Assume that there are two countries, Argentina and Brazil, each producing wheat
ID: 1233988 • Letter: A
Question
Assume that there are two countries, Argentina and Brazil, each producing wheat and wine from capital labor. Suppose that Argentina has abundant capital and scarce labor when compared to Brazil; that wheat is capital intensive relative to wine; and that the other factor-proportion assumptions apply.
Using production possibility frontiers, and indifference curves for Argentina and Brazil, illustrate and explain the movement of both countries to the free-trade equilibrium pattern of production, consumption, trade and the gains from trade for the two countries. That is, explain the sequence of the argument as to how mutually beneficial trade between the two countries is possible.
Given the above trade between the two countries, explain the trade effects on product prices, and factor incomes. Why do these effects occur?
Explanation / Answer
Solution:
MERCOSUR was established by Argentina, Brazil, Paraguay, and Uruguay in
1991 with the Treaty of Asuncion. The first article of this treaty states that the agreement
aims at achieving “the free circulation of goods, services, and production factors among
the member countries, through the elimination of the tariff and non tariff restrictions to
the circulation of merchandises and of any other equivalent measure”. It also established
the adoption of a Common External Tariff (CET) and a common trade policy with third
countries or groupings of countries. We can split up the evolution of MERCOSUR into two
sub-periods: the transition period towards the free trade area and the customs union
period.
The transition phase was between 1991 and 1994 and consisted of progressive,
linear, and automatic tariff reductions at six months intervals. This sequence aimed to
achieve free trade within the bloc by the end of 1994. The drop in preferential tariffs since
1991 reflects this policy (see Table 1). Exemptions to internal free trade were nevertheless
allowed for a limited number of products on a temporary basis. Brazil included in its
national exemption list only 29 items, including wool products, canned peaches, rubber
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factories, and wines. In contrast, Argentina had 223 tariff line items on this list, of which
57% were steel products, 19% textiles, 11% paper, and 6% footwear, while Uruguay had
an extensive list with 953 items, including textiles (22%), and steel and electric machinery
(8%) (see INTAL, 1996). In addition to the general exceptions already indicated, the sugar
and automotive sectors were not included in the general intra-MERCOSUR trade
liberalization scheme due to significant divergence across member countries in their
national policies toward these sectors, especially in the cases of Argentina and Brazil. In
the interim, the exchange of these products took place under a specific set of rules and
restrictions. For autos, a managed trade arrangement was put in place, which favored
local contents, importation of parts under special conditions, and export balancing
requirements.
The customs union period began with the establishment of a Common External
Tariff (CET) entering into force at the beginning of 1995. The average level of the CET was
approximately 11%, but tariff levels were allowed to vary between 0 and 20% across
industries. In general, the lowest tariffs were set on input and materials, intermediate
tariffs were charged on semi-finished industrial goods, and the highest tariffs were
assigned to final manufactures.
During this period, two types of exceptions were established. First, remaining
products on national lists that were exempted from internal free trade were included in
the so-called "Adaptation Regime". Within this regime tariffs were progressively and
automatically reduced so that import taxes would be completely eliminated by January 1,
1999 in the case of Argentina and Brazil, and by January 1, 2000 for Uruguay. Second, just
as with intra-MERCOSUR tariffs, exceptions were granted for extra-zone trade so that
certain imports faced tariff rates different from the CET. Countries agreed that the import
taxes on these products would progressively converge toward the CET by the year 2001.
Out of approximately 9000 8-digit tariff lines, Argentina, Brazil and Uruguay initially
selected 300 each. In addition, exceptions to the CET were established for capital goods
imports (e.g., machines and equipment), computers, and telecommunication equipment