Gains from trade and preferential trading areas. 2 Gains from non-discriminatory trade

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1 Gains from trade and preferential trading areas Giorgio Basevi Class notes for the course on"international Economic Policy" Università di Bologna academic year (second semester) April 23, Introduction This chapter is based on chapter 6 of Feenstra(2004), which is here summarized, with minor additions and no specific quotations. In this chapter we further explore the gains from trade. The motivation is that, even whenacountry gains from trade, there might be "winners" and "losers" within it, and we want to identify them. Moreover, when there is preferential or discriminatory trade among countries, we also need to study when a country gains or loses from being, or not being, a member of a preferential trade area (PTA). Finally, in comparing such alternative trading equilibria, we should also study how losers could, if at all, be compensated on the basis of those who gain. 2 Gains from non-discriminatory trade 2.1 Comparing autarky with free trade: lump sum transfers Consider individual consumers indexed by h = 1,...,H. Individual h has the increasing and quasi-convave utility function u h (c h,v h ) wherec h isthen-dimensionalvectorofgoodsconsumption, 1 andv h isthemdimensional vector of factor supplies. Under autarky each consumer maximizes utility subject to the budget constraint p a c ha w a v ha (6.1) 1 Vectorsare here indicatedwith small case letters, withoutbold character. 1

2 wherep a istheautarkyvector 2 ofgoodsprices,andw a istheautarkyvectorof factor prices. The resulting utility for each consumer is u h (c ha,v ha ) Summing consumption and factor supplies over all H consumers, the vector of totaloutputsy a intheeconomyis c ha =y a andthevectoroftotalfactorinputsis v ha =v a Assume that technology is subject to costant returns to scale. Then profits in the economy are zero: p a y a w a v a =0 Consider now a free trade equilibrium with a system of lump sum taxes ortransfersfromthe Governmenttoeachindividual. LetR h beatransferto individualhifr h >0, andalumpsumtaxonindividualhifr h <0. Then the total revenue collected by the Government must be: R h 0 Denote the equilibrium goods and factors prices under free trade by(p, w). For each individual h the budget constraint is pc h wv h +R h (6.2) We want to choose a pattern of transfers/taxes that allows each and all individualstobeaswelloffastheywereunderautarky. Considerthefollowingtype of individual transfers/taxes: R h =(p p a )c ha (w w a )v ha (6.3) Thegoalofthistransfersystemistoensurethatallindividualscanstillafford their autarky choices (c ha,v ha ). To check for this, substitute these autarky choicesinto(6.2)andmakeuseof(6.3): pc ha wv ha +R h =wv ha +(p p a )c ha (w w a )v ha = (p p a )c ha +w a v ha (6.4) 2 For simplicity, we do not indicate column vectors with an apostrophe, in which case we should write: p a c ha w a v ha 2

3 Noticethat0 pc ha sothat(6.4)implies Notice also that 0 pc ha (p p a )c ha +w a v ha (6.5) p a c ha w a v ha p a c ha w a v ha (6.6) 0 pc ha (p p a )c ha +w a v ha Thus,if(6.6)holdsthen(6.4)holdsaswell. Ontheotherhand,wehaveshown in(6.5)that,if(6.4)holds,then(6.6)holdsaswell. Thuswehaveshownthat pc ha wv ha +(p p a )c ha (w w a )v ha p a c ha w a v ha Since the second inequality above is the individual s autarky budget constraint, it must be satisfied. Hencetheautarkychoices (c ha,v ha )arefeasibleforthebudgetconstraintin (6.2)andwithtransferssetasin(6.3). LetusnowconsiderthetotalGovernmentrevenuetobesetasfollows: R h = (p a p) c ha (w a w) v ha = (p a p)y a (w a w)v a (6.7) = (p a y a w a v a ) (py a wv a ) = (py a wv a ) (py wv)=0 Noticethatthesecondlinefollowsbyusing cha =y a andthefourthline followsbecauseautarkyprofitsp a y a w a v a arezero. Theexpression(py a wv a ) in the fourth line must be negative, because it represents the value of profits underfreetradepricesbutatthesuboptimalautarkypoint(y a,v a );hencethe final line is established. Thus this transfers and tax system is feasible, because the Government revenue is non-negative: the lump sum taxes collected from those gaining from trade aremorethanenoughtocoverthesubsidiestothoseharmedbytrade. The gains are of two sorts: (a) consumption gains, (b) efficiency or production gains. These are shown in Fig.1 in the 2-products space: consumption gainscorrespondtothemovementfromd 0 tod 1 0,andefficiencygainsfromD1 0 tod Taxes and subsidies on goods Letusallowthepricesofgoodsandfactorstomovetotheirfree-tradelevelsfor producers,butholdthemfixedattheirautarkylevelforconsumers. Letusset thevectorofconsumerstaxesongoodsat(p a p)andthevectorofconsumers 3

4 Figure 1: 4

5 subsidiesonfactorsat(w a w). Theconsumersthusfacetheprices(p a,w a ), sothattheymakethesamedecisionasinautarkyandachievetheutilitylevel u h (c ha,v ha ). TheGovernmentcollectsthefollowingrevenue: (p a p) c ha (w a w) v ha =(p a p)y a (w a w)v a (6.8) which is identical to (6.7) and therefore non-negative, and is strictly positive whenever there are efficiency gains from having producers face free-trade rather than autarky prices. Thus the Government is able to redistribute its revenue back to consumers as a"poll subsidy", and consumers receive more than their autarky utility level. 2.3 Comparing two alternative trade equilibria: higher vs lower tariff and subsidies Let the domestic price vector for consumers and producers be p=p +t where t i > 0 for an imported good i indicates a tariff, 3 whereas t i < 0 for an imported good i indicates a subsidy. t i > 0 for an exported good i indicates a subsidy, whereas t i < 0 for an exported good i indicates a tax. Thus the total revenue collected by the Government from the trade tax/subsidies is t( c h y h )=t(c y) tm h,1=h wherem c yistheimport/exportvector. Wecomparetwodifferenttrade tax/subsidiesvectors: t 0, t 1. Generally in the two alternatives the world prices will be different, as they are endogenous to the two alternative equilibria. In the initial situation individual consumers maximize utility subject to their budget constraints, inclusive of redistribution of tariff revenue by the Government to the consumers: p 0 c h0 w 0 v h0 + t0 m 0 (6.9) H Theresultingutilityforeachconsumerisu h (c h0,v h0 ). After the tariff reform, domestic prices change to p 1 = p 1 +t 1 and the revenuecollectedbythegovernmentchangesfromt 0 m 0 tot 1 m 1. Wedenotethe transfertoeachconsumerbyr h,whichmaydifferfromtherevenue(t 1 m 1 )/H. The budget constraint for the individual consumers is p 1 c h w 1 v h +R h (6.10) 3 Note thattindicatesthe tariff per unit quantity of the good,asdoes the price. In other words,itisexpressedasa"specific" amountratherthan an "ad valorem" rate. 5

6 Theorem 1 (Grinols and Wong 1991) Suppose that, when the prices change from p 0 = p 0 +t 0 to p 1 = p 1 +t 1, the Government transfers the following amount to each individual: Provided that R h =(p 1 p 0 )c h0 (w 1 w 0 )v h0 + t0 m 0 (p 0 p 1 )m 0 +t 1 (m 1 m 0 ) 0 H (6.11) no individual is worse off and the Government budget is balanced. Proof. Substituting the transfers in (6.11) into the individual s budget constraint(6.10)wecanconfirmthattheinitialchoices(c h0,v h0 )arestillfeasible. In fact: p 1 c h0 w 1 v h0 +(p 1 p 0 )c h0 (w 1 w 0 )v h0 +(t 0 m 0 )/H p 0 c h0 w 0 v h0 +(t 0 m 0 )/H (6.12) Since the second equation in (6.12) is the initial budget constraint (6.9), the initialchoices(c h0,v h0 )arefeasibleandutilityisatleastu h (c h0,v h0 ). Tocheck the Government budget, we subtract the transfers from the tariff revenue: t 1 m 1 R h = t 1 m 1 (p 1 p 0 ) c h0 +(w 1 w 0 ) v h0 t 0 m 0 = t 1 m 1 t 0 m 0 +(p 0 p 1 )c 0 (w 0 w 1 )v 0 = t 1 m 1 t 0 m 0 +(p 0 p 1 )y 0 +(p 0 p 1 )m 0 (w 0 w 1 )v 0 = t 1 (m 1 m 0 )+(t 1 t 0 )m 0 +(p 0 y 0 w 0 v 0 ) (p 1 y 0 w 1 v 0 )+(p 0 p 1 )m 0 = t 1 (m 1 m 0 )+(t 1 t 0 +p 0 p 1 )m 0 +(p 0 y 0 w 0 v 0 ) (p 1 y 0 w 1 v 0 ) = t 1 (m 1 m 0 )+(p 0 p 1 )m 0 +(p 0 y 0 w 0 v 0 ) (p 1 y 0 w 1 v 0 ) (p 0 p 1 )m 0 +t 1 (m 1 m 0 ) (6.13) where the last equation holds because initial profits are and p 0 y 0 w 0 v 0 =0 p 1 y 0 w 1 v 0 <p 1 y 1 w 1 v 1 =0 Provided that the last line is non-negative, the Government budget is nonnegative too. Noticethattherearetwotermsinthelastlineof(6.13),thatsummarizethe welfare impact of tariff reforms. The first measures the terms of trade effect (p 0 p 1 )m 0 whichindicatestheimpactofthereformonthetermsoftrade. Ifthepricesof imports increase, or the prices of exports decrease, the first term can be negative and gains cannot be assured. 6

7 The second term measures the efficiency effect. In fact t 1 (m 1 m 0 ) measures the change in tariff revenue, or the change in imports evaluated at the final tariff vector. The tariff vector reflects the difference between domestic and international prices: a positive value indicates that marginal costs at home exceed international prices, so that it would be more efficient for the country to importthegood;andifthevalueisnegative,thecountryshouldbeexporting thegood. Thereforethetermt 1 (m 1 m 0 )givesameasureoftheefficiencygain (if positive) due to attracting imports towards protected sectors. Thus policies to raise welfare must avoid adverse terms of trade effects or efficiency effects to ensure Pareto gains. Two special cases of the above theorem are considered in the following corollary. Corollary 2 If transfers are applied to individuals as in(6.11),then: (a) starting in autarky and moving to trade with tariffs and subsidies makes nooneworseoff,providedthatt 1 m 1 0 (b) for a small country with constant world prices, p 0 =p 1, a change in tariffsandsubsidiesmakesnooneworseoff,providedthatt 1 (m 1 m 0 ) 0. Incase(a)wesetm 0 =0inTheorem1andseethatthecriteriontoachieve Pareto gains is just t 1 m 1 0. This case indicates that "some trade is better than no trade". Moreover, if we suppose that situation 1 corresponds to free trade,sothatt 1 =0,thentheconditionin(a)issatisfied,indicatingthat"free trade is better than, or at least equivalent to, autarky". Case(b)showsthatforasmallcountryatariffreformwillraisewelfare,or at least not reduce it, provided that the efficiency effects are non-negative. If wesupposethatsituation1correspondstofreetrade,sothatt 1 =0,thenthe condition in(b) is satisfied, indicating that"free trade is better than restricted trade for a small country". 3 Preferential trade agreements 3.1 Free trade and the GATT-WTO rules The basic way through which the GATT-WTO rules aim at reaching generalized free trade, or at least try to enforce non discriminatory reductions of trade barriers by multilateral negotiations, is enshrined in the"most favoured nation clause"(mfnc).thisiscontainedinparti,article1,ofthegatt: 4 General Most-Favoured-Nation Treatment 1. With respect to customs duties and charges of any kind imposed on or in connection with importation or exportation or 4 See the WTO website at: 7

8 imposed on the international transfer of payments for imports or exports,andwithrespecttothemethodoflevyingsuchdutiesand charges, and with respect to all rules and formalities in connection with importation and exportation[...], any advantage, favour, privilege or immunity granted by any contracting party to any product originating in or destined for any other country shall be accorded immediately and unconditionally to the like product originating in or destined for the territories of all other contracting parties. In exception to this general rule for multilateral and non discriminatory trade, the GATT-WTO rules allow the formation of customs unions and free trade areas. This has opened the way to the formation of many and diverse regionaltradeagreements(rtas) 5 orpreferentialtradingagreements(ptas). 6 The exception to the general rule is granted on the basis of Part III, Article XXIVoftheGATT, 7 inparticularitsfollowingparagraphs: 4. The contracting parties recognize the desirability of increasing freedom of trade by the development, through voluntary agreements, of closer integration between the economies of the countries parties to such agreements. They also recognize that the purpose of a customs union or of a free-trade area should be to facilitate trade between the constituent territories and not to raise barriers to the trade of other contracting parties with such territories. 5. Accordingly, the provisions of this Agreement shall not prevent, as between the territories of contracting parties, the formation ofacustomsunionorofafree-tradeareaortheadoptionofaninterim agreement necessary for the formation of a customs union or of a free-trade area; provided that: (a) with respect to a customs union, or an interim agreement leading to a formation of a customs union, the duties and other regulations of commerce imposed at the institution of any such union or interim agreement in respect of trade with contracting parties not parties to such union or agreement shall not on the whole be higher or more restrictive than the general incidence of the duties and regulations of commerce applicable in the constituent territories priortotheformationofsuchunionortheadoptionofsuchinterim agreement,asthecasemaybe; (b) with respect to a free-trade area, or an interim agreement leading to the formation of a free-trade area, the duties and other regulations of commerce maintained in each of the constituent territories and applicable at the formation of such free trade area or the adoption of such interim agreement to the trade of contracting parties not includedin such areaor not parties to suchagreement 5 SeetheWTOwebpageat: 6 SeeBasevi,Calzolari,Ottaviano(2003): 7 SeetheWTOwebsiteat: 8

9 shall not be higher or more restrictive than the corresponding duties and other regulations of commerce existing in the same constituent territories prior to the formation of the free-trade area, or interim agreementasthecasemaybe;and (c) any interim agreement referred to in subparagraphs(a) and (b) shall include a plan and schedule for the formation of such a customs union or of such a free-trade area within a reasonable length of time. 3.2 Partial equilibrium analysis We assume that the reader is familiar with the standard argument originally due to Viner(1950) and Meade(1955) against the fallacy that regional trade liberalization implies a movement towards free trade and therefore it necessarily improves efficiency and economic welfare. A standard textbook treatment can be found in Baldwin and Wyplosz(2004). 3.3 General equilibrium analysis Consideracustomsunionandletusindexgoodsbytheirregionoforiginand their region of destination. We have four subsets of goods: a)thefirstn CC goodsdenotethoseproducedintheunionandsenttothe union; b)thesecondn WW goodsdenotethosethatareproducedoutsidetheunion and sent outside the union; c) the third N CW goods denote those that are produced in the union and sent outside the union; d)thefourthn WC goodsdenotethosethatareproducedoutsidetheunion andsentintotheunion. Only the goods under (c) and (d) involve trade between the union and the outside world. For a country member of the union the first N CC tariffs are zero, the second N WW tariffs are irrelevant, and the last N CW and N WC import/export tariffs 8 are equalized for all countries in the union, say at the tariffvectort 1. Noticethatwithzerotariffsoncountrieswithintheunion,thetermt 1 (m i1 m i0 )of(6.13)measuresthechangeintariffrevenueforcountryiimportsfrom outside the union. "Trade diversion" means that a country i switches from the lowest-price supplier from outside the union(whence tariff revenue is collected) to another supplier within the union(whence no tariff revenue is collected), so thatt 1 (m i1 m i0 )<0. Therefore, asaconsequenceoftheorem1, countryi canbeworseoff. 8 The "tariff" vector t contains elements that are import duties or export subsidies, depending on whether the elements of the"import" vector m are positive(imports) or negative (exports). 9

10 3.3.1 A rule for welfare improving customs union We search for a rule such that a customs union benefits its members without harmingtherestoftheworld. Todoso,thecustomsunionshouldnotaffectthe world price p, or equivalenty, should keep the purchases from the rest of the world x fixed. ThisismorestringentthantherulecontainedinArticleXXIV of the GATT-WTO, specifically at paragraph 5(a) quoted above. Letusdenotethecountriesintheunionbyi=1,...,C. Priortotheunion they have tariffs t i0. Let p 0 denote world prices in this equilibrium and m i0 denote the import vector of country i in the pre-union equilibrium. Let the net exportvectoroftherestoftheworld 9 bedenotedbyx (p 0 ). Noticethatthis vectoriszerobydefinitionforthefirstn CC +N WW goods,andpotentiallyzero otherwise. Summing imports over all countries in the union, the equilibrium condition prior to the union is m i0 =x (p 0 ) (6.14) i=1,c After the customs union is formed, the member countries have a unified tariff t 1, the elements of which are zero for purchases from member countries. Let m i1 denotethevectorofimportsofcountryiinthissituation. Thenitcanbe shown 10 thatthereexistsaunifiedtarifft 1 suchthat m i1 =x (p 0 ) (6.15) i=1,c The fact that the prices p 0 and aggregate exports from the rest of the world x (p 0 )areunchangedduetothecustomsunionguaranteesthattherestofthe worldisnotaffectedbyit. Thequestionnowis(a)whetherthemembersofthe customs unions also gain, and(b) whether this requires some transfers between the member countries. This question is answered by the following theorem: Theorem3 (Kemp and Wan 1976) Let the countries i = 1,...,C form a customs union, with a common external tariff such that prices and the total purchases by the customs union from the rest of the world are unchanged. Suppose that each country i within the customs union receives the transfers t 1 (m i1 m i0 ) from the rest of the union. Then there is a pattern of lump sumtransferswithineachcountrysuchthatnoindividualisworseoff,andthe Government budget in each country is non-negative. Proof. Consider the transfers described in(6.11), but applied within each country. Itfollowsthatallconsumersineverycountryoftheunioncanstillafford their previous consumption bundles. Furthermore, noting that prices p from therestoftheworldarefixed,thenfrom(6.13)thegovernmentbudgetineach 9 Some countries in the rest of the world may be importing a particular good from the customs union; others may be exporting it. The net export of the rest of the world is the algebraic sum of its individual member countries trade in that particular good vis-à-vis the customs union. 10 AsinKemp and Wan (1976). 10

11 country is no less than t 1 (m i1 m i0 ). Therefore each country can afford to give up this amount (or receive it, if negative), and have a non-negative Government budget. It remains to be shown that these transfers within the union are self-financing, that is, i=1,c t1 (m i1 m i0 )=0. But this follows immediately from the fact that total union imports are equal in (6.14) and (6.15), i=1,c mi1 = i=1,c mi0. Notice that keeping total imports by the union fixed means that world prices are fixed, which eliminates any terms of trade impacts for the union and the restoftheworld. Thus,whensummedoverthecountriesoftheunion,theterm (p 0 p 1 )m 0 +t 1 (m 1 m 0 )oftheprevioustheoremiszero,sotheunionasa wholeisnotworseoff. Anindividualcountrymayexperiencealossinitsown tariffrevenueoft 1 (m i1 m i0 ),butthislosscouldbecompensatedbytransfers from other countries within the union. Notice also that the theorem requires the possibility of inter-national transfers among the countries that are members of the union, as well as intra-national transfers between the government and the individual residents of the countries thataremembersoftheunion A rule for welfare improving free trade areas The following theorem can also be proved: Theorem4 (KrishnaandPanagariya2002)Letthecountriesi=1,...,C formafreetradearea,withexternaltariffst i1 foreachcountrysuchthatprices andpurchasesfromtherestoftheworldareunchanged. Thenthereisapattern oflumpsumtransferswithineachcountrysuchthatnoindividualisworseoff, and the Government budget in each country is non-negative. Theproofofthistheoremislefttothestudent. 11 References [1] Baldwin and Wyplosz (2004), The Economics of European Integration, McGraw-Hill. [2] Basevi G., Calzolari G. Ottaviano G.(2003), Gli accordi commerciali preferenziali, in Krugman Paul R., Maurice Obstfeld, Economia internazionale, vol 1. Teoria e politica del commercio internazionale, terza edizione, Hoepli; see: [3] Feenstra R.C.(2004), Advanced International Trade. Theory and Evidence, Princeton University Press. [4] Grinols Earl L., Kar-Yiu Wong (1991), "An Exact Measure of Welfare Change" The Canadian Journal of Economics, Vol. 24, No. 2, May. 11 See Feenstra (2004),p

12 [5] Kemp, Murray C. and Henry Wan, Jr.(1976),"An Elementary Proposition Concerning the Formation of Customs Unions," Journal of International Economics, 6(February), pp [6] Krishna P., A. Panagariya (2002), "On necessarily welfare-enhancing free trade areas", Journal of International Economics, Volume 57, Issue 2, Pages (August) [7] Meade, J. (1955), The Theory of Customs Unions, Amsterdam, North- Holland. [8] Viner, J.(1950), The Customs Union Issue, Carnegie Endowment for International Peace, New York. 12