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NAFTA and the EU

27 January, 2016 - 15:23
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In North America, recent trade policy has led to a free trade area that covers the flow of trade between Canada, the United States, and Mexico. The Canada/United States free trade agreement (FTA) of 1989 expanded in 1994 to include Mexico in the North American Free Trade Agreement (NAFTA). The objective in both cases was to institute free trade between these countries in most goods and services. This meant the elimination of tariffs over a period of years and the reduction or removal of non-tariff barriers to trade, with a few exceptions in specific products and cultural industries. Evidence of the success of these agreements is reflected in the fact that Canadian exports have grown to 40 percent of GDP, and trade with the United States accounts for the lion’s share of Canadian trade flows.

The European Union was formed after World War II, with the prime objective of bringing about a greater degree of political integration in Europe. Two world wars had laid waste to their economies and social fabric. Closer economic ties and greater trade were seen as the means of achieving this integration. The Union was called the “Common Market” for much of its existence. The Union originally had six member states, but as of 2009 the number is 27, with several other candidate countries in the process of application, most notably Turkey. The European Union (EU) has a secretariat and parliament in Bruxelles. You can find more about the EU at http://europa.eu.

KEY TERMS

Autarky denotes the no-trade situation.
Principle of comparative advantage states that even if one country has an absolute advantage in producing both goods, gains to specialization and trade still materialize, provided the opportunity cost of producing the goods differs between economies.
Terms of trade define the rate at which goods trade internationally.
Consumption possibility frontier defines what an economy can consume after production specialization and trade.
Intra-industry trade is two-way international trade in products produced within the same industry.
Intra-firm trade is two-way trade in international products produced within the same firm.
Tariff is a tax on an imported product that is designed to limit trade in addition to generating tax revenue. It is a barrier to trade.
Quota is a quantitative limit on an imported product.
Trade subsidy to a domestic manufacturer reduces the domestic cost and limits imports.
Non-tariff barriers, such as product content requirements, limits the gains from trade.
Dumping is a predatory practice, based on artificial costs aimed at driving out domestic producers.

EXERCISES

  1. The following table shows the labour input requirements to produce a bushel of wheat and a litre of wine in two countries, Northland and Southland, on the assumption of constant cost production technology – meaning that the production possibility curves in each are straight lines.
    Labour requirements per unit produced
     
    Northland
    Southland
    Per bushel of wheat
    1
    3
    Per litre of wine
    2
    4
    1. Which country has an absolute advantage in the production of both wheat and wine?
    2. What is the opportunity cost of wheat in each economy? Of wine?
    3. What is the pattern of comparative advantage here?
    4. Suppose the country with a comparative advantage in wine reduces wheat production by one bushel and reallocates the labour involved to wine production. How much additional wine does it produce?
    5. Which country, if either, gains from this change in production and trade, and what is the gain?
    6. If the country with the comparative advantage in wheat reduced wine production enough to increase wheat production by one bushel, how much wine could it get by selling the additional bushel of wheat to the other country at that economy’s opportunity cost?
  2. Canada and the United States can produce two goods, xylophones and yogourt. Each good can be produced with labour alone. Canada requires 60 hours to produce a ton of yogourt and 6 hours to produce a xylophone. The United States requires 40 hours to produce the ton of yogourt and 5 hours to produce a xylophone.
    1. Describe the state of absolute advantage between these economies in producing goods.
    2. In which good does Canada have a comparative advantage? Does this mean the United States has a comparative advantage in the other good?
    3. Draw the production possibility frontier for each economy to scale on a diagram, assuming that each economy has an endowment of 240 hours of labour.
    4. On the same diagram, draw Canada’s consumption possibility frontier on the assumption that it can trade with the United States at the United States rate of transformation.
    5. Draw the US consumption possibility frontier under the assumption that it can trade at Canada’s rate of transformation.
  3. The domestic demand for bicycles is given by P = 36 - 0.3Q. The foreign supply is given by P = 18 and domestic supply by P = 16+0.4Q.
    1. Illustrate the market equilibrium on a diagram, and compute the amounts supplied by domestic and foreign suppliers.
    2. If the government now imposes a tariff of $6 per unit on the foreign good, illustrate the impact geometrically, and compute the new quantities supplied by domestic and foreign producers.
    3. In the diagram, illustrate the area representing tariff revenue and compute its value.
    1. In the preceding question, illustrate the deadweight losses associated with the imposition of the tariff, and compute the amounts.
    2. Compute the additional amount of profit made by the domestic producer as a result of the tariff. [Hint: refer to Figure 15.4 in the text.]
  5. The domestic demand for office printers is given by P = 40 - 0.2Q. The supply of domestic producers is given by P = 12+0.1Q, and international supply by P = 20.
    1. Illustrate this market geometrically.
    2. Compute total demand and the amounts supplied by domestic and foreign suppliers.
    3. If the government gives a production subsidy of $2 per unit to domestic suppliers in order to increase their competitiveness, calculate the new amounts supplied by domestic and foreign producers. [Hint: The domestic supply curve becomes P = 10+0.1Q].
    4. Compute the cost to the government of this scheme.
  6. The domestic demand for turnips is given by P = 128-(1/2)Q. The market supply of domestic suppliers is given by P = 12+(1/4)Q, and the world price is $32 per bushel.
    1. First graph this market and then solve for the equilibrium quantity purchased.
    2. How much of the quantity traded will be produced domestically and how much will be imported?
    3. Assume now that a quota of 76 units is put in place. Illustrate the resulting market equilibrium graphically.
    4. Compute the domestic price of turnips and the associated quantity traded with the quota in place? [Hint: you could shrink the demand curve in towards the origin by the amount of the quota and equate the result with the domestic supply curve.]
  7. The domestic market for cheese is given by P = 108 - 2Q and P = 16+(1/4)Q. These are the demand and supply conditions. The good can be supplied internationally at a constant price P = 20.
    1. Illustrate the domestic market in the absence of trade and solve for the equilibrium price and quantity.
    2. With free trade illustrate the market graphically and compute the total amount purchased, and the amounts supplied by domestic and international suppliers.
    3. Suppose now that the government wanted to maintain a minimum price in the market of $28 and it decided to do this by selling quotas to suppliers from any source. How many quota units would it sell to achieve this objective?
  8. The following are hypothetical production possibilities tables for Canada and the United States. For each line required, plot any two or more points on the line.
    Canada United States
      A B c D   A B c D
    Peaches 0 5 10 15 Peaches 0 10 20 30
    Apples 30 20 10 0 Apples 15 10 5 0
    1. Plot Canada’s production possibilities curve by plotting at least 2 points on the curve.
    2. Plot the United States’ production possibilities curve by plotting at least 2 points on the curve on the graph above.
    3. What is each country’s cost ratio of producing Peaches and Apples?
    4. Which economy should specialize in which product?
    5. Plot the United States’ trading possibilities curve (by plotting at least 2 points on the curve) if the actual terms of the trade are 1 apple for 1 peach.
    6. Plot the Canada’ trading possibilities curve (by plotting at least 2 points on the curve) if the actual terms of the trade are 1 apple for 1 peach.
    7. Suppose that the optimum product mixes before specialization and trade were B in the United States and C in Canada. What are the gains from specialization and trade?
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