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.
The growth of RTAs is shown in Figure 11.1. Under GATT, RTAs were envisioned
as being an unusual diversion from MFN. From 1948 to the early 1980s, this
essentially was the case. However, in the early 1980s the growth of RTAs in the world
economy started increasing rapidly. This trend accelerated in the 1990s and shows no
signs of abating.
5.
The rules of origin are necessary for several reasons: (1) the US gathers information
concerning the origin of imports to report statistical data on trade flows; (2) to enforce
health, sanitary, and technical regulations within the US, 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 US 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 US, 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 US administration of trade sanctions such
as those against Cuba and Iraq also require knowledge of the country of origin; and
© 2015 W. Charles Sawyer and Richard L. Sprinkle
(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.
6.
In a free-trade area each country maintains its own national tariff schedule. This
makes it possible for members to have very different tariffs on the same product. This
creates an incentive to export the product to the low-tariff country and then with some
minor processing reexport it duty free to the high-tariff country. This process is
known as trade deflection. Avoiding this particular problem is one of the reasons that
free-trade agreements sometimes move on to being customs unions.
7.
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.
8.
When two countries form an RTA nonmembers lose exports to these markets due to
trade diversion. To mitigate this effect, one or more of the nonmembers may choose
to join the RTA.
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.
P
S
P
P1
P2
P3
P4
b
Price including tariffs from Country C
Price including tariffs from Country B
Price excluding tariffs from Country C
Price excluding tariffs from Country B
a
c
D
Q 1 Q2 Q3 Q4 Q5 Q6 Q7 Q8 Q9
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 P4 and tariff-inclusive price of P2. Country C can supply the
product at a free-trade price of P3 and tariff-inclusive price of P1. Before the formation
of the customs union, Country A finds that it buys all of its imports from Country B at
a price of P2. 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
© 2015 W. Charles Sawyer and Richard L. Sprinkle
which Q2 are domestically produced and Q2 to Q8 are imported. The welfare gain
associated with this increase in consumption equals triangle a. In addition, some of
Country A’s domestic production (Q2 to Q3) 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 welfaredecreasing 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 than the
trade diversion effect (c).
11.
Now 50 years old, the EU currently contains 27 countries with a combined population
of 459 million and a combined GDP larger than the US. 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 the European Free Trade Association (EFTA) and joined the EU. The UK,
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,
ten countries became members in 2004. These countries include Cyprus, Estonia, the
Czech Republic, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia, and Slovenia.
Bulgaria and Romania joined in 2007. 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 US 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.
12.
An RTA can take on several forms from a free-trade agreement to an economic union.
A customs union is deeper than a free-trade agreement as the countries adopt a
common external tariff. A common market is even deeper as it allows for the free
mobility of capital and labor. The movement toward an economic union is more
© 2015 W. Charles Sawyer and Richard L. Sprinkle
complex. Deepening in this context involves a common currency and other measures
such as common taxation, business regulations, and labor regulations.
13.
The common agricultural policy (CAP) 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
CAP guarantees prices for all farm commodities within the EU. The EU 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 US 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.
14.
On January 1, 1989, Canada and the US signed a free-trade agreement. The provisions
of the agreement were to be phased in over 10 years. In 1992, Canada, Mexico, and
the US agreed to broaden the FTA to include Mexico. After much debate in the US
Congress, the agreement was authorized in 1993 and went into effect in 1994. In this
case, the agreement is to be phased in over a 15-year period.
15.
NAFTA has had insignificant overall effects on Canada and the US. Prior to NAFTA,
trade barriers between the two countries were relatively low. The purpose of the
agreement was to eliminate the few significant barriers to a very large volume of trade
between the two countries. The addition of Mexico has had relatively small effects on
the US economy. This is understandable considering the relative size of Mexico and
the US. The major effects of NAFTA have been a significant and ongoing
restructuring of the Mexican economy. Prior to NAFTA, Mexico had relatively high
tariff and nontariff barriers to trade. The elimination of these barriers coupled with the
size of the US economy has produced major changes in the Mexican economy.
16.
From the creation of GATT until the early 1980s, US 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 US government showed little
interest in such agreements. However, beginning in the 1970s there was a slight
change in US policy. First, the US 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 US 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 US. 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 US this is
© 2015 W. Charles Sawyer and Richard L. Sprinkle
frustrating as the US has a comparative advantage in many areas of service trade such
as financial services and insurance. Second, the US 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 US government began pursuing trade liberalization
via RTAs.
17.
MERCOSUR is a customs union composed of Argentina, Brazil, Paraguay, Uruguay,
and Venezuela. It was formed in 1991 and intra-regional tariffs were reduced to zero
by 2000. Starting in 1995, the countries began the process of harmonizing their tariffs
and attempting to create an EU-like “single market”. MERCOSUR has also
completed a free-trade agreement with Chile which will be fully phased in by 2014.
18.
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 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 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.
© 2015 W. Charles Sawyer and Richard L. Sprinkle