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Management International Business Operations

Trade Blocs

Module: 27, Trade Blocs

Paper: 08, International Business Operations

Dr. Vishal Kumar

School of Management,

Maharaja Agrasen University, Baddi (H.P.)

Dr. Shafali Nagpal

Bhagat Phool Singh Mahila Vishvidlaya,

Khanpur, Sonepat

Prof YoginderVerma

Pro–Vice Chancellor

Central University of Himachal Pradesh. Kangra. H.P.

Prof. S P Bansal Vice Chancellor

Maharaja Agrasen University, Baddi

Content Writer

Co-Principal Investigator

Paper Coordinator

Principal Investigator

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Management International Business Operations

Trade Blocs

Items Description of Module

Subject Name Management

Paper Name International Business Operations

Module Title Trade Blocs

Module Id Module no-27

Pre- Requisites Basic knowledge about Trade Blocs

Objectives To study the meaning and concept of Trade Blocs

To study the types of trade blocs

Keywords Trade blocs, Trading blocs, FTA, RTA

QUADRANT-I

Module 27: Trade Blocs

1. Learning Objective

2. Introduction

3. Trade Blocs: Meaning and Concept

4. The Causes of Trade Block Formation

5. The Effects of Trade Blocs

6. The Various Types of Trade Blocs

7. The Ambiguous Welfare Effects of a Trade Block

8. Summary

1. Learning Objective

After completing this module, you will be able to:

i. Understand the meaning and concept of Trade Blocs

ii. Understand the causes of Trade Block Formation

iii. Know about the effects of Trade Blocs

iv. Understand the types of Trade blocs

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TRADE BLOCS

2. Introduction: The concept of trade blocs is crucial in the context of international business. Trade blocs are

free trade zones designed to encourage trade activities across nations. The formation of trade blocs involves a

number of agreements on tariff, trade and tax. The activities of trade blocs have huge importance in the

economic and political scenarios of the contemporary world. Over the years trading blocs have played a major

role in regulating the trend and pattern of international trade. Regional trade blocs protect the interests of the

member countries. The primary aim of trade block activities is to create a favorable economic framework for

promotion of cross border trade among the member countries. Different regional blocs have come up in the

period of economic liberalization in various parts of the world. Some of the functionally active trading blocs are

listed below:

NAFTA (North American Free Trade Agreement)

EU (European Union)

ASEAN (Association of Southeast Asian Nations)

CEFTA (Central European Free Trade Agreement)

GAFTA (Greater Arab Free Trade Area)

SAARC (South Asian Association for Regional Cooperation)

CEMAC (Economic and Monetary Community of Central Africa)

East African Community (EAC)

SACU (South African Customs Union)

PARTA or PIF (Pacific Regional Trade Agreement)

AEC (African Economic Community)

CACM (Central American Common Market)

A particular country may be a member of more than one regional trading block. However, in order to do away

with overlapping, such nations are normally put within the most dynamic trade block.

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Stages of Economic Integration around the World

(Each country colored according to the most advanced agreement that it participates in)

Economic and monetary union (CSME/EC$, EU/€)

Economic union (CSME, EU)

Customs and Monetary Union (CEMAC/franc, UEMOA/franc)

Common market (EEA, EFTA, CES)

Customs union (CAN, CUBKR, EAC, EUCU, MERCOSUR, SACU)

Multilateral Free Trade Area (AFTA, CEFTA, CISFTA, COMESA, GAFTA, GCC,

NAFTA, SAFTA, SICA, TPP)

Activities of Trade Blocs

It is true that the principal objective of all trade blocs is promotion of trade; however, the difference lies in their

modes of operation. The activities of trade blocs can be evaluated by using three basic measures.

The number of latest agreements, meetings and other activities undertaken by the regional trade blocs

The pattern of future planning regarding trade promotion and focus on intergovernmental associations

and quicker timeframe for policy implementation.

Number of practical achievements attained by the member countries

In practice, the success of trading blocs crucially depends on the performance of the member countries. To

ensure effective trade promotion the trading blocs need to be more flexible and accommodative. Besides trade

promotion, the regional blocs are also expected to take part in other domains of the member countries. Effective

management of trade block activities ensures all-round development of the member nations.

3. Trade Blocs: Meaning and Concept

A trade block can be defined as a ‘preferential trade agreement’ (PTA) between a subset of countries, designed

to significantly reduce or remove trade barriers within member countries. When a trade bloc comprises

neighbouring or geographically close countries, it is referred to as a ‘regional trade (or integration) agreement’.

It is sometimes also referred to as a ‘natural’ trade bloc to underline that the preferential trade is between

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Trade Blocs

countries that have presumably low transport costs or trade intensively with one another. The two principal

characteristics of a trade block are that: i) it implies a reduction or elimination of barriers to trade, and ii) this

trade liberalization is discriminatory, in the sense that it applies only to the member countries of the trade block,

outside countries being discriminated against in their trade relations with trade block members. Though few,

there exist as well regional integration agreements in which co-operation rather than preferential market access

is emphasized. Trade blocs can also entail deeper forms of integration, for instance of international competition,

investment, labour and capital markets (including movements of factors of production), monetary policy, etc.

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The integration of countries into trade blocs is commonly referred to as ‘regionalism’, irrespective of whether

the trade block has a geographical basis or not. The first waves of PTAs appeared in the 1930s leading to a

fragmentation of the world into trade blocs. This ‘old (first) regionalism’ is also associated with regional

initiatives involving developing countries in the 1950s and 1960s. Based on the objective of import-substitution

industrialization, the rationale was that developing countries could reap the benefit from economies of scale by

opening up their trade preferences among themselves, hence reducing the cost of their individual import-

substitution strategy while the trade block became more self-sufficient. More successful experiences followed

with the recent proliferation of trade blocs, the so-called ‘new (second) regionalism’, which involve mostly

countries from the North with the South (the North-South trade blocs).

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Management International Business Operations

Trade Blocs

While there is a proliferation of PTAs in the world, and almost every country in Europe, in Latin America and in

Sub-Saharan Africa belongs to at least one PTA, not all PTAs are effective at liberalizing intra-block trade. For

instance, focusing on the trend in intra-block trade intensities and shares, it appears that NAFTA, the US-Israel

FTA, CACM, the Adean Group, MERCOSUR, CEAO/UEMOA and SACU can be considered as effective trade

blocs (which does not mean that they are efficient), whereas ASEAN seems to be so far a rather ineffective

grouping.

4. The Causes of Trade Block Formation

Several reasons explain the recent emergence of trade blocs. The so-called ‘old regionalism’ was motivated by

the desire to pursue in developing countries import substitution development at a regional level, to insulate a

region from the world economy and to stabilize and foster the economy at a regional level. Political and

economic considerations also played a major role, as in the case of the European Coal and Steel Community

(ECSC, 1951) and the European Economic Community (EEC, 1957).

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The recent emergence of trade blocs has been explained by various factors. Recognizing the gains from

liberalization, it is often argued that concluding a PTA is politically easier than pursuing multilateral trade

liberalization agreements. It is easier to negotiate with few partners than with a large number of participants in

the multilateral process as envisaged under the General Agreement on Tariffs and Trade (GATT)/World Trade

Organization (WTO). Not only concessions can be more easily exchanged among a small number of countries,

but effective enforcement mechanisms can also be agreed upon at a lower cost. The length and difficulties

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encountered during the Uruguay Round of GATT negotiations (1986-1994) is usually considered to have

contributed to increase the attractiveness of the regional (i.e. preferential) path to trade liberalization. PTAs also

allow trading partners to go deeper and faster in their liberalization process, addressing modern trade barriers

which are more varied, more complex and less transparent than standard tariffs and quotas traditionally

considered under GATT Rounds. Preferential integration agreements can also entail elements beyond standard

trade policy concerns, such as competition, investments, labour and capital market considerations. In other

words, the fewer the number of participants to trade negotiations, the larger the number of issues on which it is

possible to reach an agreement.

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 block. Indeed, 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. More generally, PTAs can serve as commitment, signaling and insurance mechanisms in the

policy determination of its members, hence contributing to reducing uncertainty and increasing credibility about

political and economic developments.

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5. The Effects of Trade Blocs

Discriminatory trade policy is the defining characteristic of a trade bloc. 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, but where each

member remains responsible for the determination of its trade policy vis-à-vis non-member countries;

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(2) a customs union (CU), with liberalized intra-block trade, as well as the adoption of a external tariff structure

and trade barriers towards outsiders common to all members of the CU; and

(3) a common market, which entails a CU with deeper integration between its members (such as free movements

of goods, services and factors of production, common economic policies, etc.).

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Most of the analyses on the effects of trade blocs focus on FTAs and/or CUs. The effects of a PTA are of two

types: the trade effects and the welfare effects. The trade effects comprise the impact of a PTA on the volume

and quantity of trade, on the terms of trade (i.e. prices) and on the level of protection (generally tariffs) for PTA

members and excluded countries. In analyzing the welfare effects of a PTA, it is important to distinguish

between the impact of trade bloc (formation and expansion) on the welfare of (1) each of its member, (2) the

trade bloc as a whole and (3) the countries excluded from the trade bloc.

A standard result of international trade theory is that, in a competitive environment and in the absence of market

distortions and externalities, free trade will maximise global welfare. Removing trade barriers between a subset

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Trade Blocs

of countries could therefore appear to be, a priori, a move in the right direction. Yet, the ‘theory of second best’

points out that removing a distortion while others remain in place may not increase welfare. Trade blocs are

examples of second best since a distortion is removed, i.e. trade barriers between member countries, while

another distortion is created in the form of a discrimination between members and non-members (the latter

facing trade barriers from the PTA), as well as other market imperfections. Hence, the welfare implications of a

trade bloc are ambiguous as they depend on many factors. The demonstration of the theory of second best

situation entailed by a PTA was derived from the seminal work of Jacob Viner (1950), which shows that while

liberalizing trade between a group of countries can lead to ‘trade creation’ between members (which should

increase welfare), it can also reduce trade between the CU and its trading partners.

6. The Various Types of Trade Blocs

There are several levels of regional trade blocs. Some trade blocs liberalize more economic transactions than

others. Five major categories of trade blocs are described as follows:

Under a Preferential Trade Area/Agreement (PTA), member countries agree to lower, but not

eliminate, trade barriers within the group to levels below those erected against outside economies.

A Free Trade Area/Agreement (FTA) eliminates all trade restrictions between members of the trade

bloc, but each member maintains its own restrictions on trade with third countries.

A Customs Union (CU) is a free trade area whose members agree on common tariffs against

nonmember countries.

A Common Market (CM) allows for the free trade of goods among members, sets common tariffs

against outside countries, and permits the free movement of factors of production among members.

An Economic Union (EU) has all the characteristics of a CM plus members agree to a uniform set of

macroeconomic and microeconomic policies.

The North American Free Trade Area (NAFTA), consisting of Canada, Mexico, and the United States, is an

example of a free trade area. The European Union, which in 2002 adopted a single currency, the euro,

administered by a regional central bank, is an example of an economic union.

Preferential Trade Agreement, PTA: A Preferential trade area (also Preferential trade

agreement, PTA) is a trading block which gives preferential access to certain products from the

participating countries. This is done by reducing tariffs, but not by abolishing them completely. A PTA

can be established through a trade pact. It is the first stage of economic integration. The line between a

PTA and a Free trade area (FTA) may be blurred, as almost any PTA has a main goal of becoming a FTA

in accordance with the General Agreement on Tariffs and Trade.

These tariff preferences have created numerous departures from the normal trade relations principle,

namely that World Trade Organization (WTO) members should apply the same tariff to imports from

other WTO members.

Free Trade Agreement (FTA): A free trade area (FTA) is a trade block whose member countries have

signed a free trade agreement (FTA), which eliminates tariffs, import quotas, and preferences on most

(if not all) goods and services traded between them. If people are also free to move between the countries,

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in addition to FTA, it would also be considered an Open Border. It can be considered the second stage

of economic integration. Countries choose this kind of economic integration if their economical structures

are complementary. If their economical structures are competitive, they are more likely to form a customs

union.

Customs Union: A customs union is a type of trade bloc which is composed of a free trade area with

a common external tariff. The participant countries set up common external trade policy, but in some

cases they use different import quotas. Common competition policy is also helpful to

avoid competition deficiency. Purposes for establishing a customs union normally include

increasing economic efficiency and establishing closer political and cultural ties between the member

countries. It is the third stage of economic integration. Customs union is established through trade pact.

Common Market: A single market is a type of trade block which is composed of a free trade

area (for goods) with common policies on product regulation, and freedom of movement of the factors of

production (capital and labour) and of enterprise and services. The goal is that the movement of capital,

labour, goods, and services between the members is as easy as within them. The physical (borders),

technical (standards) and fiscal (taxes) barriers among the member states are removed to the maximum

extent possible. These barriers obstruct the freedom of movement of the four factors of production.

A common market is a first stage towards a single market, and may be limited initially to a free trade

area with relatively free movement of capital and of services, but not so advanced in reduction of the rest

of the trade barriers. The European Economic Community was the first example of a both common and

single market, but it was an economic union since it had additionally a customs union.

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Economic Union: An economic union is a type of trade block which is composed of a common

market with a customs union. The participant countries have both common policies on product

regulation, freedom of movement of goods, services and the factors of production (capital and labour) and

a common external trade policy. The countries share a common currency. Purposes for establishing a

economic union normally include increasing economic efficiency and establishing closer political and

cultural ties between the member countries. Economic union is established through trade pact.

FREE TRADE

AREA

Free trade

among

members

CUSTOMS

UNION

Free trade

among

members

Common

external

commercial

policy

COMMON

MARKET

Free trade

among

members

Common

external

commercial

policy

Free factor

mobility

within the

market

ECONOMIC

UNION

Free trade

among

members

Common

external

commercial

policy

Free factor

mobility

within the

market

Harmonized

economic

policies

ECONOMIC

INTERGRATION

Free trade

among

members

Common

external

commercial

policy

Free factor

mobility

within the

market

Harmonized

economic

policies

Supranational

Organizational

Structure

7. The Ambiguous Welfare Effects of a Trade Block

All of the models of international trade discussed above showed that free trade maximizes the welfare of all

nations. It is important to understand that this conclusion only holds in the case of universal free trade, however.

In the case of trade blocs, neither the countries participating in the trade block nor the countries left outside the

trade block are guaranteed an improvement in welfare. The formation of a trade block may reduce the total value

of welfare-enhancing production in some or many countries of the world. Unlike the shift to universal free trade

among all countries, a trade block has a theoretically ambiguous welfare effect.

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The reason for the ambiguity is that a free trade area creates additional trade among members of the block, while

it also diverts trade from countries outside the bloc. That is, a trade block that eliminates tariffs among its

members, but maintains tariffs against outside countries, may induce importers in a trade block country to buy

from a higher cost producer within the block, rather than from the world’s true lowest-cost suppliers, who reside

outside the trade block.

Suppose that a tariff raises Homeland’s domestic price of trombones from Pw to Pt, as shown in Figure 1. This

price rise causes domestic deadweight losses equal to the areas b + d, 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. The welfare

loss to Homeland from the tariff is, therefore, the deadweight losses b + d minus the gain in government revenue

paid for by foreign suppliers, f.

.

Now, 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. Suppose also that producers located in the trade bloc partner

economy have higher costs than the world’s lowest cost producers. Then the gains from trade for Homeland are

not as clear as they are in the case of free trade with all other economies. If the trade block partner country’s

supply curve for trombones is represented by the supply curve SN in Figure 2, which lies above the world supply

curve SW, 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.

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The situation is further detailed in Figure 3. The trade block reduces deadweight losses by g + h, as shown in

Figure 3, but tariff revenue f is no longer paid by foreign suppliers, and the price paid to producers in the partner

country is slightly higher, which causes an additional loss equal to j. Is g + h > f + j? In general, g + h can be

larger than or smaller than f + j. Thus, forming a free trade area with one other country gives Homeland an

ambiguous welfare change.

8. Summary: In this module we have learnt about the concept of trade blocs. Trade blocs are free trade zones

designed to encourage trade activities across nations. It can be defined as a ‘preferential trade agreement’ (PTA)

between a subset of countries, designed to significantly reduce or remove trade barriers within member

countries. When a trade bloc comprises neighbouring or geographically close countries, it is referred to as a

‘regional trade agreement’. 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. The two principal characteristics of a trade block are that: i) it implies a reduction or elimination of

barriers to trade, and ii) this trade liberalization is discriminatory, in the sense that it applies only to the member

countries of the trade block, outside countries being discriminated against in their trade relations with trade

block members.