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

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ECONOMIC EFFECTS (I) 2 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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ECONOMIC EFFECTS (I) 3 PART I: THEORY

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ECONOMIC EFFECTS (I) 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) 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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ECONOMIC EFFECTS (I) 5 NUMERICAL EXAMPLE (from overview)

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ECONOMIC EFFECTS (I) 6 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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ECONOMIC EFFECTS (I) 7 GRAPHICAL REPRESENTATION: CONSTANT COST CASE FOR PARTNER ILLUSTRATED IN NUMERICAL EXAMPLE Imports of A 1 P 4 6 MTMT M FTA 2 5 3 ES B ES C ES B +t ES C +t 6 7 8 ED A net change: W=276 - 5634 > 0 RIA gain in private welfare: +1275 loss in tariff revenue: - 1234 ? N.B: What happens if ES B >ES C +t and what situation is it likely to represent?

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ECONOMIC EFFECTS (I) 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?

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ECONOMIC EFFECTS (I) 9 Suppose that partner B is too small to satisfy domestic demand by A DETERMINANTS OF WELFARE CHANGE (II) W A =( PS+ PC)+ GR = (0) +(-1234) W B = PS= +1246 W B + W A = -(236) W C = 0

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ECONOMIC EFFECTS (I) 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?

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ECONOMIC EFFECTS (I) 11 W A = PS + CS + GR =(-3456) + (089) + 0 W B = PS = 4375 W B + W A = (376)+(089) W C = 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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ECONOMIC EFFECTS (I) 12 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 CS A =CS B =035 0 P ES C = MC 5 4 3 98 7 6 2 1 DADA D A+B AC P w = 1 (1+ 1 ) (1+ 2 ) FTA with increasing returns to scale Minimum protection for monopolists in A & B (1+ 1 ) CS A = CS B =(- 245) FTA with production in A (1+ 2 ) CS A = CS B =-789 … but free trade still superior

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ECONOMIC EFFECTS (I) 13 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 D 0 (P; P 0 R ) 0 = 1 2 4 3 After RIA, firm in country that has not joined faces D 1 (P;P 1 R ) 1 = 5 6 7 8 Profit loss for non-member firm AC MC

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ECONOMIC EFFECTS (I) 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 !!!

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ECONOMIC EFFECTS (I) 15 PART II: EMPIRICS

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ECONOMIC EFFECTS (I) 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): E jk = share of good k in export of j M ik = 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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ECONOMIC EFFECTS (I) 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 S P and S N S P =(M P ) / (M P + M N + D ) ; S N =(M N ) / (M P + M N + D ) Simplistic presumption is that if S P > S N TC And S P < S N TD Following table shows trade effects 1 year before and 5 years after RIA

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ECONOMIC EFFECTS (I) 18 Trade intensity indices (TI A ) 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 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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ECONOMIC EFFECTS (I) 19

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ECONOMIC EFFECTS (I) 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.

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ECONOMIC EFFECTS (I) 21

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ECONOMIC EFFECTS (I) 22

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ECONOMIC EFFECTS (I) 23 Strong increase in MERCOSUR and UDEAC

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ECONOMIC EFFECTS (I) 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).

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ECONOMIC EFFECTS (I) 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: T ij = Imports or average trade between i and j D ij average distance (or better) average transport costs between countries

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ECONOMIC EFFECTS (I) 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.

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ECONOMIC EFFECTS (I) 27 Add to the above model the following dummy variables Following figures only report statistically significant coefficients for ’s

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ECONOMIC EFFECTS (I) 28 Fig. 2 Evolution of dummies for MERCOSUR

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ECONOMIC EFFECTS (I) 29 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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ECONOMIC EFFECTS (I) 30 ANNEX: TOOLS FOR TRADE POLICY ANALYSIS

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ECONOMIC EFFECTS (I) 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 (MC P ) = private marginal benefit (cost) MBs (MC S ) = social marginal benefit (cost)

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ECONOMIC EFFECTS (I) 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) MB P = MB S ; MC P = MC S PO in closed economy MB = MC

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ECONOMIC EFFECTS (I) 33 Checking PO condition in closed economy P Q MB MC MB>MC: one more unit leads to more benefits than costs MB

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ECONOMIC EFFECTS (I) 34 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*, Q 0 and Q 1 PS + CS = CG - PC P Q1Q1 MB MC Q0Q0 Q*Q* 0 5 3 2 1 9 6 7 84 Q Q=Q 0 CG = area 0124 PC = area 0534 PS + CS = area 1235 Q=Q 1 CG = area 0178 PC = area 0568 PS + CS = area (195-967) Q=Q * CG = area 019Q * PC = area 059Q * PS + CS = area 195

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ECONOMIC EFFECTS (I) 35 Open economy Now take into account: - either the marginal cost through trade, MC T =for imports - or the marginal benefit through trade, MB T =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 = MC T = (importing SOE) or MB = MC = MB T = (exporting SOE) Free trade is PO for SOE

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ECONOMIC EFFECTS (I) 36 MB T S D ES * MB MC IMPORTS S D ED * MB MC EXPORTS Pareto optimality of free trade for SOE

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ECONOMIC EFFECTS (I) 37 IMPORT TARIFF ES*+t p*+t ES* pdpd QFQF CFCF D S CTCT QTQT p* 2 13 4 5 6 8 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 & 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

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ECONOMIC EFFECTS (I) 38 EXERCISE 2: COMPARE EXPORT TAX & EXPORT SUBSIDY ED* ED*-t ES ED* ED*+s ES p* X ETET EFEF EFEF ESES X 1 2 3 5 4 1 2 3 4 5 pdpd 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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ECONOMIC EFFECTS (I) 39 Open economy Large exporter has monopoly power Exports world price, p W p W MR = MB T < p w PO MB = MC= MB T as before PO MB=MC = MR < p w Free trade is not PO for country with monopoly power!

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ECONOMIC EFFECTS (I) 40 MONOPOLY POWER IN EXPORTS (1) Vietnam (rice); Mongolia (cashmere) Small export tax (t 0 ): increases H welfare as revenue gain (a+b) larger than private losses (b+c) decreases F welfare (a+d) a b c ED* ES d t0t0 t1t1 As wedge becomes larger (t 0 t 1 ) 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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ECONOMIC EFFECTS (I) 41 MONOPOLY POWER IN EXPORTS (2) pdpd ES ED* MR ED*-t p1p1 w p0p0 w p1p1 w -t 1 2 3 4 7 8 6 5 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 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?)

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ECONOMIC EFFECTS (I) 42 MEETING A REVENUE CONSTRAINT pdpd S D A ES* ES*+t m ES*+t c p* B G J H E C K I F QFQF QTQT CTCT C CFCF 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

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ECONOMIC EFFECTS (I) 43 DETERMINANTS OF THE COST OF PROTECTION (a) ED B p* p*(1+t) M A =M B ED A ES* ES*(1+t) 1 3 5 2 4 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 DWL 2) A: elastic demand small revenue, large DWL Efficiency of tax collection: REVENUE/DWL

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ECONOMIC EFFECTS (I) 44 DETERMINANTS OF THE COST OF PROTECTION (b) M A =M B 1 ES* ES*(1+t) ES*(1+2t) 3 5 6 4 2 p*(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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ECONOMIC EFFECTS (I) 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 = P X /P M = M/E 2) The income terms of trade (which is equal to the barter TOT times a quantity index of exports (Q E )) is a measure of the purchasing power (in terms of imports) of a country ’s exports: Income TOT = TOT x Q E

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ECONOMIC EFFECTS (I) 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, t X and an import tariff, t M 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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ECONOMIC EFFECTS (I) 47 NOMINAL RATE OF PROTECTION (NRP) EFFECTIVE RATE OF PROTECTION (ERP) The NRP is the percentage difference between the price of X (p X ) in domestic currency and the price of X at the border (p * X ) Note that: The official (or formal) tax, t x, 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

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ECONOMIC EFFECTS (I) 48 Definition: Percentage excess of domestic value-added in activity X (VA X ) over corresponding value-added at world prices (VA * X ) ERP X = (VA X - 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 ERP X >0 activity is protected ERP X <0 activity is taxed

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ECONOMIC EFFECTS (I) 49 AN EXAMPLE: CLOTHING ERP in clothing (shirts). Textiles serves as an input t t (t c ) :ad-valorem tariff on textiles (clothing) VA D (VAw) = Value-added at domestic (world) prices Free trade VA D = VA W. Numerical example. Under free trade: Sales value= 100;Textile input purchase= 40 Value-added (VA) in shirt-making : 100 - 40=60 Case I: t c = 20%; t t = 10% VA D = 100(1.2)-40(1.1)=76 ERP =VA D -VA W = (76-60)/60 = 27% Case II: t c = 10%; t t = 30% VA D = 100(1.1)-40(1.3)=58 ERP = VA D -VA W = (58-60)/60 = -3%

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ECONOMIC EFFECTS (I) 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 (ERP e i ) and (ERP d i ) Effective rates of subsidies to take into account effects of fiscal policies (ERS e i ) and (ERS d i ) Bias: B>1 home-market bias B t i = (1+ERP e i )/(1+ERP d i ) tariffs B s i = (1+ERS e i )/(1+ERS d i ) subsidies circa 1980 Argentina Korea Taiwan (China) B t i (all sectors) 1.94 1.10 1.10 B s i (all sectors) 1.86 1.01 0.89

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