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

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. 92-121.

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

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

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

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

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

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

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

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

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

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

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

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

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

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) ]

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

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

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

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