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Regional Economic Arrangements 187

CHAPTER OUTLINE

I. Introduction
MFN dilemma
Figure 9.1
II. Degrees of Economic Integration
Figure 9.2
PASSPORT: Foreign Trade Zones
III. Rules of Origin in International Trade
reasons
nationality
complexity
IV. Trade Effects of Economic Integration
trade creation and trade diversion
Figure 9.3
V. The Static Effects of a Customs Union
Figure 9.4
PASSPORT: Estimating Trade and Employment Effects of Trade
Agreements
VI. The European Union
the Treaty of Rome
widening Table 9.1
deepening
the common agricultural policy (CAP)
the Maastricht Treaty
the Euro
VII.NAFTA and Other U.S. Trade Agreements
A. North American Free Trade Agreement (NAFTA)
B. Other U.S. Trade Agreements Table 9.2
PASSPORT: MERCOSUR
VIII. Multilateralism Versus Regional Trade Agreements
MTN vs. RTA
PASSPORT: Trade Diversion in Action: The EU-Mexico Free-Trade
Agreement
188 Chapter 9

TEACHING NOTES AND TIPS

I. Introduction

Notes
Chapter 9 considers the development of regional trade arrangements that are an adjunct to the
MTNs discussed in the previous chapter. The introduction covers the proliferation of these
agreements and sets up the discussion of them as a source of benefits but also costs.

Teaching Tip
Alert the students not to over focus on NAFTA or the EU. These are important but ask them to
subtract 2 from the 250 given in the introduction. This is a global issue.

II. Degrees of Economic Integration

Notes
Regional trade agreements take on a number of forms that can be usefully thought of as a
continuum. On the one side is a very limited preferential trade agreement covering only part of
trade. Moving further along the continuum one moves from free-trade areas; to customs unions;
to a common market; and to an economic union. The levels of economic integration get
deeper as one moves along the continuum.

Teaching Tip
The 13 original U.S. states tried to form something like an economic union under the Articles of
Confederation. The U.S. found the situation unworkable. Perhaps the Europeans will have
better luck.

III. Rules of Origin in International Trade

Notes
The section covers the increasingly important issue of rules of origin. All countries enforce these
rules to collect data; enforce health regulations; enforce higher tariffs on non-WTO members;
enforce sanctions; enforce antidumping and countervailing duty orders; and enforce various
quotas such as the MFA. With the advent of more preferential trading arrangements, the
enforcement of these rules is becoming more difficult. Finally, the rules are moving from the
vague substantial transformation test to more precise percentage of value added rules.

Teaching Tip
The rules may act something like a low tariff. It has been shown that in existing free-trade areas
there is a substantial amount of trade occurring where the importer has just paid the tariff rather
than bother with the paperwork of trying to prove the good qualifies for duty-free treatment.
Regional Economic Arrangements 189

IV. Trade Effects of Economic Integration

Notes
This section starts by defining trade creation and trade diversion. A U.S.-Mexico-Japan
numerical example for cars is shown in Figure 9.3.

Teaching Tip
A world with a lot of preferential trade agreements is starting to suspiciously look like the non-
MFN world of the nineteenth century. Were losing some of the comforting characteristics of the
old MFN world.

V. The Static Effects of a Customs Union

Notes
The usual static effects of a customs union are shown in Figure 9.4. A useful adjunct to the
discussion is given in the boxed feature, "PASSPORT: Estimating Trade and Employment Effects
of Trade Agreements".

Teaching Tip
It is important to re-enforce that regional trade agreements create both benefits and costs. RTAs
normally create more benefits than costs but once again there is no such thing as a free lunch.

VI. The European Union

Notes
The section covers the history, expansion, and operation of the worlds foremost regional trade
agreement. The first part of the section covers the history of the EU as it went from the ECSC to
the European Economic Community to the European Union. The second part of the section
covers the operation of the CAP and the damage it does to the U.S. and other countries. A final
section looks at the continued deepening of the EU and the creation of the Euro.

Teaching Tip
There tends to be an over focus on the widening of the EU (adding more countries). What is
almost as important and usually overlooked is the continual deepening of the EU (the attempt
to make laws affecting businesses in the EU more similar). Within the EU the latter is often a
larger source of controversy than the former as countries are being asked to surrender ever-larger
amounts of sovereignty. This is a really interesting process to watch from the outside.

VII. NAFTA and Other U.S. Trade Agreements

Notes
This section begins with the history of NAFTA from the original agreement with Canada to its
extension to Mexico. The second part of the section covers the other RTAs that the U.S. has
implemented, signed, or is in the process of negotiating.
190 Chapter 9

Teaching Tip
This is a good place to bring in the point that virtually all preferential trade agreements are
phased in over a number of years. This is one of the reasons trade agreements do not cause
immediate changes in a countrys industrial structure or factor prices.

VIII. Multilateralism Versus Regional Trade Agreements

Notes
This section discusses the contentious issue of trade liberalization on a multilateral basis versus
trade liberalization on a regional basis.

Teaching Tip
This is a good place to bring in the point that regional versus multilateral trade negotiations can
be viewed as either complements or substitutes.

BRIEF ANSWERS TO PROBLEMS AND QUESTIONS FOR REVIEW

1. Regional trade agreements involve the reduction or elimination of some or all trade
barriers among some but not all countries. These reductions in trade barriers differ from
the reduction of trade barriers on a multilateral basis. Under multilateral trade
negotiations, tariffs and other barriers to trade are reduced for all countries that are
members of the WTO. Such multilateral reductions in tariffs are nondiscriminatory.
Because tariffs and other trade barriers are reduced for some countries but not for all,
regional trade agreements and the associated reduction of trade barriers are
discriminatory. The implementation of a regional trade agreement entails benefits and
costs. The reduction of trade barriers increases the amount of trade between the countries
involved and the countries that are not a part of the agreement lose some trade.

2. Economic integration refers to the process of eliminating restrictions on commodity


flows, flows of the factors of production, and flows of capital between countries. There
are various degrees of economic integration between countries. The different degrees of
economic integration can be placed along a continuum. On one end of the continuum is a
regional trade agreement among countries that provides a limited reduction in trade
barriers. On the other end of the continuum is an agreement among a group of countries
to act as if the group is one distinct country in every economic respect.

3. The different types of economic integration are: 1) a free-trade area, 2) a customs union,
3) a common market, and 4) an economic union. A free-trade area is an agreement
between countries to reduce or eliminate trade barriers between countries while
maintaining separate national tariff schedules. A customs union is an agreement between
countries to maintain a free-trade area and a common external tariff. A common market
is an agreement between countries to maintain a free-trade area, a common external tariff,
and free mobility of capital and labor. An economic union is an agreement between
countries to maintain a free-trade area, a common external tariff, free mobility of capital
and labor, a common currency, and some degree of unification in government policies.
Regional Economic Arrangements 191

4. The rules of origin are necessary for several reasons: (1) The U.S. gathers information
concerning the origin of imports to report statistical data on trade flows; (2) to enforce
health, sanitary, and technical regulations within the U.S., the origin of imports is
necessary to protect the health and safety of the public; (3) not all countries are members
of the WTO and the U.S. can enforce higher tariffs or import restrictions on goods
originating in these countries; (4) to administer antidumping and countervailing duty
tariffs on goods imported into the U.S., a determination of the country of origin is
necessary; (5) administration of quotas on textiles or agricultural products requires the
determination of country of origin; (6) the U.S. administration of trade sanctions such as
those against Cuba and Iraq also require knowledge of the country of origin; and (7) the
recent trend towards the adoption of regional trade agreements has made the rules of
origin even more critical in order to restrict the amount of trade deflection.

5. Trade creation is an efficiency gain that results from a free-trade area because more
efficient member countries displace less efficient member countries. Trade diversion is
an efficiency loss that results from a free-trade area because less efficient member
countries displace more efficient nonmember countries. Trade deflection is the diversion
of exports to a country within a free-trade area that has lower tariffs on a good.
192 Chapter 9

6. The following figure illustrates Country As domestic demand and supply for a specific
imported good.

P S

P1 Price including Tariffs from Country C


P2 Price including Tariffs from Country B
P3 b a Price excluding Tariffs from Country C
P4 c Price excluding Tariffs from Country B
D

Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8 Q9 Q

Assume that the world is composed of three countries: Countries A, B, and C. Now,
suppose that Country A and C decide to form a customs union and Country B is a
nonmember. Also, assume that Country B is the most efficient supplier of the product at
a free-trade price of P4 and tariff-inclusive price of P2. Country C can supply the product
at a free-trade price of P3 and tariff-inclusive price of P1. Before the formation of the
customs union, Country A finds that it buys all of its imports from Country B at a price of
P2. After the formation of the customs union, Country A removes the tariff on Country
Cs products but not on Country Bs products. Country A now buys all of its imports
from Country C. The movement to freer trade under a customs union affects world
welfare in two opposing ways. First, there is a welfare increasing effect called trade
creation. In this case, consumers in Country A buy more total cars of which Q2 are
domestically produced and Q2 to Q8 are imported. The welfare gain associated with this
increase in consumption equals triangle a. In addition, some of Country As domestic
production (Q2 to Q3) is replaced by lower-price imports. This represents a favorable
production effect, and the welfare gain associated with this production change equals
triangle b. The overall trade creation effect is given by the sum of the triangles a + b.
The second effect of a customs union is a welfare- decreasing effect called trade
diversion. Trade diversion occurs when a higher-price supplier within the union replaces
imports from the low-price supplier outside the union. As a result of the customs union,
world production is organized in a less efficient manner. The box c indicates this welfare
loss to Country A and the world as a whole. The formation of a customs union will
increase the welfare of its members, as well as the rest of the world, if the trade creation
effect (a + b) is larger and than trade diversion effect (c).

7. Now 50 years old, the EU currently contains 25 countries with a combined population of
372 million and a combined GDP larger than the U.S. The EU began its development in
1951, when the European Coal and Steel Community (ECSC) was formed. This
agreement provided for the elimination of tariffs and quotas for the coal and steel
industries among Belgium, France, Italy, Luxembourg, the Netherlands, and West
Germany. The basic idea of the ECSC was to promote free trade in two important
commodities as a deterrent to future military conflicts in Europe. In 1957, the countries
Regional Economic Arrangements 193

involved in the ECSC signed the Treaty of Rome, which provided for the elimination of
tariffs and nontariff barriers to trade between member countries and the institution of a
common external tariff. This treaty established the European Economic Community
(EEC) as a customs union, which has been enlarged to cover more and more of Europe.
This enlargement has occurred mostly as countries in Europe left EFTA and joined the
EU. The U.K., Ireland, and Denmark joined the EEC in 1973; Greece joined in 1981;
Spain and Portugal joined in 1986; and Austria, Finland, and Sweden joined in 1995. In
addition, 10 countries became members in 2004. These countries include Cyprus,
Estonia, the Czech Republic, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia, and
Slovenia. As the EU has widened to include more countries it has also deepened. As
the EU adopted a common agricultural policy for all members, this created constant trade
frictions between the U.S. and other more efficient producers of agricultural commodities
such as Canada, Australia, New Zealand and many developing countries. In looking at
the continuum of economic integration, the EU is taking a number of steps to create a full
economic union. Beginning in 1985, an EU commission set about determining the steps
necessary to create a genuinely barrier-free internal market in the EU. This commission
listed hundreds of actions that member governments needed to take in order to create
something like a unified market. Most of the government actions were completed by
1992 with much fanfare about the single market. The Maastricht Treaty of 1992 laid out
plans for a new European currency (the Euro) that replaced some of the separate national
currencies in January 2002.

8. The common agricultural policy of the EU is an agreement between the member


countries to subsidize agriculture in the same manner. All member countries farmers are
paid subsidies from the EU rather than by each national government. Currently,
approximately half of the total EU budget is spent on farm subsidies. The common
agricultural policy guarantees prices for all farm commodities within the EU. The EU
purchases whatever the farmers cannot sell on the open market and farmers are protected
by a variable levy (tariff) from international competition. If farm prices within the EU
decline, then the tariff rises and vice versa. Since the support prices are generous, there
has been a problem of chronic oversupply of agricultural commodities in Europe. In
addition, surplus agricultural commodities are sometimes dumped on world markets to
reduce EU losses. As a result, the common agricultural policy has created constant trade
frictions between the U.S. and other more efficient producers of agricultural commodities
such as Canada, Australia, New Zealand and many developing countries. Such countries
not only lose exports to the EU but also at times suffer losses in other export markets
when the EU sells or dumps surpluses.

9. The formation of a customs union will increase the welfare of its members, as well as the
rest of the world, if the trade creation effect is larger than the trade diversion effect.

10. From the creation of GATT until the early 1980s, U.S. trade policy was focused on
reducing trade barriers through the various MTNs. Regional trade agreements were
mostly centered around the expansion of the EU and the U.S. government showed little
interest in such agreements. However, beginning in the 1970s there was a slight change in
U.S. policy. First, the U.S. began granting preferential trade status to developing countries
under the Generalized System of Preferences. These preferences had the advantage of
194 Chapter 9

enhancing economic growth in developing countries without the monetary and political
complications normally associated with foreign aid. This trend continued with the passage
of the Caribbean Basin Initiative (CBI) in 1981 as a means of encouraging economic
development in that area. The result of these agreements was that the U.S. was now
deviating from a purely multilateral approach to reducing trade barriers. Also, there was
rising frustration with the slow pace of trade liberalization in several areas of interest to
the U.S. As discussed in Chapter 1, international trade in services is a fast-growing part of
world trade. However, liberalizing trade in services has been a very slow process. For the
U.S. this is frustrating as the U.S. has a comparative advantage in many areas of service
trade such as financial services and insurance. Secondly, the U.S. government is also
interested in liberalizing trade in agricultural products. Liberalization in this sector under
the auspices of the GATT/WTO has been even slower. For these and other reasons,
beginning in the early 1980s the U.S. government began pursuing trade liberalization via
regional trade agreements.

11. One of the more contentious issues in international economics is the debate over trade
liberalization. Until the 1980s, trade liberalization occurred primarily through
multilateral trade negotiations under the auspices of GATT. If trade barriers are only
reduced on an MFN basis then there is only trade creation and no trade diversion. Trade
diversion occurs if trade liberalization is discriminatory meaning that one country is
treated differently than another country. This is one of the strongest arguments for
MTNs. RTAs inherently threaten this process. An RTA is inherently discriminatory as
member countries are treated differently than nonmember countries. Since there are
many countries now involved in many different RTAs world trade has become more
complicated. The world trading system is at risk of going back to the situation that
existed prior to GATT. Each country potentially had a different tariff for each product for
specific countries. In economic terms, this causes an increasing amount of trade
diversion that potentially reduces world welfare. A second issue of RTAs is more subtle.
Countries only have a limited amount of time and expertise to expend on the issue of
trade liberalization. As RTAs spread, governments will spend more resources on RTA
negotiations. This implies that they will expend fewer resources negotiating under the
WTO framework. As a result, the process of obtaining multilateral trade liberalization
becomes more difficult with the spread of RTAs. The opponents of RTAs emphasize
these costs. They fear that the spread of RTAs is jeopardizing the nondiscriminatory
nature of world trade that had been developed under the GATT/WTO framework.
Further, they fear that RTAs tend to distract government attention away from the process
of liberalizing world trade in a nondiscriminatory fashion. Also the spread of RTAs may
be saying something about the preferences of governments for RTAs. One of the current
problems with multilateral liberalization is that the depth of integration being pursued is
not very deep. If one compares the agenda of the Doha round to the current depth of
integration in the EU or even NAFTA then the issue becomes obvious. In some cases
countries want to pursue a level of economic integration that is not possible in a
multilateral framework. A useful way of summarizing this debate is to think in terms of
substitutes and complements. Those that fear the spread of RTAs really fear that they are
a substitute for multilateral liberalization. Economists that are less concerned about the
spread of RTAs tend to view them as complementary to MTNs. While the WTO may no
Regional Economic Arrangements 195

longer be the force for multilateral liberalization that it once was, its role in the world
economy may still be increasing rather than diminishing.

MULTIPLE-CHOICE QUESTIONS

1. Preferential trade agreements are troublesome in the sense that they weaken the important
principle of international trade policy known as:
a. TC.
b. TD.
c. WTO.
* d. MFN.

2. Preferential trade agreements inherently discriminate against countries that do not belong
to the agreement and inflict losses on their exporters. This phenomenon is know as:
a. Trade deflection.
b. Trade creation.
* c. Trade diversion.
d. The gains from trade.

3. Which of the following is an exception to the most favored nation principle?


a. Trade in petroleum
b. trade with Japan
* c. A free-trade area or a customs union
d. Trade in services

4. Regional trade agreements:


a. are the same for all countries.
b. reduce tariffs and trade barriers equally in all countries.
* c. result in the negotiating countries obtaining a margin of preference over
countries that are not part of the agreement.
d. favor developed countries.

5. In order for a preferential trade agreement to be legal under international trade rules:
a. it must reduce trade barriers on all agricultural products among member countries.
* b. it must reduce trade barriers on a substantial proportion of trade among
the member countries.
c. it must reduce restrictions on the mobility of labor and capital among member
countries.
d. it must provide a common external tariff for member countries.
196 Chapter 9

6. GATT/WTO regulations state that in order for a regional trade agreement to be legal:
* a. trade barriers must be reduced on substantially all trade within the
group.
b. trade barriers must be reduced on only some of the trade within the group.
c. all countries must come to an agreement on the number and size of the quotas that
will be in force.
d. all members will be subject to membership fees.

7. Which of the following is not a level of economic integration between countries?


a. A free-trade area
b. A customs union
* c. A common union
d. An economic union

8. The least integrated category of economic integration is:


a. a common market.
* b. a free-trade area.
c. an economic union.
d. a customs union.

9. A significant feature of a customs union is:


a. that agricultural products are always excluded.
b. that corporate tax rates are always made common.
c. that the only WTO legal customs union is the EU.
* d. a common external tariff.

10. Which statement is correct?


a. Both customs unions and free-trade areas have a common external tariff.
b. A free-trade area has a common external tariff and a custom union does not.
c. Neither free-trade areas nor customs unions have a common external tariff.
* d. A customs union has a common external tariff but a free-trade area does
not.

11. To solve the problems associated with trade deflection within an FTA, countries may
adopt:
a. a common market.
b. a common external tariff.
* c. rules of origin.
d. rules of negotiation.

12. What is the major difference between a customs union and a free-trade area?
* a. Each country replaces its national tariff schedule with a common external
tariff under a customs union.
b. A customs union usually means a more shallow level of economic integration.
c. A free-trade area is national in nature and a customs union is regional.
d. In a customs union, tariffs are eliminated and in a free-trade area they are not.
Regional Economic Arrangements 197

13. Which of the following is not one of the features of a common market?
a. Free mobility of labor
b. Free mobility of capital
c. A common external tariff
* d. A common currency

14. Which of the following is not a characteristic of a common market?


a. Capital and labor can freely move within member countries.
b. The are no trade restrictions between member countries.
c. Member countries have a common external tariff.
* d. Member countries have a common currency.

15. To create an economic union, countries must complete all of the following except:
a. for the adoption of a common currency.
b. for the harmonizing of specific country policies to those of other members.
c. providing for the mobility of labor and capital among member countries.
* d. creating only one political party within the member countries.

16. Rules of origin are necessary for which of the following reasons?
a. To determine which company produced the product
* b. To determine which country produced the product
c. To determine which country consumes the product
d. To determine where the profits of the firm are taxed

17. When compliance costs associated with the rules of origin exceed the value associated
with the reduction of the tariff, then rules of origin become:
* a. an effective nontariff barrier to trade.
b. an effective tariff imposed on the foreign firm.
c. a non-effective nontariff barrier to trade.
d. a non-effective tariff imposed on the foreign firm.

18. Rules of origin are used to counteract:


a. offshore assembly provisions.
* b. trade deflection.
c. technical regulations.
d. government procurement regulations.

19. Which of the following is not one of the reasons rules of origin are necessary?
a. To gather statistical information on imports
b. To enforce health and safety regulations
c. To enforce higher tariffs on imports from nonWTO countries
* d. To assist in balancing the balance of payments

20. Traditionally, the U.S. has relied on the _____ transformation test to determine the
nationality of an import.
a. import
b. environmental
198 Chapter 9

* c. substantial
d. legal

21. In recent trade agreements, the U.S. has been moving toward defining the origin of
imports using a percentage of ______.
* a. value added
b. imports
c. exports
d. weight

22. Trade creation refers to:


* a. the expansion of trade among member countries as a result of the
elimination of tariffs.
b. the creation of new products for trade in countries.
c. the creation of a trade program that enhances multinational corporations.
d. the creation of government sanctioned trade with terrorist countries.

23. When products from a high-cost country within a customs union replace imports from a
low-cost country that is not a member of the union, this is called:
a. trade creation.
* b. trade diversion.
c. trade deflection
d. trade development.

24. When preferential trade agreements are formed, the result is often a reduction of trade
with countries that are not members of the group. Such a result is known as:
a. reciprocity.
b. trade creation.
c. purchasing power parity.
* d. trade diversion.

25. The U.K. joins the EU and imports wheat from France rather than from Canada and/or
the U.S. This is an example of:
a. trade creation.
* b. trade diversion.
c. trade modification.
d. trade deflection.

26. When developed countries extend tariff preferences to developing countries and imports
from the latter displace imports from the former, a phenomenon known as _____ is taking
place.
a. trade creation
b. trade inflation
* c. trade diversion
d. trade deflection
Regional Economic Arrangements 199

27. A customs union will increase the welfare of its members and the rest of the world if:
* a. trade creation is greater than trade diversion.
b. trade creation is less than trade diversion.
c. trade creation is positive.
d. trade diversion is positive.

The following figure illustrates Country As domestic market for a specific imported good.
P S

P1 Price including Tariffs from Country C


P2 Price including Tariffs from Country B
P3 a b c d e Price excluding Tariffs from Country C
P4 f g h Price excluding Tariffs from Country B
D

Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8 Q9 Q

28. With free trade Country A imports:


* a. Q1 to Q9 from Country B.
b. Q2 to Q8 from Country C.
c. Q3 to Q7 from Country B.
d. Q4 to Q6 from Country C.

29. If Country A imposes a tariff on imports from both Country B and C, Country A will
import:
a. Q1 to Q9 from Country B.
b. Q2 to Q8 from Country C.
* c. Q3 to Q7 from Country B.
d. Q4 to Q6 from Country C.

30. Suppose Country A forms a customs union with Country B, Country A will import:
* a. Q1 to Q9 from Country B.
b. Q2 to Q8 from Country C.
c. Q3 to Q7 from Country B.
d. Q4 to Q6 from Country C.

31. Suppose Country A forms a customs union with Country C, Country A will import:
a. Q1 to Q9 from Country B.
* b. Q2 to Q8 from Country C.
c. Q3 to Q7 from Country B.
d. Q4 to Q6 from Country C.

32. Suppose Country A forms a customs union with Country C, trade creation is represented
by the area:
200 Chapter 9

a. a + b + c + d + e.
* b. a + e.
c. b + c + d.
d. f + g + h.

33. Suppose Country A forms a customs union with Country C, trade diversion is represented
by the area:
a. g.
b. f + h.
* c. f + g + h.
d. b + c +d.

34. The economic integration of Western Europe began in the:


a. 1930s.
* b. 1950s.
c. 1970s.
d. 1990s.

35. The beginning of the European Union can be traced back to the early 1950s and the
creation of:
* a. the European Coal and Steel Community.
b. the European Monetary Union.
c. the International Monetary Fund.
d. the Treaty on European Enlargement.

36. European economic integration began with:


* a. the European Coal and Steel Community.
b. the Treaty of Rome.
c. the European Economic Community.
d. the European Free Trade Area.

37. The treaty in the late 1950s calling for establishment of a European common market
known as the EEC was:
a. the Treaty of Paris.
* b. the Treaty of Rome.
c. the Treaty of Brussels.
d. the Treaty on European Union.

38. The European Union is:


a. a free-trade area.
b. a customs union.
c. a limited preferential trade agreement covering only agricultural products.
* d. an economic union.

39. Which of the following countries is not a member of the EU?


a. Portugal
b. Austria
Regional Economic Arrangements 201

* c. Switzerland
d. Finland

40. Which of the following countries was not among the founders of what is now known as
the EU?
a. Belgium
* b. the U.K.
c. Italy
d. France

41. A U.S. exporter of wheat to the EU faces the same tariff rate on exports to Germany and
the U.K. This type of tariff schedule is called:
* a. a common external tariff.
b. a common agricultural policy.
c. a common internal tariff.
d. a common market.

42. The Common Agricultural Policy was adopted by which group of countries?
a. EFTA
* b. EU
c. NAFTA
d. WTO members

43. Which of the following is the acronym for the EU policy of subsidizing farmers?
a. APA
b. EURO
* c. CAP
d. CBI

44. Which of the following is not strongly in favor of liberalizing world trade in agricultural
products?
a. New Zealand
* b. The EU
c. Australia
d. Chile

45. Which of the following is not true concerning the EU?


a. Its integration began over 50 years ago.
b. Its integration began with the ECSC.
* c. It includes all Western European countries.
d. Its common currency is the Euro.
202 Chapter 9

46. One of the most problematic areas for the EU is:


a. the common currency.
* b. agriculture.
c. labor movements between member countries.
d. trade barriers between member countries.

47. Which country is not a member of the European Union?


* a. Norway
b. Spain
c. Greece
d. The U.K.

48. Which EU country has not adopted the Euro as its currency?
a. Finland
b. Portugal
* c. Denmark
d. Germany

49. The creation of the Euro was an important milestone for the EU. This new currency was
created through the:
a. Treaty of Rome.
b. Uruguay Round.
* c. Maastricht Treaty.
d. European Free Trade Association.

50. The name of the currency to be issued by the European Monetary Union is the
_________ and it began to circulate as a currency in __________ .
a. Eurodollar; 2000
b. ECU; 2002
c. euro; 2005
* d. euro; 2002

51. NAFTA is:


* a. a free-trade area.
b. a customs union.
c. a limited preferential trade agreement covering only trade in automobiles and
parts.
d. an economic union.

52. The NAFTA agreement was most strongly opposed in the U.S. by which group?
a. Automobile firms
* b. Labor unions
c. Manufacturing firms
d. Financial institutions
Regional Economic Arrangements 203

53. NAFTA:
* a. is a free-trade area.
b. must be renewed every five years.
c. will eventually eliminate restrictions on the movement of labor among the
member countries.
d. is a customs union.

54. The level of integration provided under NAFTA is:


* a. a free-trade area.
b. a customs union.
c. a common market.
d. an economic union.

55. When NAFTA was authorized in 1994, the maximum phase in period for tariff reductions
was:
a. 1 year.
b. 3 years.
c. 8 years.
* d. 15 years.

56. NAFTA and its side agreements do not have provisions dealing with which of the
following:
a. tariff reductions.
b. environmental regulations.
c. labor standards.
* d. a common currency.

57. The U.S. factor of production that is most likely to be made worse off because of NAFTA
is:
a. capital.
b. skilled labor.
c. land.
* d. unskilled labor.

58. Which of the following statements is correct concerning NAFTA?


a. The agreement includes Mexico, Canada, and the U.S.
b. The agreement covers merchandise trade, trade in services, and
investment.
c. Tariff reductions are to be phased in over 15 years.
* d. All of the above

59. Which of the following is not a member of MERCOSUR?


a. Brazil
b. Uruguay
c. Paraguay
* d. Venezuela
204 Chapter 9

60. Which of the following countries is not a full member of MERCOSUR?


a. Brazil
* b. Ecuador
c. Argentina
d. Uruguay

61. Until the _____, trade liberalization was occurring primarily through _____ .
a. 1970s, WTO
* b. 1980s, multilateral trade negotiations
c. 1950s, GATT
d. 1990s, MFN

TRUE FALSE QUESTIONS

1. T Multilateral reductions in the MFN tariff are essentially nondiscriminatory.

2. T Regional trade agreements are inherently discriminatory because they include some
countries and exclude other countries.

3. F Regional trade agreements and the associated reduction of trade barriers embodied in
them are nondiscriminatory.

4. F Preferential trade agreements are relatively rare in todays world economy.

5. T Free-trade areas and customs unions were legal under GATT and also under the WTO.

6. F Regional trade agreements between countries are becoming less important than they were
20 years ago because most countries now participate in multilateral trade negotiations.

7. F In terms of the depth and scope of trade, a free-trade area usually is a more
comprehensive agreement concerning free trade than the agreement associated with a
customs union.

8. T If two countries mutually eliminate their tariffs, trade between them will generally
increase. This effect is called trade creation.

9. F One of the characteristics of a common market is that member countries agree to


eliminate trade with nonmember countries.

10. F Members of a free-trade area generally allow unrestricted movements of labor and capital
among member countries.

11. F Preferential trade agreements make the rules of origin governing imports less important.
Regional Economic Arrangements 205

12. F The rules of origin refer to the determination of what company actually produced the
product.

13. F Rules of origin are so trivial that they have no impact on international trade.

14. T Rules of origin are more important when a country is a party to various preferential trade
agreements.

15. F The U.S. currently relies on the export transformation test to determine the nationality of
an imported product.

16. T If the costs of complying with a countrys rules of origin are higher than the cost of the
tariff then the importer is better off just paying the tariff.

17. T The increasing complexity of rules of origin allows countries to legally engage in a new
form of protectionism.

18. T Businesses engaging in international trade would like to see a global harmonization of the
rules of origin.

19. T The principle embodied in the rules of origin is to determine the nationality of the
imported product.

20. F In a free-trade agreement the countries involved no longer maintain their own separate
national tariff schedules.

21. F In order to qualify for duty-free treatment, a certain percent of value added must have
been performed in one of the nonmember countries.

22. F Export losses by countries outside of a trade agreement are known as trade deflection.

23. F In world welfare terms whether or not a trade agreement increases world welfare depends
on whether trade creation is smaller than trade diversion.

24. F In order to maximize consumer gains, most trade agreements are implemented
immediately.

25. T In a common market, restrictions on the mobility of capital between member countries
have been eliminated.

26. T Free-trade areas are a form of regional integration where member countries lower internal
trade barriers but maintain existing barriers against nonmembers.

27. T In order for a free-trade agreement to be legal under the WTO it must cover substantially
all trade.
206 Chapter 9

28. T Trade deflection occurs in a free-trade agreement because countries maintain their own
national tariff schedules that may have different tariffs on the same product.

29. F Both free-trade areas and customs unions have a common external tariff.

30. T Customs unions are a form of regional integration where member countries lower internal
trade barriers and establish a common barrier against nonmembers.

31. F Customs unions and free-trade areas are the same in the way in which member countries
treat imports from nonmember countries.

32. T Trade diversion is said to exist when the formation of a regional trading group leads to
the reduction of trade with nonmember countries in favor of member countries.

33. T Trade creation is said to exist when the formation of a regional trading group leads to an
expansion of trade above pre group levels.

34. T The increase in trade associated with the formation of preferential trade agreements leads
to what is known as trade creation.

35. T A customs union will be beneficial to world welfare if the amount of trade creation
resulting from its formation is larger than the amount of trade diversion.

36. F In a free-trade area, trade creation occurs if trade between member countries expands as a
result of less trade with nonmember countries.

37. F In a free-trade area, trade deflection occurs if trade between member countries expands as
a result of less trade with nonmember countries.

38. F The EU is an example of a free-trade area in Western Europe.

39. T The attempt to make business regulations within a customs union more similar is an
example of deepening.

40. T The process of adding countries to the EU is known as widening.

41. T The EU is the worlds largest and most successful customs union.

42. F Currently, the EU is composed of 11 countries.

43. T Currently, the EU is composed of 15 countries.

44. T A goal of the EU is the unification of member country currencies into a single currency.

45. F NAFTA is a free-trade agreement between the U.S., Canada, Ecuador, and Mexico.
Regional Economic Arrangements 207

46. F Under NAFTA, Canada, Mexico, and the U.S. will have a common external tariff that
they will apply to all nonmember countries.

47. F NAFTA is an example of a customs union in North America.

48. F The U.S. at this time is a leader in the reduction of trade barriers within the western
hemisphere.

49. T The most important country within MERCOSUR is Brazil.

50. F Mexico is currently a member of MERCOSUR.

51. F Because the U.S. participates in numerous RTAs, it is completely clear what the U.S.
tariff is on any product.

52. F Virtually all economists oppose the formation of RTAs.

53. F Since all countries have the same preferences with respect to free trade, multilateral trade
negotiations are easier than attempting to negotiate an RTA.

54. T In the late 1990s, Mexico and the EU concluded a free-trade agreement.

55. F Trade diversion and the spread of RTAs are completely unrelated.

SHORT ANSWER ESSAY

1. What is the difference between a free-trade area and a customs union?

2. Describe how trade deflection occurs when countries form a free-trade area.

3. List and describe the features of an economic union.

4. List the reasons that rules of origin are necessary for imports.

5. Suppose that you were given the task of determining the effects on imports of a
preferential trade agreement for a particular industry. In general terms, how would you
estimate the effects on trade and employment in the industry?

6. What is a foreign trade zone? How do businesses use them as a part of engaging in
international trade?

7. Why is trade diversion considered harmful to world welfare?

8. Describe the historical development of the EU.


208 Chapter 9

9. Why has the CAP caused friction in international trade relations between the U.S. and the
EU?

10. What are the major differences between the history and structure of the EU and NAFTA?

11. Describe MERCOSUR and discuss its development.

12. Describe the relationship between RTAs and MTNs in terms of substitutes and
complements.

BRIEF ANSWERS TO SHORT ANSWER ESSAY

1. A customs union is an agreement between countries to maintain a free-trade area and a


common external tariff. A customs union is similar to a free-trade area but with two
differences. First, a customs union has a common external tariff. A common external
tariff means that each country replaces its own national tariff schedule with a common
tariff schedule applicable to all member countries. Second, not all free-trade areas
include trade in agricultural products, services, and financial flows. However, most
customs unions include a broad range of international trade. The level of international
economic integration implied by a customs union is usually deeper than the level of
integration implied by a free-trade area.

2. With an FTA each country maintains its own separate national tariff schedule and trade
deflection may occur within the free-trade area. Trade deflection is the diversion of
exports to a country within a free-trade area that has lower tariffs on a good. For example,
suppose the tariff on cars is 4 percent in the U.S. and Canada and 20 percent in Mexico.
A car exporter to this free-trade area has an incentive to ship cars to say San Diego, pay
the 4 percent U.S. tariff, and then ship the car to Mexico for sale. When the national
tariffs of the free-trade area members are very different, exporters have a clear incentive
to try to evade the higher tariffs. Differences in tariffs and/or quotas can also lead to the
establishment of screwdriver plants. These plants are designed to provide minor
assembly work on a product that is essentially produced in a foreign country but
assembled within the free-trade area to avoid the higher tariffs. To solve this problem,
free-trade areas and other trade agreements have rules of origin in order to qualify for
duty-free treatment.

3. The determination of what country actually produced the good is known as the rules of
origin. As part of its routine enforcement of U.S. trade laws, the U.S. Customs Service
makes this determination on all imports at the time the good enters the country. The rules
of origin are necessary for several reasons. First, the U.S. gathers information concerning
the origin of imports to report statistical data on trade flows. Second, to enforce health,
sanitary, and technical regulations within the U.S., the origin of imports is necessary to
protect the health and safety of the public. Third, not all countries are members of the
WTO and the U.S. can enforce higher tariffs or import restrictions on goods from
originating in these countries. Fourth, to administer antidumping and countervailing duty
tariffs on goods imported into the U.S., a determination of the country of origin is
Regional Economic Arrangements 209

necessary. Fifth, the U.S. administration of quotas on textiles or voluntary export


restraints (VERs) requires the determination of country of origin. Finally, the U.S.
administration of trade sanctions such as those against Cuba and Iraq also require
knowledge of the country of origin.

4. An economic union is an agreement between countries to maintain a free-trade area, a


common external tariff, the free mobility of capital and labor, and some degree of
unification in government policies and monetary policies. There are two requirements for
an economic union. The first requirement is the creation of a common currency. This
implies the abolition of each countrys central bank and the creation of a common central
bank. The second requirement is that each national government has to align its national
policies with those of the other member countries. The policies would need to cover such
things as tax rates, competition policy, labor regulations, environmental regulations, and
so forth. Any national policies that tend to distort trade flows would be candidates for
harmonization.

5. Two methods are used to estimate the economic impacts of a trade agreement. The first
method is tedious but relatively simple. Suppose that Mexico has a 10 percent tariff on a
particular product imported from the U.S. Further suppose that the price elasticity of
demand for this product is 1.0. If the tariff were eliminated, exports of this product from
the U.S. to Mexico would rise by 10 percent. Next the Department of Labor produces
estimates of the number of employment opportunities involved if production changes in
U.S. industry. If you know how much production changes as a result of the tariff
reduction, you now have an estimate of the number of jobs gained. For U.S. tariff
reductions, you can estimate the increase in imports from Mexico, and as U.S. output
falls, the U.S. loses jobs. By totaling up the effects for all products and all industries, add
the gains and losses, and you have an estimate of the total effect on jobs due to NAFTA.
One side could argue that total jobs would rise while the other side could claim that
they would fall. Aside from the politics, these partial equilibrium estimates are useful in
the negotiating process. To reduce the political opposition, industries in which the effects
are large the tariff reductions are conveniently phased in toward the end of the 15-year
transition period. A more recent way of calculating the effects of trade agreements is to
use a computable general equilibrium model (CGE). The difference in this estimating
method is that CGE models allow for the interactions among related industries. For
instance, if the automobile industry is affected by a trade agreement, this will indirectly
affect many other industries, which provide inputs into the production of automobiles.
Building such a model requires four steps. First, one needs to collect data on production,
consumption, prices, and trade flows. The second step is to construct a mathematical
representation of the structure of the economy. Third, various parameters, price elasticity
being one, are then put into the model. The model is then calibrated to ensure that it
generates known results that make sense. Finally, one can use the model to answer
questions concerning changes in economic policy. These models are now widely used to
determine the possible effects of changes in trade policy as well as other economic
policies. While these models are informative, they are not perfect. For an exercise such
as NAFTA, the policy change for the U.S. was so small that the results of the exercise
were also small. Partial equilibrium models are still useful for capturing the changes at
the narrowly defined industry level where the changes for the economy as a whole are
210 Chapter 9

small. For Canada and Mexico, the relative size of the policy change was substantially
larger and the effects on the structure of their economies would be larger.

6. Countries have the option of making part of their territory free of trade barriers. Under
the rules of the WTO, a country can designate certain geographical areas as zones of free
trade, even when the rest of the country is subject to normal trade restrictions. These
zones of free trade within a country are called Foreign Trade Zones (FTZ). Currently
there are approximately 400 zones in over 80 countries and these zones process
approximately 10 percent of world trade. Currently, firms can manufacture inside a FTZ
and the domestic processing costs incurred in the zones and profits earned there are free
from duty. As a result, tariffs apply only to the imported inputs. The changes in the laws
governing FTZs have caused an increase in their growth.

7. The second effect of a customs union is trade diversion that decreases world welfare.
Trade diversion occurs when a higher-price supplier within the union replaces imports
from a low-price supplier outside the union. As a result of the customs union, world
production is organized in a less efficient manner.

8. The worlds largest and most successful customs union is the European Union (EU), an
association of European countries that has agreed to a free trade area and has imposed a
common external tariff. Now 50 years old, the EU currently contains 15 countries with a
combined population of 372 million and a combined GDP larger than the U.S. The
European Union began its development in 1951, when the European Coal and Steel
Community (ECSC) was formed. This agreement provided for the elimination of tariffs
and quotas for the coal and steel industries between Belgium, France, Italy, Luxembourg,
the Netherlands, and West Germany. The basic idea of the ECSC was to promote free
trade in two important commodities as a deterrent to future military conflicts in Europe.
The basic premise behind the ECSC was that the more closely integrated countries are
economically, the less likelihood of war between them. In 1957, the countries involved
in the ECSC signed the Treaty of Rome, which provided for the elimination of tariffs and
nontariff barriers to trade between member countries and the institution of a common
external tariff. This treaty established the European Economic Community (EEC) as a
customs union, which has been continually enlarging itself to cover more and more of
Europe. Over time, the enlargement of the European Union has occurred mostly as
countries within Europe left EFTA and joined the EU. While EU membership grew,
EFTA membership declined. The U.K., Ireland, and Denmark joined the EEC in 1973;
Greece joined in 1981; Spain and Portugal joined in 1986; and Austria, Finland, and
Sweden joined in 1995. In addition, 10 countries became members in 2004. These
countries include Cyprus, Estonia, the Czech Republic, Hungary, Latvia, Lithuania,
Malta, Poland, Slovakia, and Slovenia.

9. From its beginning the EU has had something extra called the common agricultural
policy (CAP), that is an agreement among the European countries to subsidize the
agricultural sector. Belgian farmers are subsidized in the same way as Portuguese
farmers. All member countries provide revenue to the EU and the EU, rather than each
national government, pays subsidies to farmers. Currently, approximately half the EU
total budget is spent on farm subsidies. The common agricultural policy guarantees
Regional Economic Arrangements 211

prices for all farm commodities within the EU, and the EU purchases whatever the
farmers cannot sell on the open market. In addition, farmers are protected by a variable
levy (tariff) from international competition. If farm prices within the EU decline, then
the tariff rises and vice versa. Since the support prices are generous, there has been a
problem of chronic oversupply of agricultural commodities in Europe. In addition, the
surplus agricultural commodities are sometimes dumped on world markets to reduce EU
losses. As a result, the common agricultural policy has created constant trade frictions
between the U.S. and other more efficient producers of agricultural commodities such as
Canada, Australia, New Zealand and many developing countries. Such countries not only
lose exports to the EU, but also at times suffer losses in other export markets when the
EU sells or dumps surpluses. Demands by countries that the EU reform the system to
produce less damage to other countries delayed the Uruguay Round. Most likely, any
future negotiations concerning world trade in agriculture will have as its central issue the
CAP. The situation is politically charged as European farmers, particularly French
farmers, are very active in defense of the system.

10. In 1992, Canada, the U.S., and Mexico agreed to broaden the free-trade area to include
Mexico. After much discussion, the U.S. Congress authorized the free-trade area in 1993
and it went into effect in 1994. The tariff reductions provided in the NAFTA agreement
are to be phased in over a 15-year period. The Agreement covers all merchandise trade as
well as trade in services, investment, and intellectual property rights. In addition, any
trade disputes under the agreement are to be adjudicated by a 5-member panel. In
addition to the free-trade agreement, two additional agreements were signed in the areas
concerning labor standards and environmental issues. These two additional agreements
simply commit each country to enforce its own labor and environmental laws. What
makes NAFTA and the EU different is that the development of the latter was designed to
both widen and deepen over time by creating a customs union that ultimately led to an
economic union. On the other hand NAFTA is designed only as a free-trade agreement.

11. MERCOSUR is an acronym for a free-trade area that is on its way to becoming a customs
union. This free-trade area is currently composed of Argentina, Brazil, Uruguay, and
Paraguay. The first phase of the agreement, signed in 1991, is to cut intra-regional tariffs
to zero by the year 2000. For the most part, tariffs are at zero for most trade within the
region. Starting in 1995, the countries set about harmonizing their tariffs to a common
external tariff by 2006. Beginning in 1995, the countries began negotiating the
harmonization of regulations necessary for creating a single market. As the Europeans
discovered when they tried to create a common market, this project is quite difficult and
will take time to complete. There is also a commitment to the free movement of labor
within the countries, but no formal date has yet been made. MERCOSUR has signed a
free-trade area agreement with Chile that will be implemented in phases through 2014.
However, substantial tariff cuts have already been made on both sides. MERCOSUR
plus Chile is now a trade area containing 240 million people with a total economic output
of over $1 trillion. The agreement has had an explosive effect on trade. From 1990 to
1995, intra-regional trade expanded from less than $6 billion to over $14 billion. The
trade flows could grow even larger. Intra-group trade in NAFTA is 4.5 percent of GDP
and in the EU it is 14 percent. Within MERCOSUR, intra-group trade is still only 1.6
percent. MERCOSUR is also likely to expand as it is currently negotiating with Bolivia
212 Chapter 9

and will likely expand to the other members of the Andean Group (Bolivia, Colombia,
Ecuador, Peru, and Venezuela).

12. In a sense, RTAs and MTN are substitutes. If a country desires to move toward freer
trade, then it could do so by negotiating in an MTN under the auspices of the WTO.
Likewise, the country could move toward freer trade by negotiating bilateral trade
agreements with any number of countries. In both cases the country has moved towards
freer trade. However, RTAs and MTNs also are complements. The participation of a
country in an MTN does not preclude a country from negotiating RTAs. Since both types
of trade agreements lead to freer trade, MTNs and RTAs are complements.