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Trade Agreements & Free Trade Areas

Author: Geoff Riley  Last updated: Sunday 23 September, 2012

Trading Blocs and Regional Trade Agreements (RTAs)

Over the years average tariffs and other import controls have declined, with progress especially marked in developing Asia and in Eastern Europe after the break-up of the Soviet Union. But the breakdown of the Doha trade talks has dashed hopes of a globally based multi-lateral reduction in import tariffs and other forms of protectionism. In its place there has been a flurry of bi-lateral trade deals between countries and the emergence of regional trading blocs.

Some of these deals are free-trade agreements that involve a reduction in current tariff and non-tariff import controls to liberalise trade in goods and services between countries. The most sophisticated RTAs include rules on flows of investment, co-ordination of competition policies, agreements on environmental policies and the free movement of labour.

Examples of Regional Trade Agreements (RTAs):

  • The number of RTAs has risen from around 70 in 1990 to over 300 today
  • The European Union (EU) – a customs union, a single market and now with a single currency
  • The European Free Trade Area (EFTA)
  • The North American Free Trade Agreement (NAFTA) – created in 1994
  • Mercosur - a customs union between Brazil, Argentina, Uruguay, Paraguay and Venezuela
  • Association of Southeast Asian Nations (ASEAN) Free Trade Area (AFTA)
  • Common Market of Eastern and Southern Africa (COMESA)
  • South Asian Free Trade Area (SAFTA) created in January 2006 and containing countries such as India and Pakistan

In 2012 there were numerous new bi-lateral trade agreements between countries – here is a selection:

Each of these is a reciprocal trade agreement between two or more partners that the countries hope will stimulate cross-border trade and investment. One of the dangers of this bi-lateral approach rather than progress in reaching multi-lateral trade agreements through the World Trade Organisation is that a patchwork quilt of trade deals is emerging, including over-lapping agreements between clusters of countries.

Far from promoting mutual gains, RTAs might cause numerous distortions of markets. Keep in mind also that trade agreements can be expensive to monitor – eating into some of the economic welfare benefits.

Stage of Economic Integration

No Internal Trade Barriers

Common External Tariff

Factor and Asset Mobility

Common Currency

Common Economic Policy

Free Trade Area






Customs Union






Single Market






Monetary Union






Economic Union






Customs Union

The European Union is a customs union. A customs union comprises countries which agree to:

Abolish tariffs and quotas between member nations to encourage free movement of goods and services. Goods and services that originate in the EU circulate between Member States duty-free. However these products might be subject to excise duty and VAT.

Adopt a common external tariff (CET) on imports from non-members countries. Thus, in the case of the EU, the tariff imposed on, say, imports of Japanese TV sets will be the same in the UK as in any other EU country.

Preferential tariff rates apply to preferential or free trade agreements that the EU has entered into with third countries or groupings of third countries.

A customs union shares the revenue from the CET in a pre-determined way – in this case the revenue goes into the EU budget fund. The EU receives its revenues from customs duties from the common tariff, agricultural levies and countries paying 1% of their VAT base. Payments are also made through contributions made by member states based on their national incomes. Thus relatively poorer countries pay less into the EU and tend to be net recipients of EU finances.

A single market represents a deeper form of integration than a customs union. It involves the free movement of goods and services, capital and labour and the concept are broadened to encompass economic policy harmonization for example in the areas of health and safety legislation and monopoly & competition policy. Deeper economic and business ties requires some degree of political integration, which also requires shared aims and values between nations

Trade Creation and Trade Diversion with Customs Unions and Regional Trade Agreements

Trade Creation

Trade creation arising from trade deals between countries involves a shift in domestic consumer spending from a higher cost domestic source to a lower cost partner source for example - within the EU - as a result of the abolition tariffs on intra-union trade

So for example UK households may switch their spending on car and home insurance away from a higher-priced UK supplier towards a French insurance company operating in the UK market

Similarly, Western European car manufacturers may be able to find and then benefit from a cheaper source of glass or rubber for tyres from other countries within the customs union than if they were reliant on domestic supply sources with trade restrictions in place.

Trade creation should stimulate an increase in trade between countries that have signed trade agreements and should, in theory, lead to an improvement in the efficient allocation of scarce resources and gains in consumer and producer welfare.

Trade Diversion

  • Trade diversion is best described as a shift in domestic consumer spending from a lower cost world source to a higher cost partner source (e.g. from another country within the EU) as a result of the elimination of tariffs on imports from the partner
  • The common external tariff on many goods and services coming into the EU makes imports more expensive. This can lead to higher costs for producers and higher prices for consumers if previously they had access to a lower cost / lower price supply from a non-EU country
  • The diagram next illustrates the potential welfare consequences of imposing an import tariff on goods and services coming into the European Union.
  • In general, protectionism in the forms of an import tariff results in a deadweight social loss of welfare. Only short term protectionist measures, like those to protect infant industries, can be defended robustly in terms of efficiency. The common external tariff will have resulted in some deadweight social loss if it has in total raised tariffs between EU countries and those outside the EU.

The overall effect of a customs union on the economic welfare of citizens in a country depends on whether the customs union creates effects that are mainly trade creating or trade diverting.

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