You might have noticed that some particular items you have like a pencil or pen are made in the same country. That country and the country you live in most likely have a trading agreement that has allowed your pen and pencil to be shipped from one place in the world to another. How do countries decide who to trade with and what to trade? In this explanation, you will learn about the different types of trading agreements and their advantages and disadvantages.
Types of trading blocs
When it comes to trading blocs, there are two different kinds of common agreements between governments: bilateral agreements and multilateral agreements.
Bilateral agreements are those that are between two countries and/or trading blocs.
For instance, an agreement between the EU and some other country would be called a bilateral agreement.
Multilateral agreements are simply those that involve at least three countries and/or trading blocs.
Let’s look at the different kinds of trading blocs around the world.
Preferential trading areas
Preferential trading areas (PTAs) are the most basic form of trading blocs. These kinds of agreements are relatively flexible.
Preferential trading areas (PTAs) are areas where any trade barriers, such as tariffs and quotas, are reduced on some but not all goods traded between member countries.
India and Chile have a PTA agreement. This allows the two countries to trade 1800 goods between them with reduced trade barriers.
Free trade areas
Free trade areas (FTAs) are the next trading bloc.
Free trade areas (FTAs) are agreements that remove all trade barriers or restrictions between the countries involved.
Each member continues to retain the right to decide on their trade policies with the non-members (countries or blocs not part of the agreement).
The USMCA (United States-Mexico-Canada Agreement) is an example of an FTA. As its name says, it is an agreement between the US, Canada, and Mexico. Each country freely trades with one another and can trade with other countries that are not a part of this agreement.
Customs unions
Custom unions are an agreement between countries/trading blocs. Members of a customs union agree to remove trade restrictions between each other, but also agree to impose the same import restrictions on non-member countries.
The European Union (EU) and Turkey have a customs union agreement. Turkey can trade freely with any EU member but it has to impose common external tariffs (CETs) on other countries that are not EU members.
Common markets
The common market is an extension of the customs union agreements.
A common market is the removal of trade barriers and the free movement of labour and capital between its members.
A common market is sometimes also referred to as a ‘single market’.
The European Union (EU) is an example of a common/single market. All 27 countries freely enjoy trading with each other without restrictions. There is also free movement of labour and capital.
Economic unions
An economic union is also known as a ‘monetary union’, and it is a further extension of a common market.
An economic union is the removal of trade barriers, the free movement of labour and capital, and the adoption of a single currency between its members.
Germany is a country in the EU that has adopted the euro. Germany is free to trade with other EU members who have adopted the euro, like Portugal, and who haven’t adopted the euro, like Denmark.
As a single currency is adopted, this means that member countries who also choose to adopt the same currency must also have a common monetary policy, and to some extent, fiscal policy.
Examples of trade blocs
Some examples of trade blocs are:
- The European Free Trade Association (EFTA) is an FTA between Iceland, Norway, Liechtenstein, and Switzerland.
- The Common Market of the South (MERCOSUR) is a customs union between Argentina, Brazil, Paraguay, and Uruguay.
- The Association of Southeastern Asian Nations (ASEAN) is an FTA between Brunei, Cambodia, Indonesia, Laos, Malaysia, Myanmar, the Philippines, Singapore, Thailand, and Vietnam.
- The African Continental Free Trade Area (AfCFTA) is an FTA between all African countries except Eritrea.
Advantages and disadvantages of trading blocs
The formation of trade blocs and agreements has become a lot more common. They have consequences on global trade and they have become an important factor in shaping the international economy.
It's important to discuss both their positive and negative impacts on trade and countries (members and non-members) around the world.
Advantages
Some main advantages of trading blocs are:
- Promote free trade. They help with improving and promoting free trade. Free trade results in lower prices of goods, opens up opportunities countries’ opportunities for export, increases competition, and most importantly drives economic growth.
- Improves governance and state of law. Trading blocs help lessen international isolation and can help improve the rule of law and governance in countries.
- Increases investment. Trading blocs like customs and economic unions will allow for members to benefit from foreign direct investment (FDI). Increased FDI from firms and countries help create jobs, improve infrastructure, and the government benefits from the taxes these firms and individuals pay.
- Increase in consumer surplus. Trading blocs promote free trade, which increases consumer surplus from lower prices of goods and services as well as the increased choice in goods and services.
- Good international relations. Trading blocs can help promote good international relationships between its members. Smaller countries have more of a chance to have greater involvement in the wider economy.
Disadvantages
Some main disadvantages of trading blocs are:
- Trade diversion. Trading blocs distort world trade as countries trade with other countries based on whether they have an agreement with each other rather than if they are more efficient in producing a certain type of good. This reduces specialisation and distorts the comparative advantage some countries may have.
- Loss of sovereignty. This particularly applies to economic unions as countries have no longer control over their monetary and to some extent their fiscal instruments. This can be particularly problematic during times of economic hardship.
- Greater interdependence. Trading blocs lead to greater economic interdependence of the member countries as they all rely on each other for certain/all goods and services. This problem can still occur even outside of trading blocs due to all countries having close connections with the trade cycles of other countries.
- Difficult to leave. It can be extremely difficult for countries to leave a trading bloc. This can cause further problems in a country or cause tension in the trading bloc.
Impact of trading blocs on developing countries
Perhaps an unintended consequence of trading blocs is that there are sometimes winners and losers. Most of the time, the losers are the smaller or developing countries.
Trading agreements can negatively impact developing countries whether they are a member of a trading agreement or not. The main impact is that it limits the economic development of these countries.
Developing countries who are non-members of a trade agreement tend to lose out as they are less likely to trade on similar terms.
Developing countries might find it difficult to lower prices in order to compete with the trading bloc whose prices are low due to economies of scale and advancement.
Having more trading blocs leads to having fewer parties that need to negotiate with each other about trading agreements. If there is only a limited number of countries a developing country can trade with, this restricts the revenue they receive in exports and thus can use to fund development policies in the country.
However, this is not always the case with developing countries as there is evidence to support the rapid economic development from free trade. This is speciality true for countries such as China and India.
The EU trading bloc
As we said before, the European Union (EU) is an example of a common market and monetary union.
The EU is the largest trading bloc in the world and it started with the aim of creating more economic and political integration among the European countries. It was established in 1993 by 12 countries and was called the European Single Market.
Currently, there are 27 member states in the EU, out of which 19 are part of the European Economic and Monetary Union (EMU). EMU is also known as the Eurozone and those countries part of EMU have also adopted a common currency: the euro. The EU also has its own central bank, called the European Central Bank (ECB), created in 1998.
A country needs to meet certain criteria before it can adopt the euro:
- Stable prices: the country must not have an inflation rate of more than 1.5% higher than any of the average of the three member countries with the lowest inflation rate.
- Stable exchange rate: their national currency must have been stable for a period of two years relative to other EU countries prior to entry.
- Sound governance finances: the country must have reliable government finances. This means that the country’s fiscal deficit must not be more than 3% of its GDP, and its national debt must not be more than 50% of its GDP.
- Interest rate convergence: this means that the five-year government bond interest rate must not be more than 2% points higher than the average of the Eurozone members.
Adopting the euro also has pros and cons. Adopting the euro means that a country is no longer in total control over its monetary and, to some extent, its fiscal instruments, and it is unable to change the value of its currency. This means that the country can’t use expansionary policies as freely as it would like to, and this can be particularly difficult during a recession.
However, the Eurozone members benefit from free trade, economies of scale, and more levels of investment because of the common market and monetary union agreements.
Trade creation and trade diversion
Let’s analyse the impacts of trading blocs based on these two concepts: trade creation and trade diversion.
Trade creation is the increase of trade when trade barriers are removed, and/or new patterns of trade emerge.
Trade diversion is the shift of importing goods and services from low-cost countries to high-cost countries. This mainly occurs when a country joins a trading bloc or some sort of protectionist policy is introduced.
The examples that we will consider will also link to the concepts discussed in our Protectionism article. If you are unfamiliar with this or are struggling to understand, don't worry! Just read our explanation in our Protectionism before continuing.
To further understand trade creation and trade diversion, we will use the example of two countries: Country A (member of customs union) and Country B (non-member).
Trade creation
When trading countries are choosing the cheapest source to procure products and/or services, this opens up the opportunity for them to specialise in products and/or services where competitive advantage is possible or already exists. This leads to efficiency and increased competitiveness.
Before Country A was a member of a customs union, it imported coffee from Country B. Now that Country A has joined a customs union, it can create trade freely with other countries in the same trading bloc, but not with Country B, as it isn't a member. Thus, Country A must impose import tariffs on Country B.
Looking at Figure 1, the price for coffee from Country B was at P1, well below the world price for coffee (Pe). However, after imposing the tariff on Country B, the price of importing coffee from it has risen to P0. Importing coffee is much more expensive for Country A, so they choose to import coffee from a country in their trading bloc.
Figure 1. Trade creation, StudySmarter Originals
Country B now decides to join the customs union where Country A is a member. Because of this, the tariff is removed.
Now, the new price at which Country B is able to export coffee drops back to P1. With the fall in the price of coffee, the quantity demanded for coffee in Country A increases from Q4 to Q2. Domestic supply falls from Q3 to Q1 in Country B.
When the tariff was imposed on Country B, Areas A and B were deadweight loss areas. This was because there was a fall in net welfare. Consumers were worse off from the increase in the price of coffee and Country A’s government was worse off as it was importing coffee at a higher price.
After the removal of the tariff, Country A benefits by exporting from the most efficient source and Country B benefits as it gains more trading partners to export coffee to. Thus, trade has been created.
Trade diversion
Let’s consider the same example again, but this time Country B doesn’t join the customs unions that Country A is a part of.
As Country A has to impose a tariff on Country B, the price to import coffee becomes more expensive for Country A and so it chooses to import coffee from Country C (another member of the customs union). Country A doesn’t have to impose a tariff on Country C as they can trade freely.
However, Country C doesn’t produce coffee as efficiently and cost-effectively as Country B does. So Country A decides to import 90% of its coffee from Country C and 10% of its coffee from Country B.
In Figure 2 we can see that after imposing the tariff on Country B, the price of importing coffee from them has risen to P0. Because of this, the quantity demanded for Country B’s coffee falls from Q1 to Q4 and less is imported.
Figure 2. Trade diversion, StudySmarter Originals
Because Country A has moved to importing coffee from a low-cost country (Country B) to a high-cost country (Country C), there is a loss in net welfare, resulting in two deadweight loss areas (Area A and B).
Trade has been diverted to Country C, which has a high opportunity cost and a lower comparative advantage compared to Country B. There is a loss in world efficiencies and there is a loss in consumer surplus.
Trading Blocs - Key takeaways
- Trading blocs are agreements between governments and countries to manage, maintain, and promote trade between the member countries (part of the same bloc).
- The most prominent part of trading blocs is the removal or reduction of trade barriers and protectionist policies which improve and increase trade.
- Preferential trading areas, free trade areas, customs unions, common markets, and economic or monetary unions are different types of trading blocs.
- Trading blocs agreements between countries improve trade ties, increase competition, provide new opportunities to trade, and improve the health of an economy.
- Trading blocs can make trading with other countries that are not within the same trading bloc more expensive. It can also result in greater interdependence and a loss of power over economic decisions.
- Trading agreements can impact developing countries more severely, as it can result in limiting their development if they are non-members.
- Trading blocs can allow for trade creation, which refers to the increase of trade when trade barriers are removed, and/or new patterns of trade emerge.
- Trading blocs can result in trade diversion which refers to the shift of importing goods and services from low-cost countries to high-cost countries.
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