Transcript 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.