International Economics · International Economics WoraphonYamaka Chapter 8: Regional Trading Arrangements Modified form International Economics 9th Editionby Robert J. Carbaugh

International Economics

Woraphon Yamaka

Chapter 8:Regional Trading Arrangements

Modified form International Economics 9th Edition byRobert J. Carbaugh

Review Since World War II, advanced nations have significantly

lowered their trade restrictions. This trade liberalization has stemmed from two approaches.

The first is a reciprocal reduction of trade barriers on a nondiscriminatory basis. Under the General Agreement on Tariffs and Trade (GATT) and World Trade Organization (WTO), member nations acknowledge that tariff reductions agreed on

A second approach to trade liberalization occurs when a small group of nations, typically on a regional basis, form a regional trading arrangement. Under this system, member nations agree to impose lower barriers to trade within the group than to trade with nonmember nations.

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Types of regional trade arrangements Free trade areas is an association of trading nations in which

members agree to remove all tariff and nontariff barriers among themselves. However, each member maintains its own set of trade restrictions against outsiders. (NAFTA, for example)

Customs unions is an agreement among two or more trading partners to remove all tariff and nontariff trade barriers between themselves. In addition, however, each member nation imposes identical trade restrictions against nonparticipants (Benelux)

Common markets is a group of trading nations that permits (EU)

(1) the free movement of goods and services among member nations

(2) the initiation of common external trade restrictions against nonmembers.

(3) the free movement of factors of production across national borders within the economic bloc.

Economic/monetary union : national, social, taxation, and fiscal policies are harmonized and administered by a supranational institution

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Regional trade agreements

Effects of regional trade agreements Static effects (short run)

Trade creation effect Welfare increase(consumption effect, production effect)

Trade diversion effect Welfare loss Dynamic effects (long run)

Economies of scale

Greater competition Investment stimulus

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Static effects of a customs union

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Suppose, There are three countries : Germany, US, and Luxemburg

Germany and Luxemburg form a customs union US is non-member

Situation Luxembourg and Germany abolish all tariff restrictions between themselves while maintaining a common tariff policy against the United States.

Luxe

mbu

rg

Scenario 3

Scenario 2

Scenario 1

Scenario 4

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Scenario 2: Luxembourg and Germany form a customs union Luxembourg must import form Germany

Scenario 3: Luxembourg impose the tariff on US Germany becomes the low-price supplier compared to US. Luxembourg only imports form Germany

trade-creation effect Welfare increasetrade-diversion effectWelfare decrease

There are two short run effects :

Scenario 4: Luxembourg impose the tariff on Germany US becomes the low-price supplier compared to Germany again. Luxembourg only imports form US

Scenario 1: Free Trade: US is the low-price supplier compared to Germany. Luxembourg only imports form US

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The formation of a customs union leads to a welfare-increasing trade creation effect and a welfare-decreasing trade diversion effect. The overall effect of the customs union on the welfare of its members, as well as on the world as a whole, depends on the relative strength of these two opposing forces.

Scenario 1 & 2 : Area c = Luxembourg's imports from a low-cost supplier outside the union are replaced by purchases from a higher-cost supplier within the union (Import expensive products) trade-diversion effect

Scenario 2 & 3 : Area b = Luxembourg increases its consumption of grain (consumption effect)

Scenario 2 & 3 : Area a = Luxembourg decrease its production of grain (production effect) (In this case, the inefficient producer move out from the market)

Regional trade agreements: case studies

Carbaugh, Chap. 9 8

The European Union (EU)

Created by the Treaty of Rome (1957)

Policy aims included:

Abolition(cancel) of tariffs, quotas and other restrictions

Common external tariff (The same customs duties, import quotas, preferences or other non-tariff barriers to trade apply to all goods entering the area, regardless of which country within the area they are entering)

Free movement of capital, labor and business

Common policies on transport, agriculture, and competition and business conduct.

Coordination of monetary and fiscal policies

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The European Union (cont’d)

Lowering of barriers caused within-region trade to grow much more quickly than overall world trade in the 1960s

Steps to remove remaining barriers (1985-92) further increased integration

Maastricht Summit (1991) began process of economic and monetary union (EMU) consists of progressively closer economic integration. EMU came into full effect in 2002 with the

introduction of a common currency, the euro

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Economic & Monetary Union(EMU) Member nations which met economic criteria by 1999 replaced their

national currencies with the Euro in 2002 New European Central Bank created to control monetary and exchange

rate policy

“Convergence criteria” has led to a high degree of uniformity in terms of price inflation, money supply growth, and other key economic factors.

The specific convergence criteria as mandated (announced) by the Maastricht Treaty are as follows

Price stability inflation in each prospective member is supposed to be no more than 1.5 percent above the average of the inflation rates in the three countries with the lowest inflation rates

Low long-term interest rates no more than 2 percent above the average

Stable exchange rates (Stabilizing Euro ) Sound public finances budget deficit in a prospective member should

be at most 3 percent of GDP; the government debt should be no more than 60 percent of a year’s GDP.

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Other key EU policies1) Common agricultural policy (CAP):It has replaced the agricultural-stabilization policies of individual member nations, which differed widely before the formation of the EU.

Support payments to farmers

Variable import levies : A variable import levy is a levy on imports that raises their price to a level at least as high as the domestic price

Export subsidies: to ensure that any surplus agricultural output will be sold overseas.

2) Government procurement policies All EU businesses can bid for larger contracts in any

nation

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CAP: variable levies and export subsidies

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The common agricultural policy of the EU has used variable levies to protect EU farmers from low-cost foreign competition. During periods of falling world prices, the sliding-scale nature of the variable levy results in automatic increases in the EU’s import tariff.At Sworld0 = Free trade, EU need to levy import of $1 per bushel to achieve $ 4.50At Sworld1 = Free trade, EU need to levy import of $2 per bushel to achieve $ 4.50At SEU1 = Export subsidy, boosting the farmer to produce more to offset import goods

European Union Enlargement The EU is negotiating with 12 applicant nations,

mostly transition economies in eastern Europe, for EU membership by 2004

Candidate members had to demonstrate their fitness by achieving: Stability of institutions, and guaranteed

democracy, rule of law, human rights and protection of minorities

A functioning market economy which is ready to compete in the EU market

Adherence to the EU’s aims of political, Economic and Monetary union

However, British exit from the European Union, is the impending withdrawal of the United Kingdom (UK) from the European Union (EU) in 2016

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Costs & benefits of EMU Europe does not meet all the requirements of a

theoretical “optimal currency area” Advantages of EMU

Lower transaction costs

Easier to compare the price Exchange rate risk eliminated

Stimulates competition of EU member

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Costs & benefits of EMU (cont'd)

Disadvantages of EMU: Loss of monetary policy and the exchange rates

as economic adjustment tools

Use of fiscal policy for adjustment is also constrained

Adjustment to shocks therefore depends on wage flexibility and labor mobility, which are both low in Europe

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North American Free Trade Agreement. NAFTA(1994) Gradual and comprehensive elimination of trade

barriers among US, Mexico and Canada over 15 years: Full, phased elimination of import tariffs

Elimination of most NTBs

Protection of intellectual property rights Dispute settlement procedures

Side agreements on environmental protection and labor law

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NAFTA's benefits Mexico stood to gain the most, with access to

large industrial markets and new inward investment flows

Canada maintained its preferences in the US market and hoped for future access to South American markets

US stood to gain from access to the Mexican market and cheap labor and parts, access to reliable oil supplies, and less immigration pressure; but the benefits were modest

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Concerns about NAFTA Main US losers from NAFTA would be import-

protected industries competing with Mexican producers, and unskilled workers

US industrial workers also worried about lower pay scale in Mexico and plant relocations

Concerns Mexico would not enforce environmental protection measures

Thus, the side agreements on environment and labor law were concluded to address those concerns

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NAFTA’s impact so far Trilateral trade increased significantly Some US jobs were lost to Mexico, but

the numbers were small compared to job creation that came with US growth

Changes in investment flows were small (in relation to total US foreign investment)

Closer political ties were built among the three nations, and they refrained from building new trade barriers even during recession

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Special case: economies in transitionNations of eastern Europe and the former

Soviet Union have been making a transition from a non-market economy to a market economy since the early 1990s - which has been very disruptive

These nations’ planned economies required them to be largely isolated from world trade - instead, set up their own trading bloc (trade liberation), the Council for Mutual Economic Assistance (CMEA) with only limited trade with the West

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Economies in transition (cont’d)

Even after the collapse of the central planning system, the nations remained tied together because of historical trade links inside CMEA and their common legacy as non-market economies

There is an ongoing debate over the best pace for economic reform (including trade and financial liberalization) - “shock therapy” vs. “gradualism therapy”

Carbaugh, Chap. 9

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Economies in transition (cont’d)

Barriers to trade with the West used to make strategies such as countertrade, co-production agreements, joint R&Dagreements, and contract manufacturingagreements very common

Gradual elimination of barriers to foreign business in most transition countries has allowed foreign firms to operate in the region more normally in recent years

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International Economics · International Economics WoraphonYamaka Chapter 8: Regional Trading Arrangements Modified form International Economics 9th Editionby Robert J. Carbaugh