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  • 1. Regional Trade Agreements Reinert/Windows on the World Economy, 2005
  • 2. Introduction   “Multilateralism” refers to the GATT/WTO system as well as the trade negotiations that take place among all GATT/WTO members as a group Recall that one of the founding principles of this system is nondiscrimination  Involves the most favored nation (MFN) and national treatment (NT) subprinciples • Each WTO member must grant to each other member treatment as favorable as they extend to any other member country  “Regionalism” refers to a violation of the nondiscrimination principle in which one member of a regional trade agreement (RTA) discriminates in its trade policies in favor of another member of the RTA and against nonmembers  Has been allowed by the GATT/WTO under certain circumstances • Free trade areas (FTAs) • Customs unions (CUs) • Interim agreements leading to a FTA or CU “within a reasonable length of time” Reinert/Windows on the World Economy, 2005 2
  • 3. Introduction Regionalism and multilateralism represent two alternative trade policy options  When multilateralism “falters” regionalism “picks up the pace”   Nearly every member of the WTO is also a member of at least one RTA  Over 150 RTAs exist Reinert/Windows on the World Economy, 2005 3
  • 4. Types of Regional Trade Agreements Reinert/Windows on the World Economy, 2005 4
  • 5. Regional Trade Agreements  Consider two countries—Brazil and Argentina  Suppose these countries initially pursue independent and non-preferential trade policies • Trade policies of these two countries are not coordinated in any •  way and do not discriminate among countries There is no integration of the countries’ labor, capital, and money markets First-level RTA is known as preferential trade area  Brazil and Argentina lower their trade barriers between  each other, but do not eliminate them • Labor and capital markets remain unintegrated Because the two countries have not fully eliminated trade barriers between each other, this type of RTA is not allowed by the WTO Reinert/Windows on the World Economy, 2005 5
  • 6. Regional Trade Agreements  Second-level RTA is known as free trade area  Brazil and Argentina eliminate the trade barriers between each other  With regard to non-member countries Brazil and Argentina pursue independent policies Labor and capital markets remain unintegrated   Third-level regional agreement is known as customs union  Brazil and Argentina eliminate the trade barriers between each other  Additionally, member countries adopt common trade barriers with regard to non-member countries (often referred to as a common external tariff) Labor and capital markets remain unintegrated   Fourth-level RTA is known as common market  A customs union in which labor and capital markets are integrated into a regional market • Any restrictions on movements of labor and physical capital (direct foreign investment) have been removed Reinert/Windows on the World Economy, 2005 6
  • 7. Regional Trade Agreements  WTO members who wish to form FTAs or CUs may do so  However, there are certain requirements • Trade barriers against non-members cannot be “higher or more • • • restrictive than” those in existence prior to the FTA or CU FTA or CU must be formed “within a reasonable length of time” FTA or CU must eliminate trade barriers on “substantially all the trade” among the members With regard to services, the General Agreement on Trade in Services (GATS) requires that the FTA or CU involve “substantial sectoral coverage” Reinert/Windows on the World Economy, 2005 7
  • 8. Regional Trade Agreements  How to determine whether a product is from a partner country  Suppose that Brazil and Argentina form a RTA • Shirt produced in Venezuela is imported into Brazil and label • • “Made in Brazil” is attached Shirt can then be imported into Argentina with no restrictions or tariffs—product is not really made in Brazil To protect against such possibilities, RTA members usually define rules of origin  Can be defined in a number of ways, including by  Amount of value added in an RTA partner country  Degree of product transformation Reinert/Windows on the World Economy, 2005 8
  • 9. The Economic Effects of Regional Trade Agreements  Trade creation  Occurs when the formation of a FTA or CU leads to a switching of imports from a high-cost source to a low-cost source • Tends to improve welfare  Trade diversion  Occurs when imports switch from a low-cost source to a high-cost source • Tends to worsen welfare Reinert/Windows on the World Economy, 2005 9
  • 10. Trade Creation and Trade Diversion Let’s discuss trade creation and trade diversion using country specific examples  Along with Brazil (B) and Argentina (A), we are also going to refer to a third country, Venezuela (V)   Brazil and Argentina are members of a RTA, whereas Venezuela is not Reinert/Windows on the World Economy, 2005 10
  • 11. Trade Creation    Before the RTA, Brazil has in place a specific (per unit) tariff on imports from both Argentina and Venezuela Argentina is the lower-cost producer in comparison to Venezuela  Therefore Brazil imports good from Argentina Once Brazil joins either a FTA or CU with Argentina, tariff is removed on imports from Argentina  Good continues to be imported from Argentina and imports increase because price has fallen due to removal of tariff   Consumer surplus in Brazil increases while producer surplus and government tariff revenue falls Net increase in welfare due to trade creation Reinert/Windows on the World Economy, 2005 11
  • 12. Trade Diversion      Before the RTA, Brazil has in place a specific (per unit) tariff on imports from both Argentina and Venezuela Assume Venezuela is now the lower-cost producer in comparison to Argentina  Brazil imports the good from Venezuela Once Brazil joins a FTA or CU with Argentina, however, Brazil switches to Argentina as an import supplier  Imports expand as the domestic price falls Consumer surplus in Brazil increases while producer surplus and government revenue falls Whether net welfare effect is positive or negative depends  If trade-diverting effects outweigh trade-creating effects then RTA will reduce welfare in Brazil Reinert/Windows on the World Economy, 2005 12
  • 13. Regional Trading Agreements (cont.)  Regional/preferential trading agreements increase national welfare when new trade is created, but not when existing trade from the outside world is diverted to trade with member countries.  Trade creation  occurs when high cost domestic production is replaced by low cost imports from other members.  Trade diversion  occurs when low cost imports from non-members are diverted to high cost imports from member nations.
  • 14. Trade Creation       Three countries: Britain($8)>French($6)>US($4) for wheat production. Suppose British Import tariff =$5. Suppose Britain and French forms a customs union. British consumer will buy products domestically since 8<9<11 without a customs union With a CU, then British consumer will purchase from his member country—French since 6<8. This is trade creation since Britain only needs to pay $6 to foreign country compared to its own initial cost $8.
  • 15. Trade Diversion       Three country: Britain($8)>French($6)>US($4) for wheat production. Suppose British Import tariff =$3. Suppose Britain and French forms a customs union. British consumer will buy products from U.S. since 7<8 without a customs union With a CU, then British consumer will purchase from his member country—French since 6<7. Trade diversion: (1) US wheat is really cheaper than French; (2) Import Tariffs revenue disappear.
  • 16. Welfare Effects of Trade Creation  PP’ is the partner-country supply curve.  Tariff removal cuts domestic price from OT to OP, expands imports to M’N’, and raises welfare by areas 2+4.  Here supply curve is perfectly elastic supply so that unlimited quantity is available at price OP.  British consumers enjoy a gain in surplus 1+2+3+4.  But area A is formerly the production gain.  Area 3 is the tariff revenue.  Net benefit=2+4=production benefit + consumption benefit
  • 17. Figure 14.1 Welfare Effects of Trade Creation
  • 18. Welfare Effects of Trade Diversion  Britain and France form the CU, but US has a lowest cost.  Pb indicates pretariff supply price in partner country— France  Pc is the pretariff supply price in the U.S.  Tariff preference lowers internal price from Tc to Pb.  Lowering a tariff (even preferentially) allows a gain to British consumers (areas 3+4)  But areas 3+5 measure the total tariff revenue.  Therefore, welfare loss occurs if area 5 exceeds area 4.
  • 19. Figure 14.2 Welfare Effects of Trade Diversion
  • 20. Net Gains or Losses?  For trade creation predominates trade diversion, UK and FR should be actually competitive before the union and potentially complementary after it comes into effect.  Trade creation gains are greater when protected production is reduced more.  This happens when protective tariffs have made the output pattern of the two economics look similar.  To avoid trade diversion, each member of the PTA must also be the most efficient producer of goods protected.