Economics Chapter 11 Homework While Unions May Seem Better Choice They

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11 International Agreements: Trade, Labor, and the

Environment

Notes to Instructor

Chapter Summary

This chapter shows that without international agreements, countries have a strong

incentive to choose policies that could result in the prisoner’s dilemma. Namely, a

country would impose tariffs to benefit its own welfare. When all countries act in the

same manner, world welfare decreases due to the deadweight loss created from the trade

restrictions. To avoid this outcome, multilateral agreements such as the World Trade

Organization (WTO) promote free trade by requiring members to reduce tariffs. This

chapter also presents the difference between regional trade agreements such as free–trade

areas and customs unions. The discussion on regional trade agreements details the impact

on welfare when international pacts lead to either trade creation or trade diversion.

Also discussed in this chapter are international agreements on labor and the environment.

Global agreements on labor are controversial because they require judgment and

comparison of labor standards across countries.

Comments

This chapter presents topics that allow for class discussions. Although the benefits of

multilateral agreements over regional trade agreements are clear, students may be divided

over international agreements pertaining to labor and the environment. Encourage

Lecture Notes

Introduction

The year 2015 marked the birth and death of a number of international agreements. To

start, the international climate agreement (COP21) reached in Paris is one that commits

members to create national plans for reducing greenhouse gas emissions. A second new

agreement for free trade, the Trans–Pacific Partnership (TPP), is an agreement involving

Europe. On the other hand, the Doha Round (Doha Development Agenda or DDA) was

lost in 2015 as its goals were not reaffirmed at the Nairobi, Kenya, meeting.

The 2015 regional trade agreements like TTP and TTIP began in response to the failure

of the Doha Round agreement of WTO. Multilateral agreements may be more difficult to

establish with so many members, while smaller groups of regional partners with more in

1 Multilateral Trade Agreements

A trade agreement is a pact between two or more countries to reduce or eliminate trade

restrictions. The WTO is an example of a multilateral trade agreement. Under the most-

favored-nation (MFN) principle of the WTO, countries agree to extend the tariff set for

The Logic of Multilateral Trade Agreements

We will briefly review the effects of a tariff imposed by a large country under perfect

competition before analyzing the impact of trade agreements.

Tariffs for a Large Country Recall that a large importer may benefit by imposing a

tariff if the terms-of-trade gain (e) is greater than the sum of the consumption and

Payoff Matrix We will now use these results to analyze optimal behavior and strategic

interaction when multiple large countries apply tariffs. We will not examine the welfare

effects when multiple large countries engage in strategic interaction. In our previous

analysis, we found that it is optimal for large countries to engage in small tariffs. But, is

We now assume that both Home and Foreign are large countries and examine the change

in welfare when both decide whether to impose a tariff on the other. The payoff matrix is

shown in Figure 11-2, where the lower-left corner of each quadrant gives Home’s payoff

and the upper-left corner denotes Foreign’s payoff.

Free Trade Starting with the upper-left quadrant where neither country imposes a tariff,

Tariffs However, if Home imposes a tariff and Foreign does not, then the former

potentially gains relative to free trade as long as e − (b + d) > 0, whereas the latter loses

by the amount −(e + f), which is Foreign’s deadweight and terms-of-trade loss. By

Prisoner’s Dilemma The payoffs described in Figure 11-2 have a special structure called

the prisoner’s dilemma. It takes this name from the story of two accomplices caught for

a crime they committed, where each must decide to confess or remain silent in solidarity

Nash Equilibrium Working out the solution of the game, we find that both countries will

impose a tariff even though they are clearly better off when neither imposes the trade

restriction. Given their payoffs, neither country has an incentive to individually move

Trade Agreement By entering into a trade agreement such as the WTO, the prisoner’s

dilemma outcome is eliminated because all members agree to reduce or avoid imposing

tariffs on one another. Of course, in order to make these agreements, both countries must

In essence, if a country’s payoff matrix does not reflect a simple prisoner’s dilemma

where losses and gains are comparable or equal in size, or even if these payoffs are not

known, then trade agreements are much more difficult to establish.

H E A D L I N E S

Trade Talks Lead to “Death of Doha and Birth of New WTO”

At the meeting during the Nairobi, Kenya, “round”—as the WTO meetings are called—

frustration had become so acute that countries abandoned the original Doha Round goals

and instead focused on smaller specific trade issues, resulting in more success. Trade

2 Regional Trade Agreements

When countries within a region make a pact to eliminate tariffs, these arrangements are

referred to as regional trade agreements (RTAs). Under such agreements, member

countries reduce trade barriers on one another but may maintain separate tariffs against

nonmember countries. RTAs are permitted under Article XIV of the General Agreement

on Trade and Tariffs (GATT) as long as member countries do not jointly increase their

tariffs against outside members. These agreements are sometimes called preferential

trade agreements (PTAs) because member countries are favored over nonmembers,

hence violating the MFN principles of the GATT. Examples include the Dominican

Free–Trade Area A free-trade area (FTA) consists of a group of countries that agree to

The TPP and TTIP are both other such examples. TPP seeks to establish a free–trade area

among 12 countries that border the Pacific Ocean, and TTIP exists between Europe and

the United States.

Customs Union In addition to agreeing to eliminate tariffs, a customs union requires

another condition, that member countries hold a common tariff against the rest of the

world. The European Union (EU) is an example of a customs union, consisting of

Rules of Origin Although a free-trade area allows each country the flexibility to impose

different tariffs on the rest of the world, it creates an incentive for a nonmember country

to take advantage of the duty-free zone by first exporting to the member with the lowest

tariff. To counter this problem, NAFTA members’ trade areas establish rules of origin

Notice that customs unions do not have this issue because tariffs are identical on all

outside members and all countries in the union must abide by the established tariffs,

eliminating the incentive for outside countries to seek out the lowest-tariff country. While

H E A D L I N E S

Making the Case for Trade

Unlike past presidents, most U.S. presidential candidates in 2016 stood opposed to free

trade and an open economy. According to President–Elect Donald Trump, “Foreigners are

killing us on trade.” Democratic Party primary candidate Bernie Sanders suggested that

we have engaged in “disastrous trade agreements written by corporate America,” while

Republican Party primary candidate Ted Cruz argued that “we’re getting killed in

The fact is that nations benefit from free trade and agreements that encourage even freer

trade. Overall, countries and the world dos not benefit from protectionism. Research

indicates that agreements that drop barriers to trade ultimately increase national income.

According to one study by Peter Petri and Michael Plummer (2016), they have the

potential to boost it by 130 billion annually. The truth is that creation of trade barriers is

APPLICATION

The Trans–Pacific Partnership

The Trans–Pacific Partnership (TPP) is a large regional agreement that involves 12

nations, including Australia, Brunei, Canada, Chile, Japan, Malaysia, Mexico, New

Zealand, Singapore, the United States, and Vietnam. It is part of a larger Asian foreign

policy agenda and has been considered highly controversial. The “Headlines: Making the

Case for Trade” feature reviews the main arguments for free trade and argues the

following:

1. Freer trade results in a wider variety of goods at lower prices.

2. Firms engaged in trade tend to have higher wages than other firms.

4. Predicted gains from TPP are $130 billion per year and will amount to

Controversial Issues in the Trans–Pacific Partnership

Below is a summary of the main controversies surrounding the TPP agreement.

TPP Was Negotiated in Secret Among the most controversial criticisms lodged against

the TPP is that it was made in “secret,” and the agreement’s details were withheld from

Congress. It was on “fact-track” trade promotion authority, which means that the final

This may seem like an odd process and some have even suggested that it is somehow a

new approach. In fact, all such prior trade agreements have been made in secret and on

the so–called fast–track promotion authority. This kind of modulated process occurs

because negotiations tend to be very sensitive between nations, and once an agreement is

This is not to suggest that there are not important differences between TPP and previous

Dispute Settlement The WTO and regional trade agreements must establish means for

settling disputes when one country believes that another is violating their agreement.

Establishing these processes and procedures can be a sensitive issue with consumer

bypassing member nations’ court systems and relying on arbitration boards run by trade

agreements do give industries new power that lies outside the reach of any individual

Intellectual Property Protection TPP provides patents for 8 years or 5 years plus the

protection period established within each country. This is less than the 12 years

Organizations like Doctors Without Borders have also expressed concern over the high

prices that poor countries will face, and too often will not be able to afford, during the

years of protection. It is a difficult issue because in order to encourage the development

of medicine in the first place, means must be established to fairly compensate private

companies for their extensive R&D costs. Within the free market and most developed

Labor Rights TPP requires that member countries ban child labor, and allow workers to

form independent unions and to strike regardless of the labor policies within member

nations. This has required special agreements with nations that have weak laws or engage

in human trafficking. International human rights organizations, including Human Rights

Watch, have remained neutral on this issue as TPP’s new requirements are much more

Environment Protection Another important section of the TPP is devoted to

environmental protection laws. They require that member countries stand by the

Convention on International Trade in Endangered Species (CITES) agreement. This

Tariffs and Rules of Origin As discussed earlier, rules of origin must be established to

determine when a good may be sent duty-free. With NAFTA, if the product is identified

as made in North America, it may be shipped duty–free between Mexico, Canada, and the

Who Would Lose Without TPP If TPP is approved within the U.S. Congress and the

legislatures of the pact’s 11 other member states, and if at least 6 countries approve the

If TPP fails, what are the possible consequences? This agreement is part of a much larger

foreign policy goal for the United States in Asia. And since the TPP was written such that

any other nation may join, it provides a good means for the United States to establish a

Trade Creation and Trade Diversion We now discuss the economic effects of regional

trade agreements. When countries form a regional trade agreement that results in one

country importing from another member rather than producing the product on its own,

By contrast, trade diversion has a negative impact on nonmember countries because the

tariff reduction via the regional agreement leads one member to import from another

instead of outside exporters. Although producers of the exporting member gain from this

Numerical Example of Trade Creation and Diversion

The following numerical example shows the effect of a diversion using the NAFTA trade

agreement and assuming the United States imports auto parts from Mexico rather than

and a 20% tariff, respectively. Without barriers to trade, the United States would import

the product from the lowest-cost producer, namely Asia, for $19, rather than purchasing

from Mexico for $20 or producing the good domestically at a cost of $22. Prior to

Trade Creation Beginning with a 20% tariff before the formation of NAFTA, the United

States would find it cheaper to produce the product domestically ($22.0) than to import

auto parts from Mexico ($24) or Asia ($22.8). With the establishment of NAFTA, auto

part imports from Mexico enter duty–free and those from Asia are still subject to the 20%

tariff. Therefore, the United States will import auto parts from Mexico at $20, which is

Trade Diversion Now consider the tariff at 10%. The least costly option for the United

States, before NAFTA, is to import the product from Asia for $20.90 instead of Mexico

in Mexico are better off but those in Asia are worse off. For the United States, before

NAFTA, it imported from Asia at a price of $19 and received $1.90 per unit from the

Trade Diversion in a Graph

For the graphical analysis of trade diversion (Figure 11-3), we assume that the United

States is a small importer of auto parts, as denoted by the horizontal free-trade price