Market Presence, Contestability, and the Terms-of-Trade Effects of Regional Integration

How firms react to a given shock may depend on the degree to which rivals are present and on whether potentially viable entrants to that market exist. A preferred supplier market presence and threat of entry lessen a nonmember country's price reaction to most-favored-nation trade liberalization and increase its price reaction to preferential trade liberalization.How firms react to a given shock may depend on the degree to which rivals are present and on whether potentially viable entrants to that market exist. Schiff and Chang try to measure these effects internationally by examining the price behavior of the United States in Brazil's market when MERCOSUR trade liberalization and most-favored-nation (MFN) trade liberalization take place.Using detailed panel data on trade and tariff rates, they find that both the market presence of a preferred supplier and expected entry lessen the U.S. price reaction to MFN trade liberalization and increase the U.S. price reaction to preferential trade liberalization. Argentina's presence in Brazil's market results in a smaller U.S. price response to Brazil's MFN tariff change and in a larger response to a preferential tariff change.More surprisingly, the quantitative effects of market presence and expected entry (contestability) are not significantly different from each other. Contestability plays no significant role when Argentina is present in Brazil's market. When Argentina is absent from Brazil's market, contestability lessens the U.S. response to changes in the MFN tariff and increases it in response to changes in the preferential tariff.It follows from these results that presence in, as well as threat of entry into, partners' markets implies lower optimal external tariffs and suggests that regional agreements can have pro-competitive effects in the presence of contestability.The authors also examine the hypothesis of quot;symmetryquot; between the effect of tariffs and that of exchange rates.This paper - a product of Trade, Development Research Group - is part of a larger effort in the group to understand the effects of regional integration. Maurice Schiff may be contacted at mschiff@worldbank.org