Regionalism and permanent diversion

We compare free trade reached through expanding regional trading blocks to free trade accomplished by multilateral negotiation. With sunk costs, the outcomes are different. Trade in an imperfectly competitive good flows disproportionately more between the original members of a regional agreement even after free trade is reached. They secure a higher welfare level from regionalism than from free trade achieved multilaterally; non-members, however, reach a lower welfare level. A surprising result is that world welfare during free trade is greater when it is achieved by the regional path. We conclude with some empirical evidence from the European Union that is consistent with the model.