2. Trade negotiations
The North American Free Trade Agreement (NAFTA) is an example of a![]()
free trade area 
.
.Points:
1 / 1
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Explanation:
Free trade areas (FTAs) and customs unions are examples of regional trading areas. Regional trading areas remove the barriers to trade between countries in the area. The difference between FTAs and customs unions lies in their treatment of external tariffs. The countries in a customs union, such as the European Union, impose common tariffs on countries outside of the union. In an FTA, such as the North American Free Trade Agreement (NAFTA), consisting of Canada, the United States, and Mexico, each country in the area imposes its own set of tariffs on countries outside of the area.
Multilateral trade negotiations involve simultaneous reductions in tariffs by many countries. Such mutual reductions in trade restrictions are more politically palatable than regional trading arrangements, such as free trade areas and customs unions, because potential gains to domestic exporters counterbalance potential losses to domestic firms in import-competing industries. The most recently completed multilateral negotiation was the Uruguay Round, which ended in 1994. The Uruguay Round pushed average U.S. tariff levels to less than 3% of total U.S. imports.
3. Trade creation and trade diversion
Suppose that with free trade, the cost to the United States of importing a backpack from Mexico is $10.00, and the cost of importing a backpack from China is $9.00. A backpack produced in the United States costs $14.00.
Suppose further that before NAFTA, the United States maintained a tariff of 20% against all backpack imports. Then, under NAFTA, all tariffs between Mexico and the United States are removed, while the tariff against imports from China remains in effect. Assume that the tariff does not affect the world price of backpacks.
In the following table, indicate which country the United States imported backpacks from before NAFTA. Then indicate which country the United States imported backpacks from under NAFTA. Check all that apply. (Note: Leave the row blank if the United States doesn’t import from either country.)
|
Scenario
|
United States Imports from . . .
|
|
|---|---|---|
|
Mexico
|
China
|
|
| Before NAFTA | ||
| Under NAFTA | ||
Points:
1 / 1
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Explanation:
Before NAFTA, with the 20% tariff, the cost of a backpack imported from Mexico was $10.00+(0.2×$10.00)=$12.00$10.00+0.2×$10.00=$12.00, and the cost of a backpack imported from China was $9.00+(0.2×$9.00)=$10.80$9.00+0.2×$9.00=$10.80. Thus, the cost of importing a backpack from China was lower than the cost of producing it in the United States ($14.00) or importing it from Mexico.
Under NAFTA, Mexico pays no tariff on its imports into the United States, while China continues to have the tariff applied against its imports. Thus, a backpack imported from Mexico costs $10.00, which is less than the cost of a backpack imported from China ($10.80) or produced in the United States ($14.00). Therefore, the United States imports backpacks from Mexico.
In the following table, indicate whether each stakeholder gains, loses, or neither gains nor loses as a result of NAFTA.
|
Stakeholder
|
Gains
|
Loses
|
Neither Gains nor Loses
|
|---|---|---|---|
| Chinese producers | |||
| Consumers in the United States | |||
| Mexican producers | |||
| U.S. government |
Points:
0.75 / 1
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Explanation:
Consumers in the United States gain from the lower price of backpacks. The U.S. government loses its tariff revenue from importing backpacks from China (20%×$9.00 per backpack=$1.80 per backpack20%×$9.00 per backpack=$1.80 per backpack). Mexico gains from being able to export backpacks to the United States. China loses because its producer surplus decreases as a result of the lost export sales.
This is an example of trade![]()
diversion resulting from a regional agreement.
Points:
0 / 1
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Explanation:
Trade creation occurs when regional trade agreements allow international trade to occur, when previously all production was done domestically. On the other hand, trade diversion occurs when regional trade agreements lead to tariff distortions that shift production from low-cost firms outside of the trade area to higher-cost firms within the trade area.
The example given shows how a regional agreement results in trade diversion: Before NAFTA, the United States imported backpacks from the lowest-cost producer (China), while under NAFTA, it imports them from a higher-cost producer (Mexico), which is a member of the trade agreement.
4. Effects of a regional trading arrangement
Consider a hypothetical world consisting of only three countries: Luxembourg, the United States, and Germany. Each country produces grain. Luxembourg is a small economy compared to the United States and Germany and thus cannot influence foreign prices.
On the following graph, the supply and demand schedules of Luxembourg are shown as SLuxSLux and DLuxDLux. Foreign supply schedules of grain are perfectly elastic: The United States is a more efficient supplier of grain than Germany because its supply price is $1.00 per bushel (SUSSUS), whereas Germany’s supply price is $2.00 per bushel (SGerSGer).
Calculate the quantity of bushels Luxembourg imports when the three nations engage in free trade. Enter this value in the first row of the following table. Also indicate which country Luxembourg imports from.
|
Scenario
|
Imports
|
Imports from . . .
|
|---|---|---|
|
(Thousands of bushels)
|
||
| Free trade |
48
|
|
| With tariff |
24
|
|
| With customs union |
36
|
Points:
0.5 / 1
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Explanation:
Under the conditions of free trade, Luxembourg is better off purchasing all of its import requirements from the United States at the price of $1.00 per bushel. Germany is unable to participate in the market because its supply price is too high. In free trade equilibrium, Luxembourg’s consumption equals 27,000 bushels, production equals 3,000 bushels, and imports—the difference between consumption and production—equal 24,000 bushels.
At some point in time, Luxembourg decides to protect its domestic grain producers and imposes a tariff of $2.00 per bushel of grain on imports from both the United States and Germany. SUS+ TSUS+ T and SGer+ TSGer+ T represent the after-tariff prices for both countries.
In the second row of the previous table, enter the quantity of bushels Luxembourg imports with the tariff and the country it imports from.
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Explanation:
With a tariff of $2.00 per bushel, the United States still remains a more efficient supplier than Germany. The United States is able to supply at the price of $3.00 per bushel, while Germany’s price is $4.00 per bushel. So, Luxembourg continues importing solely from the United States. However, the volume of trade decreases as the tariff reduces Luxembourg’s imports to 12,000 bushels and consumption to 21,000 bushels, while the domestic producers pick up the rest—now supplying 9,000 bushels instead of the 3,000 bushels under free trade.
Later on, Luxembourg and Germany form a customs union as part of a trade liberalization agreement, while the trade between Luxembourg and the United States continues with the previous terms.
In the last row of the previous table, enter the quantity of bushels Luxembourg imports with the customs union and the country it imports from.
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Explanation:
As a result of the formation of the customs union between Luxembourg and Germany, Luxembourg drops the import tariff against Germany while maintaining the import tariff on imports from the nonmember, the United States. Therefore, Luxembourg is now able to purchase all of its imports, totaling 18,000 bushels, from Germany at $2.00 per bushel while importing nothing from the United States.
Complete the following table by identifying which trade effect of the customs union formation is represented by each of the shaded areas on the previous graph. Check all that apply.
|
Effect
|
Area
|
||
|---|---|---|---|
|
A
|
B
|
C
|
|
| Consumption effect | |||
| Favorable production effect | |||
| Trade creation effect | |||
| Trade diversion effect | |||
Points:
1 / 1
True or False: Relative to a global tariff, the effect of creating a customs union in Luxembourg is positive.
Points:
1 / 1
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Explanation:
The following table explains each effect shown on the graph:
|
Effect
|
Area
|
Explanation
|
|---|---|---|
| Consumption effect | Triangle B | Luxembourg’s entry into the customs union results in dropping all tariffs against Germany. Facing a lower import price of $2.00 per bushel, Luxembourg increases its consumption of grain by 24,000 bushels−21,000 bushels=3,000 bushels24,000 bushels−21,000 bushels=3,000 bushels. |
| Production effect | Triangle C | Eliminating the tariff barrier against Germany means that Luxembourg’s producers now compete against lower cost, more efficient German producers, which forces inefficient domestic producers to drop out of the market. This results in a decline in home output of 9,000 bushels−6,000 bushels=3,000 bushels9,000 bushels−6,000 bushels=3,000 bushels. The reduction in the cost of obtaining this output creates the favorable production effect. |
| Trade creation effect | Triangles C and B | The overall trade creation effect provides net improvement of the price, whereas the trade diversion means that trade from the cheapest supplier (the United States) is diverted to the country in the union (Germany), and the resulting price is lower due only to the decrease of tariffs but is higher compared with the rest of the world. |
| Trade diversion effect | Rectangle A | Although the total volume of trade increases under the customs union compared to trade with a tariff for all suppliers, part of this trade—specifically, 21,000 bushels−9,000 bushels=12,000 bushels21,000 bushels−9,000 bushels=12,000 bushels—has been diverted as a result of replacing a low-cost supplier outside the union (the United States) with a higher-cost supplier within the union (Germany). The increase in the cost of obtaining these 12,000 bushels of imported grain generally implies a welfare loss and a less efficient world production. |
The movement toward freer trade under a customs union affects world welfare in two opposing ways: a welfare-increasing trade creation effect and a welfare-reducing trade diversion effect. The overall consequence of a customs union on the welfare of its members, as well as on the world as a whole, depends on the relative strengths of these two opposing forces.
Luxembourg gains consumer surplus, which is represented by area B. It also gains through the elimination of the deadweight loss represented by the production effect, area C. Luxembourg is now able to buy grain from Germany at $2.00, which is lower than the price Luxembourg paid to import from the United States when the trade barrier was in effect for both the United States and Germany. As a result, Luxembourg’s imports increase from 12,000 bushels to 18,000 bushels.
However, Luxembourg also experiences a welfare loss equal to the trade diversion effect, area A. Because A>(B+C)A>B+C, the overall welfare effect of the customs union formation on Luxembourg is negative. Therefore, the statement is false.
Welfare effects of a regional trading arrangement are not always static. There are also dynamic gains that influence growth rates over the long run and offset unfavorable static effects due to trade diversion.
Which of the following represent dynamic gains from creating a customs union? Check all that apply.
Points:
1 / 1
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Explanation:
Dynamic gains include economies of scale, greater competition, market enlargement, and stimulus of investment.
The most noticeable result of a customs union is market enlargement. When producers freely access member nations’ markets, they take advantage of economies of scale that would not have occurred in markets limited by trade restrictions. Larger markets permit greater specialization of workers and machinery and the use of the most efficient equipment. For example, the European Union has achieved significant economies of scale in the production of such goods as steel, automobiles, footwear, and copper.
With customs unions, domestic producers face more competition and must keep prices down, improve quality, and raise productivity or face the possibility of financial bankruptcy. Trade also accelerates the pace of technical advance and boosts productivity by enhancing the exchange of technical knowledge among countries as human and physical capital move more freely. As a result, an economy’s rate of growth increases, causing not just a one-time boost to economic welfare, but a persistent increase in income that grows steadily larger as time passes.
5. Membership in the European Monetary Union
Suppose that applying for membership in the European Monetary Union (EMU) is expensive, so three hypothetical countries, Baltia, Polsha, and Letvonia, have come to you with their relevant data and want advice on if they should apply to join the EMU. Suppose that the average inflation rate of the three European countries with the lowest inflation rates is 3.0%, and the average long-term interest rate of those countries is 3.2%.
Evaluate the characteristics of Baltia, Polsha, and Letvonia presented in the following table using the Maastricht convergence criteria. Then, complete the bottom row by identifying whether each country is eligible to become an EMU member.
|
Criteria
|
Baltia
|
Polsha
|
Letvonia
|
|---|---|---|---|
| Inflation | 4.5% | 4.0% | 4.1% |
| Long-term interest rates | 5.0% | 4.0% | 3.0% |
| Exchange rates | Last devaluated three years ago | Stable | Stable |
| Budget deficit | 2.4% of GDP | 2.4% of GDP | 2.3% of GDP |
| Debt outstanding | 45% of GDP | 46% of GDP | 47% of GDP |
| Qualifies to enter the EMU? |
Points:
1 / 1
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Explanation:
Membership in the EMU is not automatic. The prospective countries must satisfy the convergence criteria as mandated by the Maastricht Treaty in 1991. A successful candidate should meet the following requirements:
| • | Inflation: No more than 1.5% above the average of the inflation rates in the three countries with the lowest inflation rates. In this scenario, it should not exceed 3.0%+1.5%=4.5%3.0%+1.5%=4.5%. |
| • | Long-term interest rates: No more than 2.0% above the average interest rate in the three countries with the lowest inflation rates. In this scenario, it should not exceed 3.2%+2%=5.2%3.2%+2%=5.2%. |
| • | Exchange rates: No devaluations for at least two years prior to joining the EMU. |
| • | Budget deficit: At most, 3.0% of GDP. |
| • | Debt outstanding: No more than 60.0% of a year’s GDP. |
All three countries meet all of the convergence criteria. Thus, all three qualify to enter the European Monetary Union.
6. Variable levies
The following graph shows the market for wheat in the European Union (EU). The world price of wheat is $2.00 per bushel, so SWorldSWorld represents the world supply assuming that the EU cannot affect the world price of wheat. To support the agricultural sector, the EU guarantees a certain price for the farmers by imposing a variable levy of $2.00 per bushel to limit the import of wheat.
On the graph, use the purple line (diamond symbol) to show the support price the farmers receive due to the variable $2.00 levy.
Note: Select and drag the line segment from the palette to the graph. Then select a point on the line segment and drag it to its desired position.
Points:
1 / 1
Fill in the following table by entering the quantities for production, consumption, and imports of wheat in the EU before and after the $2.00 levy.
|
Production
|
Consumption
|
Imports
|
|
|---|---|---|---|
|
(Bushels)
|
(Bushels)
|
(Bushels)
|
|
| Before the levy |
4,000
|
16,000
|
12,000
|
| After the levy |
8,000
|
12,000
|
4,000
|
Points:
0 / 1
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Explanation:
The import levy of $2.00 per bushel raises the price in the EU to $2.00 per bushel+$2.00 per bushel=$4.00 per bushel$2.00 per bushel+$2.00 per bushel=$4.00 per bushel. This price increase decreases consumption of wheat from 8,000 bushels to 6,000 bushels.
However, the levy enables the EU farmers to produce 4,000 bushels of wheat, as opposed to the 2,000 bushels that would be produced under free trade. The end result is a decrease in total imports from 6,000 bushels under free trade to 2,000 bushels under the levy.
Suppose that the world price of wheat falls to $1.00 per bushel, but the EU keeps the same support price for the farmers.
On the previous graph, use the grey line (star symbol) to draw the new world supply curve (SWorld,NewSWorld,New).
Given the change in the world price, the variable levy adjusts to
$3
per bushel of wheat in order to maintain the support price.
Points:
1 / 1
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Explanation:
Because the EU takes the world price of wheat as given, the new world supply curve of wheat is a horizontal line at a price of $1.00.
Under a variable levy system, the import tariff is adjusted daily and equals the difference between the lowest price in the world market ($1.00 per bushel) and the support price ($4.00 per bushel):
| Variable LevyVariable Levy | = = | Support Price−Current World PriceSupport Price−Current World Price |
Therefore, in this example, the sliding-scale nature of the variable levy results in the EU actually increasing its import tariff from $2.00 to $4.00 per bushel−$1.00 per bushel=$3.00 per bushel$4.00 per bushel−$1.00 per bushel=$3.00 per bushel.
Which of the following describe the effects of the variable levy on international trade? Check all that apply.
Points:
1 / 1
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Explanation:
The variable import levy is more restrictive than a fixed tariff because foreign producers are discouraged from reducing prices to maintain export sales. Cutting prices only triggers higher variable levies. For the same reason, foreign producers have no incentive to subsidize their exports to penetrate domestic markets.
The completion of the Uruguay Round of trade negotiations in 1994 resulted in conversion of all nontariff barriers, including variable levies, into equivalent tariffs.
7. Economic costs and benefits of a common currency
Identify whether each attribute in the following table is an advantage or disadvantage of sharing a currency across country boundaries.
|
Attribute
|
Advantage
|
Disadvantage
|
|---|---|---|
| Elimination of exchange fluctuations | ||
| Greater certainty for investors | ||
| Greater risk of macroeconomic shocks | ||
| Lower protectionism | ||
| Dependent monetary policy |
Points:
0.6 / 1
Close Explanation
Explanation:
Advantages of having a common currency area include elimination of the risks associated with exchange fluctuations and reduction of political pressures for trade protection. By replacing the various European currencies with a single currency, the euro, the European Monetary Union (eurozone) not only increased certainty for investors but also lowered the costs for individuals and firms in the European Union. Using a single currency lowers the costs of goods and services and facilitates a comparison of prices within the EU, which promotes more uniform prices.
The disadvantages of adopting a common currency include the absence of individual domestic monetary policy to counter macroeconomic shocks and a loss of an independent monetary policy as an instrument to fight economic disturbances, because individual countries are not able to absorb shocks by adopting a more expansionary (or contractionary) monetary policy.
Which of the following are reasons the European Union is considered![]()
a suboptimalcurrency area? Check all that apply.
7. Economic costs and benefits of a common currency
Identify whether each attribute in the following table is an advantage or disadvantage of sharing a currency across country boundaries.
|
Attribute
|
Advantage
|
Disadvantage
|
|---|---|---|
| Increased difficulty adjusting out of recession | ||
| Uniform prices | ||
| Higher risk of public debt | ||
| Enhanced competition | ||
| Lower cost of currency conversion |
Points:
1 / 1
Close Explanation
Explanation:
Advantages of having a common currency area include reduction of costs of currency conversion, an increased efficiency due to more uniform prices, and enhanced competition. By replacing the various European currencies with a single currency, the euro, the European Monetary Union (eurozone) not only increased certainty for investors but also lowered the costs for individuals and firms in the European Union. Using a single currency lowers the costs of goods and services and facilitates a comparison of prices within the EU, which promotes more uniform prices.
The disadvantages of adopting a common currency include the inability of an individual country to use inflation to reduce public debt in real terms and a higher risk of economic recession. Also, a disadvantage of joining a monetary union is inability to respond easily to a balance of payments crisis through currency devaluation.
Which of the following are reasons the United States is considered![]()
an optimal currency area? Check all that apply.
Points:
1 / 1
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Explanation:
An optimum currency area is defined as a region in which it is economically preferable to have a single official currency rather than multiple official currencies. The United States can be considered an optimal currency area, because it has high labor mobility due to the absence of legal, cultural, or linguistic barriers to labor mobility, flexible prices and wages, and a mechanism for transferring fiscal resources across state borders.
Workers in the United States are able and willing to move freely across borders. The flexibility of prices and wages ensures that they can be adjusted in response to an economic shock, and resources can be moved across borders via an automatic mechanism of stabilizing transfers. For a currency area to have the best chance of success, the entities involved—in this case, states—should have similar business cycles and economic structures. Moreover, the United States uses a single monetary policy across state borders.
Points:
0.2 / 1
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Explanation:
An optimum currency area is defined as a region in which it is economically preferable to have a single official currency rather than multiple official currencies. The European Union can be considered a suboptimal currency area. Optimum currency theory suggests that for a common currency area to succeed, countries involved should have similar business cycles and economic structures. Also, the single monetary policy should affect all the participating countries in the same manner. There should be no legal, cultural, or linguistic barriers to labor mobility across borders; there should be wage flexibility; and there should be some system of stabilizing transfers.
Although economic efficiency in the European Union may be improved through lower transaction costs of exchanging one currency for another; decreased exchange-rate risk; stronger competition; and broader and deeper financial markets, there are significant disadvantages of the European Monetary Union. A main disadvantage is that each participating European country loses the use of monetary policy and the exchange rate as a tool in adjusting to economic disturbances. Also, recovering from a recession can be difficult due to wage rigidity and low labor mobility.
Some economists argue that the costs exceed the gains for the EU countries as a whole, and thus monetary union is not a good idea for all countries. However, for a smaller set of countries, the gains may exceed the costs, and monetary union makes sense. Trade among the smaller set of countries is much higher than trade with all countries, so the efficiency gains are higher.
1. Regional trade agreements
In the following table, indicate whether each statement about regional trade agreements is true or false.
|
Statement
|
True
|
False
|
|---|---|---|
| Under regional trade agreements, several countries eliminate tariffs among themselves and lower tariffs against all other countries. | ||
| Regional trade agreements contradict GATT’s most favored nation principle. | ||
| NAFTA member countries maintain a common schedule of tariffs with countries outside NAFTA. | ||
| A good imported into Mexico from China will not be granted duty-free access to the U.S. market if no value is added to this good in Mexico. | ||
| Rules of origin specify the types of goods that can be shipped duty-free within a free trade area. | ||
| Rules of origin are not needed in a customs union. |
Points:
0.83 / 1
Close Explanation
Explanation:
Under regional trade agreements, several countries eliminate tariffs among themselves but maintain tariffs against countries outside the region. Although such agreements are permitted under GATT, they contradict GATT’s most favored nation principle, which states that every country belonging to GATT/WTO should be treated equally.
Countries that enter into a free trade area agreement (for example, NAFTA) keep the tariffs that they formerly had with the rest of the world. The countries within a customs union (for example, the European Union) agree to a common schedule of tariffs with countries outside the union.
Rules of origin specify the types of goods that can be shipped duty-free within a free trade area. For example, products can be shipped duty-free within NAFTA only if most of their production occurred in the United States, Canada, or Mexico. Rules of origin are not needed in a customs union, because the members of the union have the same tariffs with countries outside the union.
