TRADE BLOCS. Trade Blocs page 1

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1 TRADE BLOCS The Treaty of Rome reached in 1957 set in motion a process of integrating the economies of Western Europe. As we enter the new millennium, the European Union, instituting a common currency (the Euro) is achieving a level of economic integration which is beginning to rival that in the US. The student is encouraged to visit the EU s homepage at on the web. In 1988 the US signed a free trade agreement with Canada. In 1994 the agreement was extended to include Mexico. With concurrent trade liberalization in the rest of Latin America, there is a momentum that may lead to a Western Hemispheric trade bloc. The Bush and Clinton administrations have advocated the expansion of NAFTA into the Trade Bloc of the Americas, but resistance by labor groups in the US has stalled progress. NAFTA s homepage at is also interesting reading. The countries of the Pacific Rim already in the political union called ASEAN - Association of South East Asian Nations - are slowly progressing in forming a free trade agreement between them. On a broader scale APEC, the Asian Pacific Economic Cooperation, includes not only the ASEAN nations but all Pacific Rim countries. Current APEC membership includes Australia, Brunei, Canada, Chile, People's Republic of China, Hong Kong, Indonesia, Korea, Japan, Malaysia, Mexico, New Zealand, Papua New Guinea, the Philippines, Singapore, Chinese Taipei, Thailand, and the United States of America. What are the implications of this regionalization on continued liberalization of international trade? This is a controversial topic. The two sides of the issue give opposing answers to the following two questions. Does regionalization mean the abandonment of WTO (GATT)? Will regionalization help or hinder the goal of global free trade? What is important is that regionalization is occurring and we need to have an understanding of its implications. There are several types of preferential trading arrangements. These are based on the level of integration among participating countries. These are listed below in order of the level of economic integration from least to most.a free trade agreement is the removal of barriers of trade between members. It still requires border checks between members since individual countries still have different trade relations with the rest of the world. This leads to what is known as the transshipment problem. Transshipment is when goods are shipped through a third country. A foreign exporter in order to avoid high tariffs would export its goods to the member country with Trade Blocs page 1

2 TRADE BLOCS Andean Group Arab Maghreb Union Asia Pacific Economic Cooperation Forum APEC Association of Southeast Asian Nations ASEAN Caribbean Community and Common Market CARICOM Central American Common Market Commonwealth of Independent States CIS Economic Community of Central African States CEEAC Economic Community of West African States ECOWAS European Free Trade Association EFTA European Union EU Latin American Integration Association LAIA North American Free Trade Agreement NAFTA South Asian Association for Regional Cooperation SAARC Southern Cone Common Market MERCOSUR members of the customs union. the lowest tariff rates and then ship the product to other member countries with relatively higher tariff rates. To avoid this problem, free trade agreements usually contain local content regulations. Customs unions not only have removal of trade barriers the same as FTA but they have a higher level of integration by including a common external tariff. With a common external tariff, all members adopt the same trade policies with the rest of the world. This does away with the transshipment problem since tariff rates are the same across all A common market has the same provisions as a customs union but also eliminates barriers to factor movements among its members. This is a significant jump in the level of integration. Labor is now free to migrate between countries in a common market. An economic union, the European Union for example, augments the level of integration found in a common market. It requires the coordination of economic policy among its members. This may take the shape of a common currency or restrictions on fiscal policy. As we move up the level of economic integration the greater will be the loss of national sovereignty for the individual member. A country s ability to set its own course diminishes as policymaking is done at the union level. THEORY OF TRADE BLOCS The formation of a trade bloc is achieved by granting preferential treatment to member nations as opposed to non-members. The realignment of countries into a trade bloc will have effects that are both immediate and also that develop over time. Trade Blocs page 2

3 Static effects The static effect leads to a change in the trade patterns among members as well as with nonmember countries. We use the welfare economic tools of consumer and producer surplus to analyze the implications of forming a trade bloc. The change in the patterns of trade has two major static effects, one that leads to a more efficient allocation of resources, and the other which is movement away from global comparative advantage. Trade creation, which increases efficiency in the allocation of resources, arises from the removal of trade barriers between member countries. The major result of this is, barring any other impediments, that resources among member countries will be applied to activities for which they have the lowest opportunity costs among S the member nations, in essence to their comparative advantages. Suppose there are two countries in a trade bloc, the US and Mexico. Further suppose P* + t A B C D that Mexico is a lower cost producer of an P* item. Thus the US would import the good. Figure 1 portrays the US s demand and D supply of the good. With a tariff, imports qs qst qdt qd Quantity are restricted to qdt-qst. Figure 1 The elimination of the US tariff (t) on Mexican imports, leads to a gain for US consumers of the areas A+B+C+D. Of these, A and C represent transfers for producers and government, respectively. Hence the net gain which accrues to the country are areas B and D which results from the elimination of deadweight loss. This is similar to our previous discussion of the costs of a tariff. The other static effect, trade diversion, leads to a less efficient allocation of resources. The discussion of trade diversion requires introducing an outside non-member nation into the analysis. In essence by giving preferential treatment to member countries over non-members, the possibility exists that production of the good will shift from the lowest cost producer to a higher cost Trade Blocs page 3

4 producer. This would represent a shift away from comparative advantage and a less efficient allocation of resources. Suppose there are three countries, the US, Mexico and Chile. Of these, let Chile be the lowest cost producer of the good, while the US is the highest cost producer. In Figure 2 Chile s price (Pc) is lower than Mexico s (Pm), whereas the US autarkic price (Pa) is higher than both the others. Pm + t Pc + t Pm Pc Figure 2 A B qs qst C E Sa D Da qdt qd Quantity Prior to the US entering a trade bloc with Mexico, Chile has both the comparative advantage as well as the competitive advantage in producing and selling the good. Competitive advantage is defined here as the full price of the good to US consumers. This would be inclusive of taxes and tariffs. With a uniform tariff against both Mexico and Chile, Chile s competitive price (Pc + t) would still be lower than Mexico s competitive price (Pm + t). In this case, the US will import the good from Chile. If the US and Mexico form a trade bloc exclusive of Chile, the set of relevant prices to US consumers changes because the tariffs on Mexican goods are eliminated. This gives Mexico the competitive advantage even though Chile has a comparative advantage. Now, with Pm being less than Pc+t, the good will be imported from Mexico instead of Chile. So, as a result of the trade bloc, production of the good shifts away from the lowest cost producer, Chile, to the higher cost producer, Mexico. This represents a movement away from comparative advantage and leads to a less efficient allocation of resources. The welfare implications require comparing consumer and producer surpluses before and after the formation of the trade bloc. Initially, US consumers paid Pc+t for the good and the US government earned tariff revenues of t*(q dt -q st ) given by areas C+E. With the formation of the trade bloc, price fell to Pm when the tariff was eliminated. Consumers in the US gain areas A+B+C+D of which A and C represent transfers from producers and government, respectively. Government lost all tariff revenue. Area C is transferred to consumers and area E represents a loss not being captured by anyone. Areas B + D represented the deadweight loss of having the tariff which now goes to Trade Blocs page 4

5 consumers because of the trade bloc. Therefore the net gain to society is the sum of areas B+D less area E. Should area E be greater than B+D, then the US could be made worse off for having joined the trade bloc. The degree of trade diversion will depend upon two factors: the level of protection levied against non-member nations, and the differential in the costs of production between the low-cost member producer and the lowest-cost non-member producer. What is important is a comparison of the competitive costs between the two. The country that will prevail, after all is said and done, is the one that can provide the good to US consumers the most cheaply. Mexico has the advantage of not having the tariff but Chile has the lower cost of production. For trade diversion to occur, Chile has the comparative advantage ( Pm > Pc) but Mexico has the competitive advantage (Pc + t > Pm). With this last statement, the greater the difference between Pc+t and Pm, the greater the scope for trade diversion. Subtracting Pm from Pc+t and rearranging terms gives the price spread of (Pc-Pm) + t. The larger this number, the greater the possibilities for trade diversion. Note that we have two counteracting forces. The tariff (t) is a positive number and so the greater the preferential treatment accorded to the member nation the more likely trade diversion will occur. The first term represents the differential in the cost of production between Chile and Mexico. Since Chile has the comparative advantage, it is a negative number. If Chile s costs of production are less than Mexico s by an amount greater than the tariff, [ -(Pc-Pm) > t ], then Chile can absorb the tariff and still retain the competitive advantage and no trade diversion occurs. But, as either the tariff rises or the cost differential narrows, the greater the price spread and the scope for trade diversion. In a world of growing regionalization where industrial countries are including middle-income countries in trade blocs, the implications for trade diversion are enormous. For example, NAFTA s combining the US and Mexico will lead to a great deal of trade diversion from nonmember countries with similar cost structures as Mexico. The advantages that accrue to Mexico will be at the expense of other middle- income countries, particularly of the Pacific Rim and Latin America. Trade Blocs page 5

6 Dynamic Effects Joining a trade bloc increases the size of the market that a firm can sell to. This has important implications with regards to economies of scale, especially for smaller countries. A small country may not have sufficient market demand for a firm to fully capture economies of scale. In Europe s situation with many small countries, there was a high degree of redundancy in the number of firms, each servicing domestic markets. Each firm was in essence inefficient in that the size of the domestic market did not allow it to expand production sufficiently to enjoy the low costs of largescale production. With the formation of the EU, the number of firms will decrease but the size of the remaining firms will expand, creating efficiency. Reports about the European Union estimate the gains from economies of scale will lead to about a 3% expansion of European production. Increasing market size will also diminish the market power of individual firms. By opening up markets, domestic firms will face greater competition. Monopoly power will fade as a result, and domestic firms will have an incentive to increase productivity through implementing newer technology or better management. In situations where partner countries are dissimilar in capital endowments, there may also exist possibilities for investment. Capital will find the highest return. In general this is where capital is scarce. Trade Blocs page 6

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