Regional Trading Arrangements

International Economics Chapter 5 Regional Trading Arrangements

Chapter 5 Regional Trading Arrangements • 5.1 Types of Regional Trading Arrangements • 5.2 Effects of Customs Union • 5.3 Practice of Regional Integration

5.1 Types of Regional Trading Arrangements • Free Trade Area • The most common scheme is referred to as a free trade area (FTA), in which all members of the group remove tariffs on each other’s product, while at the same time each member retains its independence in establishing trading policies with nonmembers. • North American Free Trade Agreement (NAFTA)

5.1 Types of Regional Trading Arrangements • Customs Union • Like a free trade association, a customs union (CU) is an agreement among two or more trading partners to remove all tariff and nontariff trade barriers among themselves. • Belgium, the Netherlands, and Luxembourg (BENELUX)

5.1 Types of Regional Trading Arrangements • Common Market • A common market is a group of trading nations that permits the free movement of goods and services among member nations, the initiation of common external trade restrictions against nonmembers, and the free movement of factors of production across national borders within the economic bloc. • The Treaties of Rome in 1957 established a common market within the European Community (EC).

5.1 Types of Regional Trading Arrangements • Economic Union • Beyond these stages, economic integration could evolve to the stage of economic union, which includes all features of a common market but also implies the unification of economic institutions and the coordination of economic policy throughout all member nations. • The Treaties of Rome in 1957 established a common market within the European Community (EC).

5.1 Types of Regional Trading Arrangements Some Regional Trading Arrangements in the World Economy

5.2 Effects of Customs Union • Static Effects • Country A, B, and C. • Assuming that A is the world high-cost producer of beer, and that initially A protects its producer with an ad valorem tariff of 100 percent against all foreign producers. • Suppose that, in autarky, beer would cost $5 per bottle in A, and B would be willing to export beer to A for $2 per bottle, while C, the low-cost world producer, is willing to export beer at a price of $1.5 per bottle.

5.2 Effects of Customs Union Static Effects of Customs Union

5.2 Effects of Customs Union • Now, recall that we have assumed that A has a 100 percent tariff in place. The effect of this tariff is to double the price of imported beer. Thus, the price of beer imported from C rises to $3 per bottle. • Suppose that A were to negotiate a CU with Country B. Under such an arrangement, goods coming to A from Country B would not be charged a tariff. The tariff would remain on any goods coming from Country C. Then, consumers in A could buy beer from B at a price of $2. If they were to buy from C instead, the price would be $3.

5.2 Effects of Customs Union • As this example shows, the formation of a CU can have two effects on international trade. • First, there is the shift in the source of trade from C, the lowest-cost world producer, to B, the lowest-cost CU member nation. This shift in the source of trade is known as trade diversion. • The second effect of the formation of the CU is that trade expands for Country A. Imports rise from EF to GH. This comes about because consumers are able to pay a lower price for imports. The expansion of trade that results from CU formation is known as trade creation.

5.2 Effects of Customs Union • Let us calculate the welfare impact on Nation A of the creation of a CU between A and B. • If A forms a CU with Country B, consumers in A’s benefit. The price they pay fall from $3 to $2. Consumer surplus rises by a+b+c+d. Producer surplus falls by a, while tariff revenue falls by c+e. Netting out these changes in surpluses yields a welfare impact on A of (b+d)−e. • Because of the trade diversion, A no longer trades with Country C. The impact of this is for tariff revenues to fall. Part of this loss of tariff revenues, c, accrues to domestic residents in the form of lower prices. The remaining loss of tariff revenues, Area e, measures the amount of the effect oftrade diversion.

5.2 Effects of Customs Union • Consumers in A pay a lower price to purchase the good, and hence, trade expands. The benefits of international trade are the familiar triangles equal in value to b+d. • The lengths of the bases of the two triangles sum to equal the amount that trade has increased because of the CU. Thus, the sum of these two triangles represents the gain to A from trade creation. Thus, Areas b+d measure the amount of the effect oftrade creation.

5.2 Effects of Customs Union • What about the other nations? • B gains on the export side from this arrangement. It obtains export markets in A that it had previously been unable to penetrate. On the other hand, if A is a higher-cost producer than C, then when B lowers its tariffs on goods from A, it faces ambiguous welfare prospects. Meanwhile, Country C loses because its producers have lost markets. • Clearly, since the effect on A and B is ambiguous and C loses, the worldwide welfare effect of the formation of CU or other preferential trading relationships is anything but certain.

5.2 Effects of Customs Union • In general, A would eliminate its tariff with respect to Country C. The price of beer would fall to $1.5, and imports from C would expand to IJ. • The increase in imports represents pure trade creation. That is, in this example, trade diversion would be zero, since, both before and after the agreement, A trades with C. • For A, the welfare gains of the formation of a CU relative to tariff are b+f+g+d+h+i. • Country C gain as well, because its exports rise. B neither gains nor loses in this case, because its trade has not been affected.

5.2 Effects of Customs Union The Welfare Effects of a CU on Country A

5.2 Effects of Customs Union • Dynamic effects • when a CU is formed and trade barriers among member nations are eliminated, producers in each nation become more efficient to meet the competition of other producers within the union. • A second possible benefit from the formation of a CU is that economies of scale are likely to result from the enlarged market. • Another possible benefit is the stimulus to investment to take advantage of the enlarged market and to meet the increased competition. • These dynamic gains resulting from the formation of a CU are presumed to be much greater than the static gains discussed above and to be very significant.

5.3 Practice of Regional Integration • European Union • In the 1950s, Western Europe began to dismantle its trade barriers in response to successful tariff negotiations under the auspices of the General Agreement on Tariffs and Trade (GATT). • the European Union (EU), first known as the European Community, was created by the Treaty of Rome in 1957. • The EU initially consisted of six nations: Belgium, France, Italy, Luxembourg, the United Kingdom and Ireland, and then Denmark had joined the trade bloc. • Greece became the tenth member in 1981, and the entry of Spain and Portugal in 1987 raised the membership to 12 nations. In 1995, Austria, Finland, and Sweden were admitted into the EU.

5.3 Practice of Regional Integration • Members of the EU first dismantled tariffs and established a free-trade area by 1968. In 1970, the EU became a full-fledged customs union when it adopted a common external tariff system for its members. On January 1, 1993, the EU removed all remaining restrictions on the free flow of goods, services, and resources among its members, thus becoming a single unified market. • The formation of the EU significantly expanded trade in industrial goods with nonmembers. This was due to: • The rapid growth of the EU, which increased its demand for imports of industrial products from outside the union. • The reduction to very low levels of the average tariff on imports of industrial products as a result of the Kennedy and Tokyo Rounds of GATT.

5.3 Practice of Regional Integration • At the Lome Convention in 1975, the EU eliminated most trade barriers on imports from 46 developing nations in Africa, the Caribbean, and the Pacific region that were former colonies of EU nations. • Quotas and tariffs on developing nations’ exports are now scheduled to be gradually reduced as a result of the Uruguay Round of GATT completed in December 1993. • In February 2000, Lome IV expired and was replaced by a new agreement has the same general purpose as the Lome Convention and is to remain in force for 20 years, subject to revisions every five years.

5.3 Practice of Regional Integration • Other highlights in the operation of the EU are as follows: • Member nations have adopted a common value-added tax system, under which a tax is levied on the value added to the product at each stage of its production and passed on to consumers. • The Commission (the executive body of the EU headquartered in Brussels) proposes laws, monitors compliance with treaties, and administers common policies such as antitrust policies. • The Council of Ministers (whose members represent their own national governments) makes final decisions but only on the recommendation of the Commission. • Plans have also been drawn for harmonization of monetary and fiscal policies, and eventual full political union.

5.3 Practice of Regional Integration • North American Free Trade Agreement • The United States discussed for a free-trade agreement with Canada, which became effective in 1989. This paved the way for Mexico, Canada, and the United States to form the North American Free Trade Agreement (NAFTA) that went into effect in 1994. • The establishment of NAFTA was expected to provide each member nation better access to the other’s markets, technology, labor and expertise. • The United States would benefit from Mexico’s pool of cheap and increasingly skilled labor, while Mexico would benefit from the U.S. investment and expertise. • NAFTA eliminates tariffs among the three member nations over a 15-year period and at the same time substantially reduces nontariff barriers.

5.3 Practice of Regional Integration • In the case of automobiles, Mexican tariffs were immediately reduced from 20 to 10 percent and were scheduled to decline to zero over the next 10 year. • In the textile and apparel industry, trade barriers were eliminated on 20 percent of U.S.-Mexican trade and barriers on an additional 60 percent are to be removed over a 6-year period. • With respect to foreign investment and financial services in general, all barriers to the movement of capital were immediately dropped. • NAFTA was the first regional agreement among nations with such diverse income levels

5.3 Practice of Regional Integration • Association of Southeast Asian Nations • The Association of Southeast Asian Nations (ASEAN) now comprises 10 members: Brunei, Indonesia, Malaysia, Philippines, Singapore, Thailand, Vietnam, Laos, Myanmar and Cambodia. • In 1992, ASEAN signed ASEAN Free Trade Area (AFTA) agreement supporting local manufacturing in all members. • The primary goals of AFTA seek to • Increase ASEAN's competitive edge as a production base in the world market through the elimination of tariffs and non-tariff barriers within ASEAN. • Attract more foreign direct investment to ASEAN.

5.3 Practice of Regional Integration • ASEAN Plus Three is a forum that functions as a coordinator of cooperation between ASEAN and the three East Asian nations of China, Japan, and South Korea. • The ASEAN–China Free Trade Area (ACFTA) is a free trade area among the ten members of ASEAN and China. The initial framework agreement was signed in 2002 with the intent on establishing a free trade area among the eleven nations by 2010. • The free trade area came into effect on 1 January 2010. ACFTA is the largest free trade area in terms of population and the third largest in terms of nominal GDP. By July 2010, ASEAN had become China’s third largest trade partner and China had been ASEAN’s largest trade partner.

Regional Trading Arrangements