and the European Economic Area (EEA). in the sense that it applies only to the member countries of the trade bloc. the rationale was that developing countries could reap the benefit from economies of scale by opening up their trade preferentially among themselves. The main trade blocs in the world are: (1) in Europe. the European Union (EU). for instance of international competition. Though few. the Canada-US Free Trade Agreement (CUSTA). which involve mostly countries from the North with the South (the North-South trade blocs). investment. This ‘old (first) regionalism’ is also associated with regional initiatives involving developing countries in the 1950s and 1960s. etc. the European Free Trade Agreement (EFTA).1 Based on the objective of import-substitution industrialization. there exist as well regional integration agreements in which co-operation rather than preferential market access is emphasized. The integration of countries into trade blocs is commonly referred to as ‘regionalism’. irrespective of whether the trade bloc has a geographical basis or not. labour and capital markets (including movements of factors of production). It is sometimes also referred to as a ‘natural’ trade bloc to underline that the preferential trade is between countries that have presumably low transport costs or trade intensively with one another. Trade blocs can also entail deeper forms of integration. the so-called ‘new (second) regionalism’. outside countries being discriminated against in their trade relations with trade bloc members.INTRODUCTION A trade bloc can be defined as a ‘preferential trade agreement’ (PTA) between a subset of countries. and the USIsrael Free Trade Agreement. The two principal characteristics of a trade bloc are that: (1) it implies a reduction or elimination of barriers to trade. monetary policy. hence reducing the cost of their individual importsubstitution strategy while the trade bloc became more self-sufficient. More successful experiences followed with the recent proliferation of trade blocs. the European Agreements. (2) with the United States. (3) in . designed to significantly reduce or remove trade barriers within member countries. and (2) this trade liberalization is discriminatory. it is referred to as a ‘regional trade (or integration) agreement’. the North American Free Trade Agreement (NAFTA). When a trade bloc comprises neighbouring or geographically close countries. The first waves of PTAs appeared in the 1930s leading to a fragmentation of the world into trade blocs.

1957). and the Caribbean Community and Common Market (CARICOM). Political and economic considerations also played a major role. the Latin American Integration Association (LAIA).3 Recognizing the gains from liberalization. as in the case of the European Coal and Steel Community (ECSC. 1951) and the European Economic Community (EEC. in Sub-Saharan Africa.Latin America. to insulate a region from the world economy and to stabilize and foster the economy at a regional level. in Latin America and in Sub-Saharan Africa belongs to at least one PTA. MERCOSUR. and (4) in Asia. CEAO/UEMOA and SACU can be considered as effective trade blocs (which does not mean that they are efficient). and almost every country in Europe. focusing on the trend in intrabloc trade intensities and shares. it is often argued that concluding a PTA is politically easier than pursuing multilateral trade liberalization agreements. Communauté Economique de l’Afrique Occidentale (CEAO)/Union Economique et Monétaire de l’Afrique Occidentale (UEMOA). the Southern African Customs Union (SACU). Union Douanière et Economique d’Afrique Centrale (UDEAC). THE CAUSES OF TRADE BLOC FORMATION Several reasons explain the recent emergence of trade blocs. the Adean Group. not all PTAs are effective at liberalising intra-bloc trade. CACM. It is easier to negotiate with few partners than with a large number of participants in the multilateral process as . the Central American Common Market (CACM). the Common Market of the South (MERCOSUR). the Common Market of Eastern and Southern Africa (COMESA)/Preferential Trade Area for Eastern and Southern African States (PTA). and the Australia-New Zealand Closer Economic Relations Trade Agreement (ANZCERTA). The recent emergence of trade blocs (the so-called ‘new regionalism’) has been explained by various factors. the US-Israel FTA. While there is a proliferation of PTAs in the world. The so-called ‘old regionalism’ was motivated by the desire to pursue in developing countries import substitution development at a regional level. the Andean Pact. the Association of Southeast Nations (ASEAN) and the ASEAN Free Trade Area (AFTA). it appears that NAFTA. whereas ASEAN seems to be so far a rather ineffective grouping. For instance.

Trade blocs may exert other types of ‘pressures for inclusion’.addressing modern trade barriers which are more varied. trade blocs may serve to pursue noneconomic objectives. Namely. investments. signalling and insurance mechanisms in the policy determination of its members. trade blocs often involve (small) reform-minded countries willing to bind their commitments to (often unilateral) liberalisation process by entering a PTA with larger entities. labour and capital market considerations.e. In other words. Moreover. they are more likely to form a trade bloc. The gravity model suggests that countries geographically close trade more than distant countries. more complex and less transparent than standard tariffs and quotas traditionally considered under GATT Rounds.envisaged under the General Agreement of Tariffs and Trade (GATT)/World Trade Organization (WTO). Finally. but effective enforcement mechanisms can also be agreed upon at a lower cost. the fewer the number of participants to trade negotiations. Not only concessions can be more easily exchanged among a small number of countries. as trade bloc formation diverts trade at the expense of non-member countries. among other things. PTAs can serve as commitment. geographic distance. As neighbouring countries tend to be ‘natural trading partners’. such as competition. that the volume of trade between two countries is negatively related to the economic distance (i.e. taking into account transport costs and trade barriers) between them. the gravity equation predicts. the larger the number of issues on which it is possible to reach an agreement. More generally. the deepening of an existing bloc or the creation of a new one may cause excluded trading partners to join the PTA in order to reduce the costs of being “left out”: the so-called ‘domino effect’ of regionalism. PTAs also allow trading partners to go deeper and faster in their liberalization process. The length and difficulties encountered during the Uruguay Round of GATT negotiations (1986-1994) is usually considered to have contributed to increase the attractiveness of the regional (i. Preferential integration agreements can also entail elements beyond standard trade policy concerns. Another claimed advantage of PTAs is that they may help ensuring the credibility of the reform process undertaken by one or several members of the trade bloc. Indeed. hence contributing to reducing uncertainty and increasing credibility about political and economic developments. or objectives beyond the immediate economic concerns of a PTA. preferential) path to trade liberalization. such as .

which entails a CU with deeper integration between its members (such as free movements of goods. on the terms of trade (i.political stability. trade barriers between member countries. In analysing the welfare effects of a PTA.7 Trade blocs are examples of second best since a distortion is removed. common economic policies. a move in the right direction. while another distortion is created in the form of a discrimination between members and non-members (the latter facing trade barriers from the PTA). the ‘theory of second best’ points out that removing a distortion while others remain in place may not increase welfare. as well as other market imperfections. a priori. or as a response to third-country security threats. prices) and on the level of protection (generally tariffs) for PTA members and excluded countries. A standard result of international trade theory is that. (2) a customs union (CU). i. The different types of trade blocs (or PTAs) can be broadly distinguished in three categories: (1) a free trade agreement (FTA) where trade barriers among member countries are removed. Hence. in a competitive environment and in the absence of market distortions and externalities.). Removing trade barriers between a subset of countries could therefore appear to be.e. The demonstration of the theory of second best situation entailed by a PTA was derived from the . as well as the adoption of a external tariff structure and trade barriers towards outsiders common to all members of the CU. Yet. or security threats between partner countries). with liberalised intra-bloc trade. but where each member remains responsible for the determination of its trade policy vis-à-vis non-member countries. THE EFFECTS OF TRADE BLOCS Discriminatory trade policy is the defining characteristic of a trade bloc. services and factors of production. and (3) a common market. democratic development or security issues (either domestic security. it is important to distinguish between the impact of trade bloc (formation and expansion) on the welfare of (1) each of its member. the welfare implications of a trade bloc are ambiguous as they depend on many factors. The trade effects comprise the impact of a PTA on the volume and quantity of trade. The effects of a PTA are of two types: the trade effects and the welfare effects. etc. Most of the analyses on the effects of trade blocs focus on FTAs and/or CUs. (2) the trade bloc as a whole and (3) the countries excluded from the trade bloc.e. free trade will maximise global welfare.

Besides. Another important element in assessing the trade impact of a PTA are the price. If the PTA is not economically small. trade diversion and optimal tariffs increase as the world integrates in a smaller number of expanding trading blocs. or ‘terms of trade’. it can also reduce trade between the CU and its trading partners.seminal work of Jacob Viner (1950).10 Hence. the members of a trade bloc can extract rents from the excluded trading partners by setting ‘optimal tariffs’ and behaving in a coordinated strategic way. In particular. and on the other hand on the potential negative welfare impacts resulting from trade diversion and adverse changes in the terms of trade. creating a positive terms of trade effect for PTA members and a likely deterioration of the terms of trade for third countries. This ‘trade diversion’ can potentially reduce welfare for all as a member switches from a relatively efficient. low cost producer outside the CU to less efficient. PTA members buy more from each other (trade creation) and less from third countries.e. effects of a trade bloc. but it also provides opportunities for greater productivity efficiency for industries facing economies of scale and increased competition within . the optimal number of trade blocs in the world depends on the one hand on the potential positive welfare effects resulting from trade creation. which shows that while liberalising trade between a group of countries can lead to ‘trade creation’ between members (which should increase welfare). higher cost producer within the CU. This capacity to influence its terms of trade is an important element in the analysis of the trade policy determination and welfare effects of a PTA. leading to a global misallocation of resources. if countries are symmetric. Due to their increased market power. world prices will be affected as the demand for (and thus the price of) non-member exports decreases. a larger market resulting from the creation and extension of trade blocs does not only increase the market power of its members.8 Most of the debate on the static impacts of trade blocs on the global economy rests on the theoretical and empirical evaluations of whether a PTA is more trade-creating or trade-diverting.12 the welfare losses associated to trade bloc formation and expansions seem to be due more to trade diversion than to potential increases in optimal tariffs. Again. comparative advantages) of the member countries.13 Ultimately.11 Although the level of optimal tariffs with expanding trade blocs depends on the factor endowments (i. Such considerations also led to some predictions with regards the dynamics of trade blocs. as intra-bloc trade is liberalised while extra-bloc trade is not. trade blocs allow member countries to exploit their joint market power over their terms of trade. it is expected that.

FTAs could be considered as more desirable on welfare grounds than CUs. For instance. The fact that countries geographically close trade more together. nor that trade barriers with distant trading partners is desirable. while most analyses on trade blocs either consider PTAs in general. This in turn may contribute to reduce distortions within the trade bloc.16 However.14 it is doubtful that transport costs considerations provide a justification (over other types of costs) for the desirability or superiority of regional trade blocs over non-regional blocs. does not imply that their welfare will improve by forming a trade bloc. Focusing on the rules of origin requirements in a FTA. in particular if the trade bloc is initially formed by large members. is crucial to determine the trade and welfare impacts of a grouping of countries. it is sometimes argued that welfare improving PTAs are likely to be those which (1) are large (stimulating intra-bloc trade). the main lesson from the new theory of regionalism is that there are no strict rules and generalisations are dangerous. it is worth noting that small countries could benefit more from joining a PTA than larger countries.the PTA market. Since trade blocs are more likely to have a positive impact on welfare if they are more trade-creating and less trade-diverting. Finally. as the impacts on trade and welfare of PTAs crucially depend on the model adopted. In this respect. although the notion of ‘natural trade blocs’ (based on lower transport costs associated to regional trade) is common. (2) involve countries at similar stages of development (generating intra-industry trade). the distinction between the forms taken by the PTA. namely a FTA or a CU. Yet. Some trade blocs liberalize more economic transactions than others. THE VARIOUS TYPES OF TRADE BLOCS There are several levels of regional trade blocs. and (3) have a regional basis (since geographic proximity favours trade). when considering the strategic interaction between members and non-members and their potential market power. as small countries will derive relatively larger economic advantages from gaining access to the potentially large market of the bloc. Five major categories of trade blocs are described in the textbook: . as suggested by the gravity model. or associate trade blocs with CUs. it is tempting to conclude that CUs are superior to FTAs as the former generate less trade diversion.

administered by a regional central bank. Preferential trade agreement. Mexico. Free trade area (FTA): . This is done by reducing tariffs. but not by abolishing them completely.  An economic union (EU) has all the characteristics of a CM plus members agree to a uniform set of macroeconomic and microeconomic policies. the euro. A PTA can be established through a trade pact.  A customs union (CU) is a free trade area whose members agree on common tariffs against nonmember countries. PTA: A Preferential trade area (also Preferential trade agreement. It is the first stage of economic integration. which in 2002 adopted a single currency. trade barriers within the group to levels below those erected against outside economies. The line between a PTA and a Free trade area (FTA) may be blurred. member countries agree to lower. and permits the free movement of factors of production among members. as almost any PTA has a main goal of becoming a FTA in accordance with the General Agreement on Tariffs and Trade. and the United States. The European Union. is an example of a free trade area. PTA) is a trading bloc which gives preferential access to certain products from the participating countries. These tariff preferences have created numerous departures from the normal trade relations principle. Under a preferential trade area (PTA). sets common tariffs against outside countries.  A free trade area (FTA) eliminates all trade restrictions between members of the trade bloc. but not eliminate. but each member maintains its own restrictions on trade with third countries.  A common market (CM) allows for the free trade of goods among members. is an example of an economic union. consisting of Canada. namely that World Trade Organization (WTO) members should apply the same tariff to imports from other WTO members. The North American Free Trade Area (NAFTA).

in addition to FTA. The participant countries set up common external trade policy. and preferences on most (if not all) goods and services traded between them. These barriers obstruct the freedom of movement of the four factors of production. they are more likely to form a customs union. and services between the members is as easy as within them.Customs union is established through trade pact. The goal is that the movement of capital. It is the third stage of economic integration. import quotas. The physical (borders). and may be limited initially to a free trade area with relatively free movement of capital and of services. which eliminates tariffs. A common market is a first stage towards a single market. but not so advanced in reduction of the rest of the trade barriers. but it was an economic union since it had additionally a customs union. The European Economic Community was the first example of a both common and single market. but in some cases they use different import quotas. Economic union: . labour. Common maket: A single market is a type of trade bloc which is composed of a free trade area (for goods) with common policies on product regulation. If their economical structures are competitive. If people are also free to move between the countries. and freedom of movement of the factors of production (capital and labour) and of enterprise and services. Customs Union: A customs union is a type of trade bloc which is composed of a free trade area with a common external tariff. Countries choose this kind of economic integration if their economical structures are complementary. technical (standards) and fiscal (taxes) barriers among the member states are removed to the maximum extent possible. goods. Purposes for establishing a customs union normally include increasing economic efficiency and establishing closer political and cultural ties between the member countries. It can be considered the second stage of economic integration.A free trade area (FTA) is a trade bloc whose member countries have signed a free trade agreement (FTA). it would also be considered an Open Border. Common competition policy is also helpful to avoid competition deficiency.

services and the factors of production (capital and labour) and a common external trade policy.An economic union is a type of trade bloc which is composed of a common market with a customs union. neither the countries . The countries share a ECONOMIC UNOIN ECONOMIC Free trade Common INTERGRATION among external members commercial policy Free factor mobility within the market Free factor mobility within the market Free factor mobility within the market Harmonized economic policies Harmonized economic policies Supranational Organizational Structure The Ambiguous Welfare Effects of a Trade Bloc All of the models of international trade discussed earlier in this course showed that free trade maximizes the welfare of all nations. FREE TRADE AREA CUSTOMS UNION COMMON MARKET Free trade among members Free trade Common among external members commercial policy Free trade Common among external members commercial policy Free trade Common among external members commercial policy of movement of goods. It is important to understand that this conclusion only holds in the case of universal free trade. Purposes for establishing a economic union normally include increasing economic efficiency and establishing closer political and cultural ties between the member countries. In the case of trade blocs. freedom common currency. however. The participant countries have both common policies on product regulation. Economic union is established through trade pact.

) Recall from Chapter 4 that this price rise causes domestic deadweight losses equal to the areas b + d. therefore. but maintains tariffs against outside countries. We do this here to simplify the analysis. Unlike the shift to universal free trade among all countries.participating in the trade bloc nor the countries left outside the trade bloc are guaranteed an improvement in welfare. rather than from the world’s true lowest-cost suppliers. That is. may induce importers in a trade bloc country to buy from a higher cost producer within the bloc. You should go back to Lesson 4 to review this model if you have trouble following the discussion here. Suppose that a tariff raises Homeland’s domestic price of trombones from Pw to Pt. a trade bloc has a theoretically ambiguous welfare effect. f. the deadweight losses b + d minus the gain in government revenue paid for by foreign suppliers. a trade bloc that eliminates tariffs among its members. The reason for the ambiguity is that a free trade area creates additional trade among members of the bloc. while it also diverts trade from countries outside the bloc. The welfare loss to Homeland from the tariff is. The formation of a trade bloc may reduce the total value of welfareenhancing production in some or many countries of the world. . (Note that Figure 9-1 shows only the left most and center diagrams from the Two Country Partial Equilibrium Model described in Lesson 4. and it also causes gains for the Homeland government equal to the tariff revenue area c + f. of which f is effectively paid by foreign suppliers. as shown in Figure 9-1. who reside outside the trade bloc.

Then the gains from trade for Homeland are not as clear as they are in the case of free trade with all other economies. which lies above the world supply curve SW. The trade bloc reduces deadweight losses by g + h. but tariff revenue f is no longer paid by foreign suppliers. Thus. as shown in Figure 9-3. g + h can be larger than or smaller than f + j. let’s suppose that Homeland forms a free trade area with one other country while it maintains its tariffs on products from all other countries in the world. The situation is further detailed in Figure 9-3. . the formation of a free trade area causes Homeland’s domestic price to fall to Pf and its imports of trombones will expand to ad = 0f > bc = 0e.Now. If the trade bloc partner country’s supply curve for trombones is represented by the supply curve SN in Figure 9-2. forming a free trade area with one other country gives Homeland an ambiguous welfare change. Is g + h > f + j? In general. which causes an additional loss equal to j. Suppose also that producers located in the trade bloc partner economy have higher costs than the world’s lowest cost producers. and the price paid to producers in the partner country is slightly higher.

mercantilism stressed that countries should simultaneously encourage exports and discourage imports. Two theories have been developed from Adam Smith's absolute advantage theory. The Heckscher-Ohlin theory is preferred on theoretical grounds. who developed the theory of absolute advantage. rather than government policy. Mercantilism Mercantilism is a philosophy from about 300 years ago. was the first to explain why unrestricted free trade is beneficial to a country. The base of this theory was the “commercial revolution”. the transition from local economies to national economies. from feudalism to capitalism. . The neoclassical economist Adam Smith. Eli Hecksher and Bertil Ohlin. develop the second theory. should determine what a country imports and what it exports.Theories of International Trade: In the 1600 and 1700 centuries. Another theory trying to explain the failure of the Hecksher-Ohlin theory of international trade was the product life cycle theory developed by Raymond Vernon. Although mercantilism is an old theory it echoes in modern politics and trade policies of many countries. from a rudimentary trade to a larger international trade. Smith argued that 'the invisible hand' of the market mechanism. The first is the English neoclassical economist David Ricardo's comparative advantage. Two Swedish economists. but in real-world international trade pattern it turned out not to be easily transferred. referred to as the Leontief paradox.

United Kingdom. . and 18th century. which could be used to encourage the economy based on money and prices.Mercantilism was the economic system of the major trading nations during the 16th. this tendency. thus enabling the nation to hold its place in foreign markets. Adam Smith (father of liberalism and economical science) brought the argument in his book “The Wealth of Nations”. that the mercantilist policies favorised producers and disadvantaged the interests of consumers. especially in Holland. Mercantilist ideas did not decline until the coming of the Industrial Revolution and of laissezfaire. chiefly through corporations and trading companies. 17th. The standard of living is weaker. to export more and import less and to receive in exchange gold (the deficit is paid in gold) is called MERCANTILISM. published in 1776. based on the premise that national wealth and power were best served by increasing exports and collecting precious metals in return. mercantilist policies became an obstacle for the economic progress. Their policy was to export in the countries that they controlled and not to import (to have a positive Balance of Trade). but also produced an affluent flow of gold and silver. The theory states that the world only contained a fixed amount of wealth and that to increase a country wealth. The Absolute Advantage (Adam Smith model) The Absolute Advantage (Adam Smith model) In the second half of the XVIII century. More money was associated with less products and inflation. Portugal and Spain. France. It superseded the medieval feudal organization in Western Europe. one country had to take some wealth from another. The state exercised much control over economic life. Belgium. So. either through having a higher import/export ratio. The monarch controlled everything. Production was carefully regulated with the object of securing goods of high quality and low cost. Geographical discoveries not only stimulated the international trade. The theory was criticized by the newly appeared class.

evaluated in the necessary of hours needed to produce a unit of measure of the products X and Y. . which results in productivity. This country has a resource of labour of 8+4=12 hours. THE PRODUCTION POSSIBILITY FRONTIER We have a single factor of production. internal or external. using one factor of production. Renounces can be illustrated by a graphic. and if a country wants to produce much of one product it has to give up producing another goods. the unitary necessary of labour for product X is HLX and for Y HLY.labour. is to determine the value of goods by measuring the labour incorporated in them. there are limits in the level of production. Symbolizing H-hours. He used a unifactorial system of economy.Adam Smith’s theory starts with the idea that export is profitable if you can import goods that could satisfy better the necessities of consumers instead of producing them on the internal market. The essence of Adam Smith theory is that the rule that leads the exchanges from any market. Adam Smith analyzed for the beginning country A. existing in this case renounce of trade. In order to demonstrate its theory. L-labour. Because all the economies have limited resources. the productivity of labour.

will there still be benefit to trade. If there is one country that does not have an absolute advantage in the production of any product. or relative cost. Comparative Advantage The most basic concept in the whole of international trade theory is the principle of comparative advantage. There is a potential problem with absolute advantage. the theory of comparative advantage. The principle of comparative advantage states that a country should specialise in producing and exporting those products in which is has a comparative. SPECIALIZATION IN PRODUCTION AND THE ADVANTAGE FROM TRADE THROUGH ABSOLUTE ADVANTAGE Products Units of product/unit of time AFTER WITHOUT TRADE COUNTRY X A B TOTAL 6 3 9 Y 3 6 9 SPECIALIZATION AND TRADE X Y 12 12 12 12 Company A is more productive than company B in the production of X and has an absolute advantage in this product and country B is more productive then B in producing product Y. first introduced by David Ricardo in 1817. and will trade even occur? The answer may be found in the extension of absolute advantage. It remains a major influence on much international trade policy and is therefore important in understanding the modern global economy. with 4 hours of labour the country can produce 1 kg of cheese  with 8 hours of labour the country can produce 1 liter of wine The production possibility frontier illustrates the variety of the mixing of goods that can be produce by economy. The opportunity cost is the number of measure unit of product Y to which the economy has to give up in ode to poduce one supplementary unit of product X. advantage .

and thus the cheapest. it can be generalised and applied to any of the developed and innovative markets of the world. The international product life cycle theory stresses that a company will begin to export its product and later take on foreign direct investment as the product moves through its life cycle. In 1953. In this theory there are several assumptions that limit the real-world application. where he tested the validity of the Heckscher-Ohlin theory.compared with other countries and should import those goods in which it has a comparative disadvantage. On the contrary. Leontief found out that the U. Out of such specialisation.S. Not produce. The Heckscher-Ohlin theory stresses that countries should produce and export goods that require resources (factors) that are abundant and import goods that require resources in short supply. Heckscher-Ohlin Theory In the early 1900s an international trade theory called factor proportions theory emerged by two Swedish economists. as earlier theories stated.S would export capitalintensive goods and import labour-intensive goods. . the goods it produces most efficiently. the Heckscher-Ohlin theory states that a country should specialise production and export using the factors that are most abundant.S's export was less capital intensive than import. it is argued. will accrue greater benefit for all. Although the model is developed around the U. Product Life Cycle Theory Raymond Vernon developed the international product life cycle theory in the 1960s. The study showed that the U. This theory is also called the Heckscher-Ohlin theory. The Heckscher-Ohlin theory is preferred to the Ricardo theory by many economists. Eventually a country's export becomes its import. because it makes fewer simplifying assumptions. Eli Heckscher and Bertil Ohlin. The assumption that countries are driven only by the maximisation of production and consumption. Wassily Leontief published a study. therefore the U.S was more abundant in capital compared to other countries. This theory differs from the theories of comparative advantage and absolute advantage since these theory focuses on the productivity of the production process for a particular good. and not by issues out of concern for workers or consumers is a mistake.

edu .unl.ucv. Companies are forced to introduce the products in many different markets at the same time to gain cost benefits before its sales declines. References  cis01.edu  rulemic.com  people.stern. Today companies design new products and modify them much quicker than before. This was an applicable theory at that time since the U.ro  en.central.The product life cycle theory was developed during the 1960s and focused on the U.S is no longer the only innovator of products in the world.nyu. The theory does not explain trade patterns of today. the U.wikipedia.org  student. Today.S dominated the world trade.S since most innovations came from that market.