result, recent reviews of
the study of regionalism (Haggard 1997; Mansfield and Milner 1999) call for
scholars to examine national preference formation and domestic politics.

Domestic Perspectives

Domestic approaches illuminate the internal political factors that cause gov-
ernments to pursue regional arrangements. A large body of work in econom-
Trading Blocs: States, Firms, and Regions in the World Economy
Kerry A. Chase
http://www.press.umich.edu/titleDetailDesc.do?id=133506
The University of Michigan Press
Introduction 11

ics and political science examines rent-seeking motives to form trading blocs.
These approaches build from two premises: first, trade diversion provides rents
for producers (who benefit from increased demand for their goods in a pro-
tected regional market) at the expense of consumers (who must pay higher
prices); second, the costs of trade creation are concentrated on a small number
of producers, while the costs of trade diversion are dispersed across a broad
range of consumers (Johnson 1965; Cooper and Massell 1965). Trading blocs
therefore tend to favor exporters that benefit from enhanced protection, be-
cause governments have incentives to exempt import-competing producers
that would lose protection to ensure political support (Grossman and Help-
man 2002, chap. 7; Hirschman 1981, chap. 12). Even when import-competing
industries are liberalized, inefficient producers will seek to convert trade cre-
ation into trade diversion through higher barriers against third countries
(Bhagwati 1993). Domestic groups also can abuse dispute settlement provi-
sions and rules of origin against nonmembers to extend national protection to
the regional level (Krueger 1997, 1999; Levy and Srinivasan 1996).14 In this
class of models, Levy (1997, 506) states, trading blocs “never increase political
support for multilateral free trade.”15
Other studies counter that regional arrangements facilitate trade liberaliza-
tion by reducing rent-seeking pressure or strengthening protrade lobbies. If
trading blocs establish a common external tariff or transfer authority to supra-
national institutions, protectionist national groups must reorganize at the re-
gional level, where they will be larger, less homogenous, and more susceptible
to free riding (Hanson 1998). Import-competing industries also lose political
influence at the national level as their output contracts after regional trade lib-
eralization (Richardson 1993). Third-country exporters injured by trade di-
version will lobby to join trading blocs to regain lost markets (Oye 1992). In
developing countries, regional trade agreements strengthen exporters and
businesses with multinational ties and weaken import-competing firms and
state-owned enterprises by ensuring that policy reforms are “locked in” (Tor-
nell and Esquivel 1997; Maggi and Rodriguez-Clare 1998). Finally, regional
arrangements help to overcome status quo bias when some groups are uncer-
tain about the adjustment costs of multilateral trade liberalization (Wei and
Frankel 1996).
However, these accounts generally fail to explain why states choose to liber-

14. Rules of origin are measures to block transshipment inside a free trade area. Their purpose
is to prevent outsiders from exploiting tariff differentials among members by exporting to the least
protected market.
15. Also see Krishna 1998.
Trading Blocs: States, Firms, and Regions in the World Economy
Kerry A. Chase
http://www.press.umich.edu/titleDetailDesc.do?id=133506
The University of Michigan Press
12 Trading Blocs

alize regionally rather than multilaterally. Rather than treating trading bloc
formation as an exogenous event that alters the preferences or lobbying capac-
ity of protrade and antitrade interests, it is important to know why domestic
groups prefer regionalism in the first place. Owners of locally abundant factors
of production and producers of exported goods would gain more from multi-
lateral or unilateral liberalization; they have few incentives to prefer a “second-
best” policy unless superior alternatives are not feasible.16 At the same time,
regional trade liberalization erodes protection for locally scarce factors and im-
port-competing producers, so these actors should prefer trade barriers at the
national rather than the regional level. Because there are opportunity costs for
competitive producers and adjustment costs for uncompetitive producers, ex-
plaining the creation of a domestic coalition supporting the formation of trad-
ing blocs is critically important.
To fill this gap, recent work incorporates imperfect competition and econ-
omies of scale into explanations for trading blocs. This research emphasizes in-
centives to ensure stable markets and capture excess profits in industries with
large returns to scale (Chase 2003; Milner 1997; Busch and Milner 1994; Froot
and Yoffie 1993). Regional integration offers especially large benefits to small-
country firms, which can move down their cost curves once they gain access to
a larger customer base (Casella 1996). But the implications for the multilateral
trading system remain open to debate. On the one hand, entry barriers in in-
dustries with large returns to scale encourage protectionism (Froot and Yoffie
1993). On the other hand, multilateral liberalization benefits industries with
large returns to scale because they tend to be export dependent.17
This body of work provides a promising approach to domestic support for
trading blocs. Moreover, it represents an alternative way of thinking about the
political economy of trade. Recent surveys underscore the growing recognition
that factors omitted from standard trade models—scale economies, product
differentiation, and intraindustry trade—are theoretically and empirically im-
portant in modern trade politics (see Frieden and Rogowski 1996, 28–30; Alt
et al. 1996, 693–95). Yet unresolved analytical puzzles remain, and empirical
work to date has not examined these variables in a systematic fashion on a large
number of cases. This book helps to fill these gaps by offering an explanation

16. As a result, some accounts also assume that large numbers and high transaction costs in
multilateral negotiations inhibit progress toward global free trade.
17. Busch and Milner (1994, 273) conclude, “the firms most likely to demand regionalism are
also the least likely to favor external protectionism.” Milner (1997), however, suggests that indus-
tries with large returns to scale tend to receive more trade liberalization in regional than in multi-
lateral agreements.
Trading Blocs: States, Firms, and Regions in the World Economy
Kerry A. Chase
http://www.press.umich.edu/titleDetailDesc.do?id=133506
The University of Michigan Press
Introduction 13

for the formation and evolution of trading blocs that begins with scale-econ-
omy considerations in the political calculus of firms and business associations.

Plan of the Book

Chapter 2 presents a theoretical explanation of the motives for domestic

groups to seek trading blocs. This section of the book emphasizes how oppor-
tunities to exploit scale economies and establish production-sharing networks
influence the political behavior of businesses. The framework is then extended
to evaluate the conditions under which domestic actors are likely to seek to in-
crease or reduce trade barriers toward the rest of the world. Lastly, the chapter
offers generalizations linking group preferences to national policy decisions,
and it discusses how to measure the variables in the analysis.
The second part of the book presents case studies of the period between the
world wars. The growing scale of manufacturing after the second industrial
revolution caused firms with small national markets in Japan, Britain, and Ger-
many to push to expand empires and form trading blocs. In these cases, chap-
ter 3 shows, businesses that could not exhaust economies of scale inside impe-
rial blocs sought protectionist barriers to blunt U.S. competition. The United
States, by comparison, had a vast continental market to sustain mass produc-
tion, and chapter 4 analyzes how large U.S. businesses pressed to dismantle for-
eign empires, dissolve trading blocs, and liberalize trade from the Smoot-Haw-
ley tariff until the 1960s.
The third section of the book examines modern trading blocs. Chapter 5
shows that European business groups campaigned for the single market because
small national markets and ongoing barriers to trade prevented the concentra-
tion of production. While some “national champions” sought external protec-
tion to deflect increased competition internally, the 1992 program helped to
prepare European industries for more vigorous external liberalization as busi-
nesses expanded and regionalized production. In North America, chapter 6 ex-
plains, U.S. multinationals sought free trade with Mexico and Canada to allow
them to reorganize factories, outsource labor-intensive tasks, and rescale pro-
duction for a regional market. Though the NAFTA treaty included some exclu-
sive provisions, this chapter finds that most supporters of regional free trade
also backed multilateral liberalization. Chapter 7 demonstrates that the reluc-
tance of Japanese businesses to establish Asian production networks has inhib-
ited the creation of a yen bloc in Pacific Asia. Even with tentative recent moves
toward regional arrangements, this chapter argues, Japanese firms have too
great a stake in the multilateral system to seriously pursue an Asian trading bloc.
Trading Blocs: States, Firms, and Regions in the World Economy
Kerry A. Chase
http://www.press.umich.edu/titleDetailDesc.do?id=133506
The University of Michigan Press
14 Trading Blocs

Chapter 8 concludes by examining how regional arrangements affect out-

siders. Though many foreign exporters are harmed, foreign multinationals can
reap large benefits when they gain a foothold inside a trading bloc. Today most
multinational companies operate in each of the world’s major trading areas, so
they are neither helped nor harmed by an increase in trade protection across
regions. This chapter further suggests that discrimination and exclusion in re-
gional arrangements can help to promote restructuring, particularly when es-
tablished businesses have large sunk costs. Because restructured firms typically
grow more favorable to external liberalization, the book concludes that present
trading blocs are not a threat to the WTO or the multilateral system.