REGIONAL-INTEGRATION AS DIPLOMACY

Regional integration agreements are examples of second-best policies a nd have an ambiguous impact on welfare. This article builds a model in which regional integration agreements unambiguously raise welfare by correcting for externalities. It assumes that trade between neighborin g countries raises trust between them and reduces the likelihood of co nflict. The optimum intervention in that case is a subsidy on imports from the neighbor. The article shows that an equivalent solution is fo r the neighboring countries to tax imports from the rest of the world- that is, to form a regional integration agreement-together with some d omestic taxes. The article shows that (1) the optimum tariffs on impor ts from the rest of the world are likely to decline over time; (2) dee p integration implies lower optimum external tariffs if it is exogenou s; (3) optimum external tariffs are higher before deep integration and lower thereafter if deep integration is endogenous; and (4) enlargeme nt of bloc size (in terms of symmetric countries) has an ambiguous imp act on external tariffs but raises welfare, and some form of domino ef fect exists.