Chapter 9 -- Preferential Trading Arrangements INTERNATIONAL ECONOMICS, ECO 486 Nearly all of the 140* WTO member countries belong to one (or more) of the 109 PTAs recognized by the WTO. * As of 11/30/2000

Customs Union versus Free Trade Area Members of a Customs Union (CU) adopt common trade policies with non-members –Common external tariff, open borders Members of a Free Trade Area (FTA) maintain independent trade policies with non-members –Rules of origin combat “trade deflection” Common market -- factors to move freely

Benefits Successful CU raises incomes of members Political (e.g., the Germans & the French) Trade should expand (e.g., intra-EU trade doubled) Welfare effects of a customs union (CU) are measured in terms of trade creation and trade diversion

Trade creation versus diversion Trade creation –Production effect (Viner) –Consumption effect (Meade) –Sum (Johnston)

Trade Creating Customs Union Small country A forms a CU with country B B is the low-cost producer of good X. Trade creation (production effect) occurs as some of A’s production is replaced by lower cost imports from another CU member –Initially, A has a $10 tariff on imports from B –Once removed, domestic production falls From 50 to 10 bu/yr.

Trade Creating CU (continued) Trade creation (consumption effect) occurs as A’s consumption expands in response to the low-priced imports from another CU member –Initially, A has a tariff ($10/bu) on imports –Once removed, domestic consumption rises From 120 to 160 bu/yr. A’s welfare and world welfare increases

Trade Creating CU (continued) b DADA SASA a Quantity (bushels of grapes per year) Price ($ per bushel of grapes) SBSB c S B + tariff d Trade creation (production) Trade creation (consumption)

Trade Creating CU (continued) b DADA SASA a Quantity (bushels of grapes per year) Price ($ per bushel of grapes) SBSB c S B + tariff d Trade creation (production) Trade creation (consumption)

Country A’s Welfare Change Trade Creating CU

Trade Diverting Customs Union Small country A forms a CU with country C B is low-cost producer, not C Trade diversion occurs as lower-cost imports from B are replaced by higher-cost imports from C –A removes its tariff on imports from C, but not B –A’s imports from B are diverted to C –Some trade is created: Domestic production falls from 50 to 30 bu/yr Consumption rises from 120 to 140 bu/yr

Welfare Cost of a CU DADA SASA Quantity (bushels of grapes per year) Price ($ per bushel of grapes) SBSB SCSC S C + tariff S B + tariff Trade creation: production Trade creation: consumption Trade diversion

Welfare Cost of a CU b DADA SASA a Quantity (bushels of grapes per year) Price ($ per bushel of grapes) SBSB c SCSC S C + tariff S B + tariff d e Trade creation: production Trade creation: consumption Trade diversion

Country A’s Welfare Change Customs Union

A Customs Union could reduce A’s welfare (& RoW)

Dynamic Benefits of a CU Increased competition –Producers must cut costs and innovate Economies of scale –Although small country producers can exploit economies of scale by exporting Stimulus to investment –“tariff factories” e.g., massive investment by US firms in Europe to avoid being excluded from this market Recent studies indicate dynamic gains are 5 to 6 times the static gains

CU is a “second-best” policy The best policy for a small country is to unilaterally eliminate all trade barriers A large country such as the US worsens its terms of trade (ToT) as it expands its imports US must balance the benefits of unilateral elimination of trade barriers with ToT effects –unilateral elimination is also politically difficult

Building Blocks or Stumbling Blocks? Does CU and FTA formation speed trade liberalization? Or does this process retard multi-lateral trade liberalization? Strong disagreement on this question!

Building Blocks or Stumbling Blocks? “Best of both regimes?” –Trading blocs strive to eliminate external as well as internal trade barriers and easily admit new members.

Welfare Cost of a CU b DADA SASA ac Quantity (bushels of grapes per year) Price ($ per bushel of grapes) SBSB d SCSC S C + tariff S B + tariff e f g h ijk lm n

A Small Country Joins a Customs Union (Horizontal Export Supply) 0 Import Demand, M Quantity (million units per year) Price ($ per unit) $8 P EU 270 = M CU P EU +T P MX 100 = M T T= $2 b+d P MX +T $6 $5 $7 e

Conditions that favor trade creation (rather than diversion) Higher per-CU trade barriers Lower post-CU trade barriers with ROW Greater economic size Competitive members versus complementary members Geographic proximity Greater pre-CU trade among members Source Salvatore, 6 th edition.

What do we mean by valid? A logical argument consists of some assumed statements, called the hypothesis, and a derived statement, called the conclusion. It is called valid if and only if the hypothesis implies the conclusion. Otherwise it is called invalid. Source Clayton W. Dodge, Numbers and Mathematics, page 15.

The domestic market failure argument for a tariff b Domestic demand for honey Domestic Supply of honey a c Quantity (millions of jars of honey per year) Price ($ per jar of honey) World price of honey 7 2 World price + tariff $2/jar 35 d

The domestic market failure argument for a tariff e Marginal Private Benefit Marginal Cost Quantity (millions of jars of honey per year) Price ($ per jar of honey) Marginal Social Benefit

The WTO Length 400 pages in agreement 22,000 pages of supplements Most important results –Trade Liberalization –Administrative reforms Go to slide 44

Trade Liberalization Tariffs reduced on developed country trade –From 6.3 to 3.9% overall –Tariffs on industrial products from 4.7 to 3% –Share of goods with zero tariffs to rise from % to 40-45% –Tariffs removed completely on: Pharmaceuticals, construction equipment, medical equipment, paper products and steel

Trade Liberalization Quotas Antidumping Subsidies Safeguards Intellectual property Services Other industry provisions Trade-related investment measures

Liberalization of Agriculture World trade has been distorted –Japan: Price of rice, beef (& other) several x P w –EU’s massive export subsidies under the CAP US goal for Uruguay: FT in Ag. by 2000 Agreement requires: –Value of subsidies down by 36% –Volume of subsidized exports down by 21% –Both over 6 years –Tariffs replace quotas in ag. Tariffs must not rise

Liberalization of Clothing Trade distorted by Multi-Fiber Arrangement MFA phased out over 10 years –Eliminating all QRs –Some high tariffs remain in place –“Back loaded” Much liberalization postponed until 2003 or 2004

Other Liberalization Government procurement procedures opened imported products VERs Prohibited Sunset clause on all safeguards

Administrative Reforms GATT Secretariat now WTO Dispute Settlement Understanding –Yes, “DSU” –Licenses retaliation General Agreement on Trade in Services –No prior rules. GATS is first set –Services now 25% of world merchandise trade –Many countries discriminate –GATS only requires negotiations to start in 2000

Benefits and Costs World output up by $500 billion per year –US output up by $100 billion per year Estimates may ignore dynamic gains Distributional implications –Benefits widely distributed –Costs imposed on smaller groups Return to slide 28

Definitions Commercial policies are regulations that govern a nation’s international commerce Industrial policy – an activist policy whereby a government seeks to develop some specific industry

Head to Head Lester Thurow popularized the idea that countries compete to “win” certain important industries Trade is NOT a zero-sum game

Which industries? High value added per worker? High wage? High tech?