The Economic Theory of Global Trade Blocs
Clarke Ricks School of Business,
Liberty University
BUSI 690: Policy and Strategy in Global Competition
Dr. Hicks
May 7, 2022
The Economic Theory of Global Trade Blocs
The drafters of the GATT believed that reducing barriers to trade should be on a
multilateral basis to get the greatest benefits of expanded production based on comparative
advantage. As noted above, they enshrined this concept in Article I of the GATT (most-favored-
nation, MFN, treatment), which requires members to give equal treatment with regard to trade
barriers to all GATT members.
However, they also recognized a role for regional integration that would allow the
members of a trade bloc to eliminate barriers on trade among themselves, while maintaining a
discriminatory tariff on imports from nonmembers.[18] Accordingly, Article XXIV of the GATT
provides for a major exception to the MFN principle that allows countries to form customs
unions or free trade areas (FTAs) that may discriminate against nonmembers of the bloc.[19]
In a customs union, the members eliminate trade barriers among themselves but erect a
common customs tariff on imports from nonmembers. Members of a free trade area also
eliminate trade barriers among themselves, but they each retain their own schedule of tariffs
on imports from nonmembers.
Customs unions and free trade area agreements may expand trade and global welfare or
they may diminish welfare depending on whether they create new trade patterns based on
comparative advantage or simply divert trade from a more competitive nonmember to a
member of the trade bloc. In 1950, the economist Jacob Viner defined trade creation as the
situation where a member of a preferential trading bloc has a comparative advantage in
producing a product and is now able to sell it to its free trade area partners because trade
barriers have been removed.
Trade creation benefits the exporters in the member of the trade bloc that has a
comparative advantage in producing a product and it benefits consumers in the importing
member who now can purchase the product at a lower price. Domestic producers competing
with the lower-cost imports from its partner country lose, but their loss is less than the gains to
the exporters and consumers. Trade creation enhances global welfare through this greater
efficiency.
In the case of trade diversion, however, a member gains its sales at the expense of a more
competitive producer in a country that is not a member of the bloc, simply because its products
enter its partner’s market duty free, while the more competitive nonmember producer faces a
discriminatory duty.[20] Nonmember country exporters that would have a comparative
advantage under equal competitive conditions lose from trade diversion.
Additionally, under trade diversion, the importing country loses the tariff revenue it had
collected on those imports which now come in duty free from its bloc partner. The consumer in
the importing partner does gain, because the imported good no longer has to bear the cost of
the tariff; however, the consumer’s gain is necessarily less than or equal to the lost customs
revenue, so the nation as a whole is less well off . Thus, trade diversion hurts both the
importing country and the rest of the world. These loses are greater than the gains to the bloc
member that gains exports due to trade diversion.
If trade diversion is greater than trade creation, formation of the customs union or FTA
would diminish world welfare. If trade creation is greater, then global welfare is enhanced.
In addition to trade diversion and trade creation, which are basically static effects,
participants in free trade areas and customs unions are also seeking dynamic benefits, such as
expanded production as firms take advantage of the increased size of the market to increase
output, and improved efficiency as firms adapt to increased competition. Access to a larger
market is particularly important for small countries whose economy is too small to justify large-
scale production.
To minimize the potential adverse consequences of such trade blocs, GATT Article XXIV
requires that the members of a customs union or an FTA must eliminate trade barriers on
“substantially all” trade between them, and that all the members of GATT have the opportunity
to review the agreement. In the event that a GATT member not a party to the customs union
faces higher tariffs on some products as a customs union is formed, Article XXIV requires that
that member be compensated for the lost trade. However, as noted in chapter 2, Article XXIV
has proven to be totally ineffective in restricting the growth of trade blocs; as a result, trade
patterns today are significantly distorted by these preferential schemes.
Trade Theory Meets New Realities
From the time of Adam Smith in 1776 to the launching of the GATT in 1947, economic
theory of trade evolved fairly slowly. Since the GATT was launched in 1947, however, there
have been a number of significant modifications to the traditional Western economic theory of
international trade. These modifications largely update the basic theory of trade to reflect the
new realities of industry and commerce.
In the times of Smith, Ricardo, and Hecksher-Ohlin, companies were generally small and
most international trade was in agricultural or mineral products or produced by small scale
manufacturing. By 1947, however, large-scale manufacturing had evolved, and a great deal of
trade was in manufactured products.
In 1979, the economist Paul Krugman noted that a great deal of trade was taking place
between developed countries that had similar factors of production. For example, the United
States and the nations of Europe have broadly similar factors of production, yet conduct an
enormous amount of trade generally within the same industries. Thus, the United States will
export automobiles and auto parts to Europe and at the same time import autos and auto parts
from Europe.
The Heckscher-Ohlin model, which is good at projecting likely trade patterns between
countries where factors of production are different, really did not explain this trade pattern.
Krugman’s theory is based on product differentiation and economies of scale. For example, a
Jeep and a Volkswagen are both automobiles, but they are highly differentiated as seen by the
consumer. And both benefit from economies of scale; that is, the larger the production, the
more costs can be reduced within a broad range of volume. Unlike wheat, where costs increase
as volume is expanded, the cost of each additional automobile produced declines as production
is increased, although at a very large volume of production costs would likely start to increase.
Goods such as automobiles require large, mechanized production runs and substantial capital
investment, and it may be extremely difficult for a new entrant to compete with an established
firm.
Under trade based on product differentiation and economies of scale, several countries
may produce the same product broadly defined and trade parts and differentiated products
with one another. Thus, the United States might specialize in producing Jeeps, and Europe
might specialize in producing Volkswagens. Clearly, a great deal of production in modern
developed country economies is in industries that experience increasing returns to scale, and in
these industries returns to factors of production would not tend to equalize as a result of
international trade. In fact, returns to labor in a labor scarce economy might well increase,
rather than decrease, as would be predicted by the factor price equalization theory.
Western economic theory has also changed in recent years to account for the fact that
world trade has increased so much more rapidly than overall economic growth since the early
1970s. In 1973, the ratio of exports to GDP was 4.9 percent for the United States, and by 2005
this had more than doubled to 10.2 percent. For the world as a whole, this ratio was 10.5
percent in 1973, increasing to 20.5 percent in 2005.
What caused exports to increase more rapidly than production is that companies evolved
from being domestically oriented to becoming multinational, and now many have evolved to
become global. The first six rounds of GATT trade negotiations had reduced developed-country
tariffs on industrial goods from the average of 40 percent after World War II to less than half
that level by the end of the Kennedy Round in 1967. Additionally, international
communications and transportation had improved enormously (the first commercial jet crossed
the Atlantic in 1958, and the first satellite for commercial telecommunications was launched in
1965.)
As a result companies in some industries, such as electronics and chemicals, became
multinational corporations and increasingly began to purchase and produce parts and materials
in a number of countries. Each time these parts and materials cross a border, an international
trade transaction has occurred; and then, when the final good is exported, another
international trade transaction has occurred.
This trend has increased enormously during the past twenty-five years, and now this
cross-border trade occurs in virtually all industries. Many products will have parts and
materials from many countries; for example, a new suit may have cotton from West Africa that
has been processed into fabric in Bangladesh, and sewn into a suit in China, with buttons
imported from India. And then the suit may be exported to the United States. Another example
is the first Airbus jumbo jet 380, which had parts and components from more than 1,500
suppliers in twenty seven countries. Many companies today have global supply chains,
procuring parts and materials worldwide. Each specific part or material in the value chain is
sourced from the country that can produce the part most cheaply, whether because of its
endowment of factors of production or because of special incentives, such as tax holidays.
Kei-Mu Yi of the World Bank notes that standard economic models account very well for
the increase in world trade through the mid-1970s but cannot explain the growth of trade since
then.[21] However, a model that accounts for supply chains does explain the growth in trade,
and he believes that such vertical specialization accounts for about 30 percent of world trade
today.
Yi notes that tariff reductions have a far greater impact on these global supply chains than
they do on traditional trade. To take the suit example, assume that China, Bangladesh, and the
United States each reduces its tariffs by 1 percent and that imported fabric and buttons account
for half the cost of the suit made in China; then the cost of producing the suit in China will be
reduced by 0.5 percent. Coupled with the 1 percent U.S. tariff reduction, the cost to the U.S.
consumer would be reduced by 1.5 percent. If the suit had been wholly produced in China, the
cost to the consumer would have been reduced by just the U.S. tariff reduction, or 1 percent.
The emergence of these extensive supply chains has enormous implications. It means
that for many products the traditional concept of “country of origin” no longer applies, because
many products have many countries of origin. This in turn means that standard trade statistics
have limitations in how useful they are for understanding what is really happening in world
trade.[22] It has an impact on how countries should approach economic development, because
it means that developing countries must become part of these global supply chains as a way to
increase the amount of value added in the parts and materials provided to these supply chains.
And it has an impact on how companies see themselves—a firm selling globally and procuring
its parts and materials globally sees itself as a “global” firm rather than as a “national” firm.
