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Economics - Mr. RusseII

" Free Trade and comparative (economic) advantage are the main justification for
internationaI trade."

i) Examine the roIes and pIace of trade bIocs in the gIobaI economy .

A trade bloc or free trade area is a group of countries between which there is free trade in goods and
services but which allows member countries to set their own level of tariffs against non-member
countries. The European Union is the largest multi-national free trade bloc, followed by NAFTA (North
American Free Trade Agreement), MERCOSUR and AFTA (ASEAN free trade area).

NAFTA is a free trade agreement involving Canada, Mexico and the USA. Of the free trade unions
NAFTA is the most limited, as it is restricted to eliminating tariffs, quotas and other trade impediments
amongst the 3 countries involved. There is no common customs or tariff agreement for imported goods
and services or any free movement of citizens allowed. t is a very powerful trade bloc, because of the
economic and political power of the USA. NAFTA is in the process of becoming a free trade zone, as it
has not reached this goal completely, since there are still a number of industries, which receive
protection, such as citrus, lumber and Mexican petroleum.

MERCOSUR is a trade agreement has members in the South America and within ten years will
represent possibly almost all the countries on the continent. Not only a free trade area, it is a customs
union, which means there is a common tariff on all imports from outside the trade bloc.

ASEAN initially began as a political organisation and later created AFTA, which is representative of
Southeast Asian countries. t is a free trade area in the making, as it continues to work out agreements
to eliminate tariffs, quotas and other restrictions on trade. t has concentrated recently on removing
restrictions on capital and services, but it is behind other trade blocs in these areas. ASEAN is trying
to protect themselves from their powerful neighbours - China, Japan and ndia.

The European Union (EU) is probably the most successful multi-national organisation ever created.
Primarily it started out to reduce or eliminate tariffs, it is now evolving into a government that is
bringing its nations of Europe closer together, politically, economically and socially. t may be
suggested that this is the trade bloc that others are trying to become.

The completion of a trade bloc involves the removal of all remaining regulatory and administrative
barriers to trade and to the free movement of labour and capital. Such barriers can be physical i.e.
border checks which are carried out on the flow of goods and the movement of people between
countries. This not only facilitates the movements of goods between member countries, but also for
non-member countries, as they only have to meet one set of requirements and can ship goods to all
countries in the EU. For example, the EU has common tariff, custom and commercial policies towards
all third or foreign countries, which has increased the bargaining power of the EU, since it now
represents around 390 million customers and thousands of businesses. The free movement of people
exists in the EU, as there is now a common European passport for all EU citizens, however airports
and other entry points into the EU will still require passports for people outside the Union.

There are also technical barriers, which are the different rules and regulations imposed by countries
on goods and services for reasons such as safety, health and environment protection. Removing
these means there is complete freedom of capital movements for financial institutions. Fiscal barriers
are the different tax rates applied to goods and services in member countries. One result of a high
indirect tax is to discourage consumption, including imports of the taxed product. Eliminating these
fiscal barriers will create harmony in the structure and rates of indirect taxation. This will reduce the
need for border controls and remove the price distortions, which adversely affects resource allocation.

t is suggested that comparative advantage, which can take place more easily in a trade bloc, shows
that free trade between countries is more likely to increase world production. Comparative advantage
is where a country is able to produce a good more cheaply relative to other goods produced
domestically than another country. A trade bloc aims to eliminate restrictions on trading barriers,
facilitating trade nationally and furthermore on a global level, hence increasing world production, as
countries are able to specialise more in the fields in which they produce more efficiently.
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ii) Comment on the benefits and disadvantages of trade bIocs to member and non -
member countries (60 marks)

t must not be forgotten that there are also long-term political and social benefits to trade blocs.
Member countries understand that they have become part of a union with other countries and
therefore make greater efforts to co-operate with each other. Business contacts will give rise to a
learning, understanding and appreciation of other cultures of trading partners. There then are
economic benefits in existence. The theory of comparative advantage, which exists when a country is
able to produce a good more cheaply relative to other goods produced domestically than another
country, shows that free trade between countries is likely to increase total world production. When a
small number of countries form a free trade area or common market, there will be both gainers and
losers.

Specialisation is increased in the free trade area. A larger market allows countries to allocate their
resources in producing goods or services, of which they can produce well, rather than producing them
inefficiently when other countries can provide them at lower prices (comparative advantage). For
example, in NAFTA, it is clear that in the foreseeable future that Mexico will become the home of
assembly industries that use low-cost labour. Such industries include computer parts, automotive and
textiles. Mexico will then specialise in manufacturing goods, which will therefore become extremely
productive. A drawback to the free trade agreement is interdependency. As countries become more
specialised, they become more dependent on their trading partners, meaning that each country will
loose some control over its economy. Decisions of foreign countries can then greatly affect decisions
in the domestic country. For example, is essential foods are not grown in the domestic economy, or
political conflicts take place, or a strike in the manufacturing sector of a company, which is based in
another country will surely have an effect other sectors of the firm, which are set in another country.
Trade blocs also provide the free movement of knowledge. Companies in the free trade area can set
up subsidiaries in other member countries, where existing technology may be of use. t also allows
businesses to create arrangements where companies can sell its knowledge easily to other
businesses. For example, a US pharmaceutical company can now sell and produce medicines in
Mexico and Canada, allowing consumers in those countries to benefit from the US medical
discoveries. Lower economically developing countries (LEDCs) that are members of trade blocs are
likely to benefit from capital investments from more economically developed countries (MEDCs), which
set up factories and plants in LEDCs, in the hope of taking advantage of cheaper labour.

The existence of trade blocs between countries increases competition. The elimination of tariffs (taxes
on imported goods), quotas (a physical limit on the quantity of goods imported) and other such
restrictions allows companies, who were once restrained from business, to compete on equal footing
with national companies. Domestic industries will therefore face greater competition than before from
firms in other member countries. ncreased competition will encourage innovation, reduce costs of
production and reduce prices, for firms will be price takers of the market, as the market becomes more
perfectly competitive. Although there is likely to be greater competition in the short run, competition is
likely to reduce in the long run, as the theory of perfect competition predicts that competition will drive
the least efficient competitors out of the market. n the USA, for example, NAFTA, has helped in
keeping the prices of textiles, lumber and some agricultural goods low. However, this does not prove
true for all free trade blocs, as the EU and MESCOSUR have created higher tariffs and other
restrictions to goods and services from external countries of the bloc, especially in regards to
agricultural goods, which have kept food prices artificially high. However, increased competition may
force some industries to downsize or shutdown. Trade blocs give rise to trade creation, which takes
place when a country moves from buying in a high cost country to a low cost country. Many people will
then find themselves out of work and may find it difficult to find jobs in that line of work, if they were
previously in specialised jobs.

The costs of production tend to decline for companies of member countries, as they take advantage of
lower costs of labour, cheaper natural resources and easier access to services of greater quality and
specialised knowledge. For example, Dell Computer Corporation, which is based in Texas, USA, is
able to make use of lower costs of labour from Mexico to assemble many of its monitors. U.S. software
and computer companies are helping to make many more Mexican companies more efficient. The
companies in the free trade area will also be able to benefit from economies of scale, where the long
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run average cost of a company will fall, bringing benefits to the consumers, as prices are likely to fall.
These economies of scale could be purchasing, marketing, financial, managerial and technical
economies of scale, and if these can be achieved by national companies, they can then carve a
market for themselves in the free trade area. Then the customer base has increased from on a
national level to the trade bloc level, where there are many other customers in member countries. For
instance, companies in the UK have increased their customer base from 59 million in the UK to 300
million in the European Union. Also with a larger consumer base, there is equally an increase in the
producer base, so that consumers can benefit from a greater variety of goods and services available
to them. These economies of scale will be achieved over a period of time as companies expand
internally or merge with other foreign companies. The size of potential gains will be greater, the more
homogenous the tastes of consumers in the market. Therefore, the firm of a member country will
benefit through greater productive efficiency (achieved when costs of production are at a minimum)
and the consumers within the trade bloc will benefit from lower prices for goods and services.

A union of countries where tariffs, quotas and other restrictions are eliminated means that an
international firm needs only to meet one set of requirements for one country, then it can freely move
its goods around the trade bloc. For example, a Japanese firm will pay the tariff to import its goods into
France and then it can ship its goods around the EU freely. However, the tariffs increase costs for the
Japanese firm, meaning the price of its good may be more expensive in comparison to a homogenous
product produced in the EU, and may cause consumers in the EU to buy domestically produced goods
rather than the Japanese good.

One will then over time be able to see an increase in employment and income. A larger market will
give rise to expansions in companies and demand labour at all levels in the company, from
manufacturing to distribution. Taking NAFTA as an example, manufacturing and assembly plants will
be set up in Mexico, creating job opportunities for Mexicans, and increasing consumption of goods or
services for the US or Canadian firm, seeking low-cost labour. The increased income of Mexican
workers has increased the consumption of US and Canadian goods and services. This increases
employment of high-paying jobs in Canada and the USA. n Mexico, Canada and the USA, income will
have risen and in the long run so will economic growth and the standard of living.