CHAPTER OUTLINE
I. Introduction
 
 
MFN dilemma
Figure 9.1
II. Degrees of Economic Integration
 
Figure 9.2
 
PASSPORT: Foreign Trade Zones
III. Rules of Origin in International Trade
  reasons
 
  nationality complexity
IV. Trade Effects of Economic Integration
  trade creation and trade diversion
 
Figure 9.3
V. The Static Effects of a Customs Union
 
Figure 9.4
 
PASSPORT: Estimating Trade and Employment Effects of Trade
Agreements
VI. The European Union
  the Treaty of Rome
 
  widening — Table 9.1 deepening
  the common agricultural policy (CAP)
  the Maastricht Treaty
  the Euro
VII. NAFTA and Other U.S. Trade Agreements
A. North American Free Trade Agreement (NAFTA)
B. Other U.S. Trade Agreements — Table 9.2
 
PASSPORT: MERCOSUR
VIII. Multilateralism Versus Regional Trade Agreements
 
MTN vs. RTA
 
PASSPORT: Trade Diversion in Action: The EU-Mexico Free-Trade
Agreement
187

188 Chapter 9
TEACHING NOTES AND TIPS
I. Introduction
Notes
Chapter 9 considers the development of regional trade arrangements that are an adjunct to the
MTNs discussed in the previous chapter. The introduction covers the proliferation of these agreements and sets up the discussion of them as a source of benefits but also costs.
Teaching Tip
Alert the students not to over focus on NAFTA or the EU. These are important but ask them to subtract 2 from the 250 given in the introduction. This is a global issue.
II. Degrees of Economic Integration
Notes
Regional trade agreements take on a number of forms that can be usefully thought of as a continuum. On the one side is a very limited preferential trade agreement covering only part of trade. Moving further along the continuum one moves from free-trade areas; to customs unions; to a common market; and to an economic union. The levels of economic integration get
“deeper” as one moves along the continuum.
Teaching Tip
The 13 original U.S. states tried to form something like an economic union under the Articles of
Confederation. The U.S. found the situation unworkable. Perhaps the Europeans will have better luck.
III. Rules of Origin in International Trade
Notes
The section covers the increasingly important issue of rules of origin. All countries enforce these rules to collect data; enforce health regulations; enforce higher tariffs on non-WTO members; enforce sanctions; enforce antidumping and countervailing duty orders; and enforce various quotas such as the MFA. With the advent of more preferential trading arrangements, the enforcement of these rules is becoming more difficult. Finally, the rules are moving from the vague “substantial transformation” test to more precise percentage of value added rules.
Teaching Tip
The rules may act something like a low tariff. It has been shown that in existing free-trade areas there is a substantial amount of trade occurring where the importer has just paid the tariff rather than bother with the paperwork of trying to “prove” the good qualifies for duty-free treatment.

Regional Economic Arrangements 189
IV. Trade Effects of Economic Integration
Notes
This section starts by defining trade creation and trade diversion. A U.S.-Mexico-Japan numerical example for cars is shown in Figure 9.3.
Teaching Tip
A world with a lot of preferential trade agreements is starting to suspiciously look like the non-
MFN world of the nineteenth century. We’re losing some of the comforting characteristics of the old MFN world.
V. The Static Effects of a Customs Union
Notes
The usual static effects of a customs union are shown in Figure 9.4. A useful adjunct to the discussion is given in the boxed feature, "PASSPORT: Estimating Trade and Employment
Effects of Trade Agreements".
Teaching Tip
It is important to re-enforce that regional trade agreements create both benefits and costs. RTAs normally create more benefits than costs but once again there is no such thing as a free lunch.
VI. The European Union
Notes
The section covers the history, expansion, and operation of the world’s foremost regional trade agreement. The first part of the section covers the history of the EU as it went from the ECSC to the European Economic Community to the European Union. The second part of the section covers the operation of the CAP and the damage it does to the U.S. and other countries. A final section looks at the continued “deepening” of the EU and the creation of the Euro.
Teaching Tip
There tends to be an over focus on the widening of the EU (adding more countries). What is almost as important and usually overlooked is the continual “deepening” of the EU (the attempt to make laws affecting businesses in the EU more similar). Within the EU the latter is often a larger source of controversy than the former as countries are being asked to surrender ever-larger amounts of sovereignty. This is a really interesting process to watch from the outside.
VII. NAFTA and Other U.S. Trade Agreements
Notes
This section begins with the history of NAFTA from the original agreement with Canada to its extension to Mexico. The second part of the section covers the other RTAs that the U.S. has implemented, signed, or is in the process of negotiating.

190 Chapter 9
Teaching Tip
This is a good place to bring in the point that virtually all preferential trade agreements are
“phased in” over a number of years. This is one of the reasons trade agreements do not cause immediate changes in a country’s industrial structure or factor prices.
VIII. Multilateralism Versus Regional Trade Agreements
Notes
This section discusses the contentious issue of trade liberalization on a multilateral basis versus trade liberalization on a regional basis.
Teaching Tip
This is a good place to bring in the point that regional versus multilateral trade negotiations can be viewed as either complements or substitutes.
BRIEF ANSWERS TO PROBLEMS AND QUESTIONS FOR REVIEW
1. Regional trade agreements involve the reduction or elimination of some or all trade barriers among some but not all countries. These reductions in trade barriers differ from the reduction of trade barriers on a multilateral basis. Under multilateral trade negotiations, tariffs and other barriers to trade are reduced for all countries that are members of the WTO. Such multilateral reductions in tariffs are nondiscriminatory.
Because tariffs and other trade barriers are reduced for some countries but not for all, regional trade agreements and the associated reduction of trade barriers are discriminatory. The implementation of a regional trade agreement entails benefits and costs. The reduction of trade barriers increases the amount of trade between the countries involved and the countries that are not a part of the agreement lose some trade.
2. Economic integration refers to the process of eliminating restrictions on commodity flows, flows of the factors of production, and flows of capital between countries. There are various degrees of economic integration between countries. The different degrees of economic integration can be placed along a continuum. On one end of the continuum is a regional trade agreement among countries that provides a limited reduction in trade barriers. On the other end of the continuum is an agreement among a group of countries to act as if the group is one distinct country in every economic respect.
3. The different types of economic integration are: 1) a free-trade area, 2) a customs union,
3) a common market, and 4) an economic union. A free-trade area is an agreement between countries to reduce or eliminate trade barriers between countries while maintaining separate national tariff schedules. A customs union is an agreement between countries to maintain a free-trade area and a common external tariff. A common market is an agreement between countries to maintain a free-trade area, a common external tariff, and free mobility of capital and labor. An economic union is an agreement between countries to maintain a free-trade area, a common external tariff, free mobility of capital and labor, a common currency, and some degree of unification in government policies.

4.
5.
6.
Regional Economic Arrangements 191
The rules of origin are necessary for several reasons: (1) The U.S. gathers information concerning the origin of imports to report statistical data on trade flows; (2) to enforce health, sanitary, and technical regulations within the U.S., the origin of imports is necessary to protect the health and safety of the public; (3) not all countries are members of the WTO and the U.S. can enforce higher tariffs or import restrictions on goods originating in these countries; (4) to administer antidumping and countervailing duty tariffs on goods imported into the U.S., a determination of the country of origin is necessary; (5) administration of quotas on textiles or agricultural products requires the determination of country of origin; (6) the U.S. administration of trade sanctions such as those against Cuba and Iraq also require knowledge of the country of origin; and (7) the recent trend towards the adoption of regional trade agreements has made the rules of origin even more critical in order to restrict the amount of trade deflection.
Trade creation is an efficiency gain that results from a free-trade area because more efficient member countries displace less efficient member countries. Trade diversion is an efficiency loss that results from a free-trade area because less efficient member countries displace more efficient nonmember countries. Trade deflection is the diversion of exports to a country within a free-trade area that has lower tariffs on a good.
The following figure illustrates Country A’s domestic demand and supply for a specific imported good.
P S
P
P 1
P 2
P 3
P 4
b
c
a
D
Q 1 Q 2 Q 3 Q 4 Q 5 Q 6 Q 7 Q 8 Q 9
Price including Tariffs from Country C
Price including Tariffs from Country B
Price excluding Tariffs from Country C
Price excluding Tariffs from Country B
Q
Assume that the world is composed of three countries: Countries A, B, and C. Now, suppose that Country A and C decide to form a customs union and Country B is a nonmember. Also, assume that Country B is the most efficient supplier of the product at a free-trade price of P
4
and tariff-inclusive price of P
2
. Country C can supply the product at a free-trade price of P
3
and tariff-inclusive price of P
1
. Before the formation of the customs union, Country A finds that it buys all of its imports from Country B at a price of
P
2
. After the formation of the customs union, Country A removes the tariff on Country
C’s products but not on Country B’s products. Country A now buys all of its imports from Country C. The movement to freer trade under a customs union affects world welfare in two opposing ways. First, there is a welfare increasing effect called trade creation. In this case, consumers in Country A buy more total cars of which Q
2
are

192 Chapter 9 domestically produced and Q
2
to Q
8
are imported. The welfare gain associated with this increase in consumption equals triangle a. In addition, some of Country A’s domestic production (Q
2
to Q
3
) is replaced by lower-price imports. This represents a favorable production effect, and the welfare gain associated with this production change equals triangle b. The overall trade creation effect is given by the sum of the triangles a + b.
The second effect of a customs union is a welfare- decreasing effect called trade diversion. Trade diversion occurs when a higher-price supplier within the union replaces imports from the low-price supplier outside the union. As a result of the customs union, world production is organized in a less efficient manner. The box c indicates this welfare loss to Country A and the world as a whole. The formation of a customs union will increase the welfare of its members, as well as the rest of the world, if the trade creation effect (a + b) is larger and than trade diversion effect (c).
7. Now 50 years old, the EU currently contains 25 countries with a combined population of
372 million and a combined GDP larger than the U.S. The EU began its development in
1951, when the European Coal and Steel Community (ECSC) was formed. This agreement provided for the elimination of tariffs and quotas for the coal and steel industries among Belgium, France, Italy, Luxembourg, the Netherlands, and West
Germany. The basic idea of the ECSC was to promote free trade in two important commodities as a deterrent to future military conflicts in Europe. In 1957, the countries involved in the ECSC signed the Treaty of Rome, which provided for the elimination of tariffs and nontariff barriers to trade between member countries and the institution of a common external tariff. This treaty established the European Economic Community
(EEC) as a customs union, which has been enlarged to cover more and more of Europe.
This enlargement has occurred mostly as countries in Europe left EFTA and joined the
EU. The U.K., Ireland, and Denmark joined the EEC in 1973; Greece joined in 1981;
Spain and Portugal joined in 1986; and Austria, Finland, and Sweden joined in 1995. In addition, 10 countries became members in 2004. These countries include Cyprus,
Estonia, the Czech Republic, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia, and
Slovenia. As the EU has “widened” to include more countries it has also “deepened.” As the EU adopted a common agricultural policy for all members, this created constant trade frictions between the U.S. and other more efficient producers of agricultural commodities such as Canada, Australia, New Zealand and many developing countries. In looking at the continuum of economic integration, the EU is taking a number of steps to create a full economic union. Beginning in 1985, an EU commission set about determining the steps necessary to create a genuinely barrier-free internal market in the EU. This commission listed hundreds of actions that member governments needed to take in order to create something like a unified market. Most of the government actions were completed by
1992 with much fanfare about the single market. The Maastricht Treaty of 1992 laid out plans for a new European currency (the Euro) that replaced some of the separate national currencies in January 2002.
8. The common agricultural policy of the EU is an agreement between the member countries to subsidize agriculture in the same manner. All member countries’ farmers are paid subsidies from the EU rather than by each national government. Currently, approximately half of the total EU budget is spent on farm subsidies. The common agricultural policy guarantees prices for all farm commodities within the EU. The EU

Regional Economic Arrangements 193 purchases whatever the farmers cannot sell on the open market and farmers are protected by a variable levy (tariff) from international competition. If farm prices within the EU decline, then the tariff rises and vice versa. Since the support prices are generous, there has been a problem of chronic oversupply of agricultural commodities in Europe. In addition, surplus agricultural commodities are sometimes dumped on world markets to reduce EU losses. As a result, the common agricultural policy has created constant trade frictions between the U.S. and other more efficient producers of agricultural commodities such as Canada, Australia, New Zealand and many developing countries. Such countries not only lose exports to the EU but also at times suffer losses in other export markets when the EU sells or dumps surpluses.
9. The formation of a customs union will increase the welfare of its members, as well as the rest of the world, if the trade creation effect is larger than the trade diversion effect.
10. From the creation of GATT until the early 1980s, U.S. trade policy was focused on reducing trade barriers through the various MTNs. Regional trade agreements were mostly centered around the expansion of the EU and the U.S. government showed little interest in such agreements. However, beginning in the 1970s there was a slight change in
U.S. policy. First, the U.S. began granting preferential trade status to developing countries under the Generalized System of Preferences. These preferences had the advantage of enhancing economic growth in developing countries without the monetary and political complications normally associated with foreign aid. This trend continued with the passage of the Caribbean Basin Initiative (CBI) in 1981 as a means of encouraging economic development in that area. The result of these agreements was that the U.S. was now deviating from a purely multilateral approach to reducing trade barriers. Also, there was rising frustration with the slow pace of trade liberalization in several areas of interest to the U.S. As discussed in Chapter 1, international trade in services is a fast-growing part of world trade. However, liberalizing trade in services has been a very slow process. For the
U.S. this is frustrating as the U.S. has a comparative advantage in many areas of service trade such as financial services and insurance. Secondly, the U.S. government is also interested in liberalizing trade in agricultural products. Liberalization in this sector under the auspices of the GATT/WTO has been even slower. For these and other reasons, beginning in the early 1980s the U.S. government began pursuing trade liberalization via regional trade agreements.
11. One of the more contentious issues in international economics is the debate over trade liberalization. Until the 1980s, trade liberalization occurred primarily through multilateral trade negotiations under the auspices of GATT. If trade barriers are only reduced on an MFN basis then there is only trade creation and no trade diversion. Trade diversion occurs if trade liberalization is discriminatory meaning that one country is treated differently than another country. This is one of the strongest arguments for
MTNs. RTAs inherently threaten this process. An RTA is inherently discriminatory as member countries are treated differently than nonmember countries. Since there are many countries now involved in many different RTAs world trade has become more complicated. The world trading system is at risk of going back to the situation that existed prior to GATT. Each country potentially had a different tariff for each product for specific countries. In economic terms, this causes an increasing amount of trade

194 Chapter 9 diversion that potentially reduces world welfare. A second issue of RTAs is more subtle.
Countries only have a limited amount of time and expertise to expend on the issue of trade liberalization. As RTAs spread, governments will spend more resources on RTA negotiations. This implies that they will expend fewer resources negotiating under the
WTO framework. As a result, the process of obtaining multilateral trade liberalization becomes more difficult with the spread of RTAs. The opponents of RTAs emphasize these costs. They fear that the spread of RTAs is jeopardizing the nondiscriminatory nature of world trade that had been developed under the GATT/WTO framework.
Further, they fear that RTAs tend to distract government attention away from the process of liberalizing world trade in a nondiscriminatory fashion. Also the spread of RTAs may be saying something about the preferences of governments for RTAs. One of the current problems with multilateral liberalization is that the depth of integration being pursued is not very deep. If one compares the agenda of the Doha round to the current depth of
*
3.
*
2. integration in the EU or even NAFTA then the issue becomes obvious. In some cases countries want to pursue a level of economic integration that is not possible in a multilateral framework. A useful way of summarizing this debate is to think in terms of substitutes and complements. Those that fear the spread of RTAs really fear that they are a substitute for multilateral liberalization. Economists that are less concerned about the spread of RTAs tend to view them as complementary to MTNs. While the WTO may no longer be the force for multilateral liberalization that it once was, its role in the world economy may still be increasing rather than diminishing.
MULTIPLE-CHOICE QUESTIONS
1. Preferential trade agreements are troublesome in the sense that they weaken the important principle of international trade policy known as: a. b. c. d.
TC.
TD.
WTO.
MFN.
Preferential trade agreements inherently discriminate against countries that do not belong to the agreement and inflict losses on their exporters. This phenomenon is know as: a. Trade deflection. b. c. d.
Trade creation.
Trade diversion.
The gains from trade.
*
Which of the following is an exception to the most favored nation principle? a. b.
Trade in petroleum trade with Japan c. d.
A free-trade area or a customs union
Trade in services

6.
*
4.
*
5.
*
7.
*
8.
*
9.
*
Regional Economic Arrangements 195
Regional trade agreements: a. are the same for all countries. b. reduce tariffs and trade barriers equally in all countries. c. d. result in the negotiating countries obtaining a margin of preference over countries that are not part of the agreement. favor developed countries.
In order for a preferential trade agreement to be legal under international trade rules: a. b. c. it must reduce trade barriers on all agricultural products among member countries. it must reduce trade barriers on a substantial proportion of trade among the member countries. it must reduce restrictions on the mobility of labor and capital among member d. countries. it must provide a common external tariff for member countries.
GATT/WTO regulations state that in order for a regional trade agreement to be legal: a. trade barriers must be reduced on substantially all trade within the b. c. group. trade barriers must be reduced on only some of the trade within the group. all countries must come to an agreement on the number and size of the quotas that d. will be in force. all members will be subject to membership fees.
Which of the following is not a level of economic integration between countries? a. A free-trade area b. c. d.
A customs union
A common union
An economic union
The least integrated category of economic integration is: a. b. a common market. a free-trade area. c. d. an economic union. a customs union.
A significant feature of a customs union is: a. that agricultural products are always excluded. b. c. d. that corporate tax rates are always made common. that the only WTO legal customs union is the EU. a common external tariff.

196 Chapter 9
10. Which statement is correct? a. Both customs unions and free-trade areas have a common external tariff. b. A free-trade area has a common external tariff and a custom union does not.
* c. d.
Neither free-trade areas nor customs unions have a common external tariff.
A customs union has a common external tariff but a free-trade area does not.
11. To solve the problems associated with trade deflection within an FTA, countries may
* adopt: a. b. c. d. a common market. a common external tariff. rules of origin. rules of negotiation.
12. What is the major difference between a customs union and a free-trade area?
* a. Each country replaces its national tariff schedule with a common external tariff under a customs union. b. c. d.
A customs union usually means a more shallow level of economic integration.
A free-trade area is national in nature and a customs union is regional.
In a customs union, tariffs are eliminated and in a free-trade area they are not.
13. Which of the following is not one of the features of a common market? a. Free mobility of labor
* b. c. d.
Free mobility of capital
A common external tariff
A common currency *
14. Which of the following is not a characteristic of a common market? a. Capital and labor can freely move within member countries. b. The are no trade restrictions between member countries. c. d.
Member countries have a common external tariff.
Member countries have a common currency.
15. To create an economic union, countries must complete all of the following except: a. for the adoption of a common currency. b. c. for the harmonizing of specific country policies to those of other members. providing for the mobility of labor and capital among member countries.
*
* d. creating only one political party within the member countries.
16. Rules of origin are necessary for which of the following reasons? a. b. c. d.
To determine which company produced the product
To determine which country produced the product
To determine which country consumes the product
To determine where the profits of the firm are taxed

Regional Economic Arrangements 197
17. When compliance costs associated with the rules of origin exceed the value associated with the reduction of the tariff, then rules of origin become:
* a. an effective nontariff barrier to trade. b. c. d. an effective tariff imposed on the foreign firm. a non-effective nontariff barrier to trade. a non-effective tariff imposed on the foreign firm.
18. Rules of origin are used to counteract:
* a. b. offshore assembly provisions. trade deflection. c. technical regulations. d.
government procurement regulations.
19. Which of the following is not one of the reasons rules of origin are necessary? a. To gather statistical information on imports b. c.
To enforce health and safety regulations
To enforce higher tariffs on imports from nonWTO countries
* d. To assist in balancing the balance of payments
20. Traditionally, the U.S. has relied on the _____ transformation test to determine the
“nationality” of an import. a. import
* b. c. d. environmental substantial legal
21. In recent trade agreements, the U.S. has been moving toward defining the origin of
* imports using a percentage of ______. a. value added b. imports c. d. exports weight
22. Trade creation refers to:
* a. the expansion of trade among member countries as a result of the b. elimination of tariffs. the creation of new products for trade in countries. c. d. the creation of a trade program that enhances multinational corporations. the creation of government sanctioned trade with terrorist countries.
*
23. When products from a high-cost country within a customs union replace imports from a low-cost country that is not a member of the union, this is called: a. trade creation. b. c. d. trade diversion. trade deflection trade development.

198 Chapter 9
*
24. When preferential trade agreements are formed, the result is often a reduction of trade with countries that are not members of the group. Such a result is known as: a. reciprocity. b. c. d. trade creation. purchasing power parity. trade diversion. *
25. The U.K. joins the EU and imports wheat from France rather than from Canada and/or the U.S. This is an example of: a. trade creation.
* b. c. d. trade diversion. trade modification. trade deflection.
26. When developed countries extend tariff preferences to developing countries and imports from the latter displace imports from the former, a phenomenon known as _____ is taking place. a. b. trade creation trade inflation
* c. d. trade diversion trade deflection
27. A customs union will increase the welfare of its members and the rest of the world if: a. b. c. d. trade creation is greater than trade diversion. trade creation is less than trade diversion. trade creation is positive. trade diversion is positive.

Regional Economic Arrangements 199
The following figure illustrates Country A’s domestic market for a specific imported good.
P S
P
P1
P 2
P 3
P 4
a b c d e
f g h
D
Q 1 Q 2 Q 3 Q 4 Q 5 Q 6 Q 7 Q 8 Q 9
Price including Tariffs from Country C
Price including Tariffs from Country B
Price excluding Tariffs from Country C
Price excluding Tariffs from Country B
Q
28. With free trade Country A imports:
* a. Q
1
to Q
9
from Country B. b. c. d.
Q
2
to Q
8
from Country C.
Q
3
to Q
7
from Country B.
Q
4
to Q
6
from Country C.
29. If Country A imposes a tariff on imports from both Country B and C, Country A will
* import: a. Q
1
to Q
9
from Country B. b. c. d.
Q 2 to Q 8 from Country C.
Q
3
to Q
7
from Country B.
Q
4
to Q
6
from Country C.
30. Suppose Country A forms a customs union with Country B, Country A will import:
* a. Q
1
to Q
9
from Country B. b. c. d.
Q
2
to Q
8
from Country C.
Q 3 to Q 7 from Country B.
Q
4
to Q
6
from Country C.
31. Suppose Country A forms a customs union with Country C, Country A will import: a. Q
1
to Q
9
from Country B.
* b. c. d.
Q
2
to Q
8
from Country C.
Q
3
to Q
7
from Country B.
Q 4 to Q 6 from Country C.
*
32. Suppose Country A forms a customs union with Country C, trade creation is represented by the area: a. a + b + c + d + e. b. c. d. a + e. b + c + d. f + g + h.

200 Chapter 9
*
33. Suppose Country A forms a customs union with Country C, trade diversion is represented by the area: a. g. b. c. d. f + h. f + g + h. b + c +d.
34. The economic integration of Western Europe began in the:
* a. b.
1930s.
1950s. c. d.
1970s.
1990s.
35. The beginning of the European Union can be traced back to the early 1950s and the creation of:
* a. b. the European Coal and Steel Community. the European Monetary Union. c. d. the International Monetary Fund. the Treaty on European Enlargement.
36. European economic integration began with:
* a. the European Coal and Steel Community. b. the Treaty of Rome. c. d. the European Economic Community. the European Free Trade Area.
37. The treaty in the late 1950s calling for establishment of a European common market
* known as the EEC was: a. the Treaty of Paris. b. the Treaty of Rome. c. d. the Treaty of Brussels. the Treaty on European Union.
38. The European Union is: a. a free-trade area. b. c. a customs union. a limited preferential trade agreement covering only agricultural products.
*
* d. an economic union.
39. Which of the following countries is not a member of the EU? a. b. c. d.
Portugal
Austria
Switzerland
Finland

Regional Economic Arrangements 201
*
40. Which of the following countries was not among the founders of what is now known as the EU? a. Belgium
* b. c. d. the U.K.
Italy
France
41. A U.S. exporter of wheat to the EU faces the same tariff rate on exports to Germany and the U.K. This type of tariff schedule is called: a. a common external tariff. b. c. d. a common agricultural policy. a common internal tariff. a common market.
42. The Common Agricultural Policy was adopted by which group of countries?
* a. b.
EFTA
EU c. d.
NAFTA
WTO members
43. Which of the following is the acronym for the EU policy of subsidizing farmers? a. APA b. EURO
* c. d.
CAP
CBI
44. Which of the following is not strongly in favor of liberalizing world trade in agricultural
* products? a. New Zealand b. The EU
* c. d.
Australia
Chile
45. Which of the following is not true concerning the EU? a. Its integration began over 50 years ago.
* b. c.
Its integration began with the ECSC.
It includes all Western European countries. d. Its common currency is the Euro.
46. One of the most problematic areas for the EU is: a. b. c. d. the common currency. agriculture. labor movements between member countries. trade barriers between member countries.

202 Chapter 9
47. Which country is not a member of the European Union?
* a. Norway b. Spain c. d.
Greece
The U.K.
48. Which EU country has not adopted the Euro as its currency? a. Finland
* b. c.
Portugal
Denmark d. Germany
49. The creation of the Euro was an important milestone for the EU. This new currency was
* created through the: a. b. c. d.
Treaty of Rome.
Uruguay Round.
Maastricht Treaty.
European Free Trade Association.
50. The name of the currency to be issued by the European Monetary Union is the
_________ and it began to circulate as a currency in __________ . a. Eurodollar; 2000 b. ECU; 2002
* c. d. euro; 2005 euro; 2002
51. NAFTA is:
* a. b. a free-trade area. a customs union. c. d. a limited preferential trade agreement covering only trade in automobiles and parts. an economic union.
52. The NAFTA agreement was most strongly opposed in the U.S. by which group? a. Automobile firms
* b. c. d.
Labor unions
Manufacturing firms
Financial institutions
53. NAFTA:
* a. b. is a free-trade area. must be renewed every five years. c. d. will eventually eliminate restrictions on the movement of labor among the member countries. is a customs union.

Regional Economic Arrangements 203
54. The level of integration provided under NAFTA is:
* a. a free-trade area. b. a customs union. c. d. a common market. an economic union.
*
55. When NAFTA was authorized in 1994, the maximum phase in period for tariff reductions was: a. b.
1 year.
3 years. c. d.
8 years.
15 years.
56. NAFTA and its side agreements do not have provisions dealing with which of the following: a. b. tariff reductions. environmental regulations.
* c. d. labor standards. a common currency.
57. The U.S. factor of production that is most likely to be made worse off because of NAFTA is: a. capital. b. c. d. skilled labor. land. unskilled labor. *
58. Which of the following statements is correct concerning NAFTA? a. The agreement includes Mexico, Canada, and the U.S. b.
The agreement covers merchandise trade, trade in services, and
* c. d. investment.
Tariff reductions are to be phased in over 15 years.
All of the above
59. Which of the following is not a member of MERCOSUR? a. b. c. d.
Brazil
Uruguay
Paraguay
Venezuela *
60. Which of the following countries is not a full member of MERCOSUR? a. Brazil
* b. Ecuador c. d.
Argentina
Uruguay

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61. Until the _____, trade liberalization was occurring primarily through _____ . a. 1970s, WTO
* b. 1980s, multilateral trade negotiations c. d.
1950s, GATT
1990s, MFN
TRUE FALSE QUESTIONS
1. T Multilateral reductions in the MFN tariff are essentially nondiscriminatory.
2. T Regional trade agreements are inherently discriminatory because they include some countries and exclude other countries.
3. F Regional trade agreements and the associated reduction of trade barriers embodied in them are nondiscriminatory.
4. F
Preferential trade agreements are relatively rare in today’s world economy.
5. T Free-trade areas and customs unions were legal under GATT and also under the WTO.
6. F Regional trade agreements between countries are becoming less important than they were
20 years ago because most countries now participate in multilateral trade negotiations.
7. F In terms of the depth and scope of trade, a free-trade area usually is a more comprehensive agreement concerning free trade than the agreement associated with a customs union.
8. T If two countries mutually eliminate their tariffs, trade between them will generally increase. This effect is called trade creation.
9. F One of the characteristics of a common market is that member countries agree to eliminate trade with nonmember countries.
10. F Members of a free-trade area generally allow unrestricted movements of labor and capital among member countries.
11. F Preferential trade agreements make the rules of origin governing imports less important.
12. F The rules of origin refer to the determination of what company actually produced the product.
13. F Rules of origin are so trivial that they have no impact on international trade.
14. T Rules of origin are more important when a country is a party to various preferential trade agreements.

Regional Economic Arrangements 205
15. F The U.S. currently relies on the export transformation test to determine the nationality of an imported product.
16. T If the costs of complying with a country’s rules of origin are higher than the cost of the tariff then the importer is better off just paying the tariff.
17. T The increasing complexity of rules of origin allows countries to legally engage in a new form of protectionism.
18. T Businesses engaging in international trade would like to see a global harmonization of the rules of origin.
19. T The principle embodied in the rules of origin is to determine the “nationality” of the imported product.
20. F In a free-trade agreement the countries involved no longer maintain their own separate national tariff schedules.
21. F In order to qualify for duty-free treatment, a certain percent of value added must have been performed in one of the nonmember countries.
22. F Export losses by countries outside of a trade agreement are known as trade deflection.
23. F In world welfare terms whether or not a trade agreement increases world welfare depends on whether trade creation is smaller than trade diversion.
24. F In order to maximize consumer gains, most trade agreements are implemented immediately.
25. T In a common market, restrictions on the mobility of capital between member countries have been eliminated.
26. T Free-trade areas are a form of regional integration where member countries lower internal trade barriers but maintain existing barriers against nonmembers.
27. T In order for a free-trade agreement to be legal under the WTO it must cover
“substantially all” trade.
28. T Trade deflection occurs in a free-trade agreement because countries maintain their own national tariff schedules that may have different tariffs on the same product.
29. F Both free-trade areas and customs unions have a common external tariff.
30. T Customs unions are a form of regional integration where member countries lower internal trade barriers and establish a common barrier against nonmembers.

206 Chapter 9
31. F Customs unions and free-trade areas are the same in the way in which member countries treat imports from nonmember countries.
32. T Trade diversion is said to exist when the formation of a regional trading group leads to the reduction of trade with nonmember countries in favor of member countries.
33. T Trade creation is said to exist when the formation of a regional trading group leads to an expansion of trade above pre group levels.
34. T The increase in trade associated with the formation of preferential trade agreements leads to what is known as trade creation.
35. T A customs union will be beneficial to world welfare if the amount of trade creation resulting from its formation is larger than the amount of trade diversion.
36. F In a free-trade area, trade creation occurs if trade between member countries expands as a result of less trade with nonmember countries.
37. F In a free-trade area, trade deflection occurs if trade between member countries expands as a result of less trade with nonmember countries.
38. F The EU is an example of a free-trade area in Western Europe.
39. T The attempt to make business regulations within a customs union more similar is an example of “deepening”.
40. T The process of adding countries to the EU is known as “widening”.
41. T The EU is the world’s largest and most successful customs union.
42. F Currently, the EU is composed of 11 countries.
43. T Currently, the EU is composed of 15 countries.
44. T A goal of the EU is the unification of member country currencies into a single currency.
45. F NAFTA is a free-trade agreement between the U.S., Canada, Ecuador, and Mexico.
46. F Under NAFTA, Canada, Mexico, and the U.S. will have a common external tariff that they will apply to all nonmember countries.
47. F NAFTA is an example of a customs union in North America.
48. F The U.S. at this time is a leader in the reduction of trade barriers within the western hemisphere.
49. T The most important country within MERCOSUR is Brazil.

Regional Economic Arrangements 207
50. F Mexico is currently a member of MERCOSUR.
51. F Because the U.S. participates in numerous RTAs, it is completely clear what the U.S. tariff is on any product.
52. F Virtually all economists oppose the formation of RTAs.
53. F Since all countries have the same preferences with respect to free trade, multilateral trade negotiations are easier than attempting to negotiate an RTA.
54. T In the late 1990s, Mexico and the EU concluded a free-trade agreement.
1.
2.
3.
4.
5.
55. F Trade diversion and the spread of RTAs are completely unrelated.
SHORT ANSWER ESSAY
What is the difference between a free-trade area and a customs union?
Describe how trade deflection occurs when countries form a free-trade area.
List and describe the features of an economic union.
List the reasons that rules of origin are necessary for imports.
Suppose that you were given the task of determining the effects on imports of a preferential trade agreement for a particular industry. In general terms, how would you estimate the effects on trade and employment in the industry?
6. What is a foreign trade zone? How do businesses use them as a part of engaging in international trade?
7. Why is trade diversion considered harmful to world welfare?
8.
9.
Describe the historical development of the EU.
Why has the CAP caused friction in international trade relations between the U.S. and the
EU?
10. What are the major differences between the history and structure of the EU and NAFTA?
11. Describe MERCOSUR and discuss its development.
12. Describe the relationship between RTAs and MTNs in terms of substitutes and complements.

208 Chapter 9
BRIEF ANSWERS TO SHORT ANSWER ESSAY
1. A customs union is an agreement between countries to maintain a free-trade area and a common external tariff. A customs union is similar to a free-trade area but with two differences. First, a customs union has a common external tariff. A common external tariff means that each country replaces its own national tariff schedule with a common tariff schedule applicable to all member countries. Second, not all free-trade areas include trade in agricultural products, services, and financial flows. However, most customs unions include a broad range of international trade. The level of international economic integration implied by a customs union is usually “deeper” than the level of integration implied by a free-trade area.
2. With an FTA each country maintains its own separate national tariff schedule and trade deflection may occur within the free-trade area. Trade deflection is the diversion of exports to a country within a free-trade area that has lower tariffs on a good. For example, suppose the tariff on cars is 4 percent in the U.S. and Canada and 20 percent in Mexico.
A car exporter to this free-trade area has an incentive to ship cars to say San Diego, pay the 4 percent U.S. tariff, and then ship the car to Mexico for sale. When the national tariffs of the free-trade area members are very different, exporters have a clear incentive to try to evade the higher tariffs. Differences in tariffs and/or quotas can also lead to the establishment of “screwdriver plants.” These plants are designed to provide minor assembly work on a product that is essentially produced in a foreign country but assembled within the free-trade area to avoid the higher tariffs. To solve this problem,
3. free-trade areas and other trade agreements have rules of origin in order to qualify for duty-free treatment.
The determination of what country actually produced the good is known as the rules of origin. As part of its routine enforcement of U.S. trade laws, the U.S. Customs Service makes this determination on all imports at the time the good enters the country. The rules of origin are necessary for several reasons. First, the U.S. gathers information concerning the origin of imports to report statistical data on trade flows. Second, to enforce health, sanitary, and technical regulations within the U.S., the origin of imports is necessary to protect the health and safety of the public. Third, not all countries are members of the
WTO and the U.S. can enforce higher tariffs or import restrictions on goods from originating in these countries. Fourth, to administer antidumping and countervailing duty tariffs on goods imported into the U.S., a determination of the country of origin is necessary. Fifth, the U.S. administration of quotas on textiles or voluntary export restraints (VERs) requires the determination of country of origin. Finally, the U.S. administration of trade sanctions such as those against Cuba and Iraq also require knowledge of the country of origin.
4. An economic union is an agreement between countries to maintain a free-trade area, a common external tariff, the free mobility of capital and labor, and some degree of unification in government policies and monetary policies. There are two requirements for an economic union. The first requirement is the creation of a common currency. This

5.
6.
Regional Economic Arrangements 209 implies the abolition of each country’s central bank and the creation of a common central bank. The second requirement is that each national government has to align its national policies with those of the other member countries. The policies would need to cover such things as tax rates, competition policy, labor regulations, environmental regulations, and so forth. Any national policies that tend to distort trade flows would be candidates for harmonization.
Two methods are used to estimate the economic impacts of a trade agreement. The first method is tedious but relatively simple. Suppose that Mexico has a 10 percent tariff on a particular product imported from the U.S. Further suppose that the price elasticity of demand for this product is 1.0. If the tariff were eliminated, exports of this product from the U.S. to Mexico would rise by 10 percent. Next the Department of Labor produces estimates of the number of employment opportunities involved if production changes in
U.S. industry. If you know how much production changes as a result of the tariff reduction, you now have an estimate of the number of jobs gained. For U.S. tariff reductions, you can estimate the increase in imports from Mexico, and as U.S. output falls, the U.S. loses jobs. By totaling up the effects for all products and all industries, add the gains and losses, and you have an estimate of the total effect on jobs due to NAFTA.
One side could argue that total “jobs” would rise while the other side could claim that they would fall. Aside from the politics, these partial equilibrium estimates are useful in the negotiating process. To reduce the political opposition, industries in which the effects are large the tariff reductions are conveniently phased in toward the end of the 15-year transition period. A more recent way of calculating the effects of trade agreements is to use a computable general equilibrium model (CGE). The difference in this estimating method is that CGE models allow for the interactions among related industries. For instance, if the automobile industry is affected by a trade agreement, this will indirectly affect many other industries, which provide inputs into the production of automobiles.
Building such a model requires four steps. First, one needs to collect data on production, consumption, prices, and trade flows. The second step is to construct a mathematical representation of the structure of the economy. Third, various parameters, price elasticity being one, are then put into the model. The model is then calibrated to ensure that it generates known results that make sense. Finally, one can use the model to answer questions concerning changes in economic policy. These models are now widely used to determine the possible effects of changes in trade policy as well as other economic policies. While these models are informative, they are not perfect. For an exercise such as NAFTA, the policy change for the U.S. was so small that the results of the exercise were also small. Partial equilibrium models are still useful for capturing the changes at the narrowly defined industry level where the changes for the economy as a whole are small. For Canada and Mexico, the relative size of the policy change was substantially larger and the effects on the structure of their economies would be larger.
Countries have the option of making part of their territory free of trade barriers. Under the rules of the WTO, a country can designate certain geographical areas as zones of free trade, even when the rest of the country is subject to normal trade restrictions. These zones of free trade within a country are called Foreign Trade Zones (FTZ). Currently there are approximately 400 zones in over 80 countries and these zones process approximately 10 percent of world trade. Currently, firms can manufacture inside a FTZ

210 Chapter 9
7.
8.
9. and the domestic processing costs incurred in the zones and profits earned there are free from duty. As a result, tariffs apply only to the imported inputs. The changes in the laws governing FTZs have caused an increase in their growth.
The second effect of a customs union is trade diversion that decreases world welfare.
Trade diversion occurs when a higher-price supplier within the union replaces imports from a low-price supplier outside the union. As a result of the customs union, world production is organized in a less efficient manner.
The worlds largest and most successful customs union is the European Union (EU), an association of European countries that has agreed to a free trade area and has imposed a common external tariff. Now 50 years old, the EU currently contains 15 countries with a combined population of 372 million and a combined GDP larger than the U.S. The
European Union began its development in 1951, when the European Coal and Steel
Community (ECSC) was formed. This agreement provided for the elimination of tariffs and quotas for the coal and steel industries between Belgium, France, Italy, Luxembourg, the Netherlands, and West Germany. The basic idea of the ECSC was to promote free trade in two important commodities as a deterrent to future military conflicts in Europe.
The basic premise behind the ECSC was that the more closely integrated countries are economically, the less likelihood of war between them. In 1957, the countries involved in the ECSC signed the Treaty of Rome, which provided for the elimination of tariffs and nontariff barriers to trade between member countries and the institution of a common external tariff. This treaty established the European Economic Community (EEC) as a customs union, which has been continually enlarging itself to cover more and more of
Europe. Over time, the enlargement of the European Union has occurred mostly as countries within Europe left EFTA and joined the EU. While EU membership grew,
EFTA membership declined. The U.K., Ireland, and Denmark joined the EEC in 1973;
Greece joined in 1981; Spain and Portugal joined in 1986; and Austria, Finland, and
Sweden joined in 1995. In addition, 10 countries became members in 2004. These countries include Cyprus, Estonia, the Czech Republic, Hungary, Latvia, Lithuania,
Malta, Poland, Slovakia, and Slovenia.
From its beginning the EU has had something extra called the common agricultural policy (CAP), that is an agreement among the European countries to subsidize the agricultural sector. Belgian farmers are subsidized in the same way as Portuguese farmers. All member countries provide revenue to the EU and the EU, rather than each national government, pays subsidies to farmers. Currently, approximately half the EU total budget is spent on farm subsidies. The common agricultural policy guarantees prices for all farm commodities within the EU, and the EU purchases whatever the farmers cannot sell on the open market. In addition, farmers are protected by a variable levy (tariff) from international competition. If farm prices within the EU decline, then the tariff rises and vice versa. Since the support prices are generous, there has been a problem of chronic oversupply of agricultural commodities in Europe. In addition, the surplus agricultural commodities are sometimes dumped on world markets to reduce EU losses. As a result, the common agricultural policy has created constant trade frictions between the U.S. and other more efficient producers of agricultural commodities such as
Canada, Australia, New Zealand and many developing countries. Such countries not only

Regional Economic Arrangements 211 lose exports to the EU, but also at times suffer losses in other export markets when the
EU sells or dumps surpluses. Demands by countries that the EU reform the system to produce less damage to other countries delayed the Uruguay Round. Most likely, any future negotiations concerning world trade in agriculture will have as its central issue the
CAP. The situation is politically charged as European farmers, particularly French farmers, are very active in defense of the system.
10. In 1992, Canada, the U.S., and Mexico agreed to broaden the free-trade area to include
Mexico. After much discussion, the U.S. Congress authorized the free-trade area in 1993 and it went into effect in 1994. The tariff reductions provided in the NAFTA agreement are to be phased in over a 15-year period. The Agreement covers all merchandise trade as well as trade in services, investment, and intellectual property rights. In addition, any trade disputes under the agreement are to be adjudicated by a 5-member panel. In addition to the free-trade agreement, two additional agreements were signed in the areas concerning labor standards and environmental issues. These two additional agreements simply commit each country to enforce its own labor and environmental laws. What makes NAFTA and the EU different is that the development of the latter was designed to both widen and deepen over time by creating a customs union that ultimately led to an economic union. On the other hand NAFTA is designed only as a free-trade agreement.
11. MERCOSUR is an acronym for a free-trade area that is on its way to becoming a customs union. This free-trade area is currently composed of Argentina, Brazil, Uruguay, and
Paraguay. The first phase of the agreement, signed in 1991, is to cut intra-regional tariffs to zero by the year 2000. For the most part, tariffs are at zero for most trade within the region. Starting in 1995, the countries set about harmonizing their tariffs to a common external tariff by 2006. Beginning in 1995, the countries began negotiating the harmonization of regulations necessary for creating a “single market.” As the Europeans discovered when they tried to create a common market, this project is quite difficult and will take time to complete. There is also a commitment to the free movement of labor within the countries, but no formal date has yet been made. MERCOSUR has signed a free-trade area agreement with Chile that will be implemented in phases through 2014.
However, substantial tariff cuts have already been made on both sides. MERCOSUR plus Chile is now a trade area containing 240 million people with a total economic output of over $1 trillion. The agreement has had an explosive effect on trade. From 1990 to
1995, intra-regional trade expanded from less than $6 billion to over $14 billion. The trade flows could grow even larger. Intra-group trade in NAFTA is 4.5 percent of GDP and in the EU it is 14 percent. Within MERCOSUR, intra-group trade is still only 1.6 percent. MERCOSUR is also likely to expand as it is currently negotiating with Bolivia and will likely expand to the other members of the Andean Group (Bolivia, Colombia,
Ecuador, Peru, and Venezuela).
12. In a sense, RTAs and MTN are substitutes. If a country desires to move toward freer trade, then it could do so by negotiating in an MTN under the auspices of the WTO.
Likewise, the country could move toward freer trade by negotiating bilateral trade agreements with any number of countries. In both cases the country has moved towards freer trade. However, RTAs and MTNs also are complements. The participation of a

212 Chapter 9 country in an MTN does not preclude a country from negotiating RTAs. Since both types of trade agreements lead to freer trade, MTNs and RTAs are complements.