What’s it: A trade bloc is a group of countries joined together through a trade agreement. Typically, this involves countries in a particular region, for example, the ASEAN Economic Community in Southeast Asia, the European Union in Europe, and NAFTA in North America.
The bloc formation’s objective is to increase the flow of goods, services, capital, and labor, depending on the agreement’s stage. This ultimately increases member countries’ economic power, spurs economic growth, and encourages a more efficient resource allocation.
Types of trade bloc
One form of trade cooperation is a free trade agreement, which involves eliminating import tariffs and liberalizing trade in goods and services between member countries.
Furthermore, a more advanced trade bloc involves free trade in goods and services and capital and labor. They also coordinate economic policy, competition policy, rules on investment flows, environmental policy agreements, and even joint monetary institutions.
Well, I’ll cover five stages or types of trade blocs:
- Preferential trading area
- Free trade area
- Customs union
- Common market
- Economic union
Preferential trading area
This is the simplest form of the trade bloc. Instead of eliminating, the deals are usually looser.
Under the preferential trade area, member countries agree to lower tariffs for certain products. They provide preferential access to specific products but do not eliminate tariffs altogether.
Free trade area
The free trade area involves removing restrictions on trading between members. Thus, goods and services flow freely between them.
Regarding non-member trading, each has separate and different policies. Some members may charge higher rates, while others are lower.
The difference in tariffs provides opportunities and benefits for non-member countries. They will export to member countries that set low tariffs. After entering the destination country, they can ship it to other member countries at no cost. This phenomenon is what we call trade deflection.
A customs union is a more advanced stage than a free trade area. Its main objective is to overcome the trade deflection problem inherent in the free trade area agreement.
Customs union members agree to joint tariffs when they trade with non-members. Hence, there is no opportunity for non-member countries to take benefits from the tariff differences.
Common market is a combination of customs unions plus the removal of barriers to the flow of factors of production. So, under this agreement, member states agree to:
- Eliminating trade barriers in goods and services
- Removing barriers to the capital and labor flows (factors of production)
- Member countries have uniform policies regarding trade with non-member countries
Trade barriers can be tariffs and non-tariff. Protective policies, such as subsidies, are also removed. In succeeding, member countries will usually harmonize some micro-policies such as regulations on monopoly and anti-competitive practices.
Economic unions combine all aspects of the common market and also coordinate economic policy. Member countries then form joint economic institutions for this purpose. An example is the formation of the economic union of the European Union.
Trade bloc advantages and disadvantages
The benefits and drawbacks of the economic bloc depend on how the member states take the agreement. Each type of trade bloc has different exposure to each member country. Also, fundamental economic factors, such as economic structure, competitive conditions, technological advancement, labor flexibility, affect the outcome of cooperation.
Trade bloc advantages
Some of the benefits of forming a trade bloc include:
- Lower prices and more varied products. Tariff elimination leads to lower prices for consumers in member countries. Free flow also increases access to a wider variety of goods.
- Larger market. Companies can increase their sales to other member countries without worrying about protection. The broader market allows them to take advantage of economies of scale.
- Boost direct investments. Under common market and union economies, capital is free to flow, encouraging companies to increase investment and create jobs in some member countries.
- Access to cheaper and more abundant capital. Under an economic union, companies can take advantage of member countries that have more developed financial markets.
- Encourage specialization. Increased trade allows for increased specialization, whereby member countries develop the most efficient industries.
- Decrease monopoly power as competition increases. Goods and services flow freely and create greater choices for consumers. It increases competition in the market and forces firms to increase innovation and efficiency to stay competitive.
- Positive effect on knowledge abundance and technology transfer. In a common market or economic union, capital and professional laborers move freely between members, allowing for a positive effect on knowledge and technology.
- Better quality intermediate inputs. This is because production factors can freely enter and exit member countries, such as in common markets and economic unions.
- Minimize the potential for conflict among members. Members – who were previously competing – can adopt mutual policies that are favorable to them.
- Increase economic power. It gives members a stronger bargaining position on trade policies and agreements because they form a united front. For example, in a palm oil dispute, the European Union has stronger negotiating power as a buyer because many countries are united to fight Indonesia.
- Offers new opportunities for trade and investment. Member countries benefit from inward investment and increase trade opportunities.
- Growth in member countries also tends to extend to other members. Economic expansion in one member country increases demand in other members.
Trade bloc disadvantages
Trade blocs may benefit some countries but not others. That raises several problems. Here is a list of trade bloc weaknesses:
- Shutting down the domestic industry. Increased competition creates winners and losers. If domestic industries are uncompetitive, they exit the market, increasing unemployment. The danger is even greater if many industries are uncompetitive, and they absorb a significant workforce.
- Increased economic dependence. Economic performance between member countries is interconnected. The economic crisis in one member spreads to other member countries. The impact is even broader due to the significant size of the trade bloc’s economy. Examples include the debt crises in Greece, Italy, and Spain, which required the European Central Bank to intervene to handle it. The intervention was to prevent the impact of the crisis from spreading to other member countries.
- Loss of state sovereignty. The trade bloc makes decisions for all members. It may conflict with the domestic economic interests of some member states. Also, the decisions may favor member countries with a more significant size of the economy.
- Bring up the trade diversion. The trade bloc distorts the benefits of world trade. The inefficient firms within the bloc can still survive and are protected from competition from more efficient firms outside the bloc.
- Retaliation from non-member countries. To protect their economies, they are likely to form new trade blocs to defend their positions.