Regional Trading Agreements

Types of Regional Agreementsfree-trade area – agreement to remove trade barriers among members

example: NAFTA

customs union – agreement to remove trade barriers among members and impose uniform trade restrictions against non-members

example: Benelux

common market – agreement that permits (1) free trade among members; (2) common external trade restrictions; and (3) free movement of factors of production

example: EU

economic union – common market agreement with :common national, taxation, fiscal, and social policies among memberstransfers of sovereignty to a supranational authority example: Belgium and Luxembourg 1920s

monetary union – economic union with additional characteristic of common monetary policy and common currencyexamples: United States and the Euro currency area

Types of Regional Agreements

Trade Diversion and Trade Creation Effect of Trade Blocs

Consider three countries A, B, and C A trade bloc reduces tariffs between A

and B. A and B maintain tariffs with C Trade Creation: A imports more products

from B Trade Diversion: Part of the increase in

trade between A and B is a result of a decrease in trade between A and C

Trade Creation and Trade Diversion Effects of A Free Trade Area

Trade Diversion—a shift in the pattern of trade from low-cost world producers to higher-cost FTA members; welfare-reducing effect.

Trade Creation—an expansion in world trade resulting from formation of an FTA; welfare-increasing effect.

Static Effects of Customs Union

With Tariff:(before customs union)

red triangle = consumer surplus

green triangle = producer surplus

black rectangle = tariff revenue

a + b = deadweight loss

agreement with Germany will lower the price to SG

trade-creation effect:welfare losses now part of consumer surplusa = production effectb = consumption effect

trade-diversion effect:area clost benefits from lower cost suppliers

Static Effects of Customs Union

With Customs Union:

Trade Diversion versus Trade Creation in Joining a Trade Bloc: UK Market for Imported Compact Cars

British Worse Off British Better Off

Dynamic Effects of Trade Arrangements

economies of scale – access to a larger market allows producers to become more efficient through greater specialization, better equipment, and usage of by-products

greater competition – increased number of producers makes collusion less likely and forces firms to become more efficient

stimulus of investment – because of increased rate of return and ability to spread R&D costs trade makes greater levels of investment more likely

European UnionTreaty of Rome – 1957 – established European Community – precursor to EU

1)1957: Belgium, France, Italy, Luxembourg, Netherlands & West Germany2)1973: United Kingdom, Ireland & Denmark3)1981: Greece4)1987: Spain & Portugal5)1995: Austria, Finland & Sweden6)2004: Cyprus, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia & Slovenia7)2007: Bulgaria & Romania

European Union: 1960 - 1985 EU members removed tariffs in 1968 leading to fivefold increase in trade

EU adopted common external tariffs in 1970 making it a customs union

trade creation: machinery, transportation equipment, chemicals & raw materialstrade diversion: agricultural commodities and raw materials

EU saw increases in economies of scale, competition & investment

EU Agricultural Subsidies

EU purchases any surplussurplus then sold on world market for lower price

Government ProcurementGovernment purchases previously were limited to domestic producers.

In 1992 EU required bidding process from EU firms

benefits:• increased competition• remaining firms produce with

economies of scale

EU Agricultural Policy

Substantial elements of this policy: Support of prices received by farmers

for their produce

Exports of any surplus quantities of EU produce have been assured through the adoption of export subsidies

Agricultural Policy

Export subsidy Ensures that any surplus agricultural

output will be sold overseas Government support for agriculture (

Table 8.1)

Arguments Against Regionalism

Bhagwati views the formation of regional trade arrangements (RTAs) as undermining the WTO

Regionalism is harmful because it encourages trade diversion

Krugman argues that trade diversion from FTAs is low because trading blocs are “natural” trading areas

Due to proximity and similarity of cultures and standards of living, regional trade agreements stimulate trade that would have occurred even in the absence of an agreement

Arguments Favoring Regionalism

Affects of a Trade Embargo Consider 3 countries; A, B, and C Initially, Country C imports from A and B Then A imposes an embargo on C, but B

does not Economic Effects

Imports from A go to zero (PSA down)

Imports from B increase (PSB up)

Price in C increases (CSC down)

Production in C increases (PSC up)

Price in A decreases (?) (CSA up)

Price in B increases (?) (PSA down)

NAFTA

Figure 12.3 – Estimates of the Effects of the North American Free Trade Area on National

Incomes and Wage Rates

Figure 12.4 – Effects of an Embargo on Exports to Iraq

Figure 12.5 – Two Kinds of Economically Unsuccessful Embargoes