TRADE BLOCS
The Treaty of Rome reached in 1957 set in motion a process of integrating the economies of
Western Europe. As we enter the new millennium, the European Union, instituting a common
currency (the Euro) is achieving a level of economic integration which is beginning to rival that in
the US. The student is encouraged to visit the EU’s homepage at www.europa.eu.int on the web.
In 1988 the US signed a free trade agreement with Canada. In 1994 the agreement was extended to
include Mexico. With concurrent trade liberalization in the rest of Latin America, there is a
momentum that may lead to a Western Hemispheric trade bloc. The Bush and Clinton
administrations have advocated the expansion of NAFTA into the Trade Bloc of the Americas, but
resistance by labor groups in the US has stalled progress. NAFTA’s homepage at www.nafta-secalena.org is also interesting reading.
The countries of the Pacific Rim already in the political union called ASEAN - Association of
South East Asian Nations - are slowly progressing in forming a free trade agreement between them.
On a broader scale APEC, the Asian Pacific Economic Cooperation, includes not only the ASEAN
nations but all Pacific Rim countries. Current APEC membership includes Australia, Brunei,
Canada, Chile, People's Republic of China, Hong Kong, Indonesia, Korea, Japan, Malaysia,
Mexico, New Zealand, Papua New Guinea, the Philippines, Singapore, Chinese Taipei, Thailand,
and the United States of America.
What are the implications of this regionalization on continued liberalization of international trade?
This is a controversial topic. The two sides of the issue give opposing answers to the following
two questions. Does regionalization mean the abandonment of WTO (GATT)? Will
regionalization help or hinder the goal of global free trade? What is important is that
regionalization is occurring and we need to have an understanding of its implications.
There are several types of preferential trading arrangements. These are based on the level of
integration among participating countries. These are listed below in order of the level of economic
integration from least to most.A free trade agreement is the removal of barriers of trade between
members. It still requires border checks between members since individual countries still have
different trade relations with the rest of the world. This leads to what is known as the
transshipment problem. Transshipment is when goods are shipped through a third country. A
foreign exporter in order to avoid high tariffs would export its goods to the member country with
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TRADE BLOCS
Andean Group
Arab Maghreb Union
Asia Pacific Economic Cooperation Forum APEC
Association of Southeast Asian Nations ASEAN
Caribbean Community and Common Market CARICOM
Central American Common Market
Commonwealth of Independent States CIS
Economic Community of Central African States CEEAC
Economic Community of West African States ECOWAS
European Free Trade Association EFTA
European Union EU
Latin American Integration Association LAIA
North American Free Trade Agreement NAFTA
South Asian Association for Regional Cooperation
SAARC
Southern Cone Common Market MERCOSUR
the lowest tariff rates and then ship the
product to other member countries with
relatively higher tariff rates. To avoid
this problem, free trade agreements
usually contain local content regulations.
Customs unions not only have removal
of trade barriers the same as FTA but
they have a higher level of integration by
including a common external tariff.
With a common external tariff, all
members adopt the same trade policies
with the rest of the world. This does
away with the transshipment problem
since tariff rates are the same across all
members of the customs union.
A common market has the same provisions as a customs union but also eliminates barriers to factor
movements among its members. This is a significant jump in the level of integration. Labor is
now free to migrate between countries in a common market.
An economic union, the European Union for example, augments the level of integration found in a
common market . It requires the coordination of economic policy among its members. This may
take the shape of a common currency or restrictions on fiscal policy.
As we move up the level of economic integration the greater will be the loss of national
sovereignty for the individual member. A country’s ability to set its own course diminishes as
policymaking is done at the union level.
THEORY OF TRADE BLOCS
The formation of a trade bloc is achieved by granting preferential treatment to member nations as
opposed to non-members. The realignment of countries into a trade bloc will have effects that are
both immediate and also that develop over time.
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Static effects
The static effect leads to a change in the trade patterns among members as well as with nonmember countries. We use the welfare economic tools of consumer and producer surplus to
analyze the implications of forming a trade bloc.
The change in the patterns of trade has two major static effects, one that leads to a more efficient
allocation of resources, and the other which is movement away from global comparative
advantage.
Trade creation, which increases efficiency in the allocation of resources, arises from the removal of
trade barriers between member countries. The major result of this is, barring any other
impediments, that resources among member countries will be applied to activities for which they
have the lowest opportunity costs among
S
the member nations, in essence to their
comparative advantages.
P* + t
B C
A
P*
D
D
qs
qst
qdt qd
Quantity
Suppose there are two countries in a trade
bloc, the US and Mexico. Further suppose
that Mexico is a lower cost producer of an
item. Thus the US would import the good.
Figure 1 portrays the US’s demand and
supply of the good. With a tariff, imports
are restricted to qdt-qst.
Figure 1
The elimination of the US tariff (t) on
Mexican imports, leads to a gain for US consumers of the areas A+B+C+D. Of these, A and C
represent transfers for producers and government, respectively. Hence the net gain which accrues
to the country are areas B and D which results from the elimination of deadweight loss. This is
similar to our previous discussion of the costs of a tariff.
The other static effect, trade diversion, leads to a less efficient allocation of resources. The
discussion of trade diversion requires introducing an outside non-member nation into the analysis.
In essence by giving preferential treatment to member countries over non-members, the possibility
exists that production of the good will shift from the lowest cost producer to a higher cost
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producer. This would represent a shift away from comparative advantage and a less efficient
allocation of resources.
Suppose there are three countries, the US, Mexico and Chile. Of these, let Chile be the lowest cost
producer of the good, while the US is the highest cost producer. In Figure 2 Chile’s price (Pc) is
lower than Mexico’s (Pm), whereas the US autarkic price (Pa) is higher than both the others.
Sa
Pm + t
Pc + t
Pm
Pc
B
D
C
E
A
Da
Figure 2
qs
qst
qdt
qd
Quantity
Prior to the US entering a trade bloc with
Mexico, Chile has both the comparative
advantage as well as the competitive
advantage in producing and selling the good.
Competitive advantage is defined here as the
full price of the good to US consumers. This
would be inclusive of taxes and tariffs. With
a uniform tariff against both Mexico and
Chile, Chile’s competitive price (Pc + t)
would still be lower than Mexico’s
competitive price (Pm + t). In this case, the
US will import the good from Chile.
If the US and Mexico form a trade bloc exclusive of Chile, the set of relevant prices to US
consumers changes because the tariffs on Mexican goods are eliminated. This gives Mexico the
competitive advantage even though Chile has a comparative advantage. Now, with Pm being less
than Pc+t, the good will be imported from Mexico instead of Chile. So, as a result of the trade
bloc, production of the good shifts away from the lowest cost producer, Chile, to the higher cost
producer, Mexico. This represents a movement away from comparative advantage and leads to a
less efficient allocation of resources.
The welfare implications require comparing consumer and producer surpluses before and after the
formation of the trade bloc. Initially, US consumers paid Pc+t for the good and the US government
earned tariff revenues of t*(qdt-qst) given by areas C+E. With the formation of the trade bloc, price
fell to Pm when the tariff was eliminated. Consumers in the US gain areas A+B+C+D of which A
and C represent transfers from producers and government, respectively. Government lost all tariff
revenue. Area C is transferred to consumers and area E represents a loss not being captured by
anyone. Areas B + D represented the deadweight loss of having the tariff which now goes to
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consumers because of the trade bloc. Therefore the net gain to society is the sum of areas B+D less
area E. Should area E be greater than B+D, then the US could be made worse off for having joined
the trade bloc.
The degree of trade diversion will depend upon two factors: the level of protection levied against
non-member nations, and the differential in the costs of production between the low-cost member
producer and the lowest-cost non-member producer. What is important is a comparison of the
competitive costs between the two. The country that will prevail, after all is said and done, is the
one that can provide the good to US consumers the most cheaply. Mexico has the advantage of not
having the tariff but Chile has the lower cost of production.
For trade diversion to occur, Chile has the comparative advantage ( Pm > Pc) but Mexico has the
competitive advantage (Pc + t > Pm). With this last statement, the greater the difference between
Pc+t and Pm, the greater the scope for trade diversion. Subtracting Pm from Pc+t and rearranging
terms gives the price spread of (Pc-Pm) + t. The larger this number, the greater the possibilities
for trade diversion.
Note that we have two counteracting forces. The tariff (t) is a positive number and so the greater
the preferential treatment accorded to the member nation the more likely trade diversion will occur.
The first term represents the differential in the cost of production between Chile and Mexico.
Since Chile has the comparative advantage, it is a negative number. If Chile’s costs of production
are less than Mexico’s by an amount greater than the tariff, [ -(Pc-Pm) > t ], then Chile can absorb
the tariff and still retain the competitive advantage and no trade diversion occurs. But, as either the
tariff rises or the cost differential narrows, the greater the price spread and the scope for trade
diversion.
In a world of growing regionalization where industrial countries are including middle-income
countries in trade blocs, the implications for trade diversion are enormous. For example,
NAFTA’s combining the US and Mexico will lead to a great deal of trade diversion from nonmember countries with similar cost structures as Mexico. The advantages that accrue to Mexico
will be at the expense of other middle- income countries, particularly of the Pacific Rim and Latin
America.
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Dynamic Effects
Joining a trade bloc increases the size of the market that a firm can sell to. This has important
implications with regards to economies of scale, especially for smaller countries. A small country
may not have sufficient market demand for a firm to fully capture economies of scale. In Europe’s
situation with many small countries, there was a high degree of redundancy in the number of
firms, each servicing domestic markets. Each firm was in essence inefficient in that the size of the
domestic market did not allow it to expand production sufficiently to enjoy the low costs of largescale production. With the formation of the EU, the number of firms will decrease but the size of
the remaining firms will expand, creating efficiency. Reports about the European Union estimate
the gains from economies of scale will lead to about a 3% expansion of European production.
Increasing market size will also diminish the market power of individual firms. By opening up
markets, domestic firms will face greater competition. Monopoly power will fade as a result, and
domestic firms will have an incentive to increase productivity through implementing newer
technology or better management. In situations where partner countries are dissimilar in capital
endowments, there may also exist possibilities for investment. Capital will find the highest return.
In general this is where capital is scarce.
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