A Conceptual Framework for the Static Trade Effects of FTAs

The static analysis of the trade effects of RTAs/FTAs is pioneered by Viner (1950). The trade effects in the Vinerian approach focus on trade creation and trade diversion. Subsequent economists such as Meade (1955), Lipsey (1957), Johnson (1960), and Mundell (1964) have developed their theoretical analysis of the trade effects based on the Vinerian framework because it is natural, rich in insights and coherent theoretical structures (Bhagwati, Krishna, and Panagariya, 1999; Jayasinghe, 2003).

The analysis of the trade effects of FTAs in this study is based on the Vinerian framework which DeRosa (1998) described as being more general with a graphical analysis. The Viner model is a partial equilibrium model which consists of three countries: a home country (H), a partner county (P) and a non-member country (N) trading in a specific good. Let us assume that the home country and the partner country form a customs union or a free trade area and the non-member country represents the rest of the world. The home country is a small and net import country which has a downward-sloped demand and upward-sloped supply curves while the partner and non-member countries have constant-cost supply curves. DeRosa analyses the static trade effects of the formation of a customs union using a graphical perspective for two cases. First, the non-member country is the most efficient producer of good X as shown in Figure 5.1. Second, the member country is the least-cost producer of good Y as shown in Figure 5.2.

assumed to be the lowest price. Under a non-discriminatory specific tariff (

X H

t _{) on imports of}

good X in the home country, all of good X are imported from the non-member country at the price level

X X

N H

P t

. Then, when the home country forms a customs union with the partner country, the import price of good X from the partner country decreases by

X H

t _to PPX _.

Therefore, the source of good X switches from the non-member country, which is the most efficient producer to the partner country which is the less efficient producer, and imports of good X in the home country expand.

Price

Quantity

Figure 5.1 Vinerian analysis of trade effects when the non-member country is the most efficient producer

Source: DeRosa (1998, p.100)

Table 5.1 provides a summary of the trade effects of the customs union shown in Figure 5.1. The trade effects on the home country include trade diversion and creation. The replacement of imports of good X from the least-cost producer by the higher-cost producer leads to trade diversion in the home country represented by the area k. However, the expansion of the home country’s imports of good X produces trade creation represented by the area (e+j+g+l). Trade creation involves two effects: a production effect (e+j) and a consumption effect (g+l). A net trade effect in the home country represented by the area (e+j+g+l-k) is ambiguous in sign depending on the magnitude of trade creation and diversion. The partner country meanwhile has a trade creation effect and no trade diversion. A net trade effect of the partner country is

X H D X H S X X N H P t X P P X N P a b c d e f g h i j k l m

positive as represented by the area (i+j+l+m). Overall, a net trade effect of the customs union as a whole is ambiguous as represented by the area (e+2j+i+g+2l+m-k).

Table 5.1 Summary of the trade effects of the customs union shown in Figure 5.1

Trade Effects Algebraic Representation Sign Home Country (H)

Trade creation (e+j)+(g+l) Positive

Trade diversion -k Negative

Net trade Effects (e+j)+(g+l)-k Uncertain

Partner Country (P)

Trade Creation i+j+l+m Positive

Trade Diversion - -

Net Trade Effects i+j+l+m Positive

Customs Union (H+P)

Net Trade Effects (e+2j+i)+(g+2l+m)-k Uncertain

Source: DeRosa (1998, p.102)

In Figure 5.2, the partner country is assumed to be the most efficient producer of good Y. S_HY

and D_HY represent supply and demand curves of the home country for good Y respectively.

Y P

P and P_NY represent supply curves of the partner and non-member countries for good Y

respectively. With levying a non-discriminatory specific tariff, tY_H, on imports of good Y, the

home country imports all of good Y from the partner country at the price level P_PY t_HY. When the formation of a customs union between the home and partner countries occurs, the home country eliminates specific tariffs (t_HY) on imports of good Y from the partner country and the

import price decreases to Y

P

P . Therefore, the home country’s import of good Y from the

partner country expands. A summary of the trade effects of the customs union in Figure 5.2 is shown in Table 5.2. There is a positive trade creation and no trade diversion because the partner country is the most efficient producer of good Y. Net trade creation of the home and partner countries is similar to the area (i+j+l+m) and net trade creation of the customs union is 2(i+j+l+m).

Price

Quantity

Figure 5.2 Vinerian analysis of trade effects when the partner country is the most efficient producer

Source: DeRosa (1998, p.101)

Table 5.2 Summary of the trade effects of the customs union shown in Figure 5.2

Trade Effects Algebraic Representation Sign Home Country (H)

Trade creation i+j+l+m Positive

Trade diversion - -

Net trade Effects i+j+l+m Positive

Partner Country (P)

Trade Creation i+j+l+m Positive

Trade Diversion - -

Net Trade Effects i+j+l+m Positive

Customs Union (H+P)

Net Trade Effects 2( i+j+l+m) Positive

Source: DeRosa (1998, p.103) Y H D Y H S Y Y P H P t Y N P Y P P a b c d e f g h i j k l m

In practice, there are two prevalent quantitative analysis approaches for measuring the trade and welfare effects of RTAs/FTAs. The first is the analytical approach using the computable general equilibrium (CGE) model to capture the effects of RTAs/FTAs. The CGE model is

mostly used in ex ante studies. The CGE model provides coherent theoretical structures and

captures intersectoral and macroeconomic effects. However, there are computational and data limitations such as computing under unrealistic baseline scenarios and requiring numerous data (Elliott and Ikemoto, 2004; Jayasinghe and Sarker, 2004; Romalis, 2007). The second is

the empirical approach involving ex post analysis with econometric models. The gravity