tween them to impose negative terms-of-trade externalities on third countries and convert those third-country losses into their own gains.<sup>109</sup> This possibility is emphasized by Bagwell and Staiger (2005a), and it provides one reason according to the terms-of-trade theory why the proliferation of PTAs could re‡ect a development which is ine¢ cient from a global perspective.

A necessary feature for PTAs to impose negative terms-of-trade externalities on third countries is that the discriminatory market access granted to PTA partners diverts trade volumes that would otherwise have occurred between PTA member countries and third countries. This trade diversion e¤ect of a PTA is the trade volume reduction that can lead to changes in trade prices with third countries, and hence to third-country terms-of-trade impacts. A number of papers have emphasized the likelihood that PTAs rely on substantial trade diversion in order to keep them viable (see, for example, Grossman and Helpman, 1995b, and Krishna, 1998; and see Ornelas, 2005a,b,c for quali...cations to this claim). The possibility described above is a particular version of this claim, in which the third-country terms-of-trade externality associated with trade diversion is the mechanism by which an otherwise nonviable PTA is kept viable.

What is the evidence regarding the importance of third-country externalities imposed by PTAs? The evidence is mixed, with some studies ...nding substantial trade diversion and terms-of-trade impacts of PTA formation on third countries and other studies ...nding only insigni...cant e¤ects.

Chang and Winters (2002) take up the international externality question by investigating the experience of third-country export prices to Brazil in light of MERCOSUR. Relying on productlevel unit values data to proxy for export prices, they ...nd that intra-PTA tari¤ reductions are empirically associated with the price declines of third-country (Chile, Korea, Japan, US) exports to Brazil, relative to the prices of these third-country’s exports of the same products to the rest of the world.<sup>110</sup> Furthermore, welfare calculations arising from the model’s estimates indicate PTA non-partner countries such as the US and Germany experienced sizeable welfare losses due to the price declines, even after taking into account the e¤ects of Brazil’s subsequent MFN tari¤ reductions in many of the same products. Winters and Chang (2000) present a similar approach by examining the impact of Spain’s 1986 EC accession on US and Japanese exports to Spain. They argue that these earlier results are not as strong due to methodological and data issues, including the reliance on data at higher levels of aggregation. Nevertheless, results from this study are consistent with the Chang and Winters (2002) evidence from MERCOSUR. In particular they ...nd that each 1 percent preferential Spanish tari¤ cut toward new PTA members is associated with roughly a 0.5 percent export price decline for Japanese and US exporters to Spain, relative to these new PTA partners’(France, Germany, Italy, UK) export prices of the same good.

That important negative terms-of-trade externalities arise after PTA formation is consistent with some, though certainly not all, of the evidence arising from other studies. Romalis (2007), for example, found that the EU’s trade with the US, Canada, and Mexico was negatively impacted by

> 109 Note that a PTA can generate a negative terms-of-trade externality for third countries even when a (modest) tari¤ complementarity e¤ect is present, since third countries receive smaller tari¤ cuts than do member countries.

> 110 In related work, Schi¤ and Chang (2003) ...nd that even the threat of duty-free exports from Argentina into Brazil resulted in price declines for US exports into Brazil.

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