KEY POINTS

1. There are two primary types of free-trade agreements: multilateral and regional. Multilateral agreements are negotiated among large groups of countries (such as all countries in the WTO) to reduce trade barriers among them, whereas regional agreements operate among a smaller group of countries, often in the same region.
2. Under perfect competition, we can analyze the benefits of multilateral agreements by considering the Nash equilibrium of a two-country game in which the countries are deciding whether to apply a tariff. The unique Nash equilibrium for two large countries is to apply tariffs against each other, which is an example of a “prisoner’s dilemma.” By using an agreement to remove tariffs, both countries become better off by eliminating the deadweight losses of the tariffs.
3. Regional trade agreements are also known as preferential trade agreements, because they give preferential treatment (i.e., free trade) to the countries included within the agreement, but maintain tariffs against outside countries. There are two types of regional trade agreements: free-trade areas (such as NAFTA) and customs unions (such as the European Union).
4. The welfare gains and losses that arise from regional trade agreements are more complex than those that arise from multilateral trade agreements because only the countries included within the agreement have zero tariffs, while tariffs are maintained against the countries outside the agreement. Under a free-trade area, the countries within the regional trade agreement each have their own tariffs against outside countries; whereas under a customs union, the countries within the regional trade agreement have the same tariffs against outside countries.
5. Trade creation occurs when a country within a regional agreement imports a product from another member country that formerly it produced for itself. In this case, there is a welfare gain for both the buying and the selling country.
6. Trade diversion occurs when a member country imports a product from another member country that it formerly imported from a country outside of the new trade region. Trade diversion leads to losses for the former exporting country and possibly for the importing country and the new trading region as a whole.
7. Labor standards refer to all issues that directly affect workers, including occupational health and safety, child labor, minimum wages, the right to unionize, and so on. The enforcement of labor standards is sometimes included within trade agreements and is an issue on which consumer groups and unions often demand action.
8. The WTO does not deal directly with the environment, but environmental issues come up as the WTO is asked to rule on specific cases. A review of these cases shows that the WTO has become friendlier to environmental considerations in its rulings.
9. In the presence of externalities, international trade might make a negative externality worse, bringing a social cost that offsets the private gains from trade. International trade can also reduce a negative externality, leading to a social gain that is in addition to the private gains from trade. From this logic and from real-world examples, we conclude that free trade can help or hurt the environment.
10. International agreements on the environment are needed for the same reasons that agreements on tariffs are needed—to avoid a prisoner’s dilemma type of outcome, which is bad for all countries. The Kyoto Protocol of 2005 had only limited success because the United States did not agree to participate, and developing countries such as China and India were excluded. The Copenhagen Accord of 2009 also did not achieve international commitments with firm enforcement, but at least the United States, China, India, and more than 100 other countries have agreed to participate.