Preferential Arrangements and Regional Issues in Trade Policy Chapter 13 Preferential Arrangements and Regional Issues in Trade Policy

Preferential Trading Agreements Preferential trading agreements are trade agreements between countries in which they lower tariffs for each other but not for the rest of the world. Under the WTO, such discriminatory trade policies are generally not allowed: Each country in the WTO promises that all countries will pay tariffs no higher than the nation that pays the lowest: called the “most favored nation” (MFN) principle. An exception to this principle is allowed only if the lowest tariff rate is set at zero.

Preferential Trading Agreements (cont.) There are two types of preferential trading agreements in which tariff rates are set at or near zero: A free trade area: an agreement that allows free trade among members, but each member can have its own trade policy towards non-member countries An example is the North America Free Trade Agreement (NAFTA).

Preferential Trading Agreements (cont.) A customs union: an agreement that allows free trade among members and requires a common external trade policy towards non-member countries. An example is the European Union.

Preferential Trading Agreements (cont.) Are preferential trading agreements necessarily good for national welfare? No, it is possible that national welfare decreases under a preferential trading agreement. How? Rather than gaining tariff revenue from inexpensive imports from world markets, a country may import expensive products from member countries but not gain any tariff revenue.

Preferential Trading Agreements (cont.) 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.

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.

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.

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

Figure 14.1 Welfare Effects of Trade Creation

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.

Figure 14.2 Welfare Effects of Trade Diversion

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.

NAFTA’s Effects Canadian economy is a tenth the size of the U.S. economy. This implies that Canada gets proportionally larger benefits. Why? Like border effects Example With free trade, Canada exports 90% of GDP to US, and sell 10% internally. Border effect (tariff) reduces cross-border trade by a factor on one half. Then, CA exports 45% to US, and sell 55% internally

Canada earns more So internal trade went up by 5.5 times (from 10% to 55%), cross border down by one half (from 90% to 45%), and so internal trade has increased by 11 times more than cross-border trade. US? US used to export 10% of GDP to Canada and 90% at home Now it exports only 5% and internal trade increases to 95%. So internal trade only has a modest change while external trade has fallen in half. So cross-state trade has increased by slightly more than 2 times cross-border trade.

NAFTA’s Effects U.S. and Mexico have very different factor endowments, the scope for trade diversion would seem large. The net benefit to the U.S. would be positive but small, the effect on Mexico positive large. The share of U.S. exports to both Canada and Mexico increase in the 1980’s and 1990’s. This supports the theory that NAFTA creates additional trade. The shift of U.S. import sources toward Mexico coincided with a shift away from East Asia, which suggests trade diversion.