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Regional Trade
Agreements
CHAPTER 8

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Introduction
 “Multilateralism” refers to the GATT/WTO system as well as the trade
negotiations that take place among all GATT/WTO members as a group
 Recall that one of the founding principles of this system is
nondiscrimination
 Involves the most favored nation (MFN) and national treatment (NT) sub-
principles
• Each WTO member must grant to each other member treatment as favorable as
they extend to any other member country
 “Regionalism” refers to a violation of the nondiscrimination principle in
which one member of a regional trade agreement (RTA) discriminates in
its trade policies in favor of another member of the RTA and against
nonmembers
 Has been allowed by the GATT/WTO under certain circumstances
• Free trade areas (FTAs)
• Customs unions (CUs)
• Interim agreements leading to a FTA or CU “within a reasonable length of time”

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Introduction
 Regionalism and multilateralism represent
two alternative trade policy options
 When multilateralism “falters” regionalism
“picks up the pace”
 Nearly every member of the WTO is also a
member of at least one RTA
 Over 150 RTAs exist

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Table 8.1. Types of Regional Trade
Agreements

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Regional Trade Agreements
 Consider two countries—Brazil and Argentina
 Suppose these countries initially pursue independent and
non-preferential trade policies
• Trade policies of these two countries are not coordinated in any
way and do not discriminate among countries
• There is no integration of the countries’ labor, capital, and money
markets
 First-level RTA is known as preferential trade area
 Brazil and Argentina lower their trade barriers between
each other, but do not eliminate them
• Labor and capital markets remain unintegrated
 Because the two countries have not fully eliminated trade
barriers between each other, this type of RTA is not
allowed by the WTO

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Regional Trade Agreements
 Second-level RTA is known as free trade area
 Brazil and Argentina eliminate the trade barriers between each other
 With regard to non-member countries Brazil and Argentina pursue
independent policies
 Labor and capital markets remain unintegrated
 Third-level regional agreement is known as customs union
 Brazil and Argentina eliminate the trade barriers between each other
 Additionally, member countries adopt common trade barriers with
regard to non-member countries (often referred to as a common
external tariff)
 Labor and capital markets remain unintegrated
 Fourth-level RTA is known as common market
 A customs union in which labor and capital markets are integrated
into a regional market
• Any restrictions on movements of labor and physical capital (direct
foreign investment) have been removed

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Regional Trade Agreements
 WTO members who wish to form FTAs or CUs may
do so
 However, there are certain requirements
• Trade barriers against non-members cannot be “higher or more
restrictive than” those in existence prior to the FTA or CU
• FTA or CU must be formed “within a reasonable length of time”
• FTA or CU must eliminate trade barriers on “substantially all the
trade” among the members
• With regard to services, the General Agreement on Trade in
Services (GATS) requires that the FTA or CU involve “substantial
sectoral coverage”

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Regional Trade Agreements
 How to determine whether a product is from a
partner country
 Suppose that Brazil and Argentina form a RTA
• Shirt produced in Venezuela is imported into Brazil and label
“Made in Brazil” is attached
• Shirt can then be imported into Argentina with no restrictions or
tariffs—product is not really made in Brazil
• To protect against such possibilities, RTA members usually
define rules of origin
 Can be defined in a number of ways, including by
 Amount of value added in an RTA partner country
 Degree of product transformation

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The Economic Effects of
Regional Trade Agreements
 Trade creation
 Occurs when the formation of a FTA or CU leads
to a switching of imports from a high-cost source
to a low-cost source
• Tends to improve welfare
 Trade diversion
 Occurs when imports switch from a low-cost
source to a high-cost source
• Tends to worsen welfare

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Trade Creation and Trade
Diversion
 Let’s discuss trade creation and trade
diversion using the absolute advantage
model
 Along with Brazil (B) and Argentina (A), we
are also going to refer to a third country,
Venezuela (V)
 Brazil and Argentina are members of a RTA,
whereas Venezuela is not

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Figure 8.1: A Trade-Creating, Regional Trade
Agreement between Brazil and Argentina

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Trade Creation
 Before the RTA, Brazil has in place a specific (per unit) tariff
on imports from both Argentina and Venezuela
 Argentina is the lower-cost producer in comparison to
Venezuela
 Therefore Brazil imports good from Argentina
 Once Brazil joins either a FTA or CU with Argentina, tariff is
removed on imports from Argentina
 Good continues to be imported from Argentina and imports increase
because price has fallen due to removal of tariff
 Consumer surplus in Brazil increases while producer surplus
and government tariff revenue falls
 Net increase in welfare due to trade creation

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Trade Diversion
 Before the RTA, Brazil has in place a specific (per unit) tariff
on imports from both Argentina and Venezuela
 Assume Venezuela is now the lower-cost producer in
comparison to Argentina
 Brazil imports the good from Venezuela
 Once Brazil joins a FTA or CU with Argentina, however,
Brazil switches to Argentina as an import supplier
 Imports expand as the domestic price falls
 Consumer surplus in Brazil increases while producer surplus
and government revenue falls
 Whether net welfare effect is positive or negative depends
 If trade-diverting effects outweigh trade-creating effects then RTA
will reduce welfare in Brazil

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Figure 8.2. A Trade-Diverting, Regional Trade
Agreement between Brazil and Argentina

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The European Union
 Set of agreements among countries of Western
Europe in the realms of economics, foreign and
security policies, and justice and home affairs
 Extend back to the Marshall Plan under which United
States aided in the reconstruction of Europe after World
War II
• Promoted liberalization of trade and payments among European
countries in its zone of influence
 1992 marked the official completion of a common
market in which barriers to labor and physical
capital were to be removed
 Actual completion of a common market is still in process

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Table 8.2: The Evolution of the
European Union

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The European Union
 Some economists argue that trade creation
dominated trade diversion in the EC and EU
 Alan Winters has a more cautionary view
 Despite common external tariff of European Union CU
nontariff barriers increased in certain sectors
 EU subsidies increased in other sectors
 Tsoukalis offers an intermediate view
 Overall trade creation in manufactured goods and overall
trade diversion in agricultural goods
• Largely the result of the Common Agricultural Policy (CAP)—has
protected EEC/EU agriculture from foreign competition and has
involved the heavy use of export subsidies

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The European Union
 Has ventured beyond a common market to a
monetary union with the euro
 A current preoccupation of the EU is the
issue of enlargement
 Expanding membership to include selected
Eastern European countries, as well as Turkey
 Crucial sticking point, especially in the case of
Poland, is the extent to which CAP provisions
are to be extended to new EU members

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The North American Free Trade
Area
 In January 1994 a FTA between Canada, Mexico
and US took place (NAFTA)
 Addressed the following
 Trade in goods
 Financial services
 Transportation
 Telecommunications
 Foreign direct investment
 Intellectual property rights
 Government procurement
 Dispute settlement

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NAFTA Issues
 Impact of NAFTA on wages in the United States—
particularly blue-collar wages
 If assumptions of Heckscher-Ohlin model of international trade hold
true, would expect increased North-South trade to adversely affect
workers in North
 Some observers concluded NAFTA would hurt US workers
• Eventually, a labor side agreement was attached to main NAFTA
agreement
 Mathematical models of NAFTA completed by that time showed an
improvement in US wages as a result of NAFTA trade liberalization
 In retrospect, issue of NAFTA and wages was probably overblown
• Average monthly layoffs in United States as a result of non-NAFTA
causes have been hundreds of times higher than the NAFTA job
displacements following the implementation of this RTA

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NAFTA Issues
 Another prominent issue was trade and the
environment
 Resulted in provisions for the creation of a North
American Commission on Environmental
Cooperation (CEC)
 Focused some of its subsequent efforts to
analysis of industrial pollution within North
America

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Mercosur and the FTAA
 RTA among Argentina, Brazil, Paraguay, and
Uruguay was launched in 1991 with the Treaty of
Asunción
 Common Market of the South, or Mercosur, took on Chile
and Bolivia as associate members in 1996 and 1997,
respectively
 Suggests that the RTA among the four core members is
an actual common market with the free movement of
labor and physical capital
• However, this is not the case
• Mercosur entered into force in 1995 as a FTA with plans to
complete a CU by 2006
• Free movement of labor and physical capital is a long way off

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Mercosur
 Had a positive impact on amount of trade among its four
core members
 Technology profile of traded goods is higher for trade within
Mercosur than for trade between Mercosur and the rest of the world
 However, intra-Mercosur trade is low by world standards
 Troubled by two asymmetries that challenge its smooth
functioning
 Argentina and Brazil dwarf Paraguay and Uruguay in economic size
• Smaller members find themselves somewhat sidelined from the core
relationship between Argentina and Brazil
 Fundamental macroeconomic asymmetries between Argentina and
Brazil
• Exchange rate asymmetries caused a great deal of friction between
Argentina and Brazil

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Free Trade Area of the Americas
 In 1994, governments of 34 countries in Western
Hemisphere agreed to pursue a Free Trade Area of the
Americas
 Negotiations were launched at the Second Summit of the
Americas in 1998 in nine negotiating groups
 Market Access
 Investment
 Services
 Government Procurement
 Dispute Settlement
 Agriculture
 Intellectual Property Rights
 Subsidies, Antidumping, and Countervailing Duties
 Competition Policy

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Regionalism and Multilateralism
 Represent two alternative trade policy options
available to the countries of the world
 The 1950s and 1960s saw “first wave” of RTAs in
developing world
 The 1980’s saw beginning of “second wave” of
RTAs
 What role will the second wave of RTAs play vis-à-
vis the multilateral efforts toward trade liberalization
pursued under the GATT-WTO framework
 Will the second wave of RTAs complement the
multilateral framework or will it work at cross-purposes to
this framework?

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Regionalism and Multilateralism
 Opponents argue
 RTAs are discriminatory by nature
 They draw attention to “spaghetti-bowl” nature of second-
wave RTAs
• Meaning the overlapping nature of most RTAs, with most WTO
members holding simultaneous membership in many RTAs at
once
 For example, Mexico has signed FTA agreements with the United
States, Canada, Nicaragua, Costa Rica, Chile, Bolivia, El Salvador,
Guatemala, Honduras, Colombia, Venezuela, and the European
Union
 The negotiating energies put into RTAs will detract from
those put into multilateral agreements under the auspices
of the WTO

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Regionalism and Multilateralism
 Key issue facing multilateral trading system is how to best manage and
regulate RTAs
 Responsibility falls to the WTO Committee on RTAs
 A number of points are worth stressing here
 GATT-era oversight of RTAs was inadequate
 Marrakesh Agreement establishing WTO included an “understanding” on
RTAs
• Specified that the relevant measure to assess the phrase “shall not be higher or
more restrictive than” is a weighted average of tariff rates and that “within a
reasonable length of time” is to be no more than ten years
• Specifies that all new RTAs must be notified to the WTO and a WTO working
party is to be established to examine each notification and to ascertain its impact
on the multilateral trading system
 WTO could go further and tighten its requirements on the external protection
of FTAs and CUs
 Is possible to lessen the tensions between regionalism and
multilateralism but probably not possible to eliminate these tensions
entirely