Trade agreements in the international economy

Trade agreements and trade liberalisation are two essential components in the drive to increase the
rate of growth of world trade.

o Trade agreements can involve two countries reducing tariffs on each other’s goods, or perhaps
reducing bureaucracy by simplifying import/export procedures.
o Trade liberalisation might involve creating free-trade areas. This creates larger markets,
greater access to raw materials, and more competition. The happy ending should be lower unit
costs, since firms are able to gain economies of scale. From the consumers’ point of view,
lower prices and greater choice should make them happy too.

Briefly now we consider the emergence of regional trading agreements between countries.

Growth of Regional Trade Agreements

An important feature of international trade arrangements between countries over the last two decades
has been a significant expansion of regional trade agreements (RTAs) across the global economy. Some
of these agreements are simply free-trade agreements which involve a reduction in current tariff and
non-tariff import controls so as to liberalise trade in goods and services between countries. The most
sophisticated RTAs go beyond traditional trade policy mechanisms, to include regional rules on flows of
investment, co-ordination of competition policies, agreements on environmental policies and the free
movement of labour.

Examples of regional trade agreements:

o The European Union (EU) – a customs union, a single market and now with a single currency
o The European Free Trade Area (EFTA)
o The North American Free Trade Agreement (NAFTA) – created in 1994
o Mercosur - a customs union between Brazil, Argentina, Uruguay, Paraguay and Venezuela
o The Association of Southeast Asian Nations (ASEAN) Free Trade Area (AFTA)
o The Common Market of Eastern and Southern Africa (COMESA)
o The South Asian Free Trade Area (SAFTA) created in January 2006 and containing countries
such as India and Pakistan

Economic Integration between Countries

There are many different types of economic integration between countries and these are summarised
below. A free trade area is a fairly loose form of integration where countries simply agree to remove
tariff and non-tariff barriers between them to promote free trade in goods and services. The North
American Free Trade Area (NAFTA) is a good example of this as is the European Free Trade Area
(EFTA). ASEAN (Association of South East Nations), the Andean Pact, and Mercosur are other examples.

Customs Union

The EU is a customs union. A customs union comprises two (or more) countries which agree to:

1. Abolish tariffs and quotas between member nations to encourage free movement of goods
and services. Goods and services that originate in the EU circulate between Member States
duty-free. However these products might be subject to other charges such as excise duty and
VAT.
2. Adopt a common external tariff (CET) on imports from non-members countries. Thus, in the
case of the EU, the tariff imposed on, say, imports of Japanese TV sets will be the same in the
 UK as in any other member country. The important point about a common external tariff is
that it prevents individual countries imposing their own unilateral tariffs on different products
that differ from other nations in the customs union.

3. Preferential tariff rates apply to preferential or free-trade agreements which the EU has
entered into with third countries or groupings of third countries.

4. The EU, as well as all its member states are a member of the World Trade Organisation and,
officially at least, subscribes to its free trade ethos. The EU certainly argues in principle for
more free trade, but mainly in areas where free trade is to the advantage of the EU! For
example, the EU is ready to use the WTO appeals mechanism in its frequent disputes with the
USA (the recent battle over the introduction of US steel tariffs is a good example to quote).
5. A customs union shares the revenue from the CET in a pre-determined way – in this case the
revenue goes into the main EU budget fund. In 2003, 80% of total EU expenditure goes on
agricultural spending and cohesion funds. We shall return to this when we consider agricultural
policy and regional policy.
6. The EU receives its revenues from customs duties from the common tariff, agricultural levies
and countries paying 1% of their VAT base. Payments are also made through contributions made
by member states based on their national incomes. Thus relatively poorer countries pay less
into the EU and tend to be net recipients of EU finances.
7. A single market represents a deeper form of integration than a customs union. It involves the
free movement of goods and services, capital and labour and the concept are broadened to
encompass economic policy harmonisation for example in the areas of health and safety
legislation and monopoly & competition policy. Deeper economic integration requires some
degree of political integration, which also requires shared aims and values between nations.
8. The economic effects of the creation and development of a customs union can be analysed
both in the short term and the long term. We make an important distinction between trade
creation and trade diversion effects

Trade Creation

This involves a shift in domestic consumer spending from a higher cost domestic source to a
lower cost partner source within the EU, as a result of the abolition tariffs on intra-union
trade. So for example UK households may switch their spending on car and home insurance
away from a higher-priced UK supplier towards a French insurance company operating in the UK
market.

Similarly, Western European car manufacturers may be able to find and then benefit from a
cheaper source of glass or rubber for tyres from other countries within the customs union than
if they were reliant on domestic supply sources with trade restrictions in place. Trade creation
should stimulate an increase in intra-EU trade within the customs union and should, in theory,
lead to an improvement in the efficient allocation of scarce resources and gains in consumer
and producer welfare.
Trade Diversion

Trade diversion is best described as a shift in domestic consumer spending from a lower cost world
source to a higher cost partner source (e.g. from another country within the EU-27) as a result of the
elimination of tariffs on imports from the partner. The common external tariff on many goods and
services coming into the EU makes imports more expensive. This can lead to higher costs for producers
and higher prices for consumers if previously they had access to a lower cost / lower price supply from
a non-EU country. The diagram next illustrates the potential welfare consequences of imposing an
import tariff on goods and services coming into the European Union.

In general, protectionism in the forms of an import tariff results in a deadweight social loss of welfare.
Only short term protectionist measures, like those to protect infant industries, can be defended
robustly in terms of efficiency. The common external tariff will have resulted in some deadweight
social loss if it has in total raised tariffs between EU countries and those outside the EU.

The overall effect of a customs union on the economic welfare of citizens in a country depends on
whether the customs union creates effects that are mainly trade creating or trade diverting.