The Political Economy of Trade Policy Chapter-9. The Welfare Effects of RTAs… An RTA has two...

The Political Economy of Trade Policy

Chapter-9

The Welfare Effects of RTAs…An RTA has two elements and thus two opposite effects:

1. Trade Creation (Trade Liberalization Element): An expansion of in world trade that results from the

formation of PTA (….Beneficial)

2. Trade Diversion (Protectionist Element): A shift in the pattern of trade from low-cost world

producer to high-cost RTA member (s)…..(Harmful).

The Welfare Effects of RTAs…

Thus, the welfare (economic) impacts economic integration, depend on the net difference between trade creation effects and the trade diversion effects

Hands-On-Practice….. Suppose autarky price of X in three countries (A, B, C) is as follows

SA

DA

$5.00

$1.50 PC

PB$2.00

M NP Q

PA

The Welfare Effects of RTAs…

1. With free international trade, from which country should A be importing?

2. how much would that be…?

A should import from C (the low cost world producer)

MN.

SADA

$5.00

$1.50 PC

M N

PA

Total Imports from C = MNTotal Value of Imports = $1.5 X MN

The Welfare Effects of RTAs…Suppose that producers in country A lobby their government so that it imposes a 100% Advalorem tariff on imports (from all countries) into A.

3. What would be the unit prices of imports from C (after tariff)?

4. What would be the unit prices of imports from B (after tariff)?

SADA

$5.00

$1.50 PC

PB$2.00

M NP Q

PC + Tariff$3.00

PB + Tariff$4.00

R S

PA

The Welfare Effects of RTAs…5. Once the tariffs are in effect, would country A

need to change its trade partner?

NO!!!6. If so, what would be the effect of the import tariff?

A Fall in Imports from C

SADA

$5.00

$1.50 PC

M N

PA

Pre-Tariff Imports from C = MN

R S

Post tariff ImportsFrom C = RS

PC + Tariff$3.00

The Welfare Effects of RTAs…• Suppose B negotiates with A and forms a

Free Trade Area (FTA) ; Eliminates the tariff on imports.

7. What will be the effect of the formation of FTA between A and B?

The Welfare Effects of RTAs…• Two effects…

1..Trade Diversion–

A now imports from B; not from C. This would divert trade…(RS)….(from the low cost world producer (C) to the high-cost FTA member (B)).

SADA

$5.00

$1.50 PC

PA

R S

PC + Tariff$3.00

PB$2.00

Amount of Trade Diverted

The Welfare Effects of RTAs…

2. Trade Expansion: The increase in import resulting from the economic

integration that eliminates trade barriers.

With integration imports will be PQ

SADA

$5.00 PA

R S

PC + Tariff$3.00

P Q

PB$2.00

Trade DivertedTrade Created

The Welfare Effects of RTAs…

What is the Economic (Welfare) Effects of Economic Integration? (Is it Beneficial/ Harmful)?

SADA

$5.00

$1.50 PC

PB$2.00

M NP Q

PC + Tariff$3.00

R S

a b c d

e

PA

The Welfare Effects of RTAs…8.1. Economic Benefits:

Consumers in A benefit (Price falls from $3.00 to $2.00)

Consumers’ surplus would rise • Area (A + B+ C+ D)

The Welfare Effects of RTAs…8.2. Economic Losses:

Producers’ Surplus Falls• Area ( A)

Government Revenue Falls• Area (C + E)

The Welfare Effects of RTAs…Net Economic Effects:

Effects of Trade creation - Effects of Trade Effects of Trade creation - Effects of Trade DiversionDiversion

(A+B+C+D) – (A+ C+E)(A+B+C+D) – (A+ C+E)

(A + B + C + D) – (A + C +E)(A + B + C + D) – (A + C +E)

(B + D) – (E)(B + D) – (E)

The Welfare Effects of RTAs… Implication

At best the welfare effects of economic integration is indeterminate (ambiguous). ..That is, there is No Guarantee that economic integration improves living standards.

Some conditions, however, could make the trade creation effects dominate the trade diversion effects

• The higher the initial tariffs between member countries • The lower the barriers to trade with non-member countries• The greater the number of the members forming the

integration and the higher the flow of goods between them

Consider the following data detailing trade before and after a hypothetical country, Javaland forms an FTA with Macau

In class exercise

Before FTA

After FTA

Imports of Javaland from Guam

100 Million 0 units

Imports of Javaland from Macau

0 280 Million

1. How much trade was diverted?

2. How much trade was created?

3. Suppose Guam charges $7.00 for this product and Macau charges $8.00.

If Javaland’s original tariff was $2 per unit, calculate the welfare gain or loss from forming FTA.

In class exercise

The Welfare Effects of RTAs… Implication

At best the welfare effects of economic integration is indeterminate (ambiguous). ..That is, there is No Guarantee that economic integration improves living standards.

? ? ? ? ? ? ?? ? ? ? ? ? ?

Why would A negotiate economic integration with B, while it can improve welfare more by integrating with C?

Reasons for the formation of trading agreements goes beyond the static gains and losses (Trade creation and trade diversion effects).

Why RTA?

I. Dynamic gains from economic integration

• Economies of large scale production

• Increased market size; Foreign investment….

• Enhanced competition…• (What keeps a RTA from expanding to include

every other country?)

Why RTA?

II. Political (non-economic) reasons

• Gesture for good neighborhood, regional security

• Long term development goals, safe haven trading arrangements

• Regional competition.

Why RTA?

Some Examples of RTA …Two waves of economic integration:

1960sMost were modeled after European Community.

• Attempts among developing countries met only with partial success.• Some African and Latin American plans failed.

Mid-1980sEuropean Union (EU)North American Free Trade Agreement (NAFTA)Association of South East Asian Nations (ASEAN)Southern Common Market (MERCOSUR)

The European Union (EU)

Some Examples of RTA …The North American Free Trade Agreement (NAFTA)

The European Union (EU)

European Union: Members and Applicants, 2001

Sweden Finland

Estonia

Latvia

Lithuania

Poland

Czech Rep.Slovakia

Romania

Bulgaria

TurkeyGreece

Italy

Austria

Germany

France

SpainPortugal

Luxembourg

Belgium

Netherlands

Denmark

UnitedKingdom

Ireland

Hungary

Slovenia

Members

Applicants

Malta

(1951): European Coal and Steel Community- (ECSC)

_____________________________________• Belgium, France, Italy,

Luxembourg, The Netherlands, and West Germany)

• Eliminate Tariff and Quotas between members and expand free trade

The European Union (EU)

(1957): European Economic Community (EEC)

__________________________________ • Rome Treaty---Agreement to reduce tariff

and non-tariff trade barriers between members and institute common external tariff.

• Gradual elimination of tariffs and quotas, expand trade flow

The European Union (EU)

(1967): ECSC and EEC merged; European Union (EU) formed

___________________________________U.K., Ireland, Denmark (1973); Greece (1981); Spain and Portugal (1986); Austria, Finland, Sweden (1995).

About a dozen other countries on the waiting list (Expanding beyond W. Europe)

The European Union (EU)

1992 (Maastricht Treaty) Agreed to establish an Economic Union and Common Currency

1999- European Monetary Union (EMU), 2002-Coomon Currency (Euro)—Less-UK, Sweden

Today EU is more than a free trade area/ custom union—Is almost an Economic Union

The benefits (trade creation effects) appear to outweigh the costs (trade diversion effects). Why?

Number of members and significance of trade between members (see graph)

The European Union (EU)

Intra-Group Trade as Percent of Total Merchandise Trade, 2000

0

EU

20

40

50

60

70Percent

30

10

Intra-Group Exports as Percent of Total Exports

Intra-Group Imports as Percent of Total Imports

The North American Free Trade Agreement (NAFTA)

The North American Free Trade Agreement (NAFTA)

What is NAFTA? A free trade area (with few added touches) between the U.S., Canada, and Mexico.

Started on January 1, 1989– as Free Trade Agreement between the U.S. and Canada

1992, Canada and the U.S. agreed to expand the free trade area to include Mexico

1993- the U.S. congress approved the agreement, NAFTA went into effect in 1994.

• Tariff Reductions to be phased out in 15 years (2010)

The North American Free Trade Agreement (NAFTA)

Additional issues relate to Labor & environmental standards• Each country is to enforce its labor and

Environmental Laws

What is special about NAFTA?

The North American Free Trade Agreement (NAFTA)

1. Expected to provide each member nation better access to the other’s markets, technology, labor and expertise.

2. Significant Differences…..Size of the Economy; Average Earnings (Wages); Labor Productivity; Efficiency of the Productive Sectors.

The North American Free Trade Agreement (NAFTA)

Year USA CAN MEX

1985 13.01 10.94 1.59

1987 13.52 12.04 1.04

1993 17.20 16.05 2.40

1995 17.20 16.03 1.51

1997 17.74 16.68 1.53

2000 19.86 15.65 2.09Hourly Manufacturing wages in US Dollars

Source: BLS (http://www.bls.gov/bls/newsrels.htm)

Significant differences in Average Hourly Earnings (Wages)

The North American Free Trade Agreement (NAFTA)

3. NAFTA is also a FTA between developed and developing country?

Is there a benefit in forming FTA between developed and developing country?

Who stands to gain from NAFTA? Who losses? Which sector?

What is/was the economic impact of NAFTA on the economy’s member countries?

The North American Free Trade Agreement (NAFTA)

Intra-Group Trade as Percent of Total Merchandise Trade, 2000

0

EU

NAFTA

20

40

50

60

70Percent

30

10

ASEAN

MERCOSUR

Intra-Group Exports as Percent of Total Exports

Intra-Group Imports as Percent of Total Imports

Effects….

Trade Flow (1994-1998)Creation (‘000$)

Diversion(‘000$)

US imports from Canada 689,997 384,189

US imports from Mexico 284,774 50,138

Canadian imports from US 38,444 25,212

Canadian imports from Mexico 3,321 163,943

Mexican imports from USA 50,036 27,651

Mexican imports from Canada 902 27,099

Source: Karemera & Ohah (1998)

The North American Free Trade Agreement (NAFTA)

Trade Creation and Diversion effects differ across countries

Negative static effects of NAFTA on the U.S. economy have been relatively small; Reason:

• the U.S. merchandise exports to, and imports from, Mexico accounts a very small proportion of the U.S. GDP

• Total job losses in USA due to increased plant relocations into Canada and Mexico (1994-1999) = 259, 618 (See Next table…)

The North American Free Trade Agreement (NAFTA)

Industry # of Job Losses % to Total Job Losses

Apparel 73,568 28.3

Electronics 33,684 13.0

Transportation Equipment 17,090 6.6

Fabricated Metals 15,372 5.9

Textiles 14,150 5.5

Non-Electrical Machinery 11,747 4.5

Lumber 9,826 3.8

Scientific Instruments 9,433 3.6

Paper Products 8,982 3.5

Rubber 7,722 3.0

Leather 7,521 2.9

Other Manufacturing 35,171 13.5

Non-Manufacturing 15,352 5.9

Source: Congressional Research Review (2000)

The North American Free Trade Agreement (NAFTA) Effects….

WINNERSHigh-Skill, High-tech US businesses

that benefit from reduced barriers

Labor intensive US businesses that relocate to Mexico benefit from lower production costs

US Domestic businesses that use imports as components in the production process save on production costs

Adherence to workers’ rights requirements in Mexico could raise Mexican Labor costs, making US exports more competitive

Consequently, less pressure on US workers in import competing business to give up their wages or the protection of their rights

LOSERSLabor Intensive, Lower wage,

import competing US businesses could lose from reduced protections ( tariffs) on competing imports

US workers in import competing businesses (because of firms relocation to Low cost area)

Some US firms who may be wanting to relocate to Mexico to save labor costs may lose because of adherence to worker-rights in Mexico

Potential Winners and Losers

The North American Free Trade Agreement (NAFTA)

MERCOSURFormed in 1991Includes Brazil, Argentina, Paraguay, and Uruguay.1994: became a customs union with average CET of 14%.Intra-MERCOSUR trade increased 400% in first 4 years.

Other RTAsMERCOSUR

Formed in 1991Includes Brazil, Argentina, Paraguay, and Uruguay.1994: became a customs union with average CET of

14%.Intra-MERCOSUR trade increased 400% in first 4

years.