A Simple Theory of Deep Trade Integration

We consider a Ricardian trade model where countries set standards to solve the externalities associated with the consumption of goods. Countries differ in their regulatory preferences over these externalities and choose different standards under autarky. When opening to trade, countries can stick to their standard or accept the other country’s standard (recognition). Countries benefit from trade if and only if the Ricardian gains arising from technological differences outweigh their asymmetric concerns over these externalities. With many countries and a continuum of industries, the model yields a structural gravity equation where bilateral resistance terms reflect countries’ divergence in their regulatory preferences. In the absence of terms-of-trade effects, the purpose of a trade agreement is the coordination of countries on their standards (harmonization). In the presence of highly-dispersed regulatory preferences, the gains from a multilateral trade policy are small, which leads the emergence of socially optimal trade blocs.