2.2 - Trade Creation & Trade Distortion

Multilateral liberalisation and X supply curve

With multilateral liberalisation we can summarise RoW with a common export supply curve

• p^w in the small country case

Regional liberalisation and X supply curve

With regional liberalisation the partner matters as nations differ in efficiencies

• More efficient = S at lower p

• Less efficient dom producers displaced

Trade Creation

Replacement of less efficient producers by more efficient

Welfare raising

Trade diversion

Efficient producers outside RTA replaced by less efficient inside RTA

Welfare lowering

Discriminatory liberalisation welfare effects

Can lead to ambiguous welfare effects under first best conditions

• TC vs TD

CU model - assumptions

1st best conditions

Increasing costs for H producers

Regional / global producers supply at constant cost

H, F and RoW

CU model - TC

RTA forming removes tariff on M for partner

p^p < p^w

M from partner increase (some dom production replaced) + C increase

CU model - TD

Discriminatory tariff cut shifts X from RoW → Partner as p^p < p^w + t

Trade diverted = d0 - q0

TC = q1-q0 + d1-d0

Welfare effects:

• CS gain = A+B+C+D

• PS loss = -A

• Tariff loss = -(C+G)

  • Net effect = B+D-G

B = TC displacement of inefficient dom producers

CU model - TC welfare effects

Welfare effects:

• CS gain = A+B+C+D

• PS loss = -A

• Tariff revenue loss = C

  • Net effect = B+D

  • Effect same as multilateral liberalisation

CU model - TD welfare effects

Welfare effects:

• CS gain = A+B+C+D

• PS loss = -A

• Tariff loss = -(C+G)

  • Net effect = B+D-G

B = TC displacement of inefficient dom producers

D = increased C

E = additional cost of M from less efficient regional partner

Caveats to gains and losses from RTAs

TD is a loss as we assume MC of partner & RoW constant

• With decreasing MC the loss may be eliminated

We assume that there is constant cost of X Supply by partner = no PS gains for partner

• with increasing costs of X, RTA loses overall in net terms as costs of TD for M < benefits to X nation

When are RTA welfare effects less ambiguous

More likely to be beneficial if:

• Regional grouping large - Share of World GDP & no. nations in RTA

  • more leverage to extract TOT gains from RoW by exploiting market power

• Region includes globally efficient producers (competing not complementary producers)

• External trade barriers low

• Internal trade barriers eliminated

• Other positive effects - TOT gains or scale effects