Lecture 11
International Agreements: Trade, Labor, and the Environment
When two or more countries seek to realize welfare gains by reducing trade barriers between
them, they enter into a trade agreement: a pact to reduce or eliminate trade restrictions.
Trade Agreements: Motivation for Mutual Tariff Reduction
Figure 10.1: Tariff for a Large Country
The tariff shifts up the export supply curve from X* to X*+t. As a result, the Home price
increases from PW to P*+t, and the Foreign price falls from PW to P*. DWL at Home is the
area of the triangle (b+d), and Home also has a ToT gain of area e.
Foreign loses the area (e+f), so the net loss in world welfare is the triangle (b+d+f).
Payoffs in a Tariff Game

This payoff matrix shows the welfare of the Home and Foreign countries as compared to
free trade. Welfare depends on whether one or both countries apply a tariff.
The structure of payoffs is similar to the “prisoner’s dilemma,” because both countries
suffer a loss when they both apply tariffs, which is the Nash equilibrium.
The same logic comes into play when countries agree to join the WTO. They are required
to reduce their own tariffs, but in return, they are also assured of receiving lower tariffs
from other WTO members. That assurance enables countries to mutually reduce their
tariffs and move closer to free trade.


Preferential Trading Agreements

Nations establish preferential trading agreements under which they lower tariffs (zero)
with respect to each other but not the rest of the world.

The formation of preferential trading agreements are permitted under Article XIV of
WTO if they lead to lower tariffs between the agreeing countries, without eliminating
tariffs on goods imported from the rest of the world.
Types of Trade Agreements
• A free trade area allows free-trade among members, but each member can have its own
trade policy towards non-member countries.
• Example: The North American Free Trade Agreement (NAFTA) creates a free
trade area.
•
A customs union allows free trade among members and requires a common external
trade policy towards non-member countries.
• Example: The European Union (EU) is a full customs union.
•
A common market is a customs union with free factor movements (especially labor)
among members.
Are Preferential Trade Agreements Always Beneficial?
 It depends on whether it leads to trade creation or trade diversion.
 Because customs unions and free trade areas involve only partial elimination of tariffs, they
can lead to unexpected results: as pointed out by Viner (1950), the countries left out of the
union and even the countries inside the union can become worse off.
 The formation of a preferential trading agreement leads to the trade creation and trade
diversion.
• Trade creation: replacement of high-cost domestic production by low-cost imports from
other members.
•
Trade diversion: replacement of low-cost imports from non members with higher-cost
imports from member nations
Case 1: Trade Distortion Dominates
P/car
PUK(Home) = PJap + uniform tariff
b
PGer(union member)
e
PJap(non-union country -world)
M (import demand in UK)
M0 M1
Car
b = gains from moving toward free trade
e = losses from encouraging people to buy from higher cost partner suppliers
= tariff loss
Case 2: Trade Creation Dominates
P/car
PUK(Home) uniform tariff
b
PGer(foreign partner i.e., Germany)
PJap(outside –world i.e., Japan)
e
M (import demand in UK)
M0
M1
Car
Numerical Example of Trade Creation and Diversion
US Cost of Importing an Automobile Part
If there is a 20% tariff on all countries, then it would be cheapest to buy the auto part from
itself (for $22). But when the tariff is eliminated on Mexico after NAFTA, then the U.S. would
instead buy from that country (for $20), which illustrates the idea of trade creation. If instead
we start with a 10% tariff on all countries, then it would be cheapest for the U.S. to buy from
Asia (for $20.90). When the tariff on Mexico is eliminated under NAFTA, then the U.S. would
instead buy there (for $20), illustrating the idea of trade diversion
Evidence on Regional Agreements (Optional)
Britain Joining the European Economic Community
Grinols (1984) examined Britain joining the EEC in 1973. This meant that Britain had to adopt
the common external tariff of the EEC.
Grinols measured the prices for British exports and imports during the years after its membership
in the EEC. In every year from 1973-1980, it turned out that the
British terms of trade had fallen from 1972, and the amount of this decline averaged about 2.3%
of British GDP. (This amount include the lost tariff revenue on imports, which automatically
become property of the customs union, and the average drop in the terms of trade without
including tariff revenue was still 1.7% of GDP.)
In order to compensate for this loss, Britain would have needed to obtain some transfer from the
EEC. There was a wide range of transfers between countries as part of EEC membership. The net
transfers were slightly in Britain’s favor, but not enough to offset the terms of trade loss.
This does not necessarily imply that Britain was worse off, however, since it still enjoys free
trade within the EEC, and so had efficiency gains on both the consumption and production side
for that reason. Grinols attempts to evaluate these gains for Britain and finds that they are quite
small. The conclusion is that its membership in the EEC in 1973 led to a welfare loss that
averaged about 2% of GDP annually through 1980.
Brazil joining MERCOSUR
Chang and Winters (2002) study the costs and benefits of Brazil joining MERCOSUR This
customs union had the effect of eliminating tariffs between Brazil and Argentina, Paraguay and
Uruguay, as well as equalizing their external tariffs. Chang and Winters find that many of the
prices charged by external countries including the U.S., Japan, Germany, Korea and Chile indeed
fell as a result of the change in Brazilian tariffs. The direct impact of the change in the Brazilian
external tariff is smaller than the indirect effect of the elimination of its tariff with Argentina.
On average, foreign prices charged to Brazil fall by one-third as much as the drop in the tariff
with Argentina (and by even more if yearly fixed effects are used). This implies a significant
terms of trade gain for Brazil and loss for the exporting countries.