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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.