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‡ Geographical proximity and often the sharing of common

borders as in the European Union and NAFTA
‡ Common economic and political interests as in the
European Union and the ASEAN
‡ Similar ethnic and cultural backgrounds as in the Free
Trade of the Americas
‡ Similar levels of economic development as in the
European Union
‡ Similar views on the mutual benefits of free trade as in
NAFTA
‡ Regional political needs and considerations as in the
ASEAN
_   
 


      

‡ Eliminates tariff and quota barriers among

member countries

‡ Each country is free to set its own tariff and quota

barriers against nonmember countries

‡ Can be formed for certain classes of goods or

services only
‡ !   " 
  #
$

‡ Eliminates tariff and quota barriers among member

countries

‡ Member countries establish common tariff and

trade barriers against nonmember countries

‡ Tariff revenues are shared among members

according to a prescribed formula

‡ E.g: The Andean Pact (Bolivia, Colombia, Ecuador

and Peru)
  #

% & 

‡ No trade barriers among member nations

‡ No restriction on the movement of labor, capital,

or technology across borders

‡ Member countries establish common tariff and

trade barriers against nonmember countries
   
 $
‡ Has all the characteristics of a common market,
and,

‡ Requires common currency, harmonization of

tax rates, common monetary & fiscal policy

‡ Requires a high degree of integration and

demands a coordinating bureaucracy and
sacrifice of a significant degree of national
sovereignty
 ( $
‡ Central political apparatus coordinates
economic, social & foreign policy of members.

‡ Example: Canada and United States

    
 
 


‡ There are two opposite effects.

  #  = Increase in trade between
two countries from mutual elimination of
tariffs
± If Mexico and US eliminate tariffs to each
other, US will import more from Mexico and
vice versa.
    
 
 


  '  = shift in imports from non-

members to member countries.
± US will import from Mexico instead of from other
countries.
± The larger the tariff before the agreement, the larger
the loss to other countries.
‡ Net effect depends on which is larger --
trade creation or diversion?
 (# )`|*  ")|`" _
"| `"
+ | '#| `"
`ccurs when high-cost domestic producers are replaced by
low-cost external suppliers within the free trade area.

+ | '',|)`"

`ccurs when lower-cost external suppliers are replaced by

higher-cost suppliers within the free trade area.

A regional free trade agreement will benefit the world only if

the amount of trade exceeds the amount it diverts.

In theory, WT` rules should ensure that a free trade

agreement does not result in trade diversion.
 !
   
* 
‡ In next slide, the US and Japan export autos to Mexico at
prices of $20,000 and $18,000 respectively.
± Suppose Mexico applies a 20% tariff.
± Prices after the tariff applies are $24,000 for the US car
and $21,600 for the Japanese car.

‡ Now let the US and Mexico form a FTA.

± The price of the US car drops to $20,000.
± Trade may be created since US cars are now cheaper
than Japanese cars to Mexican consumers.
± But trade will also be diverted since Mexican consumers
will shift from lower cost (without the tariff) Japanese
cars to higher cost US cars.
    
 
 


‡ The U.S. is less efficient producer ± cost

of production higher.
‡ And trade is diverted from more efficient
producers to less efficient producers.
  )  

‡ Supply/demand model can be used to

show effect of lowering trade barriers
among members.
‡ Mexico, U.S., Japan ± Mexico & U.S. for
customs union
‡ Mexico is small country relative to Japan
and U.S.
‡ Japan is the most efficient supplier of cars
‡ Japan free trade price of P1
‡ Japan tariff price of P3
‡ US free trade price is P2.
‡ Tariff inclusive price of P4
‡ Mexico buys all cars from Japan at P3
before agreement.
‡ Mexico buys Q3 cars and Q2 are
domestically produced.
(  # 
SM

P4 Sus + tariff
P3 Sj + tariff
P2 b a
Sus
c
P1 Sj

DM

Q1 Q2 Q3 Q4 -# 
‡ Mexico removes tariff on US cars only.
‡ US price is now lower than Japan and
Mexico buys all cars from US.
‡ Increase in welfare
± Increase cars purchased ± Q4
± Q1-Q4 imported from US
± Increase in consumption for Mexico ± A
± Less domestic production gain of B
± `verall gain of A + B
‡ Decrease in Welfare
± Trade Diversion
± Higher price supplier (US) replaces imports
from lower price supplier (Japan)
± Welfare loss of C
‡ As long as A+B > C, increase in world
welfare