Question

Is the proliferation of such agreements (free trade areas, customs unions,etc.) good for world trade in general?

Answer 1

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. 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. 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

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.