1. Free Trade Agreements by Alan V. Deardorff University of Michigan 2016
PubPol/Econ 541
Free Trade Agreements by Alan V. Deardorff University of Michigan 2016

2. Outline* Simplest Model with Horizontal Foreign Supplies
Goods
Services
Model with Upward Sloping Foreign Supplies
*Much of this is an elaboration of material in World Trade Organization, "Causes and Effects of PTAs: Is it all about preferences?", Ch. C: World Trade Report 2011, pp

3. Simplest Model Assume Partial-equilibrium model of trade in a good
3 countries:
Home, A
Partner 1, B, and
Partner 2, C
B and C have constant costs of exporting to A, at prices PB < PC
A has tariff, t > PC – PB

4. No FTA Without FTA Since PB+t < PC+t Home imports only from B P S
Paut
PC+t
PB+t PC PB D S0 D0 Q M0

5. FTA with low-cost country, B
FTA with B
Since PB < PC+t Home still imports only from B
Country C plays no role P S
Paut
PC+t
PB+t
Welfare
Suppliers lose –a
Demanders gain +(a+b+c+d)
Government loses –c
Country gains (b+d) PC a b c d PB D S1 S0 D0 D1 Q M0
Same as Free Trade

6. FTA with low-cost country, BP S
Paut
PC+t
PB+t PC a b c d PB D D1 S0 D0 D1 Q M0
Trade Creation

7. FTA with high-cost country, C
FTA with C
Since PC < PB+t Home now imports only from C P S
Paut
PC+t
Welfare
Suppliers lose –a
Demanders gain +(a+b+c+d)
Government loses –(c+e)
Country loses –e+(b+d)
PB+t a c b d PC e PB D
Not same as Free Trade
and may be a loss, if e>(b+d) S1 S0 D0 D1 Q M0

8. FTA with high-cost country, CP S
Paut
PC+t
PB+t a c b d PC e PB
Trade Diversion D S1 S0 D0 D1 Q M0
Trade Creation

9. Outline Simplest Model with Horizontal Foreign Supplies
Goods
Services
Model with Upward Sloping Foreign Supplies

10. Trade in Services
Trade in a service is not subject to tariffs, since nothing physical crosses borders
It is subject to regulatory standards, that also raise cost, by some amount, say “s”
The difference is that
Tariff t is revenue to government
Regulatory cost s is a real cost, using real resources, and not a transfer or benefit to anyone
Pictures look the same as before, except for interpretation of this cost.
Lecture 1: Overview

11. Service FTA with low-cost, B
FTA with B
Since PB < PC+s Home still imports only from B
Country C plays no role P S
Paut
PC+s
PB+s
Welfare
Suppliers lose –a
Demanders gain +(a+b+c+d)
Government loses 0
Country gains (b+c+d) PC a b c d PB D S1 S0 D0 D1 Q M0

12. Service FTA with high-cost, C
FTA with C
Since PC < PB+s Home now imports only from C P S
Paut
PC+s
Welfare
Suppliers lose –a
Demanders gain +(a+b+c+d)
Government loses 0
Country gains (b+c+d)
PB+s a c b d PC e PB D
Certain gain, but not as large as with country B S1 S0 D0 D1 Q M0

13. Outline Simplest Model with Horizontal Foreign Supplies
Goods
Services
Model with Upward Sloping Foreign Supplies

14. Model with Upward Sloping Supplies
Assume
Partial-equilibrium model of trade in a good
3 countries:
Home H
Partner P, and
ROW, Rest of world, R
H has import demand curve MD
P and R have identical export supply curves, XS,
which add to Home’s import supply MS,
but only after adjustment for tariff

15. Model with Upward Sloping Supplies
Tariffs
Without FTA, exports of both P and R are subject to MFN specific tariff, t.
With FTA, only country R’s exports are subject to tariff t.
Export supplies:
Let XSi be export supply without tariff, i=R,P
Let XSit be export supply with tariff, i=R,P
Import supplies:
MSmfn = XSRt+XSPt
MSfta = XSRt+XSP

16. Export supplies ROW Partner Home [ Xsit(P) = Xsi(P–t) ] P P XSRt XSPt
MSmfn
MSfta
XSR
XSP t t
XSP P* P* Q Q Q
[ Xsit(P) = Xsi(P–t) ]

17. MFN Equilibrium ROW Partner Home P P P XSRt XSPt MSmfn MSfta XSR XSP
P0H
P0R
P0P t t t
XSP MD P* P*
Q0R Q
Q0P Q
Q0H Q

18. FTA Equilibrium ROW Partner Home P P P XSRt XSPt MSmfn MSfta XSR XSP
P0H
P1P
P1H
P0R
P0P
P1R t
XSP MD P* P*
Q1R
Q0R Q
Q0P
Q1P Q
Q0H
Q1H Q

19. Welfare effects, MFN to FTA
ROW
Partner
Home P P P
XSRt
XSPt
MSmfn
MSfta
XSR
XSP
P0H
P1P
P1H
P0R
P0P
P1R t
XSP MD P* P*
Q1R
Q0R Q
Q0P
Q1P Q
Q0H
Q1H Q
Home Private: Gain
Partner Private: Gain
Home Gov’t: Loss
ROW Private: Loss

20. Summary of Effects
Starting from MFN tariff, an FTA with one of two identical countries causes
Home price to fall, benefiting Home demanders more than it hurts home suppliers
Partner price to rise, benefiting Partner suppliers more than it hurts partner demanders
ROW price to fall, hurting ROW suppliers more than it benefits ROW demanders
Home government to lose all the tariff revenue on
All imports from Partner
Reduced imports from ROW
Net effect on Home welfare is ambiguous, since revenue loss may exceed private benefits