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This paper analyzes trends in different components of trade of transition countries. To explain the crosscountry differences, the paper points out the important distinction between the determinants of inter-industry trade and intra-industry trade (IIT), and horizontal and vertical IIT. Using varieties of gravity models, it is shown that variables from Increasing Returns Trade Theory, such as scale economies, similarity of income levels, and number of varieties produced play important roles in IIT, especially in horizontal IIT, whereas factors such as comparative advantage, dissimilarity in income levels, and having more developed trade partners of Heckscher-Ohlin Trade Theory are crucial in determining inter-industry trade and vertical IIT to a lesser degree.

After a short background on recent developments in gravity modelling and liberalization agreements in Europe, this paper measures the trade creation and diversion effects of major European agreements based on the results of a correctly specified triple-indexed gravity model with bilateral fixed effects. For each agreement and partner country, welfare implications are discussed in sectors of different factor intensities with emphasis on the role of similarity in income or relative factor endowments between partners, as well as the date and the reciprocity of the agreement. This is followed by a description of the characteristics of the non-partner countries that are affected by these agreements in each sector. JEL Classification: F14, F15Keywords: Gravity Model, Fixed Effects for the year, the importer and the exporter countries. This model is augmented by time-invariant bilateral interaction fixed effects, as well as some other factors that explain bilateral trade flows, except liberalization agreements. An analysis of error terms for member country importer and exporter pairs against those of a member country importer from non-member countries is carried out over time to capture trade creation and diversion effects of liberalization agreements.The results show that majority of the liberalization agreements have been welfare improving for all partners involved in all sectors, especially in human and physical capital-intensive sectors.The exceptions are the Europe Agreements, and the Euro-Mediterranean Agreements, where the EU partners experienced welfare losses especially in resource-and labor-intensive sectors. While welfare gains are observed in EU's partners in the Europe Agreements across all sectors, the Euro-Mediterranean Agreements failed to create trade.Largest diversions occurred from non-partner countries with similar income levels to partner countries, and also from former colonies, developing countries, and European countries that did not take part in these agreements, such as Norway and Switzerland.The rest of the paper is organized as follows: After discussing the recent econometric developments in gravity modelling, a correctly specified fixed effects gravity model is proposed in Section 2 to decompose trade creation and diversion effects. A short background about the regional trade agreements in Europe precedes the application of the model to the trade of European countries in Section 3. Trade creation and diversion effects of agreements on different factor intensity sectors in partner countries are discussed along with an analysis of diversion from non-partner countries in Section 4. Background and the approachThere are two broad options for governments seeking to liberalize trade: Unilateral and preferential liberalization. Both of these options lead to welfare improving trade creation: The removal of trade barriers leads to elimination of domestic sourcing by firms and consumers in some industries in favor of imports more efficiently produced in partner countries. However, Viner (1950) establis...

The paper argues that vertical intra-industry trade (IIT) should be separated from horizontal IIT to have a better judgement about adjustment costs of a trade liberalization, contrary to the assumption in the literature that all IIT changes are costless. A simple method to decompose IIT is presented. Using this method, it is seen that, contrary to expectations, after the Europe Agreements, share of vertical IIT has not increased much between Germany and Central and Eastern European countries. However, when adjustment costs are analysed, it is seen that the resulting labour displacement has been substantial, explaining partly the EU's reluctant approach in these agreements.

This paper builds upon Feenstra (2002) to obtain consistent estimates of trade effects of regional blocs by adding bilateral effects to the gravity equation and analyzing its variation across blocs of different intensity. The results are then compared across different gravity equations used in the literature only to observe significant variation in sign, magnitude, and significance. The consequent equation shows that the effect is positive for economics cooperation agreements and preferential trade agreements, but free-trade agreements do not have a significant incremental effect. While customs unions have a positive incremental effect over blocs of lower intensity, the incremental effect is mixed for monetary unions, and negative for economic areas and full integrations. Furthermore, the effect varies with the duration and degree of implementation as well as the coverage of blocs. Lastly, changes in trade effects of the European blocs across time observed and policy implications are discussed. Copyright � 2008 The Author.