Preferential Trade Agreements in International Trade - Report Example

International Trade: Preferential Trade Agreements s Table of Contents Table of Contents 2 International Trade: Preferential Trade Agreements 3 Discussion on PTA 7 The determinants of PTA 8 Main PTAs 8 Types of PTAs 9 Impacts of the PTAs 11 Do preferential trading arrangements create trade? 13 1.Short Term Effects 14 a. Trade creation 14 b.Trade diversion 15 2.Long -term effects 17 Summary 18 International Trade: Preferential Trade Agreements International trade usually promotes corporation among various nations. The preferential trade agreements (PTAs) or Regional Trade Agreements are common and continue to grown in number in international trade. The most common type of PTA is free trade agreement. According to a study conducted by (Foster & Stehrer, 2011, p. 386), PTAs membership is related to an increase of intra-industry trade. The paper is going to focus on preferential trade agreements. The two most crucial concepts in international trade include absolute advantage and comparative advantage. Comparative advantage determines comparative advantage in the real world. It is more realistic due to the fact it takes into consideration the limited capacity of a nation to produce, which means that production for one good result to less production of another good (Nello, 2009). On the other hand, absolute advantage enables the utilization of supply and demand analysis to analyse trade policy and to show the gains from trade. International trade makes a participating state better off as a whole (Baier, & Bergstrand, 2004). As noted by Harrington (2009), absolute advantage entails that the ability of a firm or nation to produce more of products or services as compared to its competitors making use of the same amount of resources. On the contrary, comparative advantage refers to the capability to manufacture produce specific products at a lower opportunity cost. About 75% of the intra-EU trade comprises of intra-industry trade. This is as a result of product differentiation as products are substitutes for each other, even though they are slightly different. Therefore, the plant or firm can specialize in a few varieties of the products in order to make use longer production lines. Besides, other product varieties may be imported from similar specialized producers in other nations (Irwin, 2006). The lecture on inter-industry and intra-industry points out the drivers of international trade. Inter-industry trade is driven by differences in competitive advantage as a result of the differences in the opportunity cost of production. In addition to this, intra-industry trade is the trading sector that experiences both imports and exports. Intra-industry trade can be vertical if the imported and exported products are at different stages of production or horizontal if at the same stage. As cited by Grimwade (2000), inter-industry trade entails exchange of goods that from various industries based on comparative advantage, while intra-industry trade involves the exchange of similar products that originate from the similar industry such as Ford and Toyota. Both inter-industry and intra-industry trade bring overall gains to the participating nation, although the smooth adjustment hypothesis depicts that intra-industry is less disruptive, and it is politically acceptable compared to the inter-industry trade (Baier, & Bergstrand, 2004). In relation to the factors of production, each nation has a comparative advantage. The factors of production outline that inter-industry trade come up because of comparative advantage due to international differences in opportunity costs of production. The Heckscher-Ohlin model examines these various opportunity costs in relation to several availabilities of factors of production. The theory by Stopler-Samuelson adds that the loser form the inter-industry trade is a nation’s scarce factor of production that is used intensively in the imported sector. Therefore, opposition to trade or demand for protection arise from the scarce factor of production. In relation to the global production networks, a series of value-added tasks produce a good or a service commonly known as a value chain. When these become connected together globally in potential buyer-supplier, they are termed as global production networks. Therefore, a firm that performs more than one adjacent task is said to be vertically integrated. Vertical integration occurs in firms that have significant firm-specific assets. On trade policy, there are trade barriers in spite of agreements regarding benefits from trade. The trade barriers are most of the times focused on specific industries, in addition to being higher for finished goods and lower for the raw materials. In the recent past, overall levels of trade barriers have subsided as a result of international negotiations. A tariff diagram is key to gaining knowledge on international trade. In this respect, a tariff or tax on imports has the following welfare rates: consumers lose, producers gain, the government also gains revenue, the economy loses overall, and the consumers loose much more as compared to the producers. However, this is only applicable to a ‘small country case.’ Figure 1: Showing effects of tariffs. If a tariff of T is put into place, the domestic price increases to PT. This implies that the supply and demand of the product reduces from DT to ST respectively. A large nation that imposes a tariff has a terms of trade gain that may offset the overall economic loses, although a tariff may still cause problems because of retaliation and trade wars. According to Hunt (2012), the Fairtrade Labelling Organisations International (FLO), the World Fair Trade Organisation (WTO), and European Fair Trade Association agreed that fair trade is defined as a trading partnership that is based on dialogues, respect and transparency seeking greater equity in international trade. Fair trade makes a significant contribution to sustainable development by providing better conditions for trading, securing the rights of marginalized employees and producers particularly in the South. Fair trade usually involves exporting from poorer developing nations to the rich industrialized nations seeking terms more beneficial to the producers that are in the exporting nation. In the free markets, fair trade is an administratively burdensome interference. However, those who often lose from international trade are poor individuals in ‘developing nations’ having no safety net to offer social security, as well as having little opportunity to adjust flexibly to the changed conditions. In numerous developing nations that are agricultural in nature, the key conditions unto which trade theories are based are notably absent. The absence of these conditions nullifies or eve reverses the potential gains to producers from trade. Consequently, the absence of such conditions results to market failure. In relation to foreign market entry, it entails FDI and transnational corporation (TNC). The previous arguments on international trade have been focusing on countries as a whole. Foreign market entry looks at firms and how they approach international expansion. Business entities may select from the three wide categories of international expansion: contracts (franchising, licensing, subcontracting), exporting, or FDI including mergers and acquisitions, joint ventures and Greenfield investment. Firms that engage in FDI are termed as transnational corporations or multinational enterprise. In some instances, these TNCs are so large that they exert considerable power. Furthermore, they can also influence a nation’s comparative advantage (Goldin & Reinert, 2007, p.143). With regard to internal production and development, economic growth increases the gross domestic product. Development is a broader concept of enhances quality of life such as education and health and structural change in the economy. Evidence has pointed out that investment by multinational enterprises might promote the development of the lower income nations. There are also costs setbacks that inward foreign direct investments (FDI) may impose on a host nation. Discussion on PTA Preferential trade agreement is defined by Egger and Larch (2008, p.384) as a trading bloc that provides preferential access to specific products from the participating nations. It is usually done by reducing the tariffs, although they are eliminated totally. A PTA may be created via a trade pact. A PTA is the first stage of economic integration. Any preferential trade agreement can become free trade area in accordance with General Agreement on Trade and Tariffs (GATT) (General Agreement on Tariff and Trade, 2010). The figure below shows economic integration around the globe. Green-Economic and Monetary Union Light green-Economic union Brown-Common market Red-Multinational Free Trade Area Figure 2: Showing economic integration in the world. PTAs are trade pacts between nations that are aimed at reducing tariffs for particular products to the nations that sign the agreement. Although the tariffs are not completely removed, they are set at a much lower level as compared to countries that are not parties to the agreement. More that 23 types of preferential trade agreements have been established among the 120 nations that account for 83 percent of the international trade (Fielke, 1992). The determinants of PTA The determinants of PTA include: liberal rules of origin, inclusion of measures promote cross-border competition and facilitate trade, huge and diverse membership, and low external MFN tariffs. Main PTAs A free trade area is a PTA with increased depth and scope of tariff reduction. Majority of the multinational agreements are signed between the neighbouring states, excluding global TPP agreements and WTO agreements. The operating free trade area consists of (Yi, 2011): ASEAN Free Trade Area (AFTA), Asia-Pacific Trade Agreement (APTA), Central American Integration (SICA), Central European Free Trade Agreement (CEFTA), Common Market for Eastern and Sothern Africa (COMESA), G-3 Free Trade Agreement (G-3), Greater Arab Free Trade Area (GAFTA), the Dominican Republic-Central America Free Trade Agreement (DR-CAFTA), the Gulf Cooperation Council (GCC), the North American Free Trade Agreement (NAFTA), the Pacific Alliance, South Asia Free Trade Agreement (SAFTA), Sothern African Development Community (SADC), the Southern Common Market (MERCOSUR), and lastly the Trans-Pacific Strategic Economic Partnership (TPP), India-Afghanistan, and India Mauritius. Types of PTAs Wesley argues that the proliferation of PTAs is significantly attributed to the multilateral trade liberalisation through the WTO. The spreads of PTAs implies that there are numerous motivations that inspire motivations other than economic factors that inspired PTAs deals. PTAs have been used to gain strategic benefits (2008, p.215-228). A custom union needs its members to remove the trade barriers and takes the economic integration further by creating identical barriers to trade against the non-members, most commonly in the form of external tariff. For numerous years, the European Union formerly European Community was the world’s most well established customs union. The EU is regarded as the most highly developed and structurally complex of all the globe’s regional economic blocks. It has 15 members, with 370 million people. It was the first modern agreement to enter into force in 1958 (Medvedev, 2010, p. 199). For example, the EU created a common agricultural policy (CAP) for all its members that was characterised by a variable system of levying which limited most agricultural imports from non-participating states through application of a common import duty. The other examples customs union include the Andean Community of Nations (CAN) ,which is made up of South American nations such as Colombia, Bolivia, Peru and Ecuador. The other example is CUBKR, the EUCU, EAC, SACU, and MERCOSUR. The East African Community (EAC) that is an interstate organisation that comprises of five nations in the East African region: Rwanda, Kenya, Uganda, Tanzania, and Burundi. It launched its own common market for labour and products, as well as capital within the region in 2010. The European Union Customs Union (EUCU) is a customs union that is made up of members from the EU and some of its neighbours such as Monaco, Andorra, Turkey, and San Marion. Unlike other free trade areas, no customs are charged on products travelling within the customs union. However, the customs unions’ members impose a common external tariff on all the goods that enter the union. MERCOSUR is a political and economic agreement between Brazil, Argentina, Uruguay, Paraguay, and Venezuela. Its main objective is to promote free trade and smooth movement of people, goods and currency. Lastly, the South African Customs Union is a customs union amongst five nations located in Southern Africa namely Lesotho, Swaziland, Namibia, Botswana and South Africa. Formed in 1910, it is the oldest customs in the world that is still existing (El-Agraa, 2007:7). A common market has all aspects of the customs union, but it allows free movement of products, services, capital, and labour among the member states. For example, the European Economic Area (EEA) that consists of members from European Free Trade Association (EFTA), and 27 member states of the EU. It permits the EEA-EFTA members to engage in the European Union’s internal market without necessarily being member states of the EU. They use nearly all the EU regulations about single market, excluding laws on fisheries and agriculture. EFTA is a free trade organisation between Switzerland, Iceland, Norway, and Liechtenstein. Although it operates in parallel with, it is linked to the EU. Another example of a common market is the Eurasian Economic Community (EEC). It consists of Kazakhstan Russia, and customs union of Belarus. An economic union represents the most complete aspects of economic integration. The social, fiscal, taxation, and monetary policies are harmonised. The aim of creating an economic union is to increase economic efficiency and create closer cultural and political ties between the member states. Examples of economic unions include EU’s single market and union state of Russia and Belarus, and Monaco EU. Summarily, each customs union, economic union, and trade common market has a free trade area. Impacts of the PTAs As cited by Egger and Larch (2008), the establishment of a new PTA shits the incentives of the non-members to engage in a preferential trade agreement. This may lead to the domino effect, whereby the non-participating members join the existing preferential trade agreement. Furthermore, it may also to two nations entering into a bilateral preferential trade agreement. PTAs formation alters an outsider nation’s willingness to engage in a preferential trade agreement. This is tackled in the domino theory of regionalism. Eicher and Henn (2011, p.138) note that preferential trade agreements produce strong but uneven trade effects. The study found out that WTO membership promotes trade before the formation of PTAs as well as increasing trade among proximate developing nations. The other implications of PTAs are that firms may relocate off-shore and take jobs with them. There may also be environmental consequences of making the common national borders open, the prospects of the international economy fracturing into hostile trading blocs, and increased industrialization. However, PTAs result to large economic gains because barriers create new markets for the nation’s good and cheaper products for the consumers. However, the barriers to trade between individual PTA members and nonparticipants vary and are decided by each member’s policy makers. The next effect of PTA is that it fosters economic prosperity and political stability, in so doing supporting the continuation of the process of democracy and decreasing the probability of social and political disruption in the nations that are politically and economically vital to the strategic interests of the PTA. PTAs encourage member states to undertake social, economic and political reform. For example, in the long-run, NAFTA is projected to an economic environment that will make Mexicans seek for employment opportunities in Mexico, other than the US (Salvatore, 2003). PTAs also accelerate the progress of multilateral trade negotiations, the attainment of appropriate elimination of barriers to trade, especially intellectual rights, agriculture and dispute settlement procedures, and stimulating economic growth (Baier & Bergstrand, 2004). Preferential trade agreements counter political and economic power that has been created by the expansion and integration of the European Union and the future prospects in trade cooperation with the former Soviet and Eastern bloc nations. For example, Brazil, Argentina, Uruguay and Paraguay initiated the Southern Cone Common Market in 1991 in order to promote economic growth and mutual relations among the member states. PTAs are also formed due to the geographical proximity of the interested nations such as England and Norway, the U.S and Mexico, and South Africa, Swaziland, and Lesotho. As cited by Salvatore (2003), any free trade area acting as a single unit in international trade negotiations is likely to have a much more bargaining power as compared to the total of its members acting separately. Additionally, reaching a compromise with a unified group of nations is much more as compared to dealing with each nation independently. For example, Singapore, Japan, Hong Kong, Taiwan, and South Korea have come up with plans to extend preferential trading terms to each other. This may create a basis of forming a basis for the formation of a free trade area in future. The proliferation of Asia Pacific raises the risk of trade and intra-regional trade since the MFN rates are high and dispersed in some states. Lastly, administrative complexities can typically reduce the potential benefits of PTAs and compound the problem of trade diversion. Do preferential trading arrangements create trade? The PTAs can both create trade or divert trade. Johnson (2007) asserts that nations that are exempted from the PTAs often argue that preferential trade agreements lead to increased trade within the bloc, although less when outside the bloc. Foster and Stehrer (2011, p. 386) argues that PTAs’ membership is related to an increase of intra-industry trade. The results implied that this is particularly for the PTAs formed between richer nations, with the impacts of free trade between smaller poorer nations were found to be smaller as shown in the figure below. Figure 3: Showing free trade/PTA and efficiency (Hunt, 2012). PTAs have a significant positive effect on manufactured goods exports (Dahi & Demir, 2013, p. 4754). 1.Short Term Effects The short-term impacts of coming up with a PTA are measured in terms of trade diversion and trade creation. In this perspective, where there is full use of domestic resources, trade creation improves the economic stability of the participating members since it leads to lower consumer prices, greater specialization in production and trade, and higher disposable incomes. The PTA’s members have the benefit of importing from one goods that were not previously imported at all because high tariffs. a. Trade creation The occurrence of trade creation is when domestic production of one member country is actually replaced by the cheaper imports from another member state. The trade creation effect results to efficiency gains for participating members since some nations move form an expensive domestic source of supply of an item to a much affordable foreign source. Eventually, the member states specialise in manufacturing those items that they have a comparative advantage (Dahi & Demir, 2013, p.4755). A trade-creating PTA also increases the economic status on the non-members. This economic growth results to increases in income, which in turn translates to increased imports globally. The benefits from a from a free trade area are anticipated to be huge when the tariff to be removed is also huge and also if the domestic demand and supply are more responsive to price changes over the long-term as shown in the figure below. Figure 4: Showing the net effect of forming customs on the welfre of the home country. From the diagrams, the net effect of forming customs union on the welfare of the home country is (b+d+f). It may be positive, negative or zero. This is referred to as Viner’s ambiguity. Customs union’s effect on welfare is uncertain (Viner’s ambiguity) because of the mixture between trade creation and trade diversion, and are termed as static effects. b.Trade diversion On the other hand, trade diversion come into play when if the lower-cost imports from the non-participating country are actually barred gaining entry into the PTA by either the tariff or nontariff barriers, consequently, being replaced by higher-cost imports from a participating member. Diversion of trade reduces international economic well-being. The figure below shows the harmful effects of trade diversion if nation joins a PTA (El-Agraa, 2007). Figure 5: Showing the negative effects of trade diversion in PTA The products supply increase from S1 to S2, while the prices drop from P0 to pc. As a result, the global resource allocation becomes less efficient and production deviates away from the comparative advantage’s pattern suggested (Baier & Bergstrand, 2004). Figure 6: Showing trade diversion. From the diagrams, the net effect of forming customs union on the welfare of the home country is (b+d+f). It may be positive, negative or zero. 2.Long -term effects PTA formation can be expected to have long-term benefits that are vital to the member countries. Recent studied have shown that the long-term benefits from forming a preferential trade agreement often supersedes the short-term benefits by a factor of 5 or 6 (Salvatore, 2003). The most crucial long-term benefits are economies of scale, increased competition, stimulus to investment, and efficient utilization of economic resources. First, the potential for increased competition: business entities particularly in oligopolistic and monopolistic may become complacent if protected by barriers to trade as shown below. Figure 7: Showing the effect of barriers of trade. Therefore, with the formation of PTAs, trade barriers among members are eliminated, and producers become more efficient in competing with foreign firms since the demand is high while the supply is low. This increases the quantity demanded from Q2 TO Q3 (Medvedev, 2010). The increased level of competition is more likely to stimulate the development, production of new products and adoption of new technology. Second, another benefit of the PTAs is that significant economies of scale are become possible in the enlarged market area (Goldin & Reinert, 2007). A firm that was previously operating only in the domestic market, PTA and expanded market creates export opportunities. On condition that the production process has economies of scale, an increase in output reduces costs per unit as well as the price charged to consumers (Salvatore, 2003). Stimulus to investment; PTA formation is likely to inspire outside investment in marketing and production facilities in order to avoid the discriminatory barriers that are imposed on the non-member states products. Consequently, investment is likely to increase if firms to meet the increased competition and also take advantage of the enlarged market. Mostly, investment in a PTA area is considered as an alternative to the export of commodities from non-participating nations (Wesley, 2008). Efficient resource use, since the PTA is a common market, the free transport of capital and labour and capital is expected to stimulate efficient utilization of economic resources of the entire trading bloc (Dahi & Demir, 2013). In general, the efficiency of individual firms and industries is also likely to increase with the improved access to additional labour and lower-cost capital and consumer costs (Egger and Larch, 2008). Summary In recent years, PTAs have been growing in importance. The trading blocs account for an estimated three-fourths of international trade. PTA majorly affects intra-industry trade. According to the nature, prudential trade agreements favour among participating states and discriminate against the non-participating nations. Trade amongst participating nations develops at the expense of the rest of the world. The PTAs operate legally under the framework of previous GATT rules. Free trade is certainly more efficient, although in a world of less-than-free trade, PTAs main economic benefits within specific circumstances. The long-run benefits, for instance, increased competition and economies of scale surpasses the short term gains from trade creation. The consumers gain from the formation of PTA since formation because restrictive trade barriers are lowered and at long last eliminated. The tariff revenue also declines. Reference List Baier, S. L., & Bergstrand, J. H. (2004). Economic determinants of free trade agreements. 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