Unit 4 Article Review: International Economics

BBA 4351, International Economics 1

Course Learning Outcomes for Unit IV Upon completion of this unit, students should be able to:

5. Differentiate between various regional trading arrangements. 5.1 Discuss the types of regional trading arrangements.

Course/Unit Learning Outcomes

Learning Activity

5.1

Unit IV Lesson Chapter 8 Chapter 9 Article: “How Regional Trade Agreements Can Spark a Fight Over Feta Cheese” Unit IV Article Review

Reading Assignment Chapter 8: Regional Trading Arrangements Chapter 9: International Factor Movements and Multinational Enterprises While the European Union and Canada agree that Feta cheese must come from Greece, the deal underscores the problems with regional trade deals not giving other countries a say. Wolff, A. (2015, August 25). How regional trade agreements can spark a fight over Feta cheese. Fortune.

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Unit Lesson Regional Trade Arrangement A preferential trade represents an agreement between countries to reduce but not eliminate trade restrictions (Carbaugh, 2017). To understand how this agreement works, take a hypothetical example of a trade between Japan and South Korea. Suppose the two countries initially pursue independent policies with non-preferential trade policies. Then, the two countries will not coordinate in any way. In the presence of a preferential trade area, however, Japan and South Korea will lower the trade restrictions with each other—but not eliminate them—while they pursue independent policies when it comes to non-member countries.

UNIT IV STUDY GUIDE

Regional Trading Arrangements

BBA 4351, International Economics 2

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A free trade represents an agreement on the part of a set of countries to remove trade restrictions, tariffs, and import quotas completely among members (Carbaugh, 2017). Using the same scenario above, suppose the

two countries initially pursue independent policies with no free trade area. Then, the two countries will not coordinate in any way. In the presence of a free trade area, Japan and South Korea will eliminate their trade restrictions while they pursue independent policies when it comes to non-member countries. A free trade area is good news to consumers because it could provide access to inexpensive imported goods or services with good quality. Producers might not be happy about it due to an increase in domestic competition; however, in the end, they will find a way to stay competitive through innovations. A customs union represents a group of

countries that agree to eliminate trade barriers and adopt a common external tariff to non-members (Carbaugh, 2017). Using the same scenario above, suppose the two countries initially pursue independent policies with no customs union. Then, the two countries will not coordinate in any way. In the presence of a customs union, however, Japan and South Korea will eliminate the trade restrictions with one another while they impose tariffs on imported goods or services of non-member countries. A common market represents an agreement among a group of countries to eliminate trade restrictions among themselves to employ a common external tariff and to allow free movement of labor and capital among its members (Carbaugh, 2017). Using the same scenario above, suppose the two countries initially pursue independent policies with no custom market; the two countries will not coordinate in any way. In the presence of a common market, however, labor and capital markets are combined into a regional market, and restrictions on movements of labor and physical capital are removed. We have looked at various types of regional trade arrangements, but from an international economist’s perspective, it is more crucial to understand the economic consequences of implementing those treaties in the global environment. Are there any parties gaining or losing from a regional trade arrangement? Why is it occurring? Consider the economic impact of a regional trade arrangement. The course textbook shows graphical analysis (supply and demand, consumer and producer surplus), which might be too complicated if you are not proficient with math and graphs. What follows is a more practical view on economic benefits and costs associated with one type of regional trade arrangement, which is a customs union. A customs union has two types of effects on the world economy: static and dynamic effects. Static Effects First, a customs union influences world welfare in two opposing ways. First, it generates the trade creation effect, which increases a welfare. Second, it generates trade diversion effect, which decreases a welfare. Recall the law of comparative advantage discussed previously. Suppose there are two union member countries: A and B. If country A replaces its domestic production by cheaper imports from country B, then both countries would be better off because each country could engage in producing goods or services that one could produce at a lower opportunity cost. Keep in mind that trade creation effect is comprised of two distinct effects: a consumption effect and a production effect. A consumption effect is represented by an increase in the welfare gain associated with an increase in consumption of goods in an importing country. Under a tariff, let’s say that country A is purchasing imports from country B at a price of $5; however, this country would purchase the same good at a lower price

Individual monitoring the stock exchange on her tablet and laptop (Nagy, 2015)

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of $4.50 as a member of a customs union. As a result, country A could increase domestic consumptions of goods, increasing the welfare gain of country A. Likewise, both countries will be better off through a production effect. When the trade barrier in country A is removed against country B, domestic firms (producers) are encouraged to compete against low production costs. In other words, firms have more incentives to utilize limited resources and time to produce more efficiently. This, in turn, will drive inefficient firms out of the domestic markets, improve the quality of products, and lower the prices of final products. The increase in the welfare associated with more efficient use of limited resources is represented by a production effect. Moreover, the sum of both a consumption and a production effect is trade creation effect. A trade diversion effect indicates that members of a customs union might suffer a welfare loss. Suppose that country C, a non-member of a customs union, is producing goods at a lower cost than countries A and B. This indicates that either country might be worse off in terms of a welfare if country A only imports goods from country B or vice versa. Why? Country A could be better off by importing cheaper products from country C, which is a non-member. A decrease in the welfare loss associated with inefficient world production like this is called a trade diversion effect. Does a customs union increase or decrease the world welfare? The answer is that it depends. If trade creation effect dominates the trade diversion effect, one would expect the total world welfare to increase as a result of forming a customs union; however, the total world welfare would decrease if the opposite is the case. Dynamic Effects Not all welfare consequences of a customs union are static in nature. We also need to consider the dynamic nature of welfare change associated with a regional trading arrangement. Suppose domestic producers of country A can infiltrate into domestic markets of other member countries (B, C, and D) under a customs union. Then, producers will be able to exploit advantages of economies of scale that would have occurred in smaller markets under the trade barrier. Economies of scale under a customs union promote greater competition among producers of member nations. Without a customs union, competition is strictly restricted because a small number of domestic firms tend to dominate the market. Under a loosened market, firms have strong incentives to produce more efficiently (e.g., by keeping prices down, improving or differentiating quality of products), which, in turn, leads to a benefit for consumers. The benefits associated with the aforementioned factors are due to a customs union, which is more dynamic and occurs over the long-term. If these gains dominate the short-term (static) gains or losses associated with a customs union, then the long-term welfare might be even bigger or smaller. Customs Union Example The European Union (EU) is a good example of a customs union, which includes the 28 EU member states (“Reality Check,” 2016). Recent empirical data shows that the EU nations have been achieving economies of scale in products such as automobiles, steel, and copper refining (Carbaugh, 2017). The dynamic effects of economies of scale could be well represented by the European refrigerator industry. Before the EU, only a small number of firms were supported to produce refrigerators to meet domestic demands. With the formation of the EU, large-scale production methods were employed, and countries such as Germany and Italy began to produce 8.5 times more by the late 1960s. The EU is the largest customs union in the world in terms of the economic output of its members (Carbaugh, 2017).

References Carbaugh, R. J. (2017). International economics (16th ed.). Boston, MA: Cengage Learning. Nagy, C. [PIX1861]. (2015). Trading, analysis, forex, chart [Photograph]. Retrieved from

https://pixabay.com/en/trading-analysis-forex-chart-643723/ Reality check: What is a customs union? (2016, July 28). Retrieved from http://www.bbc.com/news/uk-

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