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. This paper attempts to measure these effects in an international context by examining the price behavior of the US in Brazil’s market when MERCOSUR and MFN trade liberalization take place. Using very detailed panel data on trade and tariff rates, we find that both the preferred supplier’s market presence and expected entry lower (raise) the US price reaction to MFN (preferential) trade liberalization. More surprisingly, the quantitative effects of market presence and expected entry (contestability) are not significantly different from each other. It follows from these results that presence in, as well as threat of entry into, partners’ markets implies lower optimal external tariffs, and regional agreements can have pro-competitive effects in the presence of contestability. The “symmetry” hypothesis between the effect of tariffs and exchange rates is examined as well.