Chapter 12
Trade Blocs and Trade Blocks
Overview
This chapter examines two types of trade barriers that are intended to discriminate between
foreign countries. A trade bloc has lower or no barriers for trade between its members, while they
maintain higher barriers for trade with outside countries. A trade embargo or trade block places
extra barriers against trade with a specific foreign country, usually because of a broader policy
disagreement.
There are four major types of trade or economic blocs: free-trade area, customs union, common
market, and economic union. WTO rules generally call for equal trade barriers against all other
countries (at least those that are also members of the WTO)—the most-favored-nation principle.
But the WTO rules also have a few exceptions, including an exception for a trade bloc that
achieves substantially free trade among its members.
A trade bloc can have several effects on the well-being of its member countries and the world
overall. We usually analyze trade blocs by comparing them to countries maintaining barriers
against all other countries. To the extent that forming or joining the trade bloc results in lower
prices in the importing member country, the country and the world gain as additional trade is
created. To the extent that forming or joining the trade bloc results in shifting the source of
imports into the country from low-priced suppliers in countries outside the trade bloc to
higher-priced partner suppliers, the country and the world lose as trade is diverted from low-cost
to higher-cost producers. The net effect depends on whether the gains from trade creation are
larger than the losses from trade diversion. There are also possible dynamic gains from forming
or joining a trade bloc, including gains if extra competition within the larger, bloc-wide market
area leads to lower prices, lower costs, or greater innovation, gains if scale economies are
achieved within the larger area,and gains if consumers obtain access to product varieties
produced in partner countries.
For the European Union, most estimates are that the EU gains from its internal free trade in
manufactures, because trade creation has been larger than trade diversion, and because there are
probably also dynamic gains, although these are harder to measure. Additional gains came as the
move toward a true common market in 1992 removed nontariff barriers and freed resource
movements. However, the EU also incurs substantial losses from its highly protectionist common
agricultural policy. In 2004, 10 additional countries joined the EU, in 2007 two more, and in
2013 one more (Croatia), bringing the total number of members to 28. Integration of the new
members has been relatively smooth, though some features of EU policies have been phased in
slowly for them.
The North American Free Trade Area (NAFTA) began in 1994, subsuming the previous
Canada-U.S. Free Trade Area. NAFTA has eliminated tariffs, reduced some nontariff barriers,
and liberalized trade in services and cross-border business investments. The formation of
NAFTA was controversial. In Mexico there were fears of jobs lost to more productive U.S. and
Canadian firms, as well as the loss of political sovereignty as NAFTA committed Mexico to
change a number of its government policies. In the United States there were fears of job losses to
low-wage Mexico, as well as complaints about linking with a country that has a corrupt political
system and poor environmental protection. Proponents in both Mexico and the United States
hoped that NAFTA would commit the Mexican government to maintain and extend its
market-oriented reforms.
NAFTA has resulted in substantial increases in trade among the three members. The standard
view is that trade creation has been larger than trade diversion, with substantial net gains for
Mexico. However, there is also some research that suggests that trade diversion has been large,
so that the net gains are close to zero. Studies of Canada indicate that it gained from increased
competition that forced high-cost plants to close down, from the achievement of scale economies
through longer production runs as access to the large U.S. market became assured, and from
increased innovation driven by increased competition and assured market access. In addition to
the trade effects, Mexico has also gained from the substantially increased inflows of direct
investment by foreign firms that have located production in Mexico to serve the NAFTA area.
NAFTA has not caused massive shifting of total employment between the member countries, but
it has altered the composition of jobs, with pressures on wage rates for different types of
workers.
For decades efforts to form functioning trade blocs among developing countries failed. Success
is now more likely, as many developing countries have shifted toward outward-oriented and
market-oriented government policies. MERCOSUR (the Southern Common Market) began in
1991 and has been reasonably successful in freeing internal trade and establishing common
external tariffs. Yet, there are some fears that it has also led to substantial trade diversion.
A trade embargo is economic warfare. It hurts both the target country and the country imposing
the trade block, and it creates opportunities for other countries that are not taking part in the
embargo. An embargo can fail to force the target country to change its policy for at least two
reasons. First, the target country’s national decision makers may decide that they can and must
endure their losses, even if these losses are large—political failure of an embargo. Second, the
embargo may simply fail to inflict much loss on the target country—economic failure of an
embargo. An embargo that prohibits exports to the target country is more likely to succeed
economically when the target country has an inelastic demand for imports and countries outside
the embargo have low elasticities of export supply. This is more likely when a group of large
countries imposes an embargo on a small country, and when the embargo is sudden and extreme.
Tips
The unifying theme is trade discrimination, and the material is not too difficult. The diagrams
represent fairly straightforward extensions from those in previous chapters.
For class presentation of trade blocs, it may be useful to present a case of pure trade creation (in
which the partner country is the low-priced world supplier), a case of pure trade diversion (in
which the partner’s export price is just slightly less than the tariff-inclusive outsider price), and
then the general case in which there is both trade creation and trade diversion.
There are two distinct parts to the chapter, and they are separable. For instance, an instructor can
assign and cover only the material on trade blocs if there is a need to slim down the total course
content.