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Chapter 11 Overview This chapter examines two types of trade barriers that are intended to discriminate between foreign countries. A trade bloc has lower or no barriers for trade between its members, while they maintain higher barriers for trade with outside countries. A trade embargo or trade block places extra barriers against trade with a specific foreign country, usually because of a broader policy disagreement. There are four major types of trade or economic blocs: free-trade area, customs union, common market, and economic union. We usually analyze trade blocs by comparing them to countries maintaining barriers against all other countries. WTO rules generally call for equal trade barriers against all other countries (at least those that are also members of the WTO)—the most-favored-nation principle. But the WTO rules also have a few exceptions, including an exception for a trade bloc that achieves substantially free trade among its members. A trade bloc can have several effects on the well-being of its member countries and the world overall. If forming or joining the trade bloc results in lower prices in the importing member country, the country and the world gain as additional trade is created. If forming or joining the trade bloc results in shifting the source of imports into the country from low-priced suppliers from countries outside the trade bloc to higher-priced partner suppliers, the country and the world lose as trade is diverted from low-cost to higher-cost producers. The net effect depends on whether the gains from trade creation are larger than the losses from trade diversion. There are also possible dynamic gains from forming or joining a trade bloc, including gains if economies of scale are achieved within the larger free-trade area and gains if extra competition within the area leads to better productivity, lower costs, or greater innovation. For the European Union, most estimates are that the EU gains from its internal free trade in manufactures, because trade creation has been larger than trade diversion, and because there are probably also dynamic gains, although these are harder to measure. Additional gains came as the move to a truly common market in 1992 removed nontariff barriers and freed resource movements. However, the EU also incurs substantial losses from its highly protectionist common agricultural policy. The North American Free Trade Area (NAFTA) began in 1994, subsuming the previous Canada-U.S. Free Trade Area. NAFTA eliminates tariffs, reduces some nontariff barriers, and liberalizes trade in services and cross-border business investments. The formation of NAFTA was controversial. In Mexico there were fears of jobs lost to more productive U.S. and Canadian firms, as well as the loss of political sovereignty as NAFTA committed Mexico to change a number of its government policies. In the United States there were fears of job losses to low-wage Mexico, as well as complaints about linking with a country that has a corrupt political system and poor environmental protection. Proponents in both Mexico and the United States hoped that NAFTA would commit the Mexican government to maintain and extend its market-oriented reforms. Estimates indicate that Mexico may gain substantially from the formation of NAFTA, with relatively smaller gains for the United States. Estimates suggest that Canada gained from the formation of the Canada-U.S. Free Trade Area, partly from trade creation and probably partly by achieving scale economies as access to the large U.S. market became assured. Canada had small additional gains from NAFTA. NAFTA is also likely to alter the distribution of income within each country. For instance, less-skilled labor-intensive industries in the United States are likely to face additional pressure from Mexican competition. For decades efforts to form functioning trade blocs among developing countries failed. Success is now more likely, as many developing countries have shifted toward outward-oriented and market-oriented government policies. MERCOSUR (the Southern Common Market) began in 1991 and has been largely successful in freeing internal trade and establishing common external tariffs. Yet, there are some fears that it has also led to substantial trade diversion. A trade embargo is economic warfare. It hurts both the target country and the country imposing the trade block, and it creates opportunities for other countries that are not taking part in the embargo. An embargo can fail to force the target country to change its policy for at least two reasons. First, the target country's national decision makers may decide that they can and must endure their losses, even if these losses are large—political failure of an embargo. Second, the embargo may simply fail to inflict much loss on the target country—economic failure of an embargo. An embargo that prohibits exports to the target country is more likely to succeed economically when the target country has an inelastic demand for imports and countries outside the embargo have low elasticities of export supply. This is more likely when a group of large countries impose an embargo on a small country, and when the embargo is sudden and extreme. Objectives of the Chapter Previous chapters emphasized import barriers that are mainly imposed to restrict imports from all countries. This chapter, however, examines import barriers meant to discriminate between countries, taxing goods and services (and assets) from some countries more than others. Some export barriers may also be imposed to direct the flow of merchandise and assets' trade to some countries more than others. Chapter Eleven discusses the different forms of economic integration (including trade blocs) and their economic ramifications. Trade blocs have become increasingly important in recent years. Specifically, the European Union and the North American Free Trade Area have revived interest in the study of economic integration and trade blocs. After studying Chapter Eleven you should be able to identify: I . The different forms of economic integration. Key Terms Common market: An international union going beyond a customs union by also allowing for the free movement of labor and capital (factor flows) among member nations. Customs union: One in which members remove all barriers to trade among themselves and adopt a common set of external barriers, thereby eliminating the need for customs inspection at internal borders (e.g., MERCOSUR today, and the EEC from 1957 1992). Economic sanctions: Discriminatory restrictions or complete bans on economic exchange, designed to punish the target country or countries. Economic Union: One which extends a common market by harmonizing the monetary and fiscal policies of the member nations as well. Embargoes (boycotts): Complete bans on economic exchange. Free trade area: An area in which members remove trade barriers among themselves but keep their separate national barriers against trade with the outside world. Trade blocs: Forms of economic integration whereby members remove explicit trade barriers among themselves, but keep national barriers to the flow of labor and capital and their fiscal and monetary autonomy. Trade blocs are exemplified mainly by free trade areas and custom unions. Trade creation: The increase in trade volume caused by union with a lower cost (more efficient) supplier within the trade bloc. Trade diversion: The volume of trade shifted from a lower cost (more efficient) supplier outside the trade bloc to a higher cost (less efficient) supplier within the union. Warm up Questions True or False? Explain 1. T / F Trade discrimination is bad in the sense that separate deals with separate nations may destroy much of the gains from global markets. 2. T / F The formation of a customs union will definitely raise welfare.
3. T / F The less elastic the import demand curve, the greater the gains from a customs union.
4. T / F Customs unions are more likely to be successful among developed countries than among less developed countries. 63 5. T / F An export embargo will backfire if the embargoing country has an inelastic export supply curve while the target country has an elastic import demand curve Multiple Choice 1. If all member nations of a customs union .are fully employed before and after the formation of the union, then (assuming that trade diversion does not dominate):
2. Trade sanctions are:
3. Which of the following is not correct?
4. The United States was able to initiate most of the trade embargoes in the last four decades mainly because:
5. If, after the creation of the EU, the British have an incentive to purchase less efficiently produced Irish cheese rather than importing inexpensive cheese from New Zealand, this probably shows:
Problems 1. If Saxony and Leinster currently have no barriers to free trade between them, are they a free trade area, a customs union, a common market or an economic union? Explain: 2. Suppose that the United States currently imports 1,000 pairs of shoes from South Korea at $20 per pair. With a 50 percent tariff, the consumer price in the United States is $30 per pair. The price of shoes in Mexico is $25 per pair. If the U.S. and Mexico were to reach a free trade agreement, the United States would import 1,200 pairs of shoes from Mexico and none from South Korea. Draw a graph to analyze possible welfare changes (in dollars) to American consumers, the U.S. government, and the nation as a whole. 3. Explorers from Saxony have discovered a third country called Avalon in our hypothetical world. After a rest stop and a bite to eat, they notice that telephones in Avalon are much less expensive than they are in their own country. Upon their return the explorers relay this information to Saxony's Minister of Trade, who has been thinking about setting up a customs union with Leinster. Further exploration has revealed to the Trade Minister the following additional information: autarky (pre trade) price of telephones in Saxony autarky (pre trade) price of telephones in Leinster autarky (pre trade) price of telephones in Avalon 5 loaves of bread 1 2/3 loaves of bread 1 loaf of bread Use this information to advise the Trade Minister whether a Saxony Leinster customs union would be trade creating or trade diverting assuming that: a. The initial Saxon tariff on all imported telephones was a specific tariff of 4 1/3 loaves of bread per telephone. b. The initial Saxon tariff on imported telephones was a specific tariff of 1 loaf of bread per telephone. 4. Suppose signing the North American Free Trade Agreement (NAFTA) charges U.S. import quantities as follows (you may assume there is no effect on U.S. imports from Canada): U.S. imports from Mexico U.S. imports from outside North America Before NAFTA $30 billion $300 billion After NAFTA $50 billion $295 billion Does this evidence suggest a net world welfare gain or welfare loss from NAFTA? 5. Our happy hypothetical world is not as happy as it had seemed: the Saxon government has received information about widespread human rights abuses in Leinster. It decides to embargo the export of bread to Leinster as punishment. 66 a. Would a Saxon embargo of the sale of bread to Leinster be effective? b. World the embargo be a successful political weapon? Discussion Topics 1. If Japan were to join a free trade area with one other country, which country would you suggest it be? 2. Do you think the proliferation of trade blocs will increase or decrease tensions among the countries of the world? 3. Do you think the American embargo on Cuba has be an economic success? Has it been a political success? 4. When the Soviet Union invaded Afghanistan in 1979, the United States placed a grain embargo on the U.S.S.R. Discuss the economic and noneconomic implications of using food as a "weapon."
Suggested answers to questions and problems (in the textbook) 2. The most favored nation principle states that any trade policy concession given by a country to any foreign country must be given to all other foreign countries having MFN status. WTO rules state that all WTO members are entitled to MFN status, but there are some exceptions. 4. In a free trade area the member countries permit free trade among themselves but each maintains its own set of tariffs and nontariff barriers to imports from outside countries. Rules of origin are necessary to prevent outside countries from sending their exports into a low-barrier member country and then shipping these products on to a high-barrier member country, to circumvent the high barriers in this second member country. Rules of origin can be protectionist because they act like area-wide local content requirements. If a high local content is required, then it can force firms to use materials and components produced within the free trade area (rather than importing these items from outside the area). 6. Mexico is likely to gain from NAFTA, as trade creation is likely to be larger than trade diversion, and Mexican firms also gain better access to selling to the large U.S. market. In Mexico, the gains will be largest for those sectors tied to exports and for those resources (including less-skilled labor) that are relatively abundant in Mexico. The United States and Canada are also likely to gain, with gains to those export sectors that can increase their sales to Mexico and to resources that are relatively abundant in these countries, including skilled labor. Outside countries are likely to be hurt by trade diversion, but estimates are that this effect is small. 8. Trade embargoes are usually imposed by large countries that are important in the trade of the target country. An embargo has a better chance to succeed if it is imposed suddenly rather than gradually, because a sudden interruption of economic flows damages the target country by a large amount for some time before it can develop alternatives (in economic terms, for a good that the target imports, its import demand is inelastic in the short run, and the elasticity of alternative export supplies may be inelastic in the short run as well).
There are three relevant types of countries—the embargoing countries that otherwise would import, the non-embargo importing countries, and the target country (say, Iraq). Before the embargo (free trade), the world price is P0. When the embargo is imposed, the price in the embargoing countries rises to P2, and the price that Iraq gets for its exports to the non-embargo countries falls to P1. The cost of the embargo to the embargoing countries is area a. The loss to Iraq from exporting less at a lower price is area (b + c). The embargo is more powerful if area (b + c) is larger, and this is larger if Iraq's export supply is less elastic, the non-embargo countries' import demand is less elastic, or the embargoing countries' import demand is more elastic. This last condition probably also makes it easier for embargoing countries to do without Iraq's products during the embargo, because area a is probably
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