Pearson Edexcel International Advanced Level Economics: Trading blocs, the WTO and protectionism (YEC11)

This study guide is aligned to the Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics specification (YEC11 for the full International Advanced Level), Issue 2, June 2018. It covers section 4.3.2 items 4 and 5: trade liberalisation and trading blocs, and restrictions on free trade. The specification places Unit 4, Developments in the global economy, among the International A2 units (Units 3 and 4), so it is compulsory for the full International A Level only. Units 1 and 2 are the International AS. All figures below are invented and fictional.

Related pages: revision notes, practice questions, the Edexcel economics hub, the printable checklist, exam preparation and the free diagnostics.

What this unit covers

Reference	You must be able to
4a	Explain the role of the World Trade Organization (WTO) in trade liberalisation
4b	Distinguish free-trade areas, customs unions, common markets, economic and monetary unions
4c	Assess costs and benefits of membership: trade creation, trade diversion, costs and prices, economies of scale, transaction costs, movement of factors of production
4d	Discuss possible conflicts between trading blocs and the WTO
5a	Explain reasons for restricting free trade
5b	Analyse tariffs, quotas, non-tariff barriers and subsidies to domestic producers
5c	Evaluate the impact of protection on consumers, producers, governments, living standards and equality

4a. The WTO and trade liberalisation

Trade liberalisation means reducing barriers to trade: lower tariffs, bigger quotas, fewer non-tariff barriers. The WTO is the international body that sets and polices the rules of world trade. It began in 1995 and took over from the earlier GATT arrangements.

Its main roles in liberalisation:

• Negotiation forum. Members bargain over cuts in barriers in rounds of talks. Agreed cuts are bound, so a member cannot raise tariffs above the agreed level.
• Non-discrimination. A member should give every other member the same treatment (most-favoured-nation) and treat imports no worse than home goods once they are inside the market (national treatment).
• Dispute settlement. A member that believes another has broken the rules can bring a case. Losers are asked to change policy, and the winner may be authorised to retaliate.
• Transparency and monitoring. Members publish trade policies, and these are reviewed regularly.
• Rules on unfair practice. Anti-dumping duties and some subsidy rules are allowed where the conditions are met.

Evaluation: the WTO works by consensus, so deals are slow. Weaker members may lack the resources to bring cases. Enforcement relies on retaliation, which favours large economies.

4b. Types of trading bloc

A trading bloc is a group of countries that give each other preferential trade treatment. Each type adds to the one before.

Type	Internal tariffs	Common external tariff	Free movement of factors	Single currency and monetary policy
Free-trade area	Removed	None: every member keeps its own rates	No	No
Customs union	Removed	Yes	No	No
Common market	Removed	Yes	Yes (labour and capital)	No
Economic and monetary union	Removed	Yes	Yes	Yes

In a free-trade area, an outside firm could ship goods in through the member with the lowest tariff. Members therefore need rules of origin to check where goods were made. A customs union avoids that problem with a common external tariff but requires members to agree trade policy. A common market also needs common product standards. A monetary union means members give up their own interest rate and exchange rate.

4c. Costs and benefits of membership

Trade creation and trade diversion

Trade creation happens when a member replaces higher-cost domestic output with lower-cost imports from a partner. Trade diversion happens when a member switches from a lower-cost outside supplier to a higher-cost partner because the partner is now free of tariff.

Worked example 1: trade diversion. Country A taxes all imports of washing machines at 25%. Outside Country C sells at 160 per unit. Partner B sells at 180. Demand is Q = 1,000 − 2P (thousands of units). Home firms cost 210, so imports meet all demand. Country A and B form a free-trade area.

• Before: C’s landed price is 160 × 1.25 = 200. B’s is 180 × 1.25 = 225. Buy from C at 200: Q = 1,000 − 400 = 600.
• After: B’s price is 180, below C’s 200. Buy from B: Q = 1,000 − 360 = 640.
• Consumer surplus gain = (200 − 180) × (600 + 640) ÷ 2 = 12,400.
• Tariff revenue lost = 600 × (200 − 160) = 24,000.
• Net effect on A = 12,400 − 24,000 = −11,600.

Why? The 600 units now cost the world 180 instead of 160, an extra 12,000. The new consumption adds ½ × 20 × 40 = 400. So 400 − 12,000 = −11,600. The two methods agree.

Worked example 2: trade creation. Country E makes bicycles at 100. Partner F sells at 75. The tariff is 40%. Demand is Q = 500 − 2P (thousands).

• Before: F’s landed price is 75 × 1.4 = 105, above 100. Buy at home: Q = 300.
• After: price falls to 75. Q = 350.
• Production effect: 300 × (100 − 75) = 7,500 saved.
• Consumption effect: ½ × 25 × 50 = 625.
• Net gain = 7,500 + 625 = 8,125.

What decides the balance? A bigger cost gap between partners and outsiders, higher old tariffs, and a larger share of trade that was already with partners. Trade diversion is more likely when outsiders are the world’s cheapest source.

Other effects of membership

• Costs and prices. Competition from partners pushes firms to cut costs, and consumers gain lower prices and more variety. Weak domestic firms may close, so jobs are lost in the short run.
• Economies of scale. A larger market lets firms spread fixed costs over more output, cutting average cost. This is a dynamic gain that static diversion figures miss.
• Transaction costs. Fewer customs checks, common standards and (in monetary unions) one currency cut delay and exchange-rate costs. Members still bear the cost of adjusting rules.
• Movement of factors. In a common market, workers move to where wages are higher and capital to where returns are higher. This fills skill gaps and raises output, but may cause brain drain, wage pressure or strain on public services in the destination.

Evaluation: gains depend on how like the members are, how big the bloc is and how long adjustment takes. Outsiders lose exports, which may bring retaliation.

4d. Conflicts between trading blocs and the WTO

• Discrimination. Blocs favour members over non-members, which cuts across the non-discrimination principle. The WTO allows blocs only if they cover substantially all trade between members and do not raise barriers to outsiders overall.
• Trade diversion harms efficient outside exporters, who may bring complaints.
• Rules of origin and external tariffs can become barriers by another name.
• Stepping stone or stumbling block? Blocs can move faster than large multilateral talks and spread liberalisation. They may also let large members avoid multilateral deals and set up rival regimes.
• Overlapping memberships create complex rules that raise the costs of trading.

5a. Reasons for restricting free trade

Reason	Argument	Weakness
Infant industries	New firms need time to reach scale and learn, so shield them until they can compete	Protection can become permanent, and officials may pick losers
Geriatric (declining) industries	Slow the decline to give workers time to retrain	Delays adjustment, and consumers pay more
Domestic industries and jobs	Keep output and employment	Jobs saved cost consumers more, and retaliation hits exporters
National security	Keep food, energy or defence supply under home control	Hard to define; may be used as an excuse
Dumping	Sale below cost to drive out rivals harms home firms; anti-dumping duty restores a fair price	Low prices may benefit consumers, and proving dumping is hard
Current account deficit	Cutting imports improves the balance	Does not fix causes, and retaliation cuts exports
Revenue	Tariffs are simple to collect, useful where income tax is hard to collect	Distorts prices, and revenue falls if imports fall

5b. Types of restriction

Tariff: a tax on imports. It raises the domestic price, cuts imports and raises revenue.

Worked example 3: a tariff. In Country D the home market for a good has Qd = 120 − 4P and Qs = 20 + 2P. The world price is 12.

• Free trade: Qd = 120 − 48 = 72, Qs = 20 + 24 = 44. Imports = 28.
• A tariff of 3 lifts the price to 15: Qd = 60, Qs = 50. Imports = 10.
• Consumer surplus loss = ½ × (72 + 60) × 3 = 198.
• Producer surplus gain = ½ × (44 + 50) × 3 = 141.
• Government revenue = 10 × 3 = 30.
• Welfare loss = 198 − 141 − 30 = 27. This is two triangles: ½ × 3 × 6 = 9 (inefficient extra home output) and ½ × 3 × 12 = 18 (lost consumption).

Quota: a limit on the quantity imported. With a quota of 10 in the example, the price also rises to 15. The difference is who gets the 30. A tariff gives it to the government. A quota gives it to licence holders (quota rent) unless licences are auctioned.

Non-tariff barriers: product standards, licensing, customs delays, embargoes and local-content rules. They are harder to measure and can be hidden behind health or safety aims.

Subsidy to domestic producers: with a subsidy of 3 per unit at the world price of 12, producers receive 15 and supply 50. Consumers still pay 12 and buy 72. Imports = 22. Cost to government = 50 × 3 = 150. Producer surplus gain = 141. Welfare loss = 150 − 141 = 9. Consumers are not hurt, but taxpayers pay.

5c. Impact of protection

Group	Likely effect
Consumers	Higher prices, less choice (tariffs, quotas, non-tariff barriers); subsidies spare them but need taxes
Producers	Protected home firms gain sales and profit; less pressure to cut costs; exporters may lose if others retaliate; firms using imported inputs face higher costs
Governments	Tariff revenue gained; subsidy cost incurred; risk of trade disputes
Living standards	Lower real income if prices rise and efficiency falls; may rise later if infant industries succeed
Equality	Taxes on basics hit low-income households hardest; protected jobs may help low-skilled workers; owners of protected firms gain

Common errors

• Calling any tariff cut “trade creation”. Check whether supply switches from home or from outside.
• Showing a quota as raising government revenue.
• Forgetting that the loss to consumers is bigger than the gain to producers.
• Giving a free-trade area one shared outside tariff; that belongs to a customs union.
• Giving a list of reasons for protection with no counter-argument.

Official syllabus

Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics, Specification, Issue 2, June 2018, first teaching September 2018, published by Pearson Education Limited: section 4.3.2 Trade and the global economy, items 4 and 5.