1. Chapter 9 -- Preferential Trading Arrangements INTERNATIONAL ECONOMICS, ECO 486 Nearly all of the 130 WTO member countries belong to one (or more) of the 109 PTAs recognized by the WTO.

2. 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

3. 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

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

5. 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.

6. 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

7. Trade Creating CU (continued) 15 0 10 b DADA SASA a Quantity (bushels of grapes per year) Price ($ per bushel of grapes) SBSB 10 30 c 20 25 S B + tariff d 5070100120140160 Trade creation (production) Trade creation (consumption)

8. Trade Creating CU (continued) 15 0 10 b DADA SASA a Quantity (bushels of grapes per year) Price ($ per bushel of grapes) SBSB 10 30 c 20 25 S B + tariff d 5070100120140160 Trade creation (production) Trade creation (consumption)

9. Country A’s Welfare Change Trade Creating CU

11. 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

12. Welfare Cost of a CU 15 0 10 DADA SASA Quantity (bushels of grapes per year) Price ($ per bushel of grapes) SBSB 10 30 SCSC 20 25 S C + tariff S B + tariff 5070100120140160 Trade creation: production Trade creation: consumption Trade diversion

13. Welfare Cost of a CU 15 0 10 b DADA SASA a Quantity (bushels of grapes per year) Price ($ per bushel of grapes) SBSB 10 30 c SCSC 20 25 S C + tariff S B + tariff d e 5070100120140160 Trade creation: production Trade creation: consumption Trade diversion

14. Country A’s Welfare Change Customs Union

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

16. 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

17. 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

18. 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!

19. 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.

20. Welfare Cost of a CU 15 0 10 b DADA SASA ac Quantity (bushels of grapes per year) Price ($ per bushel of grapes) SBSB 10 30 d SCSC 20 25 S C + tariff S B + tariff e f g h ijk lm n 5070100120140160

21. 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

22. 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.