Free Trade Agreement: Case of US-Australia Free Trade Agreement (AUSFTA)

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1 ree Trade Agreement: Case of US-Australia ree Trade Agreement (AUSTA) Long Run: Heckesher Ohlin Model The preferential trade agreement (AUSTA) was signed between Australia and the US May 2004, and came into force on January, It is modelled on similar lines as the North American ree Trade Agreement. A free trade area is a preferential trade agreement in which the member countries trade freely with each other, but each country can maintain their own foreign trade policy with the rest of the world. However, it is observed that in most ree trade agreements, trade in few industries or products is restricted. In some cases tariffs or other barriers are not completely removed and at others some industries are off the negotiation tables. These industries are mainly the import competing industries which have a strong lobby. Here is a portion of the news report published by the The Office of the United States Trade Representative Home, reflecting the opinion of the US Government regarding the Preferential Trade Agreement. The agreement was signed by the Australian Trade Minister Mark Vaile and the US Trade Representative Robert Zoellick in May 2004

2 2 WASHINGTON - U.S. Trade Representative Robert B. Zoellick announced that the United States - Australia ree Trade Agreement (TA) entered into force today. The U.S. - Australia TA is the first TA between the United States and a developed country since the U.S. - Canada ree Trade Agreement in 988. More than 99 percent of U.S. manufactured goods exports to Australia have immediately become duty free. Manufactured goods account for 93 percent of U.S. exports to Australia... As President Bush said when he signed the agreement, the U.S. - Australia ree Trade Agreement is a milestone in the history of our alliance, said Ambassador Zoellick. This is the most significant immediate cut in industrial tariffs ever achieved in a U.S. free trade agreement, and manufacturers are the big winners. I am also pleased that U.S. workers, businesses, farmers, and consumers will now begin to enjoy the wide-ranging benefits of this landmark agreement...by opening trade in goods and services; eliminating barriers in the agricultural sector, investment, and government procurement; and increasing protection for intellectual property; the agreement will strengthen U.S. - Australian economic ties and has the potential to increase trade between our countries by billions of dollars....by Jerry Hagstrom, Agweek, May 24, 2004 In order to analyze this case scenario and understand its impact on various sectors in the US and Australia economy, one needs to simplify the case so that you can easily model it. ree Trade Agreement between US and Australia can be thought of in the context of Hecksher Ohlin model, and we can analyze the implication of this agreement on welfare in the US. Model Two Countries: US and Australia Two Goods: Manufacturing Sector and Agriculture Sector actor of Production: Labor (L) and Land (T) To keep the model simple - we ll assume that two countries have the same demand function. (RD) However, Australia has more Land/Labor ratio than the US. and we can analyze the implication of this agreement on welfare in the US or Australia. ree Trade Agreement can be depicted as two closed countries opening to trade with each other. 3 Since Australia has a comparative advantage in producing agriculture goods. (given Australia has relatively more land; since labor is assumed to be the same across two 3 Instead of moving from autarky (prohibited tariff - zero trade) to free trade. In a TA the two countries move from high level of trade restrictions (high tariff and other non-tariff barriers) to relatively more free trade.

3 p p M RS AUS RS average RS US RD Q Q M.Relative Supply Curves for Australia and the USA countries). The Relative supply graphs for the US, RS US, lies to the right of the relative supply graph for Australia RS AUS. Relative demand faced by the two countries is the same. Thus before free trade relative price of manufactured good P M P would be higher in Australia and relative price of agriculture goods (food) P P M would be higher in the US. After the ree Trade Agreement (TA) between US and Australia, the relevant relative supply curve would be a function of RS AUS and RS US. RS average is the relative supply curve faced by the two countries after TA. US after the TA: Relative price of manufacturing good would increase ( P M P increase )after the TA and relative price of agriculture or food would decrease ( P f P M decline). Let s see how the two industries would react to this price change. The following diagram depicting the relationship between w/r, T/L and relative prices would give insights into the behavior of the two industries. As P M P increases the relative wage would increase, (w/r would increase ) from w/r to w/r 2. As labor becomes relatively more expensive both industries would substitute away from labor towards land. As a result both the manufacturing (cloth) sector and

4 SS w/ r CC 2 ( w/ r) ( w/ r) PC/ P 2 ( P / P ) ( P / P ) C C ( T / L ) ( T / L ) 2 T / L 2.Wage and Price Effects of the TA the food sector would become more land intensive; that is the T/L ratio would increase (from (T/L) to (T/L) 2 )as w/r increases in the economy. In order to understand what happens to the landowners and the laborers in the US. We need to analyze the impact on the real wages (w/p M,w/P ) and real rents (r/p M,r/P ). Let s take the case of landowners (farmers in our case). Given that there is perfect competition, we can use the zero profit condition here. Value of Marginal Product for labor in the food sector= wage where Value of Marginal Product for labor = Price in the food sector * Marginal Product of labor in the food sector, P MPL = W ; MPL = w/p and marginal product of labor is a function of T/L. As T/L increases Marginal Product for labor increases as labor has more land to work with. MPL (T/L)=w/P With increase in T/L ratio MPL increases. given MPL = w/p this would imply that w/p also increases.

5 MPL (T/L ) = w/p P m MPL M = W ; MPL m = w/p M WASHINGTON - U.S. and Australian officials signed a free trade agreement last week that may - or may not - result in a confrontation between American manufacturing and agriculture and even between American economic and security interests. U.S. manufacturers desperately want this agreement because it would remove all Australian tariffs on 99 percent of U.S. manufactured goods But most American farm groups and agribusinesses are not supporting it, although for opposite reasons. The farm groups don t like the U.S.-Australian agreement because it reduces tariffs and other restrictions on most Australian commodities coming into the United States and is likely to result in increased imports of beef, lamb and dairy products.. Of the farm groups, the National armers Union and R-CAL USA, a cattle group, have taken positions in direct opposition to the agreement. The National Cattlemen s Beef Association s executive committee has issued a statement that, We oppose any Australian free trade agreement that does not include adequate safeguards. Greg Doud, the NCBA s chief economist, added, We re sure not going to the Hill and lobby for it...

Prepared by Iordanis Petsas To Accompany. by Paul R. Krugman and Maurice Obstfeld

Chapter 4 Resources and Trade: The Heckscher-Ohlin Model Prepared by Iordanis Petsas To Accompany International Economics: Theory and Policy, Sixth Edition by Paul R. Krugman and Maurice Obstfeld Chapter