Preferential Trade Arrangements

1
Preferential Trade Arrangements
EC246 International Trade Institutions and
Policy

• Holger Breinlich
• University of Essex

2
Overview of Lecture

• Introduction
• Theory of Preferential Arrangements
• Forms and Rationale
• Welfare Effects Trade creation trade diversion
• Preferential Arrangements in Practice
• European Union
• CUSFTA and NAFTA
• Summary and Learning Outcomes

3
Theoretical Considerations
4
Forms of Preferential Trade Arrangements

• Definition inside no trade barriers, outside yes
• Forms
• Free Trade Area (FTA) free movement of goods
  inside
• Customs Union 1. common external tariff
• Common Market 2. free movement of factors of
  production inside
• Economic and Monetary Union 3.
  coordinated/unified fiscal, monetary and
  socioeconomic policies
• Clearly discriminatory recall MFN in GATT
• But exception under GATT (historical reasons
  some free trade better than none at all?)

5
Details Customs Union vs. FTA

• FTA like CU but no Common External Tariff (CET)
• Opens door to tariff cheats goods from RoW
  destined for Home market enter via Partner if
  Partner has lower external tariff (trade
  deflection).
• Solution is rules of origin to establish where
  a good was made.
• Problems Difficult and expensive to administer
• Rules often become vehicle for disguised
  protection.
• Despite the origin-problem in FTAs, almost all
  preferential trade arrangements in world are FTAs
• Coordination cost in CU Must agree on CET and
  how to change it, including anti-dumping duties,
  etc.
• Usually solved through some form of political
  integration (in the EU the Commission sets the
  CET)

6
Effects of Preferential Liberalization

• Preferential arrangements both
• Liberalise trade inside, by lower or zero
  restrictions
• Distort trade between inside and outside, by
  forcing inside consumers to pay different prices
  for identical goods at the same (inside) market
  location depending on product origin
• Jacob Viner, The Customs Union Issue, 1950 first
  formal analysis that tariff preferences can
• either improve resource allocations
• or worsen them
• depending on whether trade creation outweighs
  trade diversion or not

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Trade Creation

• CFJ, Figure 14.1 (next slide) assumptions
• A and B inside the union
• B the most efficient world producer of good x
• B the sole world exporter of good x
• x is produced in B under conditions of perfectly
  elastic supply an unlimited quantity of x is
  available at its price (P1 in diagram)
• C (the rest of the world) remains outside the
  union
• CFJ, Figure 14.1 just the inverse logic of CFJ,
  Figure 10.1 welfare effects of imposing a tariff
• 24 net benefit from trade creation ( earlier
  deadweight loss from tariff)

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Trade Creation - Illustration
9
Trade Diversion

• CFJ, Figure 14.2 (next slide) assumptions
• A and B inside, C outside the union
• Consider another good y not produced in A
• C the most efficient world producer of y
• y is produced in C under conditions of perfectly
  elastic supply
• B can also produce (and export) y - not as
  efficiently as C but efficiently enough to
  undercut C in As market when C pays a tariff but
  B not (since it is inside the union)
• Now consider removing the tariff of imports from
  B but not from C
• If area 5 gt area 4 net welfare loss from trade
  diversion

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Trade Diversion - Illustration
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Trade Creation vs. Trade Diversion

• Intuition for results
• We gain because w/o tariffs, partner prices are
  less distorted (consumers see price closer to the
  true costs of production)
• We loose because there is a new source of
  distortion Consumers in A face lower price for
  goods from B although production there is less
  efficient than in C.
• Are there net gains or losses?
• Gains will be higher if we integrate with more
  efficient producers of a good (TB-TC smaller)
• Gains higher the larger the PTA more likely to
  have most efficient producer inside
• Gains also higher if inefficient domestic
  production reduced (not in graph)
• Gains higher if we can lower ToT of outsiders
  (need market power, i.e. be a big country) (not
  in graph)

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Preferential Arrangements in Practice
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European Union Key Dates

• Establishment of a Customs Union (1957-1968)
• 1957 Treaty of Rome ? EEC6 (F, D, I, NL, B-L)
• 1968 Staged reductions in inside tariffs
  completed, common external tariff established
• Establishment of a Common Market (the Single
  Market Programme 1985-1992)
• 1985 List of 300 NTBs gt obstacles to intra-EU
  trade and factor movement (product-safety
  standards licensing of professions barriers to
  cross-border capital movements, MA etc.)
• 1988-1992 removal of most NTBs but some still
  remain

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European Union Key Dates

• Maastricht Treaty establishing the Economic and
  Monetary Union (EMU) commitment to long-run
  economic and political convergence
• 1992 Treaty of Maastricht signed, ratified by
  all members in 1993
• Not only about monetary union, also restrictions
  on fiscal policy (the Stability and Growth
  Pact)
• 1999 Euro introduced as common currency
• Various enlargements along the way 1) UK,
  Denmark, Ireland 2) Greece 3) Spain, Portugal
  4) Austria, Sweden, Finland 5) Poland, Hungary,
  Slovakia, Czech Republic, Slovenia, Estonia,
  Latvia, Lithuania, Malta, Cyprus 6) Romania,
  Bulgaria

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Trade Creation and Diversion in the EU

• Supply Switching
• EEC6 share of exports to itself increased from
  30 in 1958 to 45 in 1968.
• Share of UK, Ireland, Portugal, Spain, Denmark,
  Greece (Other 6 Europe) fell from 9 to 7.
• Share of RoW fell from 61 to 48.

Source European Commission
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Trade Creation and Diversion in the EU

• Mordechai Kreinin (1974), Trade Relations of the
  EEC An Empirical Investigation
• Looked at changes in the sources of supply of
  manufactures in EU countries to identify trade
  creation and diversion
• Approximates trade created by the reduction in
  shares of each EU countrys consumption of
  manufactures supplied by its domestic producers
• Approximates trade diversion by the increase in
  the share of EU countries imports coming from
  exporters of EU partner countries
• Finds that in 1969-1970 EU caused trade diversion
  of 1.1 billion vs. trade creation of 8.4
  billion

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PTAs and EU Enlargement Is there a Link?

• Preferential liberalization within EEC6 diverted
  trade from non-members (UK, Sweden, Switzerland
  )
• Tried to counter with creation of EFTA (figure 1)
• But EEC6 much bigger and growing faster ?
  pressure to join increased
• 1973 UK, Ireland, Denmark join remaining EFTAns
  sign FTAs with the EEC9 (Domino Effect) (figure
  2)
• Single Market Program brings second domino effect
• Remaining EFTAns participate in SMP shortly after
  completion
• Since initially no say in its functioning, most
  members join EU shortly afterwards (Austria,
  Finland, Sweden)

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1960-1973 Two Non-Overlapping Circles
IS
EFTA-7
NL
D
B
L
N
FIN
S
F
DK
I
EEC-6
UK
A
P
IRL
CH
West European Trade Arrangements in the
1960s The EFTA-7 and the EEC-6 form two
E
GR
non-overlapping circles.
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The Mid 1970s Two Concentric Circles
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CUSFTA and NAFTA

• 1987 US and Canada negotiated the Canada-U.S.
  Free Trade Agreement (an FTA, not a Customs
  Union)
• From Jan 1, 1989 Removal over a decade of all
  tariffs and quotas on most goods and services
• 1992 US-Mexico and Canada-Mexico negotiated
  similar bilateral FTAs ? NAFTA in effect since
  1994
• Both agreements expected to have strong impact on
  the two smaller partners (Canada, Mexico)
• Price changes stronger (U.S. prices dominate)
• Economies-of-scale effects and increase in
  competition stronger
• Huge differences in efficiency (U.S. vs. Mexico)

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CUSFTA and NAFTA

• Some evidence for net trade diversion
• Kimberly Clausing, 2001 no evidence of trade
  diversion in CUSFTA
• But John Romalis, 2005 High cost producers in
  U.S. and Canada crowd out imports from other
  countries in many industries (e.g. EU industrial
  machinery in Mexico)
• But generally, large positive long-run impact on
  Canada estimated by Trefler (2004)
• 1/3 of industries facing largest import-tariff
  cuts had productivity gains gt 15
• but also reduced employment by 12
• No comparable estimates for the U.S. but likely
  to be much smaller (Canada 1/10 of U.S. market
  size)

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Preferential vs. Multilateral Liberalization
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Preferential vs. Multilateral Liberalization

• Trade theory suggests free trade is beneficial
• So is some trade better than none? That is, if we
  cant get MFN liberalization, should we go for
  regional agreements?
• Pro preferential liberalization
• Regional integration seems to bring benefits (EU,
  CUSFTA, NAFTA etc.)
• Sometimes net trade diversion but not very
  important
• Contra preferential liberalization
• Gains, but would be bigger under MFN
  liberalization
• Might prevent or slow further MFN liberalization
• Renewed danger of trade wars, this time simply
  between larger regional groups (e.g. N. America
  vs. EU)?

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Summary and Learning Outcomes

• Took a closer look at the key exception to
  GATT/WTOs MFN principle preferential trade
  arrangements
• Illustrated their welfare effects both
  theoretically and using the two most prominent
  case studies
• Learning outcomes
• Distinguish the different forms of preferential
  trade arrangements (FTA vs. CU, in particular)
• Analyse their welfare effects
• Know key facts about the two major PTAs studied
• Argue whether PTAs are beneficial or not