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Most researchers focus on the political economy (interest group pressures) approach to analyzing why customs unions are formed, but terms-of-trade effects were also important in formation of the Common Market of the Southern Cone (Mercosur). Terms-of-trade externalities among Mercosur's members have been internalized in the common external tariff. The theoretical literature on trade follows two different approaches to explaining the endogenous formation of customs unions: (1) The terms-of-trade approach, in which integrating partners are willing to exploit terms-of-trade effects. Using the terms-of-trade approach, one concludes that tariffs on imports from the rest of the world should increase after the formation of a regional bloc, because the market power of the region increases and terms-of-trade externalities can be internalized in the custom union's common external tariff. As the union forms, the domestic market gets larger and members' international market power increases. (2) The interest group pressures (political economy) approach, in which, for example, the customs union may offer the potential for exchanging markets or protection within the enlarged market. Using this approach, one would usually conclude that tariffs for the rest of the world decline after the custom union's formation - a rationale related to free-rider effects in larger lobbying groups. It is important to recognize the forces behind the formation of customs unions. Most researchers have focused on the second approach and neglected terms of trade as a possible explanatory variable. Both rationales explain a significant share of tariff information. Results, write Olarreaga, Soloaga, and Winters, suggest that both forces were important in formation of the Common Market of the Southern Cone (Mercosur). Terms-of-trade effects account for between 6 percent and 28 percent of the explained variation in the structure of protection. There is also evidence that the terms-of-trade externalities among Mercosur's members have been internalized in the common external tariff. This paper - a product of Trade, Development Research Group - is part of a larger effort in the group to understand the political economy of trade protection. Marcelo Olarreaga may be contacted at molarreaga@worldbank.org.

Currencies and Exchange Rates --- Debt Markets --- Domestic Market --- Economic Policy --- Economic Theory and Research --- Emerging Markets --- External Tariff --- Finance and Financial Sector Development --- Free Trade --- International Economics & Trade --- International Market --- International Markets --- International Prices --- International Trade --- International Trade and Trade Rules --- Macroeconomics and Economic Growth --- Markets and Market Access --- Multilateral System --- Political Economy --- Private Sector Development --- Public Sector Development --- Regionalism --- Share Of World Exports --- Tariff Data --- Tariff Levels --- Tariff Structures --- Tariffs --- Terms Of Trade --- Trade --- Trade Effects --- Trade Externalities --- Trade Policy --- World Prices

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Many trade negotiations involve large cuts in high tariffs, with flexibilities allowing much smaller cuts for an agreed number of politically-sensitive products. The effects of these flexibilities on market access opportunities are difficult to predict, creating particular problems for developing countries in assessing whether to support a proposed agreement. Some widely-used ad hoc approaches to identifying likely sensitive products - such as the highest-bound-tariff rule - suggest that the impacts of a limited number of such exceptions on average tariffs and on market access are likely to be minor. This paper uses a rigorous specification based on the apparent objectives of policy makers in setting the pre-negotiation tariff. Applying this approach with detailed data allows the authors to assess the implications of sensitive-product provisions for average agricultural tariffs, economic welfare, and market access under the Doha negotiations. The authors conclude that highest-tariff rules are likely to seriously underestimate the impacts on average tariffs, and that treating even 2 percent of tariff lines as sensitive is likely to have a sharply adverse impact on economic welfare. The impacts on market access are also adverse, but much smaller, perhaps reflecting the mercantilist focus of the negotiating process.

Agricultural negotiations --- Agricultural products --- Average tariffs --- Debt Markets --- Economic welfare --- Ex ante assessment --- Export subsidies --- Factor endowments --- Finance and Financial Sector Development --- Free Trade --- High tariffs --- International Economics and Trade --- International prices --- International Trade and Trade Rules --- Macroeconomics and Economic Growth --- Market access --- Market access opportunities --- Markets and Market Access --- Tariff --- Tariff rates --- Tariff reduction --- Tariff revenues --- Trade --- Trade agreements --- Trade negotiations --- Trade Policy --- Value of imports --- World prices