SESSION II: THE ECONOMICS OF PTAs: I (traditional effects)

1. SESSION II: THE ECONOMICS OF PTAs: I (traditional effects) JAIME DE MELO This version, March 2004

2. OUTLINE: SESSION II PART I: THEORY  Viner’s analysis: trade creation and Trade diversion  What do we know about the welfare effects of RTAs? (effects related to discriminatory trade preferences) PART II: EMPIRICS  Detecting (ex-post) trade diversion and trade creation  Sophisticated anti-monde: the gravity model  Effects on third countries  Annex: Tools for trade policy analysis (you must master these to follow discussion in this and next session)

3. PART I: THEORY

4. 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) C:  If C imports are now replaced by (less efficient) B imports = trade diversion (partner is high cost supplier ) A: nothing happens! (A is not even importing initially).

5. NUMERICAL EXAMPLE (from overview)

6. Anything can happen = PTA is not necessarily welfare increasing. What does welfare effects depend on intuitively? WELFARE ANALYSIS (for country A) PTA: leads to effects that are both positive (reduction of protection) and negative (discrimination) - Elasticities (in A, B, and C) - Extent of tariff reduction in A (we assume B and C don’t change their tariff) - Extent of price reduction in A (for given tariff reduction by A) - cost differences between B and C - amount of imports affected

7. P ESB+t 1 2 ESC+t 7 6 5 ESB RIA  gain in private welfare: +1275 loss in tariff revenue: - 1234 ? 6 ESC 3 8 4 EDA MFTA MT Imports of A GRAPHICAL REPRESENTATION: CONSTANT COST CASE FOR PARTNER ILLUSTRATED IN NUMERICAL EXAMPLE net change: W=276 - 5634 > 0 N.B: What happens if ESB>ESC+t and what situation is it likely to represent?

8. 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?

9. DETERMINANTS OF WELFARE CHANGE (II) Suppose that partner B is too small to satisfy domestic demand by A WA=(PS+ PC)+ GR = (0) +(-1234) WB= PS= +1246  WB +WA= -(236) WC = 0

10. 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?

11. A welfare increasing FTA  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) WA= PS+ CS + GR =(-3456) + (089) + 0 WB= PS= 4375 WB+WA= (376)+(089) WC = 0 (by construction)

12. 0 P 2 1 (1+1) 7 6 (1+2) AC Pw = 1 ESC = MC 8 9 5 4 3 DA DA+B  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  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 FTA with increasing returns to scale

13. AC MC Profit loss for non-member firm  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; P0R) 0 = 1 2 4 3 • After RIA, firm in country that has not joined faces D1(P;P1R) 1 = 5 6 7 8

14.  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 !!!

15. PART II: EMPIRICS

16.  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): Ejk = share of good k in export of j Mik = 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

17.  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 And SP < SN  TD Following table shows trade effects 1 year before and 5 years after RIA

18. 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 intensity indices (TIA) is the trade intensity of A Suppose 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 B TI 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 Trade propensity indices = (TI) (M/GDP). Compares B’s share in A’s imports with B’s share in world trade

20. ** 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.

23. Strong increase in MERCOSUR and UDEAC

24. 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).

25. 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

26. 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.

27. Add to the above model the following dummy variables Following figures only report statistically significant coefficients for ’s

28. Fig. 2 Evolution of dummies for MERCOSUR

29. Conclusions from Carrère study: …basically a difficult business to build the counterfactual, and need good techniques (here panel estimates) to get plausible results

30. ANNEX: TOOLS FOR TRADE POLICY ANALYSIS

31. 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)

32. 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

33. P MC MB>MC: one more unit leads to more benefits than costs MB<MC: one unit less saves more costs than the loss in benefits MB Q optimality condition is: MC = MB Checking PO condition in closed economy Wheat market under autarky

34. P MC 1 2 6  Q=Q1 CG = area 0178 PC = area 0568 PS + CS = area (195-967)  Q=Q0 CG = area 0124 PC = area 0534 PS + CS = area 1235 9 7 3  Q=Q* CG = area 019Q* PC = area 059Q* PS + CS = area 195 MB 5 4 8 Q0 Q* 0 Q1 Q 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

35. 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

36. S IMPORTS ES* MC MB D S ED* MB MC EXPORTS D Pareto optimality of free trade for SOE MBT MBT

37. pd S 2 1 3 ES* 9 4 p* 5 6 8 D QT CF QF CT IMPORT TARIFF Consumers lose: 1349 Producers gain: 1289 Gov ’t gains: 2356 Efficiency loss in production: 286 Consumption: 345 ES*+t p*+t Tariff at rate t: 1) production & gov ’t rev.; consumption & imports 2)Efficiency loss or dead weight loss (DWL) is 286 + 345 3) price measures (but also NTBs) redistribute income Exercise 1: Analyze an export tax

38. pd pd ES ES 2 1 5 2 ED*+s ED* 3 4 1 ED*-t 5 3 ED* p* p* 4 X X ES ET EF EF p*+s p*-t export tax export subsidy EXERCISE 2: COMPARE EXPORT TAX & EXPORT SUBSIDY Q1)Fill the blanks below GR = (PS+CS)= W= GR = (PS+CS)= W= Q2)(more difficult) Should a large country subsidize itsexports?

39. 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!

40. Small export tax (t0): • increases H welfare as revenue gain (a+b) larger than private losses (b+c) • decreases F welfare (a+d) ES a t0 t1 d c b ED* As wedge becomes larger (t0t1) revenue gain gets smaller while private loss becomes larger  scope for an “optimum tax” at intermediate range.  But F could retaliate  no longer “optimal” MONOPOLY POWER IN EXPORTS (1) Vietnam (rice); Mongolia (cashmere)

41. pd ES A large exporting country can improve its welfare by restricting its exports provided it faces no retaliation. 2 1 4 3 5 6 7 8 ED* MR ED*-t exports -t p1 p1 w w p0 w MONOPOLY POWER IN EXPORTS (2) With tax t, GR = 1276; (PS+CS) = (-5376): W = (1245)+ (-437) which can be >0 or <0. But: 1) H and F together lose 237 2) 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?)

42. pd S A B ES*+tm F G ES*+tc J I p* ES* E C H K D QF QT CF CT CC MEETING AREVENUECONSTRAINT 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 BEJ DWL under b) W= area GHJ

43. ES*(1+t) 4 2 6 ES* 1 7 5 3 p* EDA EDB p*(1+t) MA=MB (a) DETERMINANTS OF THE COST OF PROTECTION 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 DWL 2) A: elastic demand  small revenue, large DWL Efficiency of tax collection: REVENUE/DWL

44. ES*(1+2t) 4 ES*(1+t) 6 2 1 ES* 5 3 p* MA=MB p*(1+t) p*(1+2t) (b) DETERMINANTS OF THE COST OF PROTECTION 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)

45. 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

46.  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.

47. 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 high 3) when rate is high, there is smuggling

48. THE EFFECTIVE RATE OF PROTECTION (ERP) 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 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 protected ERPX <0  activity is taxed

49. 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=60 Case 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%

50. 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  (ERPei) and (ERPdi)  Effective rates of subsidies to take into account effects of fiscal policies  (ERSei) and (ERSdi) Bias: B>1  home-market bias Bti = (1+ERPei)/(1+ERPdi)  tariffs Bsi = (1+ERSei)/(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