Chapter 12:Trade Blocs and Trade Blocks

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Trade Barriers Designed to Discriminate

• Trade blocs: Each member country can import from other member countries freely, or at least with lower tariffs or nontariff barriers.

• Trade embargoes (trade blocks): Some countries discriminate against certain other countries, usually because of a policy dispute. They deny the outflow of goods, services, or assets to a particular country while allowing export to other countries, discriminate against imports from the targeted country, or block both exports to and imports from the target

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Types of Economic Blocs• Free-trade area: members remove trade barriers among

themselves but keep their separate national barriers against trade with the outside world

• Customs union: members remove barriers to trade among themselves and adopt a common set of external barriers

• Common market: members allow full freedom of factor flows among themselves in addition to having a customs union

• Economic union: member countries unify all their economic policies, including monetary and fiscal policies as well as policies toward trade and factor migration

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Types of Economic Blocs

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The WTO and Trade Blocs• World Trade Organization (WTO) rules are

opposed to trade discrimination in principle. A basic WTO principle is the most favored nation (MFN) principle—that a country’s trade barriers should be applied equally without discrimination for all trading partners.

• WTO rules permit some deviations from MFN under specific conditions, including for trade blocs

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Is a Trade Bloc Good or Bad?

• It depends, first, on what you compare it to• Compared to free trade policy, creating new

barriers against imports from nonmember countries is bad

• But, beginning with tariff and nontariff barriers that apply equally regardless of the source country of imports, the gains and losses from removing barriers only between certain member countries will depend on the size of trade creation and trade diversion resulting from the formation of the trading bloc.

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Is a Trade Bloc Good or Bad?Two opposing views:• Forming a customs union or free trade area (FTA)

should be good because it is a move toward free trade. If we start from an equally applied set of trade barriers in each nation, having a group of them remove trade barriers among themselves means lower trade barriers in some average sense.

• Forming a free trading bloc can be bad, starting from equally applied barriers to all international trade, because it can artificially distort the pattern of trade.

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The Basics Theory of Trade Blocs: Trade Creation and Trade Diversion

• Trade creation is a source of gains. It occurs whenever economic integration leads to an increase in the total volume of trade. Total trade increases because– Consumption of high-cost domestically produced goods in

a member country is replaced by imports of these same goods produced at lower cost in some other member country.

– Lower domestic prices lead to expansion of total consumption of the goods.

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The Basics Theory of Trade Blocs: Trade Creation and Trade Diversion

• Trade diversion is a source of losses. It occurs whenever there is a shift in product origin from a low-cost non-member exporter to a higher-cost member country producer.

• Since trade creation and trade diversion are both possible outcomes of economic integration, we find ourselves in the world of “second best” because economic integration is a partial and uneven movement toward global free trade.

• The net effect of the trade bloc depends on which is larger, the gains from trade creation or the losses from trade diversion.

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Trade Diversification versus Trade Creation in Joining a Trade Bloc

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Other Possible Gains from a Trade Bloc

• Increased competition within the bloc can lower prices

• Increased competition within the bloc can lower production costs

• Expanded production within the bloc can lead to achieving economies of scale

• Increased opportunities within the bloc for business investment

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The European UnionThe basic requirements to join the European Union are:• That the country have a functioning democracy• A commitment to respecting human rights• A market economy• That the country have the willingness to adopt and

implement EU rules and standards

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North American Becomes a Bloc

The formation of the North American Free Trade Area (NAFTA) went through two steps:• The Canada-U.S. Free Trade Area (CUSFTA) in

January 1989• In 1990 the U.S. and Mexico began

negotiations on a free trade agreement, and Canada joined the talks in 1991. The NAFTA treaty replaced CUSFTA in January 1994

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Trade Blocs Among Developing Countries

• The key change in many developing countries’ trade policies since the 1970s, has been a shift in philosophy, toward an outward, pro-trade (or at least pro-export) orientation.

• As in the case of Mexico, many developing countries have pursued economic reforms to liberalize government policies toward trade and business activity more generally.

• Forming a trade bloc can be part of this thrust to liberalize (although, as we have seen, it is actually liberalizing internal trade while discriminating against external trade).

• MERCOSUR (the Southern Common Market) is the most prominent of the recent developing-country trade blocs.

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Trade EmbargoesTrade discrimination can be more belligerent—a trade block instead of a trade bloc. A nation or group of nations can keep ordinary barriers on its trade with most countries, but insist on making trade with a particular country or countries difficult or impossible.To wage economic warfare, nations have often imposed economic sanctions or embargoes, which are discriminatory restrictions or bans on economic exchange.

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Effects of an Embargo on Exports to Iran

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Trade Embargoes• Political failure of an embargo occurs when the target

country’s national decision-makers have so much stake in the policy that provoked the embargo that they will stick with that policy even if the economic cost to their nation becomes extreme.

• Such political stubbornness is more likely if the target country is a dictatorship and the dictatorship would be jeopardized by retreating from the policy that provoked the embargo. In such a case, the dictatorship will refuse to budge even as the economic costs mount.

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Trade Embargoes• Economic failure of an embargo, in which the

embargo inflicts little damage on the target country but possibly even great damage on the imposing country.

• Embargoes and other economic sanctions apply stronger pressure when the embargoing country or countries have high elasticities and the target countries have low ones.

• When is this likely to be true?

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Two Kinds of Economically Unsuccessful Embargoes

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Trade EmbargoesWhen is a trade embargo more likely to work? Actual experience:1. Big countries pick on small ones.2. Embargoes have more chance of success if they

are sudden and comprehensive when first imposed.

3. Embargoes have more chance of changing a target government’s policies when the citizens hurt by the embargo can apply political pressure on the head(s) of state, as in a democracy.