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Free Trade Revision

Both free trade areas and customs unions are agreements that remove tariffs and internal barriers between agreeing countries which form a trading bloc. Such examples of trading blocs include the EU Common Market, NAFTA (North American Free Trade Agreement; involving Mexico, the US and Canada) and Mercosur (a trade agreement involving South American nations). The difference between a free trade area and a customs union is that a customs union has a single common external tariff (that is the cost to countries which are not members of the bloc) whereas a free trade agreement allows each individual member country to set their own tariff to non-member countries.

Trade agreements can have economies of scale benefits, as firms have a larger market to sell to and so can increase production, however at the same time there is increased competition for firms. But this should be beneficial for consumers who are likely to receive a lower price; there is also likely to be economic efficiency gains as firms compete they reduce X-inefficiencies and are likely to be more productively efficient by reducing costs to maximise profits. A lower price is likely to make the market more allocatively efficient. There may be problems however if member nations subsidise or prioritise their own firm, and try to champion it, rather than adopt a fair approach when contracting out jobs.

Trade agreements wont see benefits if trade diversion occurs. Trade diversion is when a country imports goods from countries within the trading bloc which may be less efficient than from countries outside the trading bloc. This would occur despite the trading partner having higher costs, and hence higher prices due to the effects of the tariff. For example within the EU, France may produce beef less efficiently than say New Zealand, but because France is a member of the Common Market it may be cheaper for a British citizen to buy beef from France as there is no tariffs with France, but there is a tariff with New Zealand. If this tariff with New Zealand is high enough it can lead to trade diversion, whereby the British citizen purchases French beef despite it being (hypothetically) produced less efficiently. 

Therefore a trading agreement will only have benefits if trade creation occurs rather than trade diversion. Trade creation is when domestic production which may be more expensive than foreign production, is replaced by importing goods from the trading bloc which are produced cheaper and more efficiently.

Further gains can be had by the abolishment of tariffs which make goods more expensive. Within a trading bloc tariffs no longer exist and so consumers can purchase goods more cheaply, this will increase competition and should increase allocative efficiency.