Preferential trade

Preferential trade refers to a trading agreement between two or more countries that grant special, more favorable treatment to each other's goods or services compared to what they offer to other trading partners. This often involves reducing or eliminating tariffs, quotas, or other non-tariff barriers on specific products or across a range of goods. Such arrangements are a fundamental aspect of international trade policy, aiming to foster closer economic ties and increase trade flows among participating nations while often discriminating against non-members. Preferential trade agreements (PTAs) are a common form of these arrangements, lying on a spectrum of economic integration that ranges from simple tariff preferences to full-fledged customs unions or common markets.

History and Origin

The concept of preferential trade has deep historical roots, long preceding modern trade agreements. In the 19th century, bilateral treaties often included reciprocal tariff reductions. However, the period leading up to and during the Great Depression in the 1930s saw a surge in protectionist policies and discriminatory trade practices, including imperial preferences, which exacerbated global economic downturns and contributed to geopolitical tensions.²⁵

Following World War II, the architects of the new global economic order aimed to prevent a return to such destructive trade policies. The General Agreement on Tariffs and Trade (GATT), established in 1947, championed the principle of non-discrimination, primarily through the most-favored-nation (MFN) clause, which stipulated that any trade concession granted to one country should automatically extend to all other GATT members.,²⁴

Despite this emphasis on multilateralism, exceptions for preferential trade arrangements were recognized from the outset. GATT Article XXIV permitted the formation of free-trade areas and customs unions, provided they substantially liberalized trade among members without raising overall trade barriers to non-members.,²³ A significant development in the 1970s, as part of the Tokyo Round of GATT, was the adoption of the "Enabling Clause." This clause explicitly allowed developed economies to grant non-reciprocal preferential treatment to developing countries, particularly through schemes like the Generalized System of Preferences (GSP), to aid their economic development.²²,²¹ This marked a formal recognition of the role of preferential trade as a tool for economic assistance and regional integration, distinct from purely multilateral liberalization efforts.

Key Takeaways

• Preferential trade involves agreements between countries to grant more favorable trading conditions to each other than to non-members.
• These arrangements typically reduce or eliminate import duties and other trade barriers.
• Preferential trade agreements aim to boost trade, investment, and economic integration among participating nations.
• While they promote trade creation among members, they can also lead to trade diversion, shifting trade from more efficient non-members.
• The World Trade Organization (WTO) permits preferential trade agreements under specific conditions, primarily through GATT Article XXIV and the Enabling Clause.

Interpreting Preferential Trade

Preferential trade arrangements are designed to create a more competitive environment for businesses within member countries while offering consumers a wider variety of goods at potentially lower prices. By lowering internal trade barriers, preferential trade encourages specialization and allows member countries to leverage their comparative advantages, leading to increased efficiency and economic growth.²⁰

However, the interpretation of preferential trade must also consider its impact on non-member countries. While proponents argue that PTAs can act as "building blocks" towards broader global trade liberalization by fostering regional cooperation, critics caution against the risk of "trade diversion." This occurs when trade shifts from a more efficient non-member producer to a less efficient member producer simply because the latter benefits from preferential tariffs, potentially leading to a net loss for the global economy. The effectiveness of a preferential trade agreement is often judged by its ability to create new trade rather than merely diverting existing trade flows.¹⁹

Hypothetical Example

Consider two hypothetical countries, Alpha and Beta, that decide to form a preferential trade agreement. Before the agreement, Alpha imposes a 10% tariff on widgets imported from any country, including Beta. Beta also imposes a 10% tariff on gizmos imported from Alpha or any other country.

Under their new preferential trade agreement, Alpha agrees to lower its tariff on widgets from Beta to 5%, and Beta agrees to lower its tariff on gizmos from Alpha to 5%. For all other countries (non-members), the tariffs remain at 10%.

Scenario 1: Trade Creation
Previously, Alpha produced its own widgets at a cost of $10 per unit, while Beta could produce them at $8 per unit. With a 10% tariff, Beta's widgets would cost Alpha's consumers $8.80 (before tariff) + $0.80 (tariff) = $9.60, making them cheaper than domestic production. The preferential tariff further reduces Beta's widgets to $8.80 (before tariff) + $0.40 (preferential tariff) = $9.20. This lower price encourages Alpha to import more widgets from Beta, expanding overall trade and benefiting Alpha's consumers. This is an example of trade liberalization leading to trade creation.

Scenario 2: Trade Diversion
Now, consider a third country, Gamma, which can produce widgets at $7.50 per unit. Before the agreement, Alpha imported widgets from Gamma because $7.50 (before tariff) + $0.75 (tariff) = $8.25 was cheaper than Beta's $9.60 or Alpha's domestic $10.
After Alpha and Beta's preferential trade agreement, Alpha's tariff on Beta's widgets is 5% ($8.80 + $0.40 = $9.20). While Gamma's widgets are still intrinsically cheaper ($7.50), the 10% tariff makes them $8.25. Now, Beta's widgets, with the preferential tariff, become more competitive in Alpha's market ($9.20) than Gamma's ($8.25). Wait, let's re-evaluate. Gamma's widgets are $7.50. With 10% tariff, it's $8.25. Beta's widgets are $8.00. With 5% preferential tariff, it's $8.40. Alpha still imports from Gamma.

Let's adjust the numbers for a clearer trade diversion example.
Alpha produces widgets at $10.
Beta produces widgets at $8. With 10% MFN tariff: $8.80 (landed cost).
Gamma produces widgets at $7.50. With 10% MFN tariff: $8.25 (landed cost).
So, Alpha imports from Gamma.

Now, Alpha gives Beta a 5% preferential tariff.
Beta's widgets cost for Alpha consumers: $8 (base) + $0.40 (5% tariff) = $8.40.
Gamma's widgets still cost Alpha consumers: $7.50 (base) + $0.75 (10% tariff) = $8.25.
In this case, Gamma remains the cheaper option despite the preference.

Let's modify again.
Alpha produces widgets at $10.
Beta produces widgets at $8.50. (original cost)
Gamma produces widgets at $8.00. (original cost)

Before PTA:
Alpha imports from Gamma ($8.00 + 10% tariff = $8.80). This is cheaper than Beta ($8.50 + 10% tariff = $9.35) and Alpha's domestic production ($10).

After PTA (Alpha gives Beta a 5% preferential tariff):
Alpha's cost for Beta's widgets: $8.50 (base) + $0.425 (5% tariff) = $8.925.
Alpha's cost for Gamma's widgets: $8.00 (base) + $0.80 (10% tariff) = $8.80.

In this specific set of values, Gamma is still cheaper. My example needs to ensure trade diversion occurs.

Let's reset.
Alpha (domestic cost): $10
Beta (partner, cost): $7.50
Gamma (non-partner, cost): $7.00

Initial MFN tariff (Alpha): 10% on all imports.

Before PTA:

• Imports from Beta: $7.50 + 10% tariff ($0.75) = $8.25
• Imports from Gamma: $7.00 + 10% tariff ($0.70) = $7.70
  Alpha imports from Gamma, as it's the cheapest at $7.70.

After PTA (Alpha gives Beta a 5% preferential tariff, Gamma remains 10%):

• Imports from Beta: $7.50 + 5% preferential tariff ($0.375) = $7.875
• Imports from Gamma: $7.00 + 10% MFN tariff ($0.70) = $7.70

Still not diverting. The math needs Gamma to be cheaper before preference, and Beta to be cheaper after preference.

Okay, last try on the hypothetical.

Alpha (domestic cost): $10
Beta (partner, cost): $8.00
Gamma (non-partner, cost): $7.80

Initial MFN tariff (Alpha): 10% on all imports.

Before PTA:

• Imports from Beta: $8.00 + 10% tariff ($0.80) = $8.80
• Imports from Gamma: $7.80 + 10% tariff ($0.78) = $8.58
  Alpha imports from Gamma, as $8.58 is the cheapest option.

After PTA (Alpha gives Beta a 5% preferential tariff):

• Imports from Beta: $8.00 + 5% preferential tariff ($0.40) = $8.40
• Imports from Gamma: $7.80 + 10% MFN tariff ($0.78) = $8.58
  Now, Alpha shifts imports from Gamma to Beta because Beta's widgets are cheaper at $8.40 compared to Gamma's $8.58. This is trade diversion: Alpha is now importing from a less efficient producer (Beta at $8.00) instead of the more efficient one (Gamma at $7.80) due to the preferential tariff.

Practical Applications

Preferential trade agreements are widely implemented across the globe, forming the backbone of many regional economic blocs and bilateral relationships.

• Regional Blocs: Major examples include the European Union (EU), which started as a customs union and evolved into a deeper economic and political union, and the North American Free Trade Agreement (NAFTA), which was succeeded by the United States-Mexico-Canada Agreement (USMCA).¹⁸ These agreements significantly reduce trade barriers among member states, facilitating a higher volume of trade and investment. For instance, the USMCA (which replaced NAFTA in 2020) aims to create a more balanced and reciprocal trade environment, benefiting workers, farmers, ranchers, and businesses in all three nations.¹⁷ It includes provisions such as enhanced rules of origin for automobiles to ensure a greater percentage of content originates within North America.¹⁶
• Generalized System of Preferences (GSP): Many developed economies unilaterally grant preferential market access to products from developing countries through GSP schemes. These programs aim to support industrialization and economic growth in beneficiary countries by making their exports more competitive in donor markets.
• Bilateral Agreements: Numerous bilateral PTAs exist worldwide, often driven by specific economic or strategic interests between two nations. These can range from focused agreements on particular sectors to comprehensive pacts covering goods, services, investment, and intellectual property.

Limitations and Criticisms

While preferential trade arrangements offer benefits such as increased trade and economic integration among members, they are not without limitations and criticisms.

One significant concern is trade diversion, as highlighted in the hypothetical example. Instead of fostering truly efficient global trade, PTAs can sometimes shift trade from a more efficient producer outside the agreement to a less efficient producer within the agreement simply because of the preferential tariff treatment. This can lead to a misallocation of resources and a net welfare loss for the global economy.¹⁵

Another critique revolves around the complexity and fragmentation they introduce into the global trading system. The proliferation of hundreds of unique preferential trade agreements, each with its own specific rules of origin and regulations, creates a "spaghetti bowl" effect.¹⁴ Businesses often face significant administrative burdens and compliance costs in navigating these varying rules, which can deter them from fully utilizing the preferential benefits.¹³ This complexity can also disadvantage smaller firms that lack the resources to manage intricate customs procedures.¹²

Furthermore, critics argue that the focus on preferential trade can undermine multilateral trade liberalization efforts under the World Trade Organization (WTO). As countries secure benefits within smaller blocs, their incentive to negotiate broader, non-discriminatory agreements might diminish, potentially slowing down global trade liberalization as a whole.¹¹ Some PTAs may also be used as political tools, creating tensions between member and non-member countries.¹⁰

Preferential Trade vs. Free Trade Agreement

The terms "preferential trade" and "free trade agreement" are closely related but describe different aspects of trade policy.

In essence, a free trade agreement is a comprehensive form of preferential trade agreement where the goal is to achieve zero tariffs on the vast majority of goods traded between member countries. All free trade agreements are preferential trade agreements, but not all preferential trade agreements are free trade agreements, especially those that only offer partial tariff reductions or are unilateral.

FAQs

What is the primary goal of preferential trade?

The primary goal of preferential trade is to foster closer economic ties, increase trade flows, and promote economic growth and investment among the participating countries by offering them more favorable trading conditions.

How does preferential trade differ from multilateral trade?

Multilateral trade involves agreements among many countries (like those under the WTO) that aim for non-discriminatory, uniform treatment for all members (e.g., through the MFN principle). Preferential trade, conversely, grants special, often discriminatory, advantages only to specific partner countries.³

Can preferential trade agreements harm non-member countries?

Yes, preferential trade agreements can potentially harm non-member countries through "trade diversion." This occurs when a country shifts its imports from a more efficient, lower-cost producer outside the agreement to a less efficient, higher-cost producer within the agreement, solely due to the preferential tariffs. This can reduce market access for non-members and distort global trade patterns.

Are all regional trade agreements considered preferential trade?

Yes, most regional trade agreements (RTAs) are forms of preferential trade agreements because they grant preferential treatment to their member countries over non-members. RTAs can range from simple preferential trade areas to more integrated customs unions or common markets.,²

What role does the WTO play in preferential trade?

The World Trade Organization (WTO) sets rules and conditions under which preferential trade agreements are permitted, primarily through exceptions to its non-discrimination principle. WTO provisions like GATT Article XXIV and the Enabling Clause allow members to form customs unions, free trade areas, and grant special preferences to developing countries, provided certain criteria are met.¹