EC 340 International Trade Agreements (Unit 7)

Import tariffs for a large country **Flip card around to see pic** Trade gain for Home= e DWL at Home= b+d Net effect on Home welfare= e-(b+d) Trade loss for Foreign= e DWL for Foreign= f Net effect on Foreign welfare: -(e+f)

What is the trade gain for Home? What is the DWL for Home? What is the net effect on Home welfare? What is the trade loss for Foreign? What is the DWL for Foreign? What is the net effect on Foreign welfare?

What are the types of regional trade agreements in which tariff rates are set at or near 0? (2 types)

1. A free trade area 2. A customs union

Types of international trade agreement (2)

1. Multilateral trade agreements 2. Regional trade agreements

World Trade Organization (WTO) negotiations address trade restrictions (3 ways)

1. Reducing tariff rates through multilateral negotiations 2. Binding tariff rates: a tariff is bound by having the imposing country agree not to raise it in the future 3. Eliminating non tariff barriers: quotas and export subsidies are changed to tariffs because the costs of tariff protection are more apparent and easier to negotiate (subsidies for agricultural exports are an exception)

When a regional trade agreement is formed and trade increases between member countries, the increase in trade can be of what 2 types?

1. Trade creation 2. Trade diversion

Trade diversion graph: US imports from Mexico and Asia

Before NAFTA, the US imposes a tariff on all imports -US imports from Mexico= Q2 -US imports from Asia= Q1-Q2 -Domestic price= P(asia)+t After NAFTA, the US imposes a tariff on imports from Asia only -US imports from Mexico= Q3 -US imports from Asia= Q1-Q3 -Domestic price= P(asia)+t

Welfare implications of a regional trade agreement

It is very possible for any particular case to have elements of trade diversion and trade creation Trade creation increases welfare, but trade diversion reduces welfare NAFTA and other regional trade agreements have the potential to create net gains for members if the amount of trade creation exceeds the amount of trade diversion

Prisoner's dilemma

A situation involving payoffs to two people, who must decide whether to cooperate or defect In the end, trust and cooperation lead to higher joint payoffs than mistrust and defection However, since they cannot communicate and do not know what the other is doing, the Nash equilibrium for this game is that both criminals confess and serve for 5 years

Why does a move to free trade make a country worse off?

Asia is the more efficient producer of the good for units Q3−Q2 with MC = P(asia) When production is diverted to Mexico, the extra exports from Mexico are produced at MC = P(asia)+t. The combined loss c can be interpreted as the average difference between Mexico's MC and Asia's MC times the extra imports from Mexico This is similar to the "production loss" or "efficiency loss" we saw with a tariff in Unit 5

Trade diversion graph: US imports and tariff revenue, and Mexico's PS

Before NAFTA the US imposes a tariff on all imports -Total US imports= Q1 -US tariff revenue= a1+a2+b+c+d -Mexico's producer surplus= a1 After NAFTA the US imposes a tariff on imports from Asia only -US imports from Asia= Q1-Q3 -US tariff revenue= d -Mexico's PS= a1+a2+a3+b After NAFTA, US loses tariff revenue of= a1+a2+b+c -Mexico's PS increases by= a2+a3+b -The combined effect is= -c

Trade creation/Trade diversion example: cost of importing an automobile part

From Mexico before NAFTA at 10%: $22 From Asia before NAFTA at 10%: $20.90 The US cost: $22 *Q:* Before NAFTA, a 10% tariff is imposed on Mexico and Asia. Would the US import? If yes, from which country? *A:* They would import from Asia because it is the cheapest --- From Mexico after NAFTA at 0%: $20 From Asia after NAFTA at 10%: $20.90 The US cost: $22 *Q:* After NAFTA, the tariff on parts from Mexico=0% but the tariff on Asia remains at 10%. Would the US import? If yes, from which country? *A:* They would import from Mexico because it is the cheapest --- Since the US switches its trade partners from Asia to Mexico, NAFTA leads to trade diversion from Asia to Mexico Since the price reduces from $20.90 to $20, the total amount of imports should increase. Thus, there is also trade creation in this case

T/F: in brief, the difference between a free trade area and customs union is that the first is politically straight forward but an administrative headache while the second is just the opposite

True

International trade agreement

Is a pact to reduce or eliminate trade restrictions and move toward free trade

T/F: the tariff game has a structure of payoffs similar to the prisoner's dilemma

True

T/F: trade creation increases welfare

True

How does WTO eliminate the prisoner's dilemma?

The WTO provides a mechanism to eliminate the prisoner's dilemma by giving an incentive to remove tariffs Those who join the WTO must agree to remove some tariffs, but in return they get lower tariffs from other members. This allows us to move closer to free trade The WTO's dispute settlement underscores the rule of law, and is the central pillar of the multilateral trading system.

What is the most important aspect of the WTO?

The most important aspect of the WTO is its dispute settlement procedure This is a formal procedure where countries in a trade dispute can bring their case to a panel of WTO experts to rule upon

Assume Home and Foreign are both large countries. In Unit 5, we assumed that if only Home imposed a tariff but Foreign did not, then: -the net effect on Home welfare= e-(b+d) -the net effect on Foreign welfare= -(e+f) -assume that e>(b+d), so that Home gains from the tariff Now suppose that both Home and Foreign impose tariffs and that the tariffs are the same size. What is the outcome and the net effect on welfare?

The terms-of-trade gain that each country gets from its own tariff is canceled out by the terms-of-trade loss it suffers because of the other country's tariff The net effect on welfare is -(b+d+f) for both countries

How does trade creation increase welfare?

There is a gain in CS for the importing country due to lower prices. The gain in CS can outweigh the loss in PS for the importing country If there was no trade before, but there is new trade after the trade agreements, then: - there is a gain in PS for exporting country due to increased sales - thus, there are welfare gains for both member countries - no countries outside the trade agreement affected because the good was not traded at all before the agreement - same as the opening of trade in the Ricardian or Heckscher-Ohlin models

T/F: trade diversion reduces welfare

True

Payoffs in a tariff game

This payoff matrix shows the welfare of the Home and Foreign countries as compared with free trade (upper left quadrant) 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 (however this is the NE) The Nash equilibrium is the lower right quadrant. Although it leads to an undesirable outcome for both countries, it is the best choice if the other country imposes a tariff

Smoot-Hawley Tariff Act

This was passed by US Congress in 1930 and was the high point of US protectionism. US average tariffs were raised to 53% on protected imports. It provoked retaliation by US trading partners and within 2 years, world trade decreased by nearly 2/3. Following Hoover's defeat in the presidential election of 1932, the Democrats dismantled it Because of this, the average tariff rate of the US has steadily declined

The Reciprocal Trade Agreement Act

This was passed by US Congress in 1934 and set the stage for a wave of trade liberalization -US offered to lower tariffs on some imports if another country would lower its tariffs on some US exports Aimed at tariff reduction, the act contained two features: 1. negotiation authority: the president was given the unprecedented authority to negotiate bilateral tariff-reduction agreements with foreign governments 2. generalized tariff reductions through the most-favored-nation (MFN) clause. This clause is an agreement between two nations to apply tariffs to each other at rates as low as those applied to any other nation In 1998, the term most-favored-nation was replaced with normal trade relations.

Regional trade agreement: customs union

an agreement that allows free trade among members and requires a common external trade policy towards non-member countries -Example: the European Union and signatory countries of Mercosur South Africa

Regional trade agreement: free trade area

an agreement that allows free trade among members, but each member can have its own trade policy towards non-member countries -Example: NAFTA

Trade diversion

occurs when a member country imports a product from another member country that it formerly imported from a country outside of the new trade region It reduces welfare

Trade creation

occurs when a member country imports a product from another member country that it made for itself before or when the total amount of trade increases due to reduced prices after the trade agreement It increases welfare -there are welfare gains when the economy moves from no trade to free trade -there are welfare gains from increased trade due to reduced prices

Multilateral trade agreements

trade agreements involving multiple countries with agreements to lower tariffs between all members Since 1944, much of the reduction in tariffs and other trade restrictions has come about through international negotiations -In 1947, 23 countries began trade negotiations under a provisional set of rules that became known as the General Agreement on Tariffs and Trade (GATT) -In 1995, the World Trade Organization (WTO) was established for implementing multilateral trade negotiations (and policing them) Under the most favored nation principle of the WTO, the lower tariffs agreed to in multilateral negotiations must be extended equally to all WTO members

Regional Trade Agreements

trade agreements involving several countries, often located near each other Example: NAFTA, EU Article XIV of the GATT states regional trade agreements are acceptable as long as the group doesn't jointly increase tariffs against outside countries. However, they do contradict the most favored nation principle -countries in the regional trade agreement are treated better (no tariffs) than countries outside the agreement. They are also called preferential trade agreements -although they violate the most favored nation principle, they are permitted because they are viewed as a positive move toward free trade with a larger group of countries