11

1
INTERNATIONAL International Trade
Agreements
AGREEMENTS: TRADE, 2
International
LABOR, AND THE Agreements on
Labor Issues
ENVIRONMENT 3
International
Agreements on the
Environment
4
Conclusions
 Introduction
• 1999 WTO trade negotiations in Seattle, WA were
the first to be heavily protested, with protests
sometimes turning violent.
• Past trade negotiations had focused on lowering
tariffs in most sectors of members’ economies.
• Remaining barriers to trade, however, dealt with
regulatory barriers, such as environmental
regulations.
• The Uruguay Round (1986–1994) allowed for
countries to bring disputes if they felt they were
excluded from a market due to unreasonable
environmental standards.

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 Introduction
• These new rules infuriated many groups who
thought the WTO might threaten their
environmental interests.
• Additionally, many felt it undesirable for a panel in
Geneva to make rulings affecting domestic
regulations.
• All these groups gathered in Seattle to voice their
dissatisfaction with the WTO.
• The goal of this chapter is to examine why
international agreements are needed, and how
these agreements affect labor and environmental
issues.

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 International Trade Agreements
• Countries will often enter into a trade agreement to
reduce trade barriers between themselves.

• The WTO is a multilateral trade agreement, involving

many countries, all with the goal of reducing tariffs
between member countries.
 WTO has negotiated many trade agreements.
 Under the most favored nation principle, the lower tariffs agreed
to in these negotiations must be extended equally to all WTO
members.
 New members get these benefits, but must also agree to lower
their own tariffs.

• To demonstrate a multilateral trade agreement, we will

assume there are only two countries.
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 International Trade Agreements

• The Logic of Multilateral Trade Agreements

 Tariffs for a large Country
 Figure 11.1 shows the effects of a tariff on a large country
(Home).
 We found before that a tariff leads to a deadweight loss for
Home: (b+d).
 We also saw a terms-of-trade gain for Home, e, which equals
the reduction in Foreign price due to the tariff times the Home
imports with the tariff.
 If Home applied the optimal tariff, then the terms-of-trade gain
exceeds DWL, and Home gains overall.
 For Foreign, a DWL, f, exists from inefficient production levels.
 The Home gain comes at the expense of an equal terms-of-
trade loss for Foreign, e, plus the DWL, f.

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 International Trade Agreements
Figure 11.1

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 International Trade Agreements
• The Logic of Multilateral Trade Agreements
 We stated before that it is optimal for large countries to
impose small tariffs, but that did not consider strategic
interactions between multiple large countries.
 If every country imposes a small optimal tariff, is it still
optimal behavior for these countries?
 Figure 11.2 shows the payoff matrix between Home
and Foreign, both large countries deciding to impose a
tariff.
 Assume the two countries are the same size so payoffs
are symmetrical.

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 International Trade Agreements

Figure 11.2

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 International Trade Agreements
• Prisoner’s Dilemma
 The pattern of payoffs we just saw has a special
structure called the “prisoner’s dilemma”.

 This is similar to our situation where each country

acting on its own has an incentive to apply the tariff, but
doing so makes both worse off.
 Nash Equilibrium
 The only Nash equilibrium in figure 11.2 is the lower right
quadrant—both countries apply a tariff.
 To move from that point unilaterally would increase a country’s
loss, (e+f) > (b+d+f), so the Nash equilibrium for both countries
is to apply the tariff.
 Free trade agreements can help move us away from this
equilibrium.
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 International Trade Agreements
• Regional Trade Agreements
 In this case countries eliminate tariffs among
themselves, but keep tariffs against other countries.

 Article XIV of the GATT states regional trade

agreements are acceptable as long as the group does
not jointly increase tariffs against outside countries.
 Sometimes they are called preferential trade
agreements.
 Member countries are favored over other countries.

 This violates the MFN principle, but RTA’s are permitted

because they are a positive move toward free trade
with a larger group of countries.

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 International Trade Agreements

• Regional Trade Agreements

 Free trade area
 A group of countries agreeing to eliminate tariffs (and other
barriers to trade) between themselves, but keeping whatever
tariffs they formerly had with the rest of the world.
 In 1989, Canada entered into a free trade agreement with the
U.S. known as the Canada-U.S. Free Trade Agreement
(CUSFTA).
 In 1994, Mexico was included to create the North American
Free Trade Agreement (NAFTA).
 Each of these countries have their own tariffs with all other
countries of the world, but have worked to eliminate trade
barriers with each other.

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 International Trade Agreements

• Regional Trade Agreements

 Customs Union
 Similar to a free trade area, except that in addition to eliminating
tariffs among countries in the union, the countries within a
customs union also agree to a common schedule of tariffs with
each country outside the union.
 Examples are the European Union (EU) and the signatory
countries of Mercosur South America.
 All countries in the EU have identical tariffs with respect to each
outside country, as does Mercosur.

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 International Trade Agreements

• Regional Trade Agreements

 Rules of Origin
 If China is looking to export a good to Canada, it will want to do
so at the lowest cost.
 If Canada has high tariffs on that good, but Mexico has low
tariffs, why not export to Mexico and then trade it freely to
Canada?
 Free trade areas have complex rules of origin.
• content requirements
 The good from China to Mexico would not get duty-free access
to Canada in this example.

 So what are the economic effects of regional trade

agreements, in either case?

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 International Trade Agreements

• Trade Creation and Trade Diversion

 When trade agreements are made, the increased
trade can be of two types.
1. Trade creation occurs when a member country
imports a product from another member country that it
made for itself before.
 Gain in consumer surplus for importing country due to lower
prices.
 Gain in producer surplus for exporting country due to
increased sales.
 Same as opening trade effect in Ricardian or HO models.
 No other country is affected because the good was not traded
at all before—welfare gains for both countries.

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 International Trade Agreements

• Trade Creation and Trade Diversion

2. Trade diversion occurs when one member country
imports a product from another member country that it
was previously importing from an outside country.
 Trade is taken away from one country and moved to
another country.
 This is not always the most efficient move since the
former country might have been producing at lower
costs, but due to changes in tariffs, it ends up cheaper
to import from the member country.

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 International Trade Agreements

• Numerical Example of Trade Creation and

Diversion
 Let’s consider an example from NAFTA where an auto
part is now imported by the U.S. from Mexico instead of
from China.

 We can keep track of the gains and losses for the

countries involved.
 Asia loses export sales, loss in producer surplus.
 Mexico gains producer surplus from increased sales.
 Since Mexico is not the most efficient producer, there is
potential social loss due to the trade diversion.

 We can see the potential cost amount in Table 11.1.

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 International Trade Agreements

Table 11.1 Cost of Importing an Automobile Part

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 International Trade Agreements
• Trade Creation
 Assume there is a 20% tariff.
 After NAFTA, the U.S. will import from Mexico for $20, since it
costs more to import from Asia ($22.80) or to make it themselves
($22).
 The U.S. clearly gains from the lower cost of the part, Mexico gains
through exports to the U.S., and Asia is unaffected since it was not
exporting at that tariff level anyway.

• Trade Diversion
 Now suppose the tariff was 10% instead.
 Before NAFTA, the U.S. imported the part from Asia for $20.90.
 After NAFTA, it will import from Mexico at a price of $20.
 What about the U.S.? Although they gain $0.90 on each part, they
lose $1.90 in tariff revenue from each import from Asia.
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 International Trade Agreements

• Trade Diversion in a Graph

 Figure 11.3 shows the free-trade price of the part from
Asia, with the free-trade export supply curve for Asia.
 We assume the U.S. is a small country relative to the potential
supply from Asia.

 Before NAFTA, both Mexico and Asia face the same

tariff.
 Start with equilibrium at point A.

 Of total imports, Q2 comes from Mexico at B, since

under perfect competition these imports have the same
tariff-inclusive price as those from Asia.
 With NAFTA, imports from Mexico rise to Q3.

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 International Trade Agreements
Figure 11.3 The
Afterprice facedthe
NAFTA, byrelevant
the U.S. supply
with thecurve
tariff,isbefore
Smex. NAFTA,
Equilibriumis
Net Loss At this
Pimports price, theand equilibrium
U.S.Mexico imports
C. MCtotal Q1 +tat A. Of the
asia+t with
fromAsia
Mexico are nowsupply
Q3 at curves of
forSMexico
asia and
are
total
Shigher imports, Q2 will be
at Sfrom Mexico at B
mex+t so price stays asia+t
Price

•The U.S. loses tariff revenue of

(a+b+c)
Smex+t •Mexico gains producer surplus of
(a+b)
•The
The combined effect of NAFTA is a
US gains tariff
Smex
net loss ofofc (a+b+c+d)
revenue

B C A
Pasia+t Sasia+t
a b c d
Pasia Sasia

MUS

Q2 Q3 Q1 Import Quantity

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 International Trade Agreements

• Interpretation of the Loss

 The combined loss c can be interpreted as the average
difference between Mexico’s MC and Asia’s MC times
the extra imports from Mexico.

 This is similar to the “production loss” or “efficiency

loss” we saw with a tariff for a small country.

 What we have to remember is that even though we

moved to free trade between Mexico and the U.S., the
tariff with China remained.
 It is really only a partial step toward free trade, which can
clearly be bad for countries involved.

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 International Trade Agreements

• Not all trade diversion creates a loss.

 The previous loss is only a possible outcome,
depending on Mexico’s MC’s.

 There could be a gain to the importing country.

 In figure 11.3, suppose that after joining NAFTA,

Mexico has significant investment into the auto parts
industry, and its supply curve shifts to S’mex.

 Equilibrium is then at D at a price of Pasia and Mexico

will fully replace Asia as a supplier of parts.

 Clearly Mexico’s producer surplus still gains as well.

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 International Trade Agreements
Figure 11.3 If Mexico has significant investment in auto parts after
Net Gain NAFTA, supply could shift to S’mex increasing equilibrium
Price imports to point D.
U.S. still loses tariff revenue of (a+b+c+d).
But gains consumer surplus of
Smex+t (a+b+c+d+e) for a net U.S. gain of e.

Smex
S'mex

Pasia+t B C A
Sasia+t
a b c d e
Pasia Sasia
D

MUS

Q2 Q3 Q1 Import Quantity

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 International Trade Agreements

• Trade Diversion in a Graph

 It is very possible for any particular case to have
elements of trade diversion and trade creation.

 NAFTA and other regional trade agreements have the

potential to create net gains for members.

 However, this is only true if the amount of trade creation

exceeds the amount of trade diversion.

 Now we can use this information to see the effect on

Canada and the U.S. of opening free trade.

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 Trade Creation and Diversion for Canada

APPLICATION
• Professor Daniel Trefler has analyzed the effects of
CAFTA and NAFTA on Canadian manufacturing industries.
 Estimates the amount of trade creation and diversion for Canada
in its trade with the U.S.

• He finds the reduction in Canadian tariffs on U.S. goods

increased imports of those goods by 54%.
 Trade Creation

• Purchasing those goods from the U.S. decreased their

imports from other countries by 40%.
 Trade Diversion

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 Trade Creation and Diversion for Canada

APPLICATION
• 54% of the trade creation is multiplied by the 80% of
Canadian imports that come from the U.S.
• 40% of lost imports from the rest of the world is multiplied
by the 20% that typically comes from the rest of the world.
• Taking the difference between trade created and diverted,
we get:

80% x 54% - 20% x 40% = 35% > 0 Since this number is

positive, trade creation is
Share of Increase Share Decrease greater than trade
US in US of other in other
imports imports imports imports diversion. Canada gained.

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