Lecture 8, 9 & 10 - Gains and Losses from Trade
1. Brexit, Integration and the Structure of the EU
1.1 The Brexit Referendum and Regional Heterogeneity
The 23 June 2016 referendum resulted in a 51.9% vote to leave the European Union. The vote share differed substantially across regions:
- England: 53.4% Leave
- Wales: 52.5% Leave
- Northern Ireland: 44.2% Leave
- Scotland: 38.0% Leave
This heterogeneity is economically meaningful. Regions vary in:
- Exposure to EU trade
- Participation in EU supply chains
- Labour mobility patterns
- Net fiscal transfers
Brexit therefore represents not only a change in trade policy but also a redistribution shock across UK regions and sectors.
Economic integration: The reduction of trade barriers and regulatory differences between economies, facilitating cross-border flows of goods, services, capital and labour.
Integration reduces trade costs. In general equilibrium, lower trade costs expand market size, intensify competition, increase productivity through selection effects, and raise aggregate welfare. However, they also generate distributional consequences across sectors and skill groups.
1.2 The Free Movement of Goods and the Customs Union
The EU internal market for goods rests on three pillars:
- Abolition of customs duties and quantitative restrictions
- Common external tariff
- Harmonisation of national legislation
The Customs Union (CU) eliminates tariffs between members and imposes a common external tariff on third countries.
Why a Customs Union Eliminates Internal Border Checks
Without a common external tariff, countries would have incentives to import goods via the lowest-tariff member and re-export internally. This is known as trade deflection.
The Customs Union solves a collective action problem. By coordinating external tariffs, members eliminate arbitrage incentives and remove the need for rules-of-origin checks. This dramatically reduces administrative trade costs.
Advantages of a Customs Union
- Frictionless trade in goods
- Unified trade negotiations
- Reduced compliance costs
Disadvantages
- Loss of independent trade policy
- Constraints on external agreements
Distinguish clearly between Single Market and Customs Union in essays.
Single Market involves regulatory harmonisation and the four freedoms.
Customs Union concerns common external tariffs.
1.3 Border Checks Without a Customs Union
The Sweden–Norway example shows that free trade without a customs union still requires customs formalities.
Even with:
- Zero tariffs
- Free movement of people
There are:
- Customs declarations
- X-ray checks
- Compliance procedures
Tariffs are only one dimension of trade costs. Administrative and regulatory compliance costs can significantly affect trade volumes even when tariffs are zero.
This is central to understanding the EU–UK Trade and Cooperation Agreement (TCA).
2. Instruments of Protection
2.1 Tariffs
Types of Tariffs
- Ad valorem tariff:
- Specific tariff: fixed amount per unit
Tariffs increase domestic price from
Effects of Tariffs
Tariffs:
- Raise domestic prices
- Reduce import volumes
- Increase producer surplus
- Reduce consumer surplus
- Generate government revenue
But they create deadweight loss.
2.2 Non-Tariff Barriers (NTBs)
NTBs include:
- Quotas
- Voluntary export restraints
- Technical standards
- Labelling requirements
- Anti-dumping measures
High-income countries use NTBs extensively.
NTBs often substitute for tariffs when tariff bindings under WTO limit overt protection. They may reflect regulatory objectives but can also be strategically used to restrict trade.
Pitfall: Assuming NTBs are less distortionary than tariffs. NTBs can impose higher welfare losses because they raise costs without generating revenue.
2.3 WTO, MFN and Tariff Bindings
The WTO enforces:
- Most-Favoured-Nation (MFN) principle
- Tariff bindings
MFN: A WTO member must apply the same tariff to all other WTO members.
Tariff bindings cap maximum tariff rates.
Preferential Trade Agreements are exceptions to MFN.
3. Types of Preferential Trade Agreements (PTAs)
Hierarchy of integration:
- Nonreciprocal PTAs
- Reciprocal PTAs
- Customs Union
- Common Market
- Economic Union
Common Market: Customs Union plus free movement of services, capital and labour.
Economic Union: Common Market plus coordinated monetary and/or fiscal policy.
4. The EU–UK Trade and Cooperation Agreement (TCA)
The TCA includes:
- Zero tariffs
- Zero quotas
- Rules of origin
- Customs formalities
No:
- Free movement of services
- Automatic regulatory recognition
The TCA reduces tariffs but increases non-tariff barriers relative to Single Market membership. This represents an increase in trade costs.
4.1 Northern Ireland Protocol and Windsor Framework
Northern Ireland:
- Remains aligned with EU goods rules
- Applies EU customs code at ports
This avoids a hard border on the island of Ireland.
The Protocol reflects the trade-off between political sovereignty and economic friction. Maintaining regulatory alignment minimises border costs but constrains policy autonomy.
5. Trade Creation and Trade Diversion
5.1 Core Definitions
Trade creation replaces high-cost domestic production with lower-cost partner imports.
Trade diversion replaces low-cost external imports with higher-cost partner imports.
5.2 NAFTA Example
High tariff case:
- Trade creation
Lower tariff case:
- Trade diversion
Welfare effects of PTAs depend on relative cost rankings before and after tariff changes.
6. Welfare Analysis of Trade
6.1 Consumer and Producer Surplus
Consumer surplus:
Producer surplus:
Free trade increases total surplus.
6.2 Small Country Tariff
Deadweight loss:
Two distortions:
- Consumption distortion
- Production distortion
Deadweight loss: Net welfare loss not transferred to any agent.
7. Distributional Effects and Labour Markets
Trade affects:
- Wages
- Employment
- Firm entry and exit
In heterogeneous firm models, trade raises productivity through selection. Low-productivity firms exit. Labour reallocation generates transitional unemployment.
Aggregate gains coexist with concentrated losses.
8. Infant Industry and Other Protection Arguments
8.1 Infant Industry
Protection justified if:
- Learning effects exist
- Economies of scale
- Temporary protection
China Automobile Case
China gradually reduced tariffs after achieving scale.
Brazil Computer Case
Brazil’s protection failed to create competitiveness.
Governments face information and commitment problems.
9. Terms of Trade and Optimal Tariff
Terms of Trade:
Large country tariff:
- Foreign exporters lower prices
- Import price rises by less than tariff
- Terms of trade improve
Optimal tariff: Tariff that maximises national welfare for a large country by exploiting market power.
But if all countries do this:
- Retaliation
- Lower global welfare
10. The Purpose of Trade Agreements
Countries face a Prisoner’s Dilemma:
| Low Tariff | High Tariff | |
|---|---|---|
| Low Tariff | High welfare both | One gains, one loses |
| High Tariff | One gains, one loses | Low welfare both |
Trade agreements:
- Enforce reciprocity
- Internalise terms-of-trade externality
- Prevent protectionist spirals
Trade agreements move countries from a non-cooperative Nash equilibrium to a cooperative outcome.
11. Empirical Evidence: UK After Brexit
Evidence:
- 13.2% fall in exports to EU
- 14% exporter exit
- Reduction in imports
No strong evidence of trade diversion.
Interpretation:
- Increased non-tariff barriers
- Reduced deep integration
Integrated Conclusion
Lectures 8–10 integrate:
- Institutional forms of integration
- Welfare analysis of trade
- Political economy of protection
- Strategic interaction in trade policy
- Empirical Brexit evidence
Core insight:
Trade increases aggregate welfare, but distributional effects and strategic incentives create persistent political demand for protection. Trade agreements are institutional solutions to these strategic and political distortions.
Bibliography
Brown, C.P. and Crowley, M.A. (2016) ‘The empirical landscape of trade policy’, in Bagwell, K. and Staiger, R. (eds.) Handbook of Commercial Policy.
Ederington, J. and Ruta, M. (2016) ‘Non-tariff measures and trade agreements’, in Bagwell, K. and Staiger, R. (eds.) Handbook of Commercial Policy.
Feenstra, R.C. and Taylor, A.M. (2008) International Economics. New York: Worth Publishers.
Laird, S. and Yeats, A. (1990) Quantitative Methods for Trade Barrier Analysis. London: Macmillan.
OICA (various years) World Motor Vehicle Production Statistics.
UK Trade Policy Observatory (2020) The Costs of Brexit. University of Sussex.