PubPol/Econ 541
Free Trade Agreements
by
Alan V. Deardorff
University of Michigan
2016
Outline*
• Simplest Model with Horizontal Foreign
Supplies
– Goods
– Services
• Model with Upward Sloping Foreign
Supplies
*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.
2
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
3
No FTA
P
• Without FTA
S
– Since PB+t < PC+t Home
imports only from B
Paut
PC+t
PB+t
PC
PB
D
S0
M
D0
Q
0
4
FTA with low-cost country, B
P
FTA with B
S
• Since PB < PC+t Home still
imports only from B
• Country C plays no role
Paut
PC+t
PB+t
PC
Welfare
a
b
c
Suppliers lose
–a
Demanders gain +(a+b+c+d)
Government loses –c
Country gains
+(b+d)
d
PB
D
S1
S0
M
0
D0 D1
Q
Same as Free Trade
5
FTA with low-cost country, B
P
S
Paut
PC+t
PB+t
PC
a
b
c
d
PB
D
D1
S0
M
D0 D1
Q
0
Trade
Creation
6
FTA with high-cost country, C
P
FTA with C
S
• Since PC < PB+t Home now
imports only from C
Paut
PC+t
Welfare
PB+t
PC
a
b
c
Suppliers lose
–a
Demanders gain +(a+b+c+d)
Government loses –(c+e)
Country loses
–e+(b+d)
d
e
PB
D
S1 S0
M
0
D0 D1
Q
Not same as Free Trade
and may be a loss, if
e>(b+d)
7
FTA with high-cost country, C
P
S
Paut
PC+t
PB+t
PC
a
b
c
d
e
PB
Trade Diversion
D
S1 S0
M
D0 D1
Q
0
Trade
Creation
8
Outline
• Simplest Model with Horizontal Foreign
Supplies
– Goods
– Services
• Model with Upward Sloping Foreign
Supplies
9
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”
• 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: Overview
10
Service FTA with low-cost, B
P
FTA with B
S
• Since PB < PC+s Home still
imports only from B
• Country C plays no role
Paut
PC+s
PB+s
PC
Welfare
a
b
c
Suppliers lose
–a
Demanders gain +(a+b+c+d)
Government loses 0
Country gains
+(b+c+d)
d
PB
D
S1
S0
M
D0 D1
Q
0
11
Service FTA with high-cost, C
P
FTA with C
S
• Since PC < PB+s Home now
imports only from C
Paut
PC+s
Welfare
PB+s
PC
a
b
c
Suppliers lose
–a
Demanders gain +(a+b+c+d)
Government loses 0
Country gains
+(b+c+d)
d
e
PB
D
S1 S0
M
0
D0 D1
Q
Certain gain, but not as
large as with country B
12
Outline
• Simplest Model with Horizontal Foreign
Supplies
– Goods
– Services
• Model with Upward Sloping Foreign
Supplies
13
Model with Upward Sloping
Supplies
• Assume
– Partial-equilibrium model of trade in a good
– 3 countries:
• Home H
• Partner P, and
• ROW, Rest of world, R
– H has import demand curve MD
– P and R have identical export supply curves, XS,
• which add to Home’s import supply MS,
• but only after adjustment for tariff
14
Model with Upward Sloping
Supplies
• Tariffs
– Without FTA, exports of both P and R are subject to MFN
specific tariff, t.
– With FTA, only country R’s exports are subject to tariff t.
• Export supplies:
– Let XSi be export supply without tariff, i=R,P
– Let XSit be export supply with tariff, i=R,P
• Import supplies:
– MSmfn = XSRt+XSPt
– MSfta = XSRt+XSP
15
Export supplies
ROW
P
Partner
P
XSRt
Home
XSPt
MSmfn
MSfta
XSR
XSP
t
t
P*
P*
Q
XSP
Q
Q
[ Xsit(P) = Xsi(P–t) ]
16
MFN Equilibrium
ROW
P
Partner
P
XSRt
Home
P
XSPt
MSmfn
MSfta
XSR
XSP
P0R
P0H
P0P
t
t
P*
P*
Q0 R
Q
t
Q0 P
Q
XSP
Q0 H
MD
Q
17
FTA Equilibrium
ROW
P
Partner
P
XSRt
Home
P
XSPt
MSmfn
MSfta
XSR
XSP
P0H
P1P
P0R
P1H
P0P
P1R
t
P*
XSP
MD
P*
Q1 R Q0 R
Q
Q0 P Q1 P
Q
Q0 H Q1 H
Q
18
Welfare effects, MFN to FTA
ROW
P
Partner
P
XSRt
Home
P
XSPt
MSmfn
MSfta
XSR
XSP
P0H
P1P
P0R
P1H
P0P
P1R
t
P*
XSP
MD
P*
Q1 R Q0 R
Q
Q0 P Q1 P
Q
Q0 H Q1 H
Home Private: Gain
Partner Private: Gain
Home Gov’t: Loss
ROW Private: Loss
Q
19
Summary of Effects
• Starting from MFN tariff, an FTA with one of two identical
countries causes
– Home price to fall, benefiting Home demanders more than it
hurts home suppliers
– Partner price to rise, benefiting Partner suppliers more than it
hurts partner demanders
– ROW price to fall, hurting ROW suppliers more than it benefits
ROW demanders
– Home government to lose all the tariff revenue on
• All imports from Partner
• Reduced imports from ROW
• Net effect on Home welfare is ambiguous, since revenue
loss may exceed private benefits
20