The Case for Free Trade and the

Role of RTAs

P. J. Lloyd and Donald MacLaren

University of Melbourne

Seminar on
Regional Trade Agreements and the WTO
Geneva, 14th November 2003
 The Case for Free Trade and the Role
of RTAs

Introduction
1. Predictions of trade theory
2. Evidence from CGE models
3. Hub and spokes arrangements
4. Effects of RTAs on multilateral trade negotiations
5. Conclusions

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 Country 1

RTA

Country 2 ROW

3
 1. Predictions of Trade Theory

• The theory of RTAs on which GATT Article XXIV

could have been based
• Viner’s contribution:
– trade creation and trade diversion
– “... where the trade-diverting effect is predominant, one
at least of the member countries is bound to be injured,
the two combined will suffer a net injury, and there will
be injury to the outside world and to the world at large.”
• During the 1950s and 1960s it was demonstrated
that parts of Viner’s predictions may not hold,
e.g., trade diversion did not necessarily imply a
lowering of welfare
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• Modern analytics for a single, open economy with
perfect competition and constant returns to scale
(first-generation assumptions), can use a
compensation function:
B = e ( p, u ) – g ( p, v ) – ( p – p* ) m (1)
where e is national expenditure, g is national
product and ( p – p* ) m is trade tax revenue
B measures the compensation needed to allow
households in the economy to reach a given level
of utility
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Suppose this economy joins an RTA
Then p will change as tariff rates are adjusted from pre-RTA
MFN levels to preferential RTA levels
Then
B=egR
which can be expanded, after some algebra, to give
 B = + trade volume + intra-union terms of trade + extra-
union terms of trade (2)
The sign of B is ambiguous
If B < 0, the country gains; and if > 0, it loses
However, there is a presumption that members gain from the
RTA

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This expression for B also shows clearly that measuring
changes in trade volumes alone will not predict whether a
country gains or loses
Other assumptions:
– imperfect competition (love of variety and economies of scale):
second generation models
– investment, factor accumulation and growth: third generation models
Second and third generation models tend to strengthen the
presumption that members gain
For second-generation models, equation (2) becomes
 B = + trade volume + intra-union terms of trade + extra-
union terms of trade + output + average cost + varieties

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What are the welfare effects for excluded countries
which, pre-RTA, traded with the members?
– In first generation models, theory predicts that excluded
members, as a group, lose, although some individual
countries may gain
– In second generation models, theory predicts that these
losses may be greater than in first-generation models
What does the evidence from computable general
equilibrium (CGE) models suggest?

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 2. Evidence from CGE Models

Structure:
– data base of bilateral trade flows
– data base of transportation costs and tariff rates
– tariff on good i from region r to region s
– behavioural equations
– accounting identities
Caveats:
– design of the experiment
– values of the elasticities
– the Armington assumption and CES functions: biases
Summary of Results:

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• Formation of NAFTA (Brown et al. (1992)):
– using a second generation model they found that
• each member gained
• 31 excluded countries lost
– using a third generation model they found that
• the gains to Mexico were three times greater
• the excluded countries lost
• EU Single market (Haaland and Norman (1992)):
– using a second generation model and representing deeper integration by
a 2.5% reduction in intra-EU trade costs, they found that
• EU gained 0.64% of GDP (internal markets integrated) and 0.40% (internal
market segregated)
• EFTA lost 0.22% and 0.15% of GDP, respectively
– conclusion: excluded members lose but the size depends on assumptions
about market structure in the RTA
• Asia-Pacific Region

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Table 1: Welfare Changes as a percentage of base period GDP

Hub and
Bilateral Plurilateral Global
spokes
Japan-
Japan- ASEAN + APEC
Region S.Korea-
Singapore 3 (pref’ial)
China
Japan 0.00 0.25 0.34 0.74 0.98
Singapore 4.06 0.87 4.12 0.72 6.94
S. Korea 0.00 0.80 1.18 1.63 1.83
China 0.00 2.09 1.96 3.19 4.51
APEC 0.01 0.16 0.25 0.58 0.84
Total
0.05 0.50 0.64 0.58 n.a.
members
Total non-
0.01 0.03 0.06 0.12 n.a.
members
World 0.00 0.09 0.11 0.27 0.56
Source: Scollay and Gilbert (2001) 11
Conclusions about gainers and losers:
– global, multilateral trade liberalisation generates the
greatest gains to the world economy
– the size of the gains is dependent upon the underlying
theory, the base period and the design of the
experiment
– countries, in aggregate, lose from being excluded from
an RTA
– the larger the RTA, the larger are these losses
– in principle, a Pareto improvement is possible but in the
absence of inter-regional transfers, RTAs are
undesirable for outside countries

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 3. Hubs and Spokes
The configuration of RTAs has changed:
– from a given country being a member of one and only one RTA,
if a member at all
– to the same country being a member of more than one RTA
The configuration today has been described as hub and
spokes
The hub may be:
– a single country, e.g., the U.S. or Singapore
– a group of countries (plurilateral hub), i.e., an RTA itself, e.g.,
ASEAN
The spoke may be:
– a single country
– an RTA (plurilateral spoke)

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 Country 1:
Hub

RTA2 Country 3:
Spoke

RTA1

Country 2: ROW
Spoke

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 RTAs in Effect in the APEC region, 2003
•Russia •Japan
•Korea

•Hong Kong •USA

NAFTA

•China
•Mexico
ASEAN
•Canada
Cambodia Vietnam
Myanmar Laos
Malaysia Philippines
Indonesia Brunei

•Thailand
•Peru
•Chile
Singapore

•Papua New Guinea

CER
•Australia •New Zealand
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Hubs and spokes create:
– two layers of discrimination:
• the hub enjoys access to each and every spoke on a
preferential basis: as most hubs are developed countries, it
is to them that the bulk of the gains have gone
• each spoke enjoys preferential access only to the hub
• each hub and each spoke discriminates against non-
members
– complex rules of origin
– forces for RTAs to coalesce into regional blocs
– increased discrimination against excluded countries,
particularly developing and least-developed countries

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 4. Effects of RTAs on Multilateral
Trade Liberalisation
The growth of RTAs may affect the rate of
multilateral liberalisation by:
– affecting the pace of liberalisation from MTNs: the
‘building block’ or ‘stumbling block’ debate
– affecting the pace of unilateral liberalisations
Evidence on the first:
– if based on theory, is ambiguous, depending on whether
the objective is welfare maximising or political self-
interest
– if based on empirical evidence pre-Cancún, RTAs have not
slowed the pace
– post-Cancún, the EU and the U.S. have signalled a passive
role in MTN but a pro-active role in RTAs
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Evidence on the second is mixed:
– countries in ASEAN, CER and Latin America have
continued to liberalise unilaterally within their RTAs
– within NAFTA, Mexico and Canada have done likewise
– neither the EU nor the U.S. has engaged in significant
unilateral liberalisation over two decades

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 5. Conclusions

• the growth in RTAs has substantially increased

discrimination in world trade
• with the creation of plurilateral hubs and spokes,
that discrimination has become multi-layered
• rules of origin have become more complex
• Article XXIV of GATT has failed to protect the
interests of outside countries because:
– it was based on inadequate trade theory
– it is inconsistent with “the elimination of discriminatory
treatment in international commerce” (preamble to
GATT 1947, see WTO (1995))

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• “the elimination of discriminatory treatment in
international trade relations” appears in the
preamble to the Marrakesh Agreement
establishing the WTO (WTO (1995)) and yet it,
too, is being ignored by those Members who are
forming RTAs

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 References

Brown, D. K., A. V. Deardorff and Stern, R. M. (1992), “A North

American Free Trade Agreement: Analytical Issues and
Computational Assessment”, The World Economy, 15, 11-29
Haaland, J. and V. Norman (1992), “Global production effects of
European integration”, in L. A. Winters (ed.) Trade Flows and
Trade Policy after ‘1992’, Cambridge University Press,
Cambridge
Scollay, R. and J. P. Gilbert (2001), New Regional Trading
Arrangements in the Asia Pacific?, Institute for International
Economics, Washington, D. C.
Viner, J. (1950), The Customs Union Issue, Carnegie
Endowment, New York
WTO (1995), The Results of the Uruguay Round of Multilateral
Trade Negotiations: The Legal Texts, Geneva
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