Contributions of Jagdish Bhagwati to
The Theory of Preferential Trading
Arvind Panagariya
The literature on the theory of preferential trade areas (PTAs) 1 and the
contributions of Jagdish Bhagwati to it can be divided into two distinct phases with 1990
as the approximate dividing line. Phase I starts with the pioneering treatise The Customs
Unions Issue by Jacob Viner in 1950 and focuses principally on what Jagdish has called
“static” welfare questions. Phase II starts in the early 1990s and focuses instead on the
political-economy considerations behind PTAs and the “dynamic” time path question of
whether PTAs are building or stumbling blocks of multilateral freeing of trade. Jagdish
has made important contributions to the former literature and seminal contributions to the
latter. This paper outlines the main developments in each Phase, drawing attention to
Jagdish’s role in particular while highlighting the work of others as well, including my
own given my longstanding interest in this area of research.
1
Phase I: Static Theory Deploying the Traditional Tools
Four distinct approaches can be identified in the pre-1990s literature:
1. The Vinerian welfare analysis using the influential concepts of trade creation
and trade diversion;
2. The Kemp-Wan approach focusing on identifying customs unions that would
be necessarily welfare improving;
1
This phrase, insisted upon by Jagdish since it makes clear that we are talking about
discriminatory trade liberalization, has now come into widespread usage. So have his phrases
”spaghetti bowl” problem and “stumbling” versus building blocks in the “dynamic” time path
analysis of PTAs discussed in Section II. Jagdish has contributed not merely innovative analysis
to international economics but some of the most memorable and influential phrases in the field.
3. The Cooper-Massell-Johnson-Bhagwati analysis of a customs union to
minimize the cost of industrialization; and
4. Bhagwati-Brecher approach to analyzing the effect of changes in the
exogenous variables such as the external tariff and the terms of trade on
individual members of the union.
Viner set out to answer the question why many free traders and protectionists
agreed on the desirability of PTAs. In the process, he developed the important distinction
between trade creating and trade diverting unions.
A union was trade creating if
preferential liberalization by a member country allowed it to replace the higher-cost
domestic supply by the lower-cost partner-country supply. Unions that were principally
trade creating enhanced efficiency and were therefore beneficial to the member countries
and the world. Unions were trade diverting if preferential liberalization by a member
country led it to replace the lower-cost supply from non-member countries by the highercost supply by the partner country. Unions that were largely trade diverting reduced
efficiency and lowered the welfare of the union members as well as the world. Viner
concluded that free traders who supported PTAs probably had trade-creating customs
unions in mind while protectionists who supported them expected them to be trade
diverting.
The ambiguity of the outcome in the Vinerian analysis has led economists to look
for criteria that would allow them to determine whether a specific union would be largely
trade creating or trade diverting. During the debate on the North American Free Trade
Agreement, this search led Wonnacott and Lutz (1989), Summers (1991), Krugman
(1991) and others to assert that if the member countries were geographically proximate
and already traded intensively with one another, they were “natural trading partners” and
the union among them would be largely trade creating.
Bhagwati (1993) first questioned the validity of this assertion, pointing to an
earlier important contribution by Lipsey (1957) that had spelt out the welfare
improvement criteria in a specific model that differed from the ones defining the “natural
trading partners.” Subsequently, Bhagwati and Panagariya (1996) offered a systematic
critique of the natural trading partners hypothesis. Regarding proximity as the basis of
welfare-improving unions, they demonstrated that ceteris paribus, a union with a
proximate partner could be more harmful than with a distant one. Regarding the volumeof-trade criterion, following Panagariya (1996), they pointed out that there was a
presumption that the more a small country imported from its union partner, the more it
would lose from liberalizing preferentially! As long as the country continued to import
from the outside world, the price facing its consumers and producers would not change.
Therefore, it would fail to reap any efficiency benefits that accrue via the decline in the
internal price when liberalization is non-discriminatory. Instead, the country would lose
tariff revenue on good imported from the partner country with the lost revenue
transferred to the latter’s exporters.
Bhagwati and Panagariya (1996) went on to further point out that it is easy to
construct models in which the initial volume of trade bears no relationship to the welfare
effects of preferential trade liberalization. Moreover, the large initial volume of trade
may itself be the result of existing trade preferences. Finally, they pointed out that the
volume-of-trade criterion was neither symmetric nor transitive. Being its largest trading
partner, the U.S. is a natural trading partner of India but the reverse is not true. Likewise,
the U.S. may be a natural trading partner of both Mexico and Canada but Mexico and
Canada may not be natural trading partners of each other.
It is fair to say that the powerful critique by Bhagwati and Panagariya (1996) has
now been widely accepted and one hears little justification of PTAs on the grounds of the
natural trading partners hypothesis. While the simple verifiable criteria that would allow
us to judge whether a union is welfare improving or welfare worsening remain illusive,
the Kemp-Wan approach to customs unions, recently extended to free trade areas (FTAs)
by Panagariya and Krishna (2002), does offer a neat trick to get around the trade
diversion problem by adjusting the external tariff appropriately.2
Kemp and Wan (1976) demonstrated that if two or more countries form a customs
union setting the common external tariff vector such that trade with outside countries
remains precisely at its pre-customs-union level, the outcome is necessarily weakly
welfare superior to the initial equilibrium for the union as a whole and the world. As I
illustrate in my comprehensive survey of the theory of PTAs (Panagariya 2000) using a
simple partial-equilibrium example, freezing the external trade vector would typically
require the union members to lower trade barriers on the outside countries as well, which
helps eliminate trade diversion that would otherwise result. Once trade diversion is
eliminated by giving the outside world trade opportunities that are as good as those prior
to the formation of the union, union members can improve their welfare by exploiting
trade creation opportunities among themselves. As noted above, Panagariya and Krishna
(2002) have recently extended the Kemp-Wan theorem to the case of FTAs.
Cooper and Massell (1965), Johnson (1965) and Bhagwati (1968) independently
developed an alternative approach to welfare-improving customs unions in the context of
2
Pravin Krishna, in his Panel contribution today, addresses the Kemp-Wan approach more fully.
developing countries wanting to achieve a certain level of industrialization. The essential
idea was that if a group of developing countries wanted to achieve an exogenous level of
industrialization [essentially in the form of a non-economic objective analyzed by
Bhagwati and Srinivasan (1969)], they could do so at a lower cost by specializing among
themselves through a customs union. Recently, Krishna and Bhagwati (1997) have
formally proved this result by ingeniously marrying the Kemp-Wan approach with the
theory of non-economic objectives.
Finally, Jagdish has shown how the analysis by Bhagwati and Brecher (1979) and
Brecher and Bhagwati (1981), analyzing how national welfare in a small open economy
is impacted due to exogenous changes in the terms of trade and outside tariffs in the
presence of foreign-owned factors, has immediate applicability to the analysis of the
welfare impact on members of a Common Market such as the European Union. The
analysis easily lends itself to questions such as the welfare effects of exogenous changes
in external EU tariff on individual member countries such as France.
2
Phase II: The “Dynamic” Time Path Analysis
In what is perhaps the most influential post-1990s contribution on preferential
trading, Bhagwati (1993) noted that with the United States having embraced preferential
trading, the more important question was not whether a specific PTA would improve or
worsen “static” efficiency but whether the PTA path would take the world more quickly
and efficiently and with greater certainty to multilateral free trade. Subsequently, in
Bhagwati and Panagariya (1996), Bhagwati went on to separate two questions relating to
the time-path analysis:
Question I: Assume that the time-path of MTN (multilateral trade negotiations) and the
time-path of PTAs are separable and do not influence each other, so that neither hurts nor
helps the other. Will then the PTA time-path be characterized by stagnant or negligible
expansion of membership; or will we have expanding membership, with this even turning
eventually into worldwide membership as in the WTO, thus arriving at nondiscriminatory
free trade for all? The analysis can be extended to a comparison of the two time-paths,
ranking the efficacy of the two methods of reducing trade barriers to achieve the goal of
worldwide free trade for all.
Question II: Assume instead, as is plausible, that if both the MTN and the PTA timepaths are embraced simultaneously, they will interact.
In particular, the policy of
undertaking PTAs will have a malign or a benign impact on the progress along the MTN
time-path?
Regarding Question I, Bhagwati (1993) had noted that the time-path analysis
necessarily required a political-economy approach that takes into account the incentives
facing the governments and interest groups both within union members and outside
countries. The fact that Kemp-Wan theorem tells us that a path that improves welfare
every step of the way only ensures existence and says nothing about whether such a path
will actually be followed.
The interest-group politics may simply result in a very
inefficient path being pursued and one that fails to reach multilateral free trade in the end.
This conjecture found support in the subsequent theoretical work of Andriamananjara
(1999) who demonstrated that once we make the decisions to both seek and grant entry
endogenous, the PTA expansion comes to an end before it can encompass the entire
world. That is to say, within an incentive-theoretic framework, PTA expansion is likely
to stop short of bringing about multilateral free trade.3
Using the terminology Bhagwati (1991) had introduced earlier, Question II
amounts to asking whether PTAs would serve as building blocks or stumbling blocks of
multilateral free trade. In particular, we may ask, as Levy (1997) does in his important
paper: (i) whether multilateral free trade which is initially infeasible can be made feasible
by the option to form PTAs (PTAs as building blocks) and (ii) whether multilateral free
trade that is initially feasible can be rendered infeasible by the option to form PTAs
(PTAs as stumbling blocks). Levy answers first question in the negative noting that a
PTA will be formed only if it increases the value of the government’s political support
function. And if it does so, the value of the political support function is now even higher
than under multilateral free trade, making it even less inclined to go for the latter. Thus,
PTAs do not serve as building blocks. As for the second of these questions, Levy finds
that in one of his models, the option to form PTAs does render a previously feasible
multilateral liberalization infeasible: PTAs turn into stumbling blocks. Krishna (1998)
reaches the same conclusion in a Cournot oligopoly model. In his analysis, the greater
the trade diversion by the PTA, the more likely it turns into a stumbling block.
In his 1993 paper, Bhagwati also conjectured that in a political-economy setting,
formation of a PTA would actually raise trade barriers against outside countries through
either increased tariff [if it is not bound under the General Agreement on Tariffs and
Trade (GATT)] or more vigorous anti-dumping measures.
This conjecture was
This is in contrast to Baldwin (1995) who models only the outsiders’ incentive to seek entry.
This incentive rises monotonically as the PTA gets larger so that in the absence of internal
political-economy barriers in the outside countries, the PTA is predicted to expand until it
encompasses all countries.
3
subsequently shown to be true by Panagariya and Findlay (1996) in a model that allowed
tariffs to be determined endogenously through lobbying. In effect, the formation of FTA
in this model makes it more lucrative for production lobbies to lobby for higher tariff on
goods imported from outside.
Post-1990s literature has also seen models that make the decision to form FTAs
endogenous. The pioneering paper on this issue is the Grossman-Helpman (1995) paper
which shows that FTAs are more likely to be accepted when export lobbies can gain
access to the partner’s market without a threat to domestic import-competing lobbies
from the partner countries. These situations typically rule out trade creating FTAs since
such FTAs necessarily bring import competition from partner country producers.
Instead, the politically acceptable FTAs are trade diverting since they help within-union
producers at the expense of outside suppliers.
3
The Policy Debate
In the specific area of preferential trading, any account of the contributions made by
Jagdish will be very incomplete without a brief reference to his role in the policy debate.
At the time that the NAFTA debate was taking place, he was just about the only leading
trade economist to have stood firm in his opposition to PTAs. Indeed, in the subsequent
multilateralism versus regionalism debate, multilateralism became synonymous with his
name. He wrote extensively and in outlets too numerous to name, offering critiques of
open regionalism and deep integration and coining memorable terms such as “stumbling
blocks versus building blocks” and the “spaghetti bowl” of tariffs. The latter term refers
to the fact that crisscrossing PTAs would systematically destroy the clean tariff regime
that the GATT had created by requiring each member country to adopt a single tariff rate
vis-à-vis all GTAT members. PTAs, which inevitably have different starting dates and
transition periods, instead create different tariff rates for different trading partners during
the transition to full free trade within the PTAs. Moreover, the rules of origin that differ
across different PTA partners continue to discriminate among various trading partners
even after the full implementation of the PTAs.4
It is perhaps fair to say that though Jagdish—and with him this humble soldier—lost
the policy battle, he won the intellectual debate on regionalism versus multilateralism.
Today, most policy makers recognize that the trade regime has turned into the spaghetti
bowl just as Jagdish had been saying for years and that it must be addressed through
further multilateral liberalization. The unfortunate part of the story, however, is that it
took a huge proliferation of PTAs to convince policy makers of what was an obvious
danger ex ante.
4
Concluding Remarks
With more than 300 PTAs already in place, a key original argument against them
—fragmentation of the trading system—has lost its force. As Jagdish has recently joked,
with every country having a special deal in each market, the most favored nation (MFN)
treatment has now turned into the least favored nation (LFN) treatment. 5 Indeed, even
the trade diversion argument carries less force today than when we began traveling on the
PTA route in the late 1980s since some of the new PTAs may now be reversing the trade
diversion caused by the previous ones.
This, of course, does not validate the havoc the PTAs have wrought. Quite the
contrary, it calls for the use of the ultimate weapon—the Brahmastra if I may use a term
4
5
For details, see Panagariya (1999).
In the European Union, only five countries now pay its MFN tariff!
from the Hindu mythology. What we must do is to use the Doha Round to bring about
complete multilateral free trade that would end the preferences at source: preferences
against zero tariffs are also zero. In industrial products, which are now subject to quite
low tariffs worldwide, this is a fully achievable goal by, say, 2015 for developed and
2020 for developing countries. The process will take longer in agriculture and services
but considerable progress is feasible even in these areas.
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