The Simple Analytics of Trade Creation and Diversionalandear/courses/541/slides/FTAs - TCTD… · trade diversion Gain from trade creation-'-' 2"= 2% •Loss is an area, product of

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The Simple Analytics of Trade Creation and Diversion

Alan V. DeardorffUniversity of Michigan

Rishi R. SharmaColgate University

For presentation at

Conference on International Economic Integration: Firms, Workers, and Policies

Universität Tübingen May 22-23, 2019


Outline

• Background• Simplest model: horizontal supplies• Upward-sloping supplies– 3-country case, in graphs– Somewhat more general case, in

equations– 4-country case, in graphs

2


Background

• Viner’s (1950) trade creation and trade diversion are usually illustrated with

– Constant costs

– 2-country FTA or CU plus rest of world

• Then we’ll look at cases with

– Upward sloping supplies

– And in the last case, an FTA with pre-existing other FTA

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

5

PS

Paut

PB

D

QS0 M0

PC

PB+t

PC+t

• Without FTA– Since PB+t < PC+t Home

imports only from B

D0


FTA with low-cost country, B

6

PS

Paut

PB

D

QS0 M0

FTA with B• Since PB < PC+t Home still

imports only from B• Country C plays no role

PC

PB+t

PC+t

a b c d

WelfareSuppliers lose –aDemanders gain +(a+b+c+d)Government loses –cCountry gains +(b+d)

Same as Free TradeD1S1 D0


7

PS

Paut

PB

D

QS0 D0M0

PC

PB+t

PC+t

a b c d

D1D1

Trade Creation

FTA with low-cost country, B


FTA with high-cost country, C

8

PS

Paut

PB

D

QS0 M0

FTA with C• Since PC < PB+t Home now

imports only from C

PC

PB+t

PC+t

a b c d

WelfareSuppliers lose –a

Demanders gain +(a+b+c+d)

Government loses –(c+e)Country loses –e+(b+d)

Not same as Free Tradeand may be a loss, if

e>(b+d)

e

S1 D1D0


9

PS

Paut

PB

D

QS0 M0

PC

PB+t

PC+t

a b c d

e

S1 D1D0

Trade Creation

Trade Diversion

FTA with high-cost country, C


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”• Assume that FTA removes this cost through

– Harmonization of standards– Mutual recognition

• 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: Overview10


Service FTA with low-cost, B

11

PS

Paut

PB

D

QS0 M0

FTA with B• Since PB < PC+s Home still

imports only from B• Country C plays no role

PC

PB+s

PC+s

a b c d

WelfareSuppliers lose –aDemanders gain +(a+b+c+d)Government loses 0Country gains +(b+c+d)

D1S1 D0


12

PS

Paut

PB

D

QS0 M0

FTA with C• Since PC < PB+s Home now

imports only from C

PCa b c d

WelfareSuppliers lose –aDemanders gain +(a+b+c+d)Government loses 0Country gains +(b+c+d)

Certain gain, but not as large as with country B

e

S1 D1D0

PC+s

PB+s

Service FTA with high-cost, C


Upward-sloping Supplies3-country case*

13

• Three countries, importer A, and exporters B, and C

• Export supply and import demands are linear• Countries B and C are identical• Two equilibria

– 0: MFN specific tariff t on exports of both B and C– 1: FTA of A and B:

• tariff t on exports of C; • zero tariff on exports of B

For

simplicity

*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.


14

P

!" = !$

Q

Export Supplies of B and C

Q

Exports to Country A

%"&, %$& P %"& + %$&

%") + %$&

*

Export Supplies

%"), %$)


15

P

!"#, !%#

Q Q

Import Market

!"&, !%& P

'(

!)" = !)% ')( = !)" +!)%

MFN Equilibrium

," = ,%-

!"& + !%&

!"# + !%&.)(

Export Supplies


16

P

Q Q

!"#, !%# P

&'

!("= !(%

!*%

FTA Equilibrium

!*" &(' &*'

+" = +%,

!"# + !%#

!". + !%#/('/*'

!"., !%.

Export Supplies Import Market


17

Trade Creation and Diversion

P

Q Q

!"#, !%# P

&'

!(" &)' &('

*" =*%

,

!"# + !%#

!". + !%#!"., !%.

/)'/('

TD TC


!)"= !)%

!(%


18

TC & TD, another View

!"

Q Q

#$%, #'%

("

#)$ (*" ()"

+

#$% + #'%

#$- + #'%#$-, #'-

!*"!)"

TD TCTDTC


#*$= #*'

#)'2$ =2'

!"


19

Welfare Effects on Country A

Q

Export Supplies

Q

!"#, !%#

&'

!(" &)' &('

Tariff revenue lost fromB C

Net gain of A’s private sector

*

!"# + !%#

!", + !%#!",, !%,

-)'-('

TD TCTDTC

Import Market

!)"= !)%

!(%

-' -'

2"= 2%

See immediately that country A• Gains from trade creation• Loses from trade diversion• As well as from lost revenue from country B


20

Welfare Effects on Countries B and C

Q Q

!"#, !%#

&'

!(" &)' &('

*

!"# + !%#

!", + !%#!",, !%,

-)'-('

TD TCTDTC


!)"= !)%

!(%

Gain by partner country B

Loss by outside country C

-' -'

2"= 2%


21

Welfare Effects on the World

These add up, with much cancellation to yield the following:

Q Q

!"#, !%#

&'

!(" &)' &('

*

!"# + !%#

!", + !%#!",, !%,

-)'-('

TD TCTDTC


!)"= !)%

!(%

-' -'

2"= 2%


22



Q Q

!"#, !%#

&'

!(" &)' &('

*

!"# + !%#

!", + !%#!",, !%,

-)'-('

TD TCTDTC


!)"= !)%

!(%

-' -'

2"= 2%


23



Q Q

!"#, !%#

&'

!(" &)' &('

*

!"# + !%#

!", + !%#!",, !%,

-)'-('

TD TCTDTC


!)"= !)%

!(%

-' -'

2"= 2%


24



Q Q

!"#, !%#

&'

!(" &)' &('

*

!"# + !%#

!", + !%#!",, !%,

-)'-('

TD TCTDTC


!)"= !)%

!(%

-' -'

2"= 2%


25



Q Q

!"#, !%#

&'

!(" &)' &('

*

!"# + !%#

!", + !%#!",, !%,

-)'-('

TD TCTDTC


!)"= !)%

!(%

-' -'

2"= 2%

=


26



Q Q

!"#, !%#

&'

!(" &)' &('

*

!"# + !%#

!", + !%#!",, !%,

-)'-('

TD TCTDTC


!)"= !)%

!(%

-' -'

2"= 2%


27



Q Q

!"#, !%#

&'

!(" &)' &('

*

!"# + !%#

!", + !%#!",, !%,

-)'-('

TD TCTDTC


!)"= !)%

!(%

-' -'

2"= 2%


28


Q Q

!"#, !%#

&'

!(" &)' &('

*

!"# + !%#

!", + !%#!",, !%,

-)'-('

TD TCTDTC


!)"= !)%

!(%

Loss from trade diversion

Gain from trade creation

-' -'

2" =2%


29

Q Q

!"#, !%#

&'

!(" &)' &('

*

!"# + !%#

!", + !%#!",, !%,

-)'-('

TD TCTDTC


!)"= !)%

!(%

Why the Loss from Trade Diversion

C’s fall in cost

B’s rise in cost

-' -'

2" =2%


30


Q Q

!"#, !%#

&'

!(" &)' &('

*

!"# + !%#

!", + !%#!",, !%,

-)'-('

TD TCTDTC


!)"= !)%

!(%

Loss from trade diversion

Gain from trade creation

-' -'

2" =2%

• Loss is an area, product of the price change and the quantity of trade diversion, with the latter depending on the former.

• So the loss rises with the square of trade diversion.


Four-Country Model in Equations

31

• Four countries: – Importer A– Exporters B, C, and D

• Export supply and import demands are linear• Three equilibria

– 0: MFN tariff t on exports of B, C, and D– 1: FTA of A and D:

• Tariff t on exports of B and C; • Zero tariff on exports of D

– 2: FTA of A with B, keeping FTA with D• Tariff t on exports of C only• Zero tariff on exports of B and D

• Consider only cases with !" > 0, & = (, ), *


The Model

32

Exports:

Imports:

Equilibrium:

!" = $" %" − '" , ) = *, +, ,, %" ≥ '"

./ = $/ '/ − %/ , %/ ≤ '/

./ = !1 + !3 + !4


The Model

33

Let:

Then solution is:!" = $ + &'(' + &)() + &*(*

+ = ," + ,' + ,) + ,*

$ = &"-" + &'-' + &)-) + &*-*&. = ⁄,. +


The Model

34

• With more assumptions, !" are proportional to country size– (See paper)

• Therefore #" is country i’s share of world economy– (This is not really right, as it assumes both

demanders and suppliers in proportion to population. Exporters will in fact have more firms, and thus greater weight, than importers.)


The Model

35

Effect of new FTA between A and B (in presence of A’s FTA with D)

Let ∆ be change from equilibrium 1 to equilibrium 2

Thus price in A falls by a fraction of the tariff, in proportion to size of new partner compared to world.

Country B’s price rises by the rest of the tariff

Because A’s tariff on C and D does not change

∆"# = −&'(

∆"' = (1 − &')(

∆", = ∆"- = ∆"# = −&'(


The Model

36

From the price changes, one derives the following changes in quantities of trade:

∆"#= %&'#( > 0∆+&= %& '# + '- + ./ ( > 0

∆+-= −%&'1( < 0

∆+/= −%&'3( < 0


The Model

37

As must be from market equilibrium

Thus the added exports of the partner country include the new imports of country A plus the reduced exports of countries C and D. The latter trade may be said to be “diverted,” but we label

and

because it is reversal of trade diversion from the prior FTA.

∆"#= ∆%& − ∆"( −∆")

−∆"( as “trade diversion”

−∆") as “trade reversion”


The Model

38

Thus

!"#$% &"%#'()* = !& = ,-./' > 0

!"#$% 2%3%"4()* = !2 = ,-.5' > 0

!"#$% 6(3%"4()* = !6 = ,-.7' > 0


The Model

39

Welfare effects of new FTA

Country A (home):

Country B (new partner):

Country C (outside world):

Country D (old partner):

∆"#= ⁄&'# (# + *+ ⁄, 2 ./ − ,.1 − ,2'+

∆"+= ∆34+= 2'+ +12 ./ + .1 + .6 1 − *+ ,

∆"7= −2'7 +.12 *+,

∆"8= −2'8 +.62 *+,

Lost tariff revenue


The Model

40

Welfare effects of new FTA on the World

World (A+B+C+D):

∆"#= 12'() +

12 '+ − '- )


4-country case in figures

41

• Three countries, importer A, and exporters B, C, and D

• Export supply and import demands are linear

• Countries B, C, and D are identical

• Two equilibria

– 1: MFN tariff t on exports of both B and C• Zero tariff on exports of old FTA partner D

– 2: New FTA of A and B:

• tariff t on exports of C only;

• zero tariff on exports of two FTA partners B and D

For simplicity


42

P

!" =!$ =!% Q

Export Supplies of B, C, and D

Q

Export Supplies to Country B

&"', &$', &%' P

∑&* = &"* + &$* +&%*,

Export Supplies

∑&- = &"* + &$' +&%*

∑&. = &"' + &$' +&%*

/" = /$ = /%

∑&0 = &"' + &$' +&%'&"*, &$*, &%*


43

P

Q


Q

!"#, !%#, !&# P

Equilibrium 1: A has FTA with 1 country, D

∑!(

∑!)*+

!("= !(%

!(& *(+

= !(" +!(% + !(&

!"., !%., !&.

/

Import Market


44

P

Q


Q

!"#, !%#, !&# P ∑!(

∑!)*+

!("= !(%

!(& *(+

Equilibrium 2: A has FTA with 2 countries, B & D

!)% !)"= !)&

*)+

!"-, !%-, !&-

.

Import Market


45

P

Q


Q

!"#, !%#, !&# P ∑!(

∑!)*+

!("= !(%

!(& *(+

Changes in Trade from expanding FTA to Country B

!)% !)"= !)&

∆*+∆!% ∆!&

*)+

!"., !%., !&.

/

Import Market

∆!"


Trade Creation

46

P

Q


Q

!"#, !%#, !&# P ∑!(

∑!)*+

∆!" ∆*+∆!% ∆!&TD TR TC

Trade Creation (TC), Diversion (TD), and Reversion (TR)

!"1, !%1, !&1

2

Import Market

Trade CreationTrade Diversion Trade Reversion


47

P

Q


Q

!"#, !%#, !&# P ∑!(

∑!)*+

Trade Creation (TC), Diversion (TD), and Reversion (TR)

∆!" ∆*+∆!% ∆!&

TRTDTCNote that ∆!", while a gain to Country B, is the sum of TC, TD, & TR, since ∆!"= ∆*+ − ∆!% − ∆!&

!"2, !%2, !&2

3

Import Market

TD TR TC


48

P


Q

!"#, !%#, !&# P ∑!(

∑!)*+

Welfare Effects on Country ATariff

revenue lost from

B CNet gain of A’s private sector

Note that trade reversion does not appear to affect A’s welfare. I suspect this is an artifact of making export supplies from B and D the same.

!",, !%,, !&,

-

Import Market

Q

∆!" ∆*+∆!% ∆!&

∆!&TR

∆!%TD∆*+

TC

TR TCTD


49

P


Q

!"#, !%#, !&# P ∑!(

∑!)*+

Welfare Effect on Country B

!",, !%,, !&,Net gain of B’s private sector

-

Import Market

QTRTDTC

TR TCTD


50

P


Q

!"#, !%#, !&# P ∑!(

∑!)*+

Welfare Effect on Country C

Net loss of C’s private sector

!",, !%,, !&,

-

Import Market

QTRTDTC

TR TCTD


51

P


Q

!"#, !%#, !&# P ∑!(

∑!)*+

Welfare Effect on Country D

!",, !%,, !&,Net loss of D’s private sector

-

Import Market

QTRTDTC

TR TCTD


52

P


Q

!"#, !%#, !&# P ∑!(

∑!)*+

Welfare Effects on World

!",, !%,, !&,

-

Import Market

QTRTDTC

TR TCTD

I claim that these gains and losses mostly cancel out to reduce to the following:


53

P


Q

!"#, !%#, !&# P ∑!(

∑!)*+

Welfare Effect on World

!",, !%,, !&,

-

Import Market

QTRTDTC

TR TCTD


54

P


Q

!"#, !%#, !&# P ∑!(

∑!)*+


!",, !%,, !&,

-

Import Market

QTRTDTC

TR TCTD


55

P


Q

!"#, !%#, !&# P ∑!(

∑!)*+


!",, !%,, !&,

-

Import Market

QTRTDTC

TR TCTD


56

P


Q

!"#, !%#, !&# P ∑!(

∑!)*+


!",, !%,, !&,

-

Import Market

QTRTDTC

TR TCTD


57

P


Q

!"#, !%#, !&# P ∑!(

∑!)*+


!",, !%,, !&,

-

Import Market

QTRTDTC

TR TCTD


58

P


Q

!"#, !%#, !&# P ∑!(

∑!)*+


!",, !%,, !&,

-

Import Market

QTRTDTC

TR TCTD


59

P


Q

!"#, !%#, !&# P ∑!(

∑!)*+


!",, !%,, !&,

-

Import Market

QTRTDTC

TR TCTD


60

P


Q

!"#, !%#, !&# P ∑!(

∑!)*+


!",, !%,, !&,

-

Import Market

QTRTDTC

TR TCTD


61

P


Q

!"#, !%#, !&# P ∑!(

∑!)*+


!(" !(% !(&!",, !%,, !&,

-

Import Market

QTRTDTC

TR TCTD

!("= !(%

!(&


62

P


Q

!"#, !%#, !&# P ∑!(

∑!)*+


!(" !(% !(&!",, !%,, !&,

-

Import Market

QTRTDTC

TR TCTD

!("= !(%

!(&


63

P


Q

!"#, !%#, !&# P ∑!(

∑!)*+


!",, !%,, !&,

-

Import Market

QTRTDTC

TR TCTD

!("= !(%

!(&!(" !(% !(&


64

P


Q

!"#, !%#, !&# P ∑!(

∑!)*+


!",, !%,, !&,

-

Import Market

QTRTDTC

TR TCTD


65

P


Q

!"#, !%#, !&# P ∑!(

∑!)*+


!",, !%,, !&,

-

Import Market

QTRTDTC

TR TCTD


66

P


Q

!"#, !%#, !&# P ∑!(

∑!)*+


!",, !%,, !&,

-

Import Market

QTRTDTC

TR TCTD


67

P


Q

!"#, !%#, !&# P ∑!(

∑!)*+


!",, !%,, !&,

-

Import Market

QTRTDTC

TR TCTD


68

P


Q

!"#, !%#, !&# P ∑!(

∑!)*+


!",, !%,, !&,

-

Import Market

QTRTDTC

TR TCTD


69

P


Q

!"#, !%#, !&# P ∑!(

∑!)*+


!",, !%,, !&,

-

Import Market

QTRTDTC

TR TCTD


70

P


Q

!"#, !%#, !&# P ∑!(

∑!)*+


!",, !%,, !&,

-

Import Market

QTRTDTC

TR TCTD


4-country case

71

• Result:– World welfare rises with second FTA, by amount

depending on trade creation and the tariff• Recall from model:

• Here, because we’ve assumed countries B and D are the same, TR=TD

∆"#= 12'() +

12 '+ − '- )

∆"#= 12'()


4-country case

72

• In general, !" ≠ !$• Which is larger depends just on country size, size

both face the same price change.

• If the new partner is smaller than the old, !" > !$ , and world gain will be larger

• If new partner is bigger than old, then !" < !$and world gain will be smaller and perhaps a loss.

∆45= 12!9: +

12 !" − !$ :


Conclusion

• Analysis of FTAs shouldn’t treat each independently of FTAs that already exist

• Sequencing of FTAs can matter.

73

Documents

The Simple Analytics of Trade Creation and Diversionalandear/courses/541/slides/FTAs - TCTD… · trade diversion Gain from trade creation-'-' 2"= 2% •Loss is an area, product of