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Regional Trade Agreements Chapter 8 Copyright © 2009 South-Western, a division of Cengage Learning. All rights reserved. Regional Integration vs Multilateralism o regional trade blocs could be a complement to multilateralism by setting a precedent which other nations will follow o can lead to deeper integration o however regional agreements are also discriminatory in that some nations are treated differently than others o decreases incentives for nations to pursue multilateral agreements o trade bloc members may not gain additional economies of scale through multilateralism Types of Regional Agreements o free-trade area – agreement to remove trade barriers among members example: NAFTA o customs union – agreement to remove trade barriers among members and impose uniform trade restrictions against non-members example: Benelux o common market – agreement that permits (1) free trade among members; (2) common external trade restrictions; and (3) free movement of factors of production example: EU Types of Regional Agreements (cont.) o economic union – common market agreement with : 1) common national, taxation, fiscal, and social policies among members 2) transfers of sovereignty to a supranational authority example: Belgium and Luxembourg 1920s o monetary union – economic union with additional characteristic of common monetary policy and common currency example: United States Static Effects of Trade Arrangements With Tariff: (before customs union) red triangle = consumer surplus green triangle = producer surplus black rectangle = tariff revenue a + b = deadweight loss Static Effects of Trade Arrangements With Customs Union: agreement with Germany will lower the price to SG trade-creation effect: welfare losses now part of consumer surplus a = production effect b = consumption effect trade-diversion effect: area c lost benefits from lower cost suppliers Dynamic Effects of Trade Arrangements o economies of scale – access to a larger market allows producers to become more efficient through greater specialization, better equipment, and usage of by-products o greater competition – increased number of producers makes collusion less likely and forces firms to become more efficient o stimulus of investment – because of increased rate of return and ability to spread R&D costs trade makes greater levels of investment more likely European Union Treaty of Rome – 1957 – established European Community – precursor to EU 1) 1957: Belgium, France, Italy, Luxembourg, Netherlands & West Germany 2) 1973: United Kingdom, Ireland & Denmark 3) 1981: Greece 4) 1987: Spain & Portugal 5) 1995: Austria, Finland & Sweden 6) 2004: Cyprus, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia & Slovenia 7) 2007: Bulgaria & Romania European Union: 1960 - 1985 o EU members removed tariffs in 1968 leading to fivefold increase in trade o EU adopted common external tariffs in 1970 making it a customs union o trade creation: machinery, transportation equipment, chemicals & raw materials o trade diversion: agricultural commodities and raw materials o trade creation exceeded trade diversion o EU saw increases in economies of scale, competition & investment o 1985 EU eliminated nontariff barriers resulting in creation of European common market European Union & Maastricht o 1991 Maastricht Treaty established monetary union and euro as common currency by 2002 o convergence criteria: 1) inflation ≤ 1.5% above average inflation of three countries with lowest inflation 2) long term interest rates ≤ 2.0% above average of same three countries 3) exchange rate within target bands of monetary union for 2 years 4) budget deficit ≤ 3.0% of GDP 5) government debt ≤ 60.0% of GDP EU Agricultural Policy - Variable Levies o no restriction on agriculture traded internally o EU policy based in part on variable levies o adjusted to maintain desired price levels o more restrictive than an import quota in that foreign producers cannot cut prices and absorb tariff cost to maintain export sales EU Agricultural Policy - Subsidies o export subsidies also used to maintain higher prices of EU - common policy o EU producers sell for low price but receive higher price o EU purchases any surplus o surplus then sold on world market for lower price Government Procurement Policies o government purchases previously limited primarily to domestic producers o 1992 EU required bidding process from EU firms o benefits: • • • governments purchase from lower cost producers increased competition remaining firms produce with economies of scale European Monetary Union A common currency also implied the need for a single European Central Bank responsible for all monetary and exchange rate policies of the EMU. o advantages: • eliminated exchange rate risk • reduced currency conversion costs • insulation from monetary disturbance & speculation o disadvantages: • loss of individual monetary authority • transition to common currency could lead to speculative attacks Optimum Currency Areas o definition – region in which it is economically preferable to have a single official currency o success of common currency area: • similar business cycles • similar economic structures • single monetary policy affecting all members in same manner • absence of legal or cultural barriers that would limit labor mobility • wage flexibility • stabilizing transfer system o EU concerns based on rigid wages and limited labor mobility tied to cultural factors North American Free Trade Agreement o free trade area for U.S., Canada & Mexico but not a customs union o issues: • U.S. & Canada represented developed economies while Mexico was a developing economy • Mexico’s authoritarian political system • substantial difference in standard of living between Mexico and Canada & U.S. o decision: integrate Mexico to stimulate development or allow problems in that nation to continue to spill over borders Benefits to Mexico o substantial benefits for Mexico because it integrated with much larger economies o increase in production of goods in which it has comparative advantage o gains at the expense of other low-wage nations o increases in agricultural goods and labor intensive goods o agriculture represents small portion of GDP but supports roughly 25% of the population Benefits & Concerns for Canada o Benefits: • maintain status in international trade • free trade preference in U.S. market • equal access to Mexico’s market • inclusion in future free trade area with Central & South America • economies of scale associated with increased output levels o Possible Cost: closer integration with U.S. as potential threat to Canada’s social welfare system Economies of Scale from NAFTA o access to additional markets increases demand o Canadian producers can sell more autos o increased consumer surplus due to lower price o no worse for producers since costs have dropped Benefits & Costs to the U.S. o Benefits: • expanded trade • increased competition and lower prices • enhanced economies of scale • decrease in illegal immigration • improved political stability in Mexico o Costs: • U.S. industries competing with imports • impact on unskilled workers domestically • potential for environmental consequences • limited benefits due to relative size of these economies Labor Cost Compared to Productivity o Would NAFTA cause many U.S. companies to relocate to Mexico due to lower wages? o Productivity is a major factor in determining cost per unit of output. o Based on higher productivity, U.S. workers can still receive higher wages. NAFTA as Optimum Currency Area? o measures of economic integration: Canada & Mexico are the U.S. largest trading partners o Canada & U.S.: advanced industrial economies with similar per capita incomes, inflation rates and interest rates o Mexico: lower average per capita income, higher inflation rate, higher interest rates, and volatile exchange rate o Mexico adopting U.S. dollar: pro: price & interest rate stability con: loss of independent monetary policy Free Trade Area of the Americas o 1994 proposal calling for agreement among 34 nations in North and South America o potential to become largest trading bloc in the world with 850 million consumers and $14 trillion in combined income o progressive Latin American trade policies: • reduced governmental management • conventional macroeconomic policies to promote growth and stability • failure of import substitution model o challenges: o other free trade agreements o subsidies on agricultural goods Transition Economies o nations making the transition from centrally planned to market economy o countries opting for greater political & economic freedom have seen improved performance and income