Download Regional Trade Agreements and The Traditional Welfare Analysis

Theory of Economic Integration
Regional Trade Agreements and The Traditional
Welfare Analysis
Introduction
Dr Katarzyna Śledziewska
Katarzyna Śledziewska
Outline
• The Traditional Welfare Analysis
– Trade Creation and Trade Diversion
– A Welfare Gain under Trade Diversion
– Trade Creation, Trade Diversion and Trade Expansion
Dr Katarzyna Śledziewska
Trade Creation, Trade Diversion and Trade Expansion
• CENTRAL TO POLICY DEBATES ON RTAs
– Highly effective tools for focusing policy makers’ attenton on the
ambigous welfare effects of RTAs
– RTAs - combination of free trade and protectionism
• Trade creation TC
– replacement of expensive domestic production by cheaper imports
from partner
– does not affect RoW
– beneficial
• Trade diversion TD
– replacement of cheaper initial imports from the outside world by
more expensive imports from partner
– Harmful
• Trade expansion TE
The Traditional Welfare Analysis
• Pioneered by Viner (1950)
– „The Customs Union Issue”
• Partial-equilibrium model
– To identify the key factors which determine the welfare outcome
• Assume
• 3 countries: H, P and Row
–
–
–
–
Trade product (steel) with each other
Countries H & P – potential union partners
Row- represents the rest of the world
Between the union members: H is an importer, P exporter
• If FTA is formed
– Each member sets the external tariff at its pre-unin level
• If CU is formed
– The common external tariff is set equal to the pre-union tariff of H
Dr Katarzyna Śledziewska
Outline
• The Traditional Welfare Analysis
– Trade Creation and Trade Diversion
– A Welfare Gain under Trade Diversion
– Trade Creation, Trade Diversion and Trade Expansion
Dr Katarzyna Śledziewska
Trade creation and trade diversion
• Model
• Infinite supply elasticities (small coutry case)
• Zero demand elasticities
• Demand of steel DH
• Firms in H, P and R supply at constant prices PH, PP, PR
• Under perfect competition
– Prices represent
• the constant average cost
• marginal costs of production
• By assumption – H is the least efficient supplier
– PH > PP > PR
Dr Katarzyna Śledziewska
Trade Creation and Trade Diversion
Dr Katarzyna Śledziewska
Trade Creation and Trade Diversion
• P & R do not trade with each other
– P applies a per unit tariff higher than PP - PR on imports
• H imposes nondiscriminatory tariff at rate t per unit
•
PH > PR +t > PP
• Entire quantity demanded:
• 0Qo is imported from R
• Price paid by consumers is
• PR+t
• Tariff revenue
• e+ f
Dr Katarzyna Śledziewska
Trade Creation and Trade Diversion
• H eliminates the tariff on P but retains on R
•
PR +t > PP
• H purchases imports from P
• Trade diversion:
– Change
• Creates no new trade
• Substitutes the less efficient P for more efficient R
• H loses tarrif revenue
– e+f
• e- used up to pay higher production cost of R
• f- becoming part of H’s consumers’ surplus
• Net loss to H and the world form union
– e
Dr Katarzyna Śledziewska
Trade Creation and Trade Diversion
• Next, suppose the initial nondiscriminatory tariff in H is t’
– PH < PR +t’ < PP +t’
• The entire demand 0Q0 is satisfied by H’s own firms at price PH
• H removes tariff on P but not on R
• The proce paid by H’s buyers
– Drops from PH to PP
• Gain in consumers’ surplus f+g
• Trade creation:
– Union creates trade between H and P
– A swith form higher-cost suppliers in H to lower-cost suppliers in P
– Welfare rises by f+g
Dr Katarzyna Śledziewska
Trade Creation and Trade Diversion
• Meade (1955, ch. 2)
– Even the relative magnitudes of trade creation and trade diversion
alone are insufficient to determine the welfare effect on the union
• Benefits of preferential liberalization depend on not only extent of trade
creation but also the magnitude by which the costs reduced on each unit
of newly created trade
• Losses are determined not just by amount of trade diversion but also the
magnitude of the increase in costs due to the trade diversion
• Franz Gehrels (1957-57) and Richard Lipsey (1957)
– Once we drop the unrealistic assumption of zero elasticity of demand
in H
• Even the wholly trade-diverting union may lead to a net increase in
welfare
Dr Katarzyna Śledziewska
Outline
• The Traditional Welfare Analysis
– Trade Creation and Trade Diversion
– A Welfare Gain under Trade Diversion
– Trade Creation, Trade Diversion and Trade Expansion
Dr Katarzyna Śledziewska
A Welfare Gain under Trade Diversion
Dr Katarzyna Śledziewska
A Welfare Gain under Trade Diversion
•
•
•
•
•
•
Demand curve DH – negatively sloped
Initial nondiscriminatory tariff - t
H imports 0Q0 from R
H removes the tariffs on P but not on R
Expansion of import from 0Q0 to 0Q1
Result
– Loss of area e
– Gain of area h
– f- redistribution of tariff revenue to consumers
Dr Katarzyna Śledziewska
Outline
• The Traditional Welfare Analysis
– Trade Creation and Trade Diversion
– A Welfare Gain under Trade Diversion
– Trade Creation, Trade Diversion and Trade Expansion
Dr Katarzyna Śledziewska
Trade Creation, Trade Diversion and Trade Expansion
Dr Katarzyna Śledziewska
Trade Creation, Trade Diversion and Trade Expansion
• Bhagwati (1971)
• H’s supply curve is upward sloped (elasticity is positive but
finite)
• The price in H is PR+t
• FTA
– Leads to replacement R by P as foreign supplier
• Trade diversion
– Internal price falls
• Inefficient domestic production is partially replace by imports
Dr Katarzyna Śledziewska
Trade Creation, Trade Diversion and Trade Expansion
Small CU, H – small country, P – big country
Dh
P
Sh
Sw+t
Pw+t
Pp
Pw
0
a
e
b
f
g
Q1 Q2 Q3
c
h
d
i
Sp
j
Q4 Q5 Q6
t
Sw
Q
W - world
Sw – W’s perfectly elastic tarifffree supply curve for this
commodity
Sp – P’s perfectly elastic tarifffree supply curve for this
commodity
t – non-discriminatory tariff
Trade Creation, Trade Diversion and Trade
Expansion
Small CU, H – small country, P – big country
Dh
P
Sh
Sw+t
Pw+t
Pp
Pw
0
a
e
b
f
g
Q1 Q2 Q3
c
h
d
i
Sp
j
Q4 Q5 Q6
t
Sw
Q