The EU-Morocco FTA under imperfect competition and economies of scale Presented by Natalia Tourdyeva, Dereje Megeresa, Kate Harback, Nicole Nance, Sunitha Raju, Young-Han Kim, Santosh Joshi, and Kledia Dallto 15th Annual Short course in Global Economic Analysis, August 4-10, 2007

Background A Comparative Analysis of the EU-Morocco FTA vs. Multilateral Trade Liberalization, by Aziz Elbehri and Thomas Hertel FTA vs. Multilateral Liberalization Scenario Firm Entry vs. No Entry Full Employment vs. Unemployment Tax Replacement

Agenda Group 1: Introduction & Theory (Natalia and Dereje) Group 2: The Impact on Industrial Structure (Sunitha and Young-Han) Group 3: The Impact of Transfer Payments (Kledia and Santosh) Group 4: The Impact of Tax Replacement (Kate and Nicole)

Motivation of the paper Presence of imperfect competition can influence outcomes of trade reforms –8 of 15 two digit industries have 4-plant concentration ratios above 70% in Morocco –Potential for exit/entry (industry rationalization) –Potential for significant changes in employment –Monetary transfer as a part of the FTA

Scale economies Assumptions –Scale economies are internal to the firm –Firms have homothetic technologies Implementation Equation O_SCALE # computes output scaling effect for increasing returns sectors # (all,i,OLIG_COMM)(all,r,REG) OSCALE(i,r) = [SCALE(i,r)] * [qva(i,r) - firms(i,r)] - ao(i,r); = 0 Input level on a per firm basis Endogenous “change” in CRTS technology: observationally equivalent to IRTS

Oligopoly Behavior Where: M = power of markup over MC n = number of firms  i = perceived market demand elasticity Assumption: The elasticity of substitution among imports is assumed to be equal to that between domestic and imported goods i.e. ESUBD = ESUBM Equation SUPPLYPRICES # links pre- and post-tax supply prices for oligopolistic industries # (all,i,OLIG_COMM)(all,r,REG) ps(i,r) = to(i,r) + pm(i,r) - p_AC_MARKUP(i,r); Power of a.v. subsidyMarkup acts like a tax = - subsidy

CRTS vs IRTS Many CGE analysis of FTAs assume perfect competition and constant returns to scale Advocates of FTAs often argue that the gains will be larger if imperfect competition and increasing economies of scale are incorporated in the analysis –However, the theory is by no means conclusive –It is equally possible that the gains will be smaller (or losses larger) when these features are taken into account

The Consequences of Imperfect Competition and Scale Economies for Welfare They are an important part of the welfare analysis in many trade liberalization scenarios. The following welfare decomposition for a small, open economy highlights this fact: Money metric Change in Welfare Terms of Trade Effect Trade Volume = Allocative Efficiency Effect Scale Effect Profit Shifting Effect

Decomposition of Welfare Effects FTAMultilateral Liberalization No EntryEntryNo EntryEntry Allocative effect Endowment effect 0000 Scale economies Terms of trade effect IS_E Transfer from EU EV_ALT EV =

Decomposition of allocative efficiency effects FTAMultilateral Liberalization No EntryEntryNo EntryEntry Pfact tax0000 Profit shifting tax Input tax Consumption tax Government tax0000 Export tax Import tax Total

Profit shifting for selected industries (FTA) welcontdvolTax rate (before)Tax rate (after) No Entry Motor vehicles Paper Light manuf Total for all sectors Entry Motor vehicles Paper Light manuf Wearing apparel Total for all sectors

Impact of FTA on Industrial Structure without Entry/Exit Presentation Structure 1.Changes in Production Structure 2.Behavior of Firms with Respect to Changes in Mark -Up 3.How Scale Economies Define this Behavior

Results of Selected industries: Production & Prices

Behavior Of Firms: Production, Mark-up

Behavior of Firms: Scale economies

The impacts of FTA on Market structure with Entry/Exit Motivation (Questions) –Is Globalization a really Nasty One Concentrating Economic Power? –What about a country like Morocco (as a Small Open Economy with Imperfectly competitive Industries)? –What is the impacts on industrial structure when firms can enter and exit freely? Oligopoly & Free Entry? –By setting Number of firms in oligopoly markets as an endogenous variable, –Profit Ratio of Oligopoly firms (Markup over average cost) set as fixed, We examine how market structure of each industry is affected by FTA

What happened? Numbers of Firms in highly protected industries has gone down sharply (Ex: Wood products, Dairy products, etc) - even including the profit making firms with positive Mark-up over AC With Imperfect competition with higher Fixed cost and oligopoly market structure, firms might make loss even before FTA Changes in markup over MC is heavily influenced by increased imports Market structures of small open economy is dominated by the changes in trade structure

Secrets: ao: Rate of Changes of Economies of Scale as endogenous variable (x^-z^) to: rate of changes of mark-up as endogenous v.r.

Morocco-EU FTA: Entry, Full employment Scenario 1: Base transfer = $182 mln. Scenario 2: No transfer Scenario 3 : Doubled transfer = $364 mln. Welfare decompositionBase Transfer No Transfer Doubled transfer Total welfare Allocative Efficiency Labor endowment000 Scale economies (technical change) Terms of Trade Investment-savings effect Transfer payment

Morocco-EU FTA: Entry, Full employment

Transfer from EU is not affecting industrial structure significantly Bigger transfers could produce bigger effects on industry Focus should be put on demand side of analysis

MOROCCO – EU FTA EXPERIMENT: NO ENTRY, FULL EMPLOYMENT, TAX REPLACEMENT Base Case: Transfer of $182 millions from EU to Morocco Scenario 1: Transfer of $0 from EU to Morocco Scenario 2: Transfer of $ 386 millions from EU to Morocco Change in Welfare due to different transfer

Welfare Decomposition

Effect of Transfer on Private household Demand

Examining Tax Replacement Motivation: With tax replacement, you introduce a policy change at the same time you implement the FTA. To understand the pure impact of the FTA, run the model without tax replacement—or what is the impact of tax replacement. NOTE: FTA, no entry, full employment

Tax Replacement in the Model

Tax Replacement: Impact on Tax Revenue Note: Tax revenue replacement is carried out on the ratio of taxes to income, not dollar for dollar. Tax revenue lost with tariff removal & no endogenous increase in tp

Tax Replacement: Impact on Welfare

The consumption tax changed endogenously to maintain the ration of taxes to income, reducing welfare.

Conclusions: What has the group learned? The assumptions we make about imperfect competition affect the welfare results of the model. It is not obvious whether this impact will be positive or negative for welfare. Further, understanding the impact of the transfer requires differencing EV and EV_ALT. The sectoral make up of the Moroccan economy would be significantly different under a multilateral agreement that did not exempt agriculture than under the FTA with EU.

Conclusions: What has the group learned? Transfer payments have little impact on the industrial make up of the Moroccan economy. However, they do impact through the demand side. Tax revenue lost from the tariff removal is significant, so replacing it is realistic. However, tax replacement through the consumption tax creates a reduction in allocative efficiency.