1. Regional Trade
Agreements
Reinert/Windows on the World Economy, 2005

2. Introduction


“Multilateralism” refers to the GATT/WTO system as well as the trade
negotiations that take place among all GATT/WTO members as a group
Recall that one of the founding principles of this system is
nondiscrimination
 Involves the most favored nation (MFN) and national treatment (NT) subprinciples
• Each WTO member must grant to each other member treatment as favorable as
they extend to any other member country

“Regionalism” refers to a violation of the nondiscrimination principle in
which one member of a regional trade agreement (RTA) discriminates in
its trade policies in favor of another member of the RTA and against
nonmembers
 Has been allowed by the GATT/WTO under certain circumstances
• Free trade areas (FTAs)
• Customs unions (CUs)
• Interim agreements leading to a FTA or CU “within a reasonable length of time”
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3. Introduction
Regionalism and multilateralism represent
two alternative trade policy options
 When multilateralism “falters” regionalism
“picks up the pace”

 Nearly every member of the WTO is also a
member of at least one RTA
 Over 150 RTAs exist
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4. Types of Regional Trade
Agreements
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5. Regional Trade Agreements

Consider two countries—Brazil and Argentina
 Suppose these countries initially pursue independent and
non-preferential trade policies
• Trade policies of these two countries are not coordinated in any
•

way and do not discriminate among countries
There is no integration of the countries’ labor, capital, and money
markets
First-level RTA is known as preferential trade area
 Brazil and Argentina lower their trade barriers between

each other, but do not eliminate them
• Labor and capital markets remain unintegrated
Because the two countries have not fully eliminated trade
barriers between each other, this type of RTA is not
allowed by the WTO
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6. Regional Trade Agreements

Second-level RTA is known as free trade area
 Brazil and Argentina eliminate the trade barriers between each other
 With regard to non-member countries Brazil and Argentina pursue
independent policies
Labor and capital markets remain unintegrated


Third-level regional agreement is known as customs union
 Brazil and Argentina eliminate the trade barriers between each other
 Additionally, member countries adopt common trade barriers with
regard to non-member countries (often referred to as a common
external tariff)
Labor and capital markets remain unintegrated


Fourth-level RTA is known as common market
 A customs union in which labor and capital markets are integrated
into a regional market
• Any restrictions on movements of labor and physical capital (direct
foreign investment) have been removed
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7. Regional Trade Agreements

WTO members who wish to form FTAs or CUs may
do so
 However, there are certain requirements
• Trade barriers against non-members cannot be “higher or more
•
•
•
restrictive than” those in existence prior to the FTA or CU
FTA or CU must be formed “within a reasonable length of time”
FTA or CU must eliminate trade barriers on “substantially all the
trade” among the members
With regard to services, the General Agreement on Trade in
Services (GATS) requires that the FTA or CU involve “substantial
sectoral coverage”
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8. Regional Trade Agreements

How to determine whether a product is from a
partner country
 Suppose that Brazil and Argentina form a RTA
• Shirt produced in Venezuela is imported into Brazil and label
•
•
“Made in Brazil” is attached
Shirt can then be imported into Argentina with no restrictions or
tariffs—product is not really made in Brazil
To protect against such possibilities, RTA members usually
define rules of origin

Can be defined in a number of ways, including by
 Amount of value added in an RTA partner country
 Degree of product transformation
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9. The Economic Effects of
Regional Trade Agreements

Trade creation
 Occurs when the formation of a FTA or CU leads
to a switching of imports from a high-cost source
to a low-cost source
• Tends to improve welfare

Trade diversion
 Occurs when imports switch from a low-cost
source to a high-cost source
• Tends to worsen welfare
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10. Trade Creation and Trade
Diversion
Let’s discuss trade creation and trade
diversion using country specific examples
 Along with Brazil (B) and Argentina (A), we
are also going to refer to a third country,
Venezuela (V)

 Brazil and Argentina are members of a RTA,
whereas Venezuela is not
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11. Trade Creation



Before the RTA, Brazil has in place a specific (per unit) tariff
on imports from both Argentina and Venezuela
Argentina is the lower-cost producer in comparison to
Venezuela
 Therefore Brazil imports good from Argentina
Once Brazil joins either a FTA or CU with Argentina, tariff is
removed on imports from Argentina
 Good continues to be imported from Argentina and imports increase
because price has fallen due to removal of tariff


Consumer surplus in Brazil increases while producer
surplus and government tariff revenue falls
Net increase in welfare due to trade creation
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12. Trade Diversion


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
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Before the RTA, Brazil has in place a specific (per unit) tariff
on imports from both Argentina and Venezuela
Assume Venezuela is now the lower-cost producer in
comparison to Argentina
 Brazil imports the good from Venezuela
Once Brazil joins a FTA or CU with Argentina, however,
Brazil switches to Argentina as an import supplier
 Imports expand as the domestic price falls
Consumer surplus in Brazil increases while producer
surplus and government revenue falls
Whether net welfare effect is positive or negative depends
 If trade-diverting effects outweigh trade-creating effects then RTA
will reduce welfare in Brazil
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13. Regional Trading Agreements
(cont.)

Regional/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.

14. Trade Creation


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
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.

15. Trade Diversion

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



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.

16. 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

17. Figure 14.1 Welfare Effects of
Trade Creation

18. 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.

19. Figure 14.2 Welfare Effects of
Trade Diversion

20. 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.