• The relative prices of factors in each country will differ across countries if the relative abundance (availability) of factors is different among the countries.
• That is, if the prices of factors (wages by type of labor, interest rates by type of loan, land prices, returns to entrepreneurship, etc.) reflect the opportunity costs of using those factors. 
• Internal subsidies, monopoly power on the part of suppliers of a resource, price floors on wages or commodities, price ceilings on land prices or rents -- can prevent prices from reflecting opportunity costs.
• New trade theory recognizes that lowered trade barriers may increase trade between countries whose factor proportions are quite similar, because of the technology, skill, scale economies, and reputations that the producers in each country develop in very specialized parts of each sector.
• Since countries trade by producing more of some items than is needed domestically, and importing items that are not produced domestically (or are not produced in sufficient quantity or variety to satisfy domestic demand), the countries economies become inter-dependent, or "integrated."

• each country produces more than it could if it produced everything it needs (because it's producing according to its comparative advantage), and
• as long as the gains from trade are shared across the countries (generally speaking, each partner in a trade sees a gain from the trade), each country consumes more than it could under autarky.
• Think about your own household:  you could go "off the grid" and produce your own food, heating fuel, education, and entertainment.  You and your family could have a very satisfying life.  Living off the grid teaches you to live very simply, and without most of the stuff that you and I consume. 

• There's more demand (worldwide) for the products in which each country has comparative advantage.
• Thus, there's more demand for the factors used to create those products.
• Those products should be the products that make heavy use of the country's abundant factors. 
• Thus, there's more demand for the country's abundant factors.
• If there's a finite (though relatively large) supply of those factors, their prices will rise.

• There's less demand (worldwide) for the products of the country in which the country does not have comparative advantage.
• Thus, there's less demand for the factors used to create those products.
• Those products should be the products that make heavy use of the country's scarce factors.
• Thus, there's less demand for the country's scarce factors.
• If those factors don't find equally productive uses in other sectors (as in moving to the growing sectors), their prices will fall.

• Each country's abundant factors rise in price after integration, at least relative to the prices for the country's scarce factors.  The result is called factor price equalization:  the prices paid to capital, specialized labor, unskilled labor, oil reserves, etc. move down in countries where each of those things were scarce, and move up in countries where they were abundant.

• Not every use of each factor is tradable.  For example, the demand for health professionals and primary-school teachers is generally determined by the domestic economy, not by international demand.
• What's relevant is the "unit price" of each factor -- the price of a factor times the amount of output that factor can produce.  Because of infrastructure, mechanization, and management, "unskilled" labor in some countries is more productive than others, and will earn a higher wage even after international economic integration.

• Regions within the country that have inordinately high concentrations of the country's abundant resources (labor of a certain type, natural resources of a certain type) should do well after international integration.  Regions where scarce factors are concentrated will not do as well.
• Capital can move from sector to sector.  Workers, buildings, and regions find it harder to do so.

GATT (General Agreement on Tariffs and Trade)

• established in 1947;  took effect in 1948
  
• over 100 national members at its peak
• organized 8 “rounds” or multilateral tariff and NTB reductions
• final round (Uruguay), 1986-93 (effective 1995):  117 nations agreed to reduce tariffs by 36% (into industrial countries) or 24% (into less-developed countries (LDCs));  eliminate many import quotas;  restrict use of “voluntary export restraints”;  reduce agricultural subsidies;  and increase trade in services

• formed by the Uruguay Round of GATT, took effect in 1995
  
• will likely negotiate continuously, on specific issues
• stronger dispute-settlement mechanism (member unanimity not necessary;  clear member sanctions)

• each signatory to a GATT negotiation pledges to offer the same trade rules in trade with all other signatories (all nations are “most favored” — hence the switch to the phrase “normal trade relations”)
• exceptions are allowed for regional trading blocs that eliminate all or nearly all internal tariff barriers
• Generalized System of Preferences for LDCs’ exports to industrial countries

Motivations:

• economic growth (through dynamic effects)
• economic productivity and international competitiveness (through trade-creation effects)
• political alignment (or political isolation of a given nation)

• EFTA;  NAFTA;  Asian FTA; APEC (as planned)
• must settle issues of country of origin and percent local content to qualify as a product of one of the member countries

• MERCOSUR (Argentina, Brazil, Paraguay, Uruguay)

• EU;  Andean Group;  Caribbean Community and Common Market;  Central American Common Market

• The "Eurozone" is the set of countries in the EU that have adopted the Euro as a common currency, and the European Central Bank as the central bank

• the current plans for the EU move very much in this direction

Effects (all effects are limited by the size and relative size of the national economies):

I. Trade creation based on increased specialization and trade among countries in the region (in a static sense, ignoring the likely expansion of the region’s economy)

A. Trade creation is enhanced by similarity of the combined economies (in products and efficiency), maximizing potential for gains from increased specialization.  The union of very different countries will not increase their mutual specialization as much.
B. Trade creation is enhanced by a large union of disparate countries, to increase the likelihood that the joined economies will contain true low-cost areas for various products.
C. Trade creation is enhanced by high pre-union trade barriers.
D. Trade creation is enhanced by low transport costs among the countries.
 EU:  a large union of somewhat similar countries in a compact region and with substantial non-tariff barriers, even after the Treaty of Rome.
 NAFTA:  a large union of somewhat disparate economies with very varied barriers, compact but geographically very large.  Mexico's economy was the most protected, so the adjustment costs and the potential for lowered prices is greatest.

III. Dynamic effects:  overall growth in the region’s economy, based on lower costs and prices, increased scale economies, competition, and investment in new plant and equipment.

• 1967:  trade creation within the EC evaluated at $2.3 B; trade diversion evaluated at $0.9 B
• 1988:  EC-6/US dynamic effects based on increased EC economic activity, evaluated at $28.1 B;  EC-6/US trade diversion based on increased EC agricultural protection, evaluated at $6.3b

• marketing and increased investment to meet region-wide demand
• international division of control, design, and production activities according to labor requirements
• international division of production according to region-wide (or world) product mandates
• productivity increase to meet increased international competition
• seeking temporary protection
• exit the noncompetitive activity