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positive consumption externality from the installation of solar panels since this source of
In fact, when China subsidizes panels and exports them to the United States and Europe
at below cost, the social gains are even greater. Yet, both countries have instituted
retaliatory tariffs in response to China’s “dumping.” The reasons are twofold:
1. This positive consumption externality is a global externality reducing global
climate change and diffusing the social benefits globally.
Trade in Rare–Earth Minerals Processing rare–earth minerals results in radioactive
wastes—a negative production externality. There are two approaches to managing this
negative externality: limiting production or regulating disposal of the wastes. Resorting to
limiting trade in this input is unlikely as it is needed in too many high-tech products.
China has moved in the direction of managing the disposal of radioactive wastes,
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International Agreements on Pollution
Pollution is another example of the tragedy of the commons as companies and countries
allow pollutants to enter the air and water, which they view as common-property
resources. We define substances that cross country borders as “global pollutants.”
Examples include chlorofluorocarbons and carbon dioxide. By contrast, “local
pollutants” mostly remain within a country, such as smog caused by carbon monoxide.
Global Pollutants Because global pollutants are not borne entirely by the country that
Payoff Matrix In the payoff matrix shown in Figure 11-7, the lower-left (upper-right)
corner of each quadrant is the payoff for Home (Foreign). We will assume that if a
country decides to regulate the emissions of a pollutant, consumers are better off because
of lower pollution but producers bear the higher cost from the installation of special
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Nash Equilibrium From the perspective of a particular country, say, Home, if the
pollutant is global, the gain to its producers from nonregulation may outweigh loss to its
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Multilateral Agreements To avoid the prisoners’ dilemma outcome in which countries
do not regulate their pollution emissions, countries engage in multilateral agreements
such as the Montreal Protocol on Substances That Deplete the Ozone Layer. As a result
APPLICATION
The Kyoto Protocol and the COP21 Paris Agreement
Building on the 1992 UN treaty on climate change, representatives from many nations
met in Kyoto, Japan, in December 1997 to discuss nonbinding targets aimed at reducing
emissions of greenhouse gases. The Kyoto Protocol focused mainly on the reduction of
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treaty’s likely large negative impact on the U.S. economy in switching to activities that
reduce CO2 emission; (3) the exclusion of developing countries such as China and India.
But, the third reason the United States did not sign the Kyoto Protocol was likely the
primary reason and is a good example of the prisoner’s dilemma principle. If one player
refuses to regulate, there is less incentive for the other player to regulate.
H E A D L I N E S
Nations Unite in Global Agreement on Climate Change
In 2015, the COP21 Paris agreement, which included 190 member nations, agreed to a
plan to regulate the emission of gases that lead to climate change. The plan calls for
developed nations to take on a larger portion of the burden and to additionally help poor
countries move toward their committed goals by supporting them financially. In the
5 Conclusion
This chapter explains how international agreements are necessary to avoid outcomes that
would make countries worse off. A multilateral agreement such as the WTO promotes
free trade by requiring all members to lower or reduce their tariffs. Without the
international agreement, countries have an incentive to use tariffs to their own benefit or
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to avoid these bad outcomes where everyone loses.
Another type of international agreement on trade is regional trade agreements. These
agreements are also referred to as preferential trade agreements because they violate the
most-favored-nation (MFN) principle of the WTO by excluding nonmembers from
enjoying the tariff reduction. Such agreements may make member countries worse off
Global agreements also exist for the environment. One of the main purposes of these
agreements is to promote free trade while protecting the environment. Another is to
prevent the near-extinction or extinction of exhaustible resources such as fish through
export bans and restrictions. The limitations set by international agreements such as the
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environment.
Finally, without well-defined property rights for commons, overconsumption or
overharvesting to the point of the extinction of an exhaustible resource may occur.
TEACHING TIPS
Tip 1: International Trade and the Environment Debate
Chapter 9 tackles the very important issue of international trade and the environment.
Tip 2: By 2005, Mongolia was the only member of the WTO that was not party to a
Tip 3: Trade Diversion Data Exercise, ASEAN‒CHINA Free Trade Area
Ask students to look up the most recent Association of Southeast Asian Nations
(ASEAN) trade data to investigate if trade creation or trade diversion has taken place
since the China‒ASEAN Free Trade Association (FTA), which came into effect on
January 1, 2010. Have students go to http://asean.org/?static_post=external–trade–
Now download “ASEAN Community in Figures—Special Edition 2014: A Closer Look
at Trade Performance and Dependency, and Investment”
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IN–CLASS PROBLEMS
1. How do trade creation and trade diversion increase and/or decrease economic
welfare?
Answer: Trade creation increases economic welfare because a member country
2. Suppose Belarus, a small country, imposes a tariff in the amount of t per unit on
imported coal. Assume that it imports coal from Ukraine rather than Poland because
the former has a lower net-of-tariff price. Furthermore, suppose that the Belarusian
government is considering whether to apply for membership to the EU. As a member
of the EU, Belarus would have to remove its tariffs on all countries within the
customs union, such as Poland.
Using the following figure,
analyze the welfare effect of EU
membership on Belarus.
Answer: Currently, the price
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Gain in consumer surplus: +(a + b + c + d)
3. Suppose the United States could import footwear from Thailand at the price of $20
per pair or from Mexico at $24 per pair. The domestic price of footwear in the United
States is $35. Suppose prior to NAFTA, U.S. customs imposed a 50% tariff on all
footwear entering the country. Would the United States import footwear? If yes, from
which country? Why?
Answer: Before NAFTA, the United States would import footwear from Thailand
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4. Under Article XIV of the GATT, regional trade agreements are permitted provided
that countries within the arrangement do not change their tariffs against outside
members. Because the tariffs on nonmember countries are unchanged while those
levied on partners in the pact are removed or reduced, the formation of free-trade
areas and customs unions leads to an overall increase in the gains from international
trade. Comment.
Answer: This statement would be correct if the formation of the regional trade
5. How do regional trade agreements violate the most-favored-nation principle of the
GATT/WTO?
Answer: The most-favored-nation principle of the GATT/WTO requires each
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6. What is the relationship among regional trade agreements, free–trade areas, and
customs unions? What are the similarities and differences between the latter two?
How do they impact world welfare?
Answer: Free–trade areas and customs unions are two different types of regional
7. The Multifibre Arrangement (MFA) imposed quotas on textiles by developed nations
on developing nations. Explain how the elimination of this system of quotas in 2005
should reverse some of the trade diversion caused by regional agreements such as
NAFTA?
Answer: Under NAFTA, Mexico is given preferential tariffs relative to lower–cost
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8. Suppose the United States imports 1,000 pounds of bananas from Nicaragua at $0.28
per pound. Due to a 25% tariff, the consumer price in the United States is $0.35 per
pound. Farmers in the United States can provide the bananas at a price of $0.40 per
pound. Furthermore, suppose that the proposal to eliminate tariffs on the 50 poorest
nations passes. As a result, Angola devotes more resources to the production of
bananas and can supply the fruit at $0.40 per pound.
a. Does the proposal lead to trade creation or trade diversion? Explain.
b. If the banana tariff was doubled, would there be trade creation or trade
diversion?
Answer: If the tariff doubled, there would be trade diversion because the
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c. Assuming that the banana tariff is 50%, what is the net effect of the proposal on
U.S. consumers, U.S. producers, U.S. government, and world welfare?
Answer: Because the foreign producers supplied the bananas (Nicaragua before
9. Adanac, a small country, is considering whether to join the regional trade agreement
known as RTAR–U.S. Currently, it can import tires from countries outside the
regional agreement at the price of $20 each or from those inside the pact at $40 each.
In addition, Adanac imposes a 50% tariff on all imported tires. Predict whether
Adanac’s decision to join RTAR–U.S will lead to any trade diversion or trade
creation. Explain.
Answer: Even if Adanac joins RTAR-US, it will continue to import tires from