© The McGraw-Hill Companies, 2012 Chapter 5: The essential economics of preferential liberalization …the ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be exempt from any intellectual influences, are usually the slaves of some defunct economist. John Maynard Keynes, 1935

© The McGraw-Hill Companies, 2012 Analysis of unilateral discriminatory liberalization Only 3 basic elements needed to understand preferential liberalization: ­‘Smith’s certitude’ by Adam Smith: foreign firms gain (i.e., higher price and more exports) when tariffs against them are eliminated; ­‘Haberler’s spillover’ by Gottfried Haberler: third nations – those excluded from the preferences – must lose; ­‘Viner’s ambiguity’ by Jacob Viner: preferential liberalization might harm the preference-giving nation because.discriminatory liberalization is both ‘liberalization’ – which removes some price wedges and thus tends to improve economic efficiency and Home welfare – and ‘discrimination’ – which introduces new price wedges and thus tends to harm efficiency and welfare.

© The McGraw-Hill Companies, 2012 The PTA diagram Diagrams analyzing preferential liberalization are complex since they require at least 3 nations in the analysis (Home, Partner and RoW). Extend workhorse MD–MS diagram to allow for 2 sources of imports: -aggregate (i.e., horizontal sum) export supply curves of two sources (Partner and RoW); -free trade equilibrium at intersection of MS and MD; -level of imports from two sources read from each supplier’s graph. What happens when Home imposes a tariff T on all imports? -MS curve shifts up by T and no change in MD; -new intersection shows the post-tariff equilibrium domestic price for imports and new import level; -with this border price, both import suppliers supply less.

© The McGraw-Hill Companies, 2012 The PTA diagram

© The McGraw-Hill Companies, 2012 Discriminatory liberalization What happens when Home removes tariff T only from Partner? -MS curve shifts down but only halfway between MS (free trade) and MS MFN because liberalization affects only half imports; -kinked MS curve with PTA, for low enough prices where only Partner country is exporting. New equilibrium: -new domestic price is lower; -Partner-based firms see border price rise, P′ – T to P′′; -RoW firms see border price fall from P′ – T to P′′ – T; -RoW exports fall, Partner exports rise more than RoW exports fall, so domestic imports rise (supply switching).

© The McGraw-Hill Companies, 2012 Discriminatory liberalization

© The McGraw-Hill Companies, 2012 Supply-switching effects of EEC customs union

© The McGraw-Hill Companies, 2012 Welfare effects What happens when Home removes tariff T only from Partner? -Home’s welfare changes by (A + B – C), positive or negative (Viner’s ambiguity); -Partner gains area D (Smith’s certitude); -RoW loses area E (Haberler’s spillover).

© The McGraw-Hill Companies, 2012 Welfare effects

© The McGraw-Hill Companies, 2012 Home welfare effects   CS = D + A 1 + A 2 + A 3 ;   PS = -D;   tariff revenue = B – A 1 – C.

© The McGraw-Hill Companies, 2012 Analysis of a customs union European integration involved a sequence of preferential liberalizations but all reciprocal = both Home and Partner eliminate T on each other’s exports. Assume that three goods are traded (goods 1, 2 and 3). Each country produces all three goods, but cost structures are such that each nation exports two of the three goods while importing the remaining one:

© The McGraw-Hill Companies, 2012 Analysis of a customs union Price and quantity effects: -impact of Home’s discriminatory liberalization is as seen before; -impact of Partner’s discriminatory liberalization of imports of good 2 from Home can also be seen using the same diagram: price of good 2 in Partner falls from P′ to P′′ but border price for Home exporters when they sell good 2 to Partner rises from P′ – T to P′′. No change to domestic prices in RoW since they did not liberalize, but RoW exporters face a lower border price for their exports to Partner. Welfare effects: -a matter of adding up effects illustrated before.

© The McGraw-Hill Companies, 2012 Analysis of a customs union

© The McGraw-Hill Companies, 2012 Customs unions versus free trade agreements A free trade agreement (FTA) is like a customs union (CU) but without a common external tariff. This situation prompts ‘tariff cheats’: -goods from RoW destined for Home market enter via Partner if Partner has lower external tariff = ‘trade deflection’. The solution is ‘rules of origin’ meant to establish where a good was made. However, such rules are difficult and expensive to administer, especially as world get more integrated. They often become a form of disguised protection. Still, almost all preferential trade arrangements in world are FTAs because CUs require some political integration.

© The McGraw-Hill Companies, 2012 Frictional barriers: the 1992 Programme Since the mid-1970s and especially since the 1986 Single European Act, most economic integration in Europe has involved the removal of ‘frictional’ barriers to trade. Still, frictional barriers can be conceptualized as tariffs where the tariff revenue is thrown away. For such barriers, Smith’s certitude and Haberler’s spillover still hold, but Viner’s ambiguity disappears. Reciprocal preferential frictional barrier liberalization leads to: -lower Home’s domestic and border price; -Higher price received by Partner exporters and lower price received by RoW exporters. Thus, Home imports rise and Partner exports rise while RoW exports fall. Supply switching still occurs.

© The McGraw-Hill Companies, 2012 Frictional barriers: the 1992 Programme

© The McGraw-Hill Companies, 2012 WTO rules A basic principle of the WTO/GATT is non-discrimination in application of tariffs. FTAs and CUs violate this principle. However, Article 24 permits FTAs and CUs subject to conditions: -substantially all trade must be covered;. -intra-bloc tariffs must go to zero within reasonable period; -In case of CU, the common external tariff must not on average be higher than the external tariffs of the CU members were before: in EEC, the CU meant that France and Italy lowered their tariffs, Benelux nations raised theirs while German tariffs were about at the average.