Download Document

Chapter 13
Preferential
Arrangements
and Regional
Issues in Trade
Policy
Slides prepared by Thomas Bishop
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:
1. 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.)
2. 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
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.