economic effects (i) 1 session ii: the economics of ptas: i (traditional effects) this version,...

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ECONOMIC EFFECTS (I)

SESSION II: THE ECONOMICS OF PTAs: I

(traditional effects)

This version, March 2004

JAIME DE MELO

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OUTLINE: SESSION II

Viner’s analysis: trade creation and Trade diversion

What do we know about the welfare effects of RTAs? (effects related to discriminatory trade preferences)

Detecting (ex-post) trade diversion and trade creation

Annex: Tools for trade policy analysis (you must master these to follow discussion in this and next session)

Effects on third countries

PART II: EMPIRICS

PART I: THEORY

Sophisticated anti-monde: the gravity model

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PART I: THEORY

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TRADE CREATION AND TRADE DIVERSION(from overview)

3 countries: A (importer and country of interest here); B (partner in RTA) and C (ROW). Here B and C both exporters)

Unit production costs assumed to be constant

Initially A applies identical tariffs on both imports (t=20%)

Let A and B form an FTA = no more tariffs on B imports

Welfare implications for A depend on cost conditions:If the lowest cost producer is:

B: all is well as partner is low cost producer = trade creation (as partner is low cost supplier initially)

A: nothing happens! (A is not even importing initially).

C: If C imports are now replaced by (less efficient) B imports = trade diversion (partner is high cost supplier )

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NUMERICAL EXAMPLE(from overview)

B A C c 11 13 10 Shoes c (1+t0) 13.2 13 12 c (1+t1) 11 13 12

Trade Diversion

c 18 15 20 Textiles c (1+t0) 21.6 15 24 c (1+t1) 18 15 24

neither Trade Creation nor Trade Diversion

c 15 17 16 Computers c (1+t0) 18 17 23.2 c (1+t1) 15 17 23.2

Trade Creation

tB0 = t

C0 = 20%; t

B1 = 0; t

C1 = 20%

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WELFARE ANALYSIS (for country A)

PTA: leads to effects that are both positive (reduction of protection) and negative (discrimination)

Anything can happen = PTA is not necessarily welfare increasing.

What does welfare effects depend on intuitively?

- Elasticities (in A, B, and C)

- Extent of tariff reduction in A (we assume B and C don’t change their tariff)

- cost differences between B and C

- amount of imports affected

- Extent of price reduction in A (for given tariff reduction by A)

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GRAPHICAL REPRESENTATION: CONSTANT COST CASE FOR PARTNER ILLUSTRATED IN NUMERICAL EXAMPLE

Imports of A

1

P

4

6

MT MFTA

2

5

3

ESB

ESC

ESB+t

ESC+t

6

7

8EDA

net change:

W=276 - 5634 > 0

RIA gain in private welfare: +1275

loss in tariff revenue: - 1234?

N.B: What happens if ESB>ESC+t and what situation is it likely to represent?

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DETERMINANTS OF WELFARE CHANGE (I)

RIA is likely to be welfare-enhancing for the importing country if, all things equal:

•there is a small cost difference between B and C

•the import demand is elastic

•the initial tariff is high

•the initial amount of imports is small

Is the above configuration of welfare-enhancing

conditions for RIAs to be welfare enhancing likely to

be met South-South integration?

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Suppose that partner B is too small to satisfy domestic demand by A

DETERMINANTS OF WELFARE CHANGE (II)

WA=(PS+ PC)+ GR

= (0) +(-1234)

WB= PS= +1246

WB +WA= -(236)

WC = 0

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In the absence of “sudden death” of imports from C, then A necessarily loses (pure tariff revenue loss) mercantilist flavor as gains go to the country that gets market access!

Is it likely that this situation will prevail in South-South

integration?

What are implications of S-S integration among partners

of unequal size?

What should the small (usually poorer) partner do if it

cannot get compensation? Any implications for REPA

implementation?

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WA = PS + CS + GR

=(-3456) + (089) + 0

WB = PS = 4375

WB + WA = (376)+(089)

WC = 0 (by construction)

What do we know about the welfare effects of RTAs? (I)

in theory one can design a welfare augmenting PTA (but this is largely irrelevant from a practical point of view!!!)

A eliminates a quota on imports from B, but keeps same quota level on imports from C ( = TOT with C unchanged)

A welfare increasing FTA

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What do we know about the welfare effects of RTAs? (II)

Economies of scale are not a “reason for PTAs (even if welfare gains will be larger)

Best policy for A and B

Free trade CSA=CSB=035

0

P

ESC = MC543 98

76

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DA DA+B

AC

Pw = 1

(1+1)

(1+2)

FTA with increasing returns to scale

Minimum protection for monopolists in A & B(1+1) CSA=CSB=(-245)

FTA with production in A(1+2) CSA=CSB=-789

… but free trade still superior

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What do we know about the welfare effects of RTAs? (III)

Staying out will be costly (the cold shower effect)

• Prior to RIA, firm faces D0(P; P0

R)

0 = 1 2 4 3

• After RIA, firm in country that has not joined faces D1(P;P1

R)

1 = 5 6 7 8

Profit loss for non-member firm

AC

MC

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What do we know about the welfare effects of RTAs? (IV)

In theory a PTA is preferable to an FTA

Suppose that three countries A,B,C produce three differentiated goods (a,b,c). Good b and a are substitutes in consumption in A A lowers progressively its tariff on B. For a small tariff reduction, the welfare gain from reducing that distortion is about the same as the welfare loss from the reduction in imports from C (with less consumption of good a in A . By the budget constraint, exports of A will rise, so there is a net expansion of imports at world prices. And there is a welfare gain since the increase in imports from A exceeds the decrease in imports from C. As tariff reduction continues height of TC gain on goods from B falls while rectangle associated with TD on C remains constant. So eventually a net loss as tariff !!!

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PART II: EMPIRICS

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Are countries complementary?

Presumption is that countries with different endowments will be complementary and hence import different goods so that an RIA will have an effect

Michaely index (the higher the value, the more similar the economies and potential for trade):

100 ( )2ij ik jkijC M E

Ejk = share of good k in export of jMik = share of good k in imports of i

Value of index for EU and NAFTA 12 times larger than for SSA and 3 times larger than for MERCOSUR

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Trade shares in apparent consumption

Apparent consumption are total sales on the domestic market where D=X- E

Compute partners (P) and non-partners (N) shares in apparent consumption SP and SN

SP =(MP ) / (MP + MN+ D ) ; SN =(MN ) / (MP + MN+ D )

Simplistic presumption is that if SP > SN TC AndSP < SN TD

Following table shows trade effects 1 year before and 5 years after RIA

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Trade intensity indices (TIA) is the trade intensity of ASuppose A and B form an FTA. A’s imports will be biased toward B if A’s trade share from B is greater than the ROW trade share from BTI indices correct for growth effects since fast growing countries will tend to absorb more imports. In most cases in table 2A1 below, Intra-bloc TI increased while extra-bloc TI decreased

Openness indices import shares increases TC, and if share of non-partner decreases TD (see formula on previous slide and figure 2.1, 2.2,2.3 from S-W). Shares increased suggesting strong TC. But would have happened anyway because of growth?

Trade propensity indices = (TI) (M/GDP). Compares B’s share in A’s imports with B’s share in world trade

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Appendix Table 2.1: The Trade Effects of RIAs between Developing Countries

‘Before’: one year preceding; ‘after’: five years following implementation of internal preferences

Import Shares %

Trade Intensities

Import/GDP Ratios

%

Trade Propensities

Intra-bloc

Extra-bloc

Intra-bloc

Extra-bloc

Intra-bloc

Extra-bloc

Total Imports

Intra-bloc

Extra-bloc

Mercosur 1990

1996

14.5

20.2

85.5

79.8

10.52

14.12

0.87

0.81

0.57

1.64

3.34

6.48

3.91

8.10

0.41

1.15

0.03

0.07

Andean Pact I 1968

1974

4.3

7.2

95.7

92.8

2.90

6.16

0.97

0.94

0.54

1.01

12.15

13.14

12.69

14.15

0.37

0.87

0.12

0.13

CACM II 1990

1996

9.1

12.6

90.9

87.4

81.19

64.33

0.91

0.88

2.63

3.78

26.22

26.29

28.85

30.07

23.42

19.34

0.26

0.26

Andean Pact II 1990

1996

6.8

13.6

93.2

86.4

6.84

15.55

0.94

0.87

0.86

2.01

11.77

12.80

12.63

14.81

0.86

2.30

0.12

0.13

CARICOM 1972

1978

5.0

3.8

95.0

96.2

13.59

7.66

0.95

0.97

2.76

3.10

52.05

78.01

54.81

81.11

7.45

6.21

0.52

0.78

CEAO 1965

1971

3.3

4.5

96.7

95.5

11.68

20.78

0.97

0.96

0.48

0.91

14.39

19.28

14.87

20.19

1.74

4.20

0.14

0.19

UDEAC 1965

1971

1.4

4.0

98.6

96.0

8.92

30.09

0.99

0.96

0.24

0.79

17.59

18.82

17.83

19.61

1.59

5.90

0.18

0.19

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** For Mercosur this encompasses two years 1991 and 1996; Andean Pact I 1968 and 1974; Andean Pact II 1990 and 1996; CACM II 1990 and 1996; CARICOM 1972 and 1978; CEAO 1965 and 1971; AFTA 1991 and 1996; and the GCC 1980 and 1986.

Figure 2.1 Share of Imports from partners

05

10152025

Mer

cosu

r

Andea

n I

CACM II

Andea

n II

CARICO

M

CEAO

UDEAC

AFTAG

CC

per

cen

t Before

After

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Figure 2.2: Intra-RIA Imports as Share of GDP.**

0

2

4

6

8

10

Per

cent Before

After

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Figure 2.3: Extra-RIA Imports as a Share of GDP.**

0102030405060708090

Per

cent Before

After

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Figure 2.4 Intra-bloc import propensities

0.1

1

10

100

Strong increase in MERCOSUR and UDEAC

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Figure 2.5 Extra-bloc import propensities

0.01

0.1

1

Before

After

Also an increase but beware the scale is different so that extra-bloc import propensities have been increasing less than intra-bloc. So the countries in the RIAs, have been doing something right. But is it the RIA itself, other policies, etc…? Need a mor sophistiacated anti-monde (or counterfactual).

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Gravity trade model:

« Accounts » for 70% of variation in bilateral trade intensity across countries so best available model to build counterfactual.

Works particularly well for developed countries (data is better).

Formulation:

Tij = Imports or average trade between i and j

Dij average distance (or better) average transport costs between countries

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Gravity trade model formulation: Here we have IN= index of quality of infrastructure: R= remoteness index; E= landlock index; L= common language

In estimates of (8) by Carrère all coefficients have expected sign, plausible values.

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Add to the above model the following dummy variables

Following figures only report statistically significant coefficients for ’s

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Fig. 2 Evolution of dummies for MERCOSUR

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Conclusions from Carrère study:

…basically a difficult business to build the counterfactual, and need good techniques (here panel estimates) to get plausible results

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ANNEX:

TOOLS FOR TRADE POLICY ANALYSIS

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OPTIMALITY PROPERTIES OF FREE TRADE

Definition: A situation is Pareto optimal (PO), if no change can improve the welfare of some agent without reducing the welfare of at least one other agent

Implication: PO implies that marginal benefits and costs are equal across all agents (in case of externalities, PO occurs when social marginal benefits and social marginal costs are equal across all agents )

Notation: MBp (MCP) = private marginal benefit (cost)MBs (MCS) = social marginal benefit (cost)

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Closed economy

NO MARKET FAILURE ON DOMESTIC MARKETS

For now we consider only the case of no externalities (then private benefit and costs coincide with social benefits and costs)

MBP = MBS ; MCP = MCS

PO in closed economy MB = MC

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Checking PO condition in closed economy

P

Q

MB

MCMB>MC: one more unit leads to more benefits than costs

MB<MC: one unit less saves more costs than the loss in benefits

optimality condition is: MC = MB

Wheat market under autarky

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Checking PO in closed economy with PS and CS

Show that sum of producer surplus (PS) and consumer surplus (CS) is maximized when PO holds Compute total consumption gain (CG) less total production costs (PC) for Q*, Q0 and Q1

PS + CS = CG - PC

P

Q1

MB

MC

Q0 Q*0

5

3

21

9

6

7

84

Q

Q=Q0

CG = area 0124PC = area 0534PS + CS = area 1235

Q=Q1

CG = area 0178PC = area 0568PS + CS = area (195-967)

Q=Q*

CG = area 019Q*

PC = area 059Q*

PS + CS = area 195

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Open economy

Now take into account:

- either the marginal cost through trade, MCT =for imports

- or the marginal benefit through trade, MBT=for exports

for a SMALL OPEN ECONOMY (SOE), these marginal values through trade are exogenous, given by the price imports( ) or exports ( ).

PO : either MB = MC = MCT = (importing SOE)

or MB = MC = MBT = (exporting SOE)

Free trade is PO for SOE

*pm*px*pm

*px

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MBT

MBT

S

*mp

D

ES*

MBMC

IMPORTS

S*xp

D

ED*

MB MC

EXPORTS

Pareto optimality of free trade for SOE

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IMPORT TARIFF

ES*+tp*+t

ES*

pd

QF CF

D

S

CTQT

p*

21 3

4

568

9

Consumers lose: 1349

Producers gain: 1289

Gov ’t gains: 2356

Efficiency loss in production: 286

Consumption: 345

Tariff at rate t:1) production & gov ’t rev.; consumption & imports2)Efficiency loss or dead weight loss (DWL) is 286 + 3453) price measures (but also NTBs) redistribute income

Exercise 1: Analyze an export tax

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EXERCISE 2: COMPARE EXPORT TAX & EXPORT SUBSIDY

ED*ED*-t

ES

ED*

ED*+s

ES

p*

XET EF EF

ESX

1 2 3

5

4

1 2

3

45

pdpd

export tax export subsidy

p*-t

p*

p*+s

GR = (PS+CS)=W=

GR =(PS+CS)=W=

Q1) Fill the blanks below

Q2) (more difficult) Should a large country subsidize its exports?

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Open economy

Large exporter has monopoly power

Exports world price, pW

pW MR = MBT < pw

PO MB = MC= MBT as before

PO MB=MC = MR < pw

Free trade is not PO for country with monopoly power!

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MONOPOLY POWER IN EXPORTS (1)

Vietnam (rice); Mongolia (cashmere)

Small export tax (t0):

• increases H welfare as revenue gain (a+b) larger than private losses (b+c)

• decreases F welfare (a+d)

ab c

ED*

ES

dt0t1

As wedge becomes larger (t0t1) revenue gain gets smaller while private loss becomes larger

scope for an “optimum tax” at intermediate range.

But F could retaliate no longer “optimal”

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MONOPOLY POWER IN EXPORTS (2)

pd

ES

ED*MR ED*-t

p1w

p0w

p1w -t

1 2

34

78

65

exports

A large exporting country can improve its welfare by restricting its exports provided it faces no retaliation.

With tax t, GR = 1276; (PS+CS) = (-5376): W = (1245)+ (-437) which can be >0 or <0.But:1) H and F together lose 2372) if H chooses t so that ED*-t crosses ES at intersection with MR

curve, then H gains ( this is “optimum tariff”: Can you see why?)

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MEETING A REVENUE CONSTRAINT

pd

S

D

A

ES*

ES*+tm

ES*+tc

p*

B

G

J

HECK

I

F

QF QT CT CCCF

To raise revenue, gov’t can either rely on :

a) A consumption tax, tc (area FGHI= area ABCE)b) A tariff on imports, tm (area ABCE= area FGHI)DWL under a) W= area AKC + area BEJDWL under b) W= area GHJ

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DETERMINANTS OF THE COST OF PROTECTION

(a)

EDB

p*

p*(1+t)

MA=MB

EDA

ES*

ES*(1+t)

1

35

24

6

7

The less elastic, the demand for imports, the more efficient is the tax

Compare the effects of tariff at rate t on A and B

1) B: inelastic demand large revenue, small DWL2) A: elastic demand small revenue, large DWL

Efficiency of tax collection: REVENUE/DWL

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DETERMINANTS OF THE COST OF PROTECTION

(b)MA=MB

1 ES*

ES*(1+t)

ES*(1+2t)

35

6

4

2p*(1+2t)

p*

p*(1+t)Uniform taxation that gives same average level of protection is less costly (by area 2364)

Now both importers have the same elasticity of demand:

a) If both are taxed at tax t, loss W = 2 times (-123)b) If only one sector is taxed loss W = (-154)

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ASSESSING A COUNTRY ’S TRADE REGIME

- Terms of Trade

- Nominal and effective rates of protection

Definition: Terms of Trade (TOT)

1) The (barter) TOT is the ratio of an index of export prices to import prices measured at border prices:

TOT = PX/PM = M/E

2) The income terms of trade (which is equal to the barter TOT times a quantity index of exports (QE)) is a measure of the purchasing power (in terms of imports) of a country ’s exports:

Income TOT = TOT x QE

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The profitability of import-substituting activities and of exporting activities (other than natural-resource-based activities that are virtually always profitable) depends on their relative prices.

Consider an export tax, tX and an import tariff, tM

Relative profitability of each group of activities will be the same if there is either:

a) An export tax of, say, 20%

b) Or an import tariff at the same 20% rate

So tariff is equivalent to an export tax at same rate.

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NOMINAL RATE OF PROTECTION (NRP) EFFECTIVE RATE OF PROTECTION (ERP)

The NRP is the percentage difference between the price of X (pX) in domestic currency and the price of X at the border (p*

X )

Note that:The official (or formal) tax, tx, is not a good measure of the protection afforded to a sector, as:

1) there are intermediate inputs (see next slide)2) when rate is high, collected rate is less because

exemptions are high3) when rate is high, there is smuggling

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Definition: Percentage excess of domestic value-added in activity X (VAX) over corresponding value-added at world prices (VA*

X)

ERPX = (VAX- VA*X)/ VA*

X

THE EFFECTIVE RATE OF PROTECTION (ERP)

If effects of ALL trade measures on domestic prices are properly measured, then ERP is an indicator of the NET incentives to produce activity X

ERPX >0 activity is protectedERPX <0 activity is taxed

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AN EXAMPLE: CLOTHING

ERP in clothing (shirts). Textiles serves as an input

tt (tc) :ad-valorem tariff on textiles (clothing)

VAD (VAw) = Value-added at domestic (world) prices

Free trade VAD = VAW .

Numerical example. Under free trade:

Sales value= 100;Textile input purchase= 40

Value-added (VA) in shirt-making : 100 - 40=60Case I: tc= 20%; tt = 10% VAD = 100(1.2)-40(1.1)=76

ERP =VAD-VAW = (76-60)/60 = 27%

Case II: tc= 10%; tt = 30% VAD = 100(1.1)-40(1.3)=58

ERP = VAD-VAW = (58-60)/60 = -3%

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Net incentives and home-market bias estimates

Compute for each activity, i

Effective rates of protection for export sales (e) and for domestic-market (d) sales (ERPe

i) and (ERPdi)

Effective rates of subsidies to take into account effects of fiscal policies (ERSe

i) and (ERSdi)

Bias: B>1 home-market bias

Bti = (1+ERPe

i)/(1+ERPdi) tariffs

Bsi = (1+ERSe

i)/(1+ERSdi) subsidies

circa 1980 Argentina Korea Taiwan (China)

Bti (all sectors) 1.94 1.10 1.10

Bsi (all sectors) 1.86 1.01 0.89

economic effects (i) 1 session ii: the economics of ptas: i (traditional effects) this version,...

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