1. The Political Economy of Trade Policy Chapter-9

2. The Welfare Effects of RTAs… An RTA has two elements and thus two opposite effects: 1.Trade Creation (Trade Liberalization Element): An expansion of in world trade that results from the formation of PTA (….Beneficial) 2.Trade Diversion (Protectionist Element): A shift in the pattern of trade from low-cost world producer to high-cost RTA member (s)…..(Harmful).

3. The Welfare Effects of RTAs… Thus, the welfare (economic) impacts economic integration, depend on the net difference between trade creation effects and the trade diversion effects Hands-On-Practice….. Suppose autarky price of X in three countries (A, B, C) is as follows

4. SASA DADA $5.00 $1.50 PC PB $2.00 M N P Q PA

5. The Welfare Effects of RTAs… 1.With free international trade, from which country should A be importing? 2.how much would that be…? A should import from C (the low cost world producer) MN.

6. SASA DADA $5.00 $1.50 PC M N PA Total Imports from C = MN Total Value of Imports = $1.5 X MN

7. The Welfare Effects of RTAs… Suppose that producers in country A lobby their government so that it imposes a 100% Advalorem tariff on imports (from all countries) into A. 3.What would be the unit prices of imports from C (after tariff)? 4.What would be the unit prices of imports from B (after tariff)?

8. SASA DADA $5.00 $1.50 PC PB $2.00 M N P Q PC + Tariff $3.00 PB + Tariff $ 4.00 RS PA

9. The Welfare Effects of RTAs… 5.Once the tariffs are in effect, would country A need to change its trade partner? NO!!! 6.If so, what would be the effect of the import tariff? A Fall in Imports from C

10. SASA DADA $5.00 $1.50 PC M N PA Pre-Tariff Imports from C = MN RS Post tariff Imports From C = RS PC + Tariff $3.00

11. The Welfare Effects of RTAs… Suppose B negotiates with A and forms a Free Trade Area (FTA) ; Eliminates the tariff on imports. 7.What will be the effect of the formation of FTA between A and B?

12. The Welfare Effects of RTAs… Two effects… 1..Trade Diversion– A now imports from B; not from C. This would divert trade…(RS)….(from the low cost world producer (C) to the high-cost FTA member (B)).

13. SASA DADA $5.00 $1.50 PC PA RS PC + Tariff $3.00 PB $2.00 Amount of Trade Diverted

14. The Welfare Effects of RTAs… 2. Trade Expansion: The increase in import resulting from the economic integration that eliminates trade barriers. With integration imports will be PQ

15. SASA DADA $5.00PA RS PC + Tariff $3.00 P Q PB $2.00 Trade Diverted Trade Created

16. The Welfare Effects of RTAs… What is the Economic (Welfare) Effects of Economic Integration? (Is it Beneficial/ Harmful)?

17. SASA DADA $5.00 $1.50 PC PB $2.00 M N P Q PC + Tariff $3.00 RS ab c d e PA

18. The Welfare Effects of RTAs… 8.1. Economic Benefits: Consumers in A benefit (Price falls from $3.00 to $2.00) Consumers’ surplus would rise Area (A + B+ C+ D)

19. The Welfare Effects of RTAs… 8.2. Economic Losses: Producers’ Surplus Falls Area ( A) Government Revenue Falls Area (C + E)

20. The Welfare Effects of RTAs… Net Economic Effects: Effects of Trade creation - Effects of Trade Diversion (A+B+C+D) – (A+ C+E) (A+B+C+D) – (A+ C+E) (A + B + C + D) – (A + C +E) (B + D) – (E)

21. The Welfare Effects of RTAs… Implication At best the welfare effects of economic integration is indeterminate (ambiguous)...That is, there is No Guarantee that economic integration improves living standards. Some conditions, however, could make the trade creation effects dominate the trade diversion effects The higher the initial tariffs between member countries The lower the barriers to trade with non-member countries The greater the number of the members forming the integration and the higher the flow of goods between them

22. Consider the following data detailing trade before and after a hypothetical country, Javaland forms an FTA with Macau In class exercise Before FTA After FTA Imports of Javaland from Guam 100 Million0 units Imports of Javaland from Macau 0280 Million

23. 1.How much trade was diverted? 2.How much trade was created? 3.Suppose Guam charges $7.00 for this product and Macau charges $8.00. If Javaland’s original tariff was $2 per unit, calculate the welfare gain or loss from forming FTA. In class exercise

24. The Welfare Effects of RTAs… Implication At best the welfare effects of economic integration is indeterminate (ambiguous)...That is, there is No Guarantee that economic integration improves living standards. ? ? ? ? ? ? ? ? ? ? ? ? ? ?

25. Why would A negotiate economic integration with B, while it can improve welfare more by integrating with C? Reasons for the formation of trading agreements goes beyond the static gains and losses (Trade creation and trade diversion effects). Why RTA?

26. I. Dynamic gains from economic integration Economies of large scale production Increased market size; Foreign investment…. Enhanced competition… (What keeps a RTA from expanding to include every other country?) Why RTA?

27. II. Political (non-economic) reasons Gesture for good neighborhood, regional security Long term development goals, safe haven trading arrangements Regional competition. Why RTA?

28. Some Examples of RTA … Two waves of economic integration: 1960s Most were modeled after European Community. Attempts among developing countries met only with partial success. Some African and Latin American plans failed. Mid-1980s European Union (EU) North American Free Trade Agreement (NAFTA) Association of South East Asian Nations (ASEAN) Southern Common Market (MERCOSUR)

29. The European Union (EU) Some Examples of RTA … The North American Free Trade Agreement (NAFTA)

30. The European Union (EU)

31. European Union: Members and Applicants, 2001 Sweden Finland Estonia Latvia Lithuania Poland Czech Rep. Slovakia Romania Bulgaria Turkey Greece Italy Austria Germany France Spain Portugal Luxembourg Belgium Netherlands Denmark United Kingdom Ireland Hungary Slovenia Members Applicants Malta

32. (1951): European Coal and Steel Community- (ECSC) _____________________________________ Belgium, France, Italy, Luxembourg, The Netherlands, and West Germany) Eliminate Tariff and Quotas between members and expand free trade The European Union (EU)

33. (1957): European Economic Community (EEC) __________________________________ Rome Treaty---Agreement to reduce tariff and non-tariff trade barriers between members and institute common external tariff. Gradual elimination of tariffs and quotas, expand trade flow The European Union (EU)

34. (1967): ECSC and EEC merged; European Union (EU) formed ___________________________________ U.K., Ireland, Denmark (1973); Greece (1981); Spain and Portugal (1986); Austria, Finland, Sweden (1995). About a dozen other countries on the waiting list (Expanding beyond W. Europe) The European Union (EU)

35. 1992 (Maastricht Treaty) Agreed to establish an Economic Union and Common Currency 1999- European Monetary Union (EMU), 2002- Coomon Currency (Euro)—Less-UK, Sweden Today EU is more than a free trade area/ custom union—Is almost an Economic Union The benefits (trade creation effects) appear to outweigh the costs (trade diversion effects). Why? Number of members and significance of trade between members (see graph) The European Union (EU)

36. Intra-Group Trade as Percent of Total Merchandise Trade, 2000 0 EU 20 40 50 60 70 Percent 30 10 Intra-Group Exports as Percent of Total Exports Intra-Group Imports as Percent of Total Imports

37. The North American Free Trade Agreement (NAFTA)

38. What is NAFTA? A free trade area (with few added touches) between the U.S., Canada, and Mexico. Started on January 1, 1989– as Free Trade Agreement between the U.S. and Canada

39. 1992, Canada and the U.S. agreed to expand the free trade area to include Mexico 1993- the U.S. congress approved the agreement, NAFTA went into effect in 1994. Tariff Reductions to be phased out in 15 years (2010) The North American Free Trade Agreement (NAFTA)

40. Additional issues relate to Labor & environmental standards Each country is to enforce its labor and Environmental Laws What is special about NAFTA? The North American Free Trade Agreement (NAFTA)

41. 1.Expected to provide each member nation better access to the other’s markets, technology, labor and expertise. 2.Significant Differences….. Size of the Economy; Average Earnings (Wages); Labor Productivity; Efficiency of the Productive Sectors. The North American Free Trade Agreement (NAFTA)

42. YearUSACANMEX 198513.0110.941.59 198713.5212.041.04 199317.2016.052.40 199517.2016.031.51 199717.7416.681.53 200019.8615.652.09 Hourly Manufacturing wages in US Dollars Source: BLS (http://www.bls.gov/bls/newsrels.htm) Significant differences in Average Hourly Earnings (Wages ) The North American Free Trade Agreement (NAFTA)

43. 3.NAFTA is also a FTA between developed and developing country? Is there a benefit in forming FTA between developed and developing country? Who stands to gain from NAFTA? Who losses? Which sector? What is/was the economic impact of NAFTA on the economy’s member countries? The North American Free Trade Agreement (NAFTA)

44. Intra-Group Trade as Percent of Total Merchandise Trade, 2000 0 EU NAFTA 20 40 50 60 70 Percent 30 10 ASEAN MERCOSUR Intra-Group Exports as Percent of Total Exports Intra-Group Imports as Percent of Total Imports

45. Effects…. Trade Flow (1994-1998) Creation (‘000$) Diversion (‘000$) US imports from Canada689,997384,189 US imports from Mexico284,77450,138 Canadian imports from US38,44425,212 Canadian imports from Mexico3,321163,943 Mexican imports from USA50,03627,651 Mexican imports from Canada90227,099 Source: Karemera & Ohah (1998) The North American Free Trade Agreement (NAFTA)

46. Trade Creation and Diversion effects differ across countries Negative static effects of NAFTA on the U.S. economy have been relatively small; Reason: the U.S. merchandise exports to, and imports from, Mexico accounts a very small proportion of the U.S. GDP Total job losses in USA due to increased plant relocations into Canada and Mexico (1994-1999) = 259, 618 (See Next table…) The North American Free Trade Agreement (NAFTA)

47. Industry# of Job Losses% to Total Job Losses Apparel73,56828.3 Electronics33,68413.0 Transportation Equipment17,0906.6 Fabricated Metals15,3725.9 Textiles14,1505.5 Non-Electrical Machinery11,7474.5 Lumber9,8263.8 Scientific Instruments9,4333.6 Paper Products8,9823.5 Rubber7,7223.0 Leather7,5212.9 Other Manufacturing35,17113.5 Non-Manufacturing15,3525.9 Source: Congressional Research Review (2000) The North American Free Trade Agreement (NAFTA) Effects….

48. WINNERS High-Skill, High-tech US businesses that benefit from reduced barriers Labor intensive US businesses that relocate to Mexico benefit from lower production costs US Domestic businesses that use imports as components in the production process save on production costs Adherence to workers’ rights requirements in Mexico could raise Mexican Labor costs, making US exports more competitive Consequently, less pressure on US workers in import competing business to give up their wages or the protection of their rights LOSERS Labor Intensive, Lower wage, import competing US businesses could lose from reduced protections ( tariffs) on competing imports US workers in import competing businesses (because of firms relocation to Low cost area) Some US firms who may be wanting to relocate to Mexico to save labor costs may lose because of adherence to worker-rights in Mexico Potential Winners and Losers The North American Free Trade Agreement (NAFTA) MERCOSUR Formed in 1991 Includes Brazil, Argentina, Paraguay, and Uruguay. 1994: became a customs union with average CET of 14%. Intra-MERCOSUR trade increased 400% in first 4 years.

49. Other RTAs MERCOSUR Formed in 1991 Includes Brazil, Argentina, Paraguay, and Uruguay. 1994: became a customs union with average CET of 14%. Intra-MERCOSUR trade increased 400% in first 4 years.