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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