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The Simple Analytics of Trade Creation and Diversion
Alan V. DeardorffUniversity of Michigan
Rishi R. SharmaColgate University
For presentation at
Conference on International Economic Integration: Firms, Workers, and Policies
Universität Tübingen May 22-23, 2019
www.fordschool.umich.edu
Outline
• Background• Simplest model: horizontal supplies• Upward-sloping supplies– 3-country case, in graphs– Somewhat more general case, in
equations– 4-country case, in graphs
2
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Background
• Viner’s (1950) trade creation and trade diversion are usually illustrated with
– Constant costs
– 2-country FTA or CU plus rest of world
• Then we’ll look at cases with
– Upward sloping supplies
– And in the last case, an FTA with pre-existing other FTA
3
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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
4
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No FTA
5
PS
Paut
PB
D
QS0 M0
PC
PB+t
PC+t
• Without FTA– Since PB+t < PC+t Home
imports only from B
D0
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FTA with low-cost country, B
6
PS
Paut
PB
D
QS0 M0
FTA with B• Since PB < PC+t Home still
imports only from B• Country C plays no role
PC
PB+t
PC+t
a b c d
WelfareSuppliers lose –aDemanders gain +(a+b+c+d)Government loses –cCountry gains +(b+d)
Same as Free TradeD1S1 D0
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7
PS
Paut
PB
D
QS0 D0M0
PC
PB+t
PC+t
a b c d
D1D1
Trade Creation
FTA with low-cost country, B
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FTA with high-cost country, C
8
PS
Paut
PB
D
QS0 M0
FTA with C• Since PC < PB+t Home now
imports only from C
PC
PB+t
PC+t
a b c d
WelfareSuppliers lose –a
Demanders gain +(a+b+c+d)
Government loses –(c+e)Country loses –e+(b+d)
Not same as Free Tradeand may be a loss, if
e>(b+d)
e
S1 D1D0
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9
PS
Paut
PB
D
QS0 M0
PC
PB+t
PC+t
a b c d
e
S1 D1D0
Trade Creation
Trade Diversion
FTA with high-cost country, C
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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”• Assume that FTA removes this cost through
– Harmonization of standards– Mutual recognition
• 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: Overview10
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Service FTA with low-cost, B
11
PS
Paut
PB
D
QS0 M0
FTA with B• Since PB < PC+s Home still
imports only from B• Country C plays no role
PC
PB+s
PC+s
a b c d
WelfareSuppliers lose –aDemanders gain +(a+b+c+d)Government loses 0Country gains +(b+c+d)
D1S1 D0
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12
PS
Paut
PB
D
QS0 M0
FTA with C• Since PC < PB+s Home now
imports only from C
PCa b c d
WelfareSuppliers lose –aDemanders gain +(a+b+c+d)Government loses 0Country gains +(b+c+d)
Certain gain, but not as large as with country B
e
S1 D1D0
PC+s
PB+s
Service FTA with high-cost, C
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Upward-sloping Supplies3-country case*
13
• Three countries, importer A, and exporters B, and C
• Export supply and import demands are linear• Countries B and C are identical• Two equilibria
– 0: MFN specific tariff t on exports of both B and C– 1: FTA of A and B:
• tariff t on exports of C; • zero tariff on exports of B
For
simplicity
*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.
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14
P
!" = !$
Q
Export Supplies of B and C
Q
Exports to Country A
%"&, %$& P %"& + %$&
%") + %$&
*
Export Supplies
%"), %$)
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15
P
!"#, !%#
Q Q
Import Market
!"&, !%& P
'(
!)" = !)% ')( = !)" +!)%
MFN Equilibrium
," = ,%-
!"& + !%&
!"# + !%&.)(
Export Supplies
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16
P
Q Q
!"#, !%# P
&'
!("= !(%
!*%
FTA Equilibrium
!*" &(' &*'
+" = +%,
!"# + !%#
!". + !%#/('/*'
!"., !%.
Export Supplies Import Market
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17
Trade Creation and Diversion
P
Q Q
!"#, !%# P
&'
!(" &)' &('
*" =*%
,
!"# + !%#
!". + !%#!"., !%.
/)'/('
TD TC
Export Supplies Import Market
!)"= !)%
!(%
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18
TC & TD, another View
!"
Q Q
#$%, #'%
("
#)$ (*" ()"
+
#$% + #'%
#$- + #'%#$-, #'-
!*"!)"
TD TCTDTC
Export Supplies Import Market
#*$= #*'
#)'2$ =2'
!"
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19
Welfare Effects on Country A
Q
Export Supplies
Q
!"#, !%#
&'
!(" &)' &('
Tariff revenue lost fromB C
Net gain of A’s private sector
*
!"# + !%#
!", + !%#!",, !%,
-)'-('
TD TCTDTC
Import Market
!)"= !)%
!(%
-' -'
2"= 2%
See immediately that country A• Gains from trade creation• Loses from trade diversion• As well as from lost revenue from country B
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20
Welfare Effects on Countries B and C
Q Q
!"#, !%#
&'
!(" &)' &('
*
!"# + !%#
!", + !%#!",, !%,
-)'-('
TD TCTDTC
Export Supplies Import Market
!)"= !)%
!(%
Gain by partner country B
Loss by outside country C
-' -'
2"= 2%
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21
Welfare Effects on the World
These add up, with much cancellation to yield the following:
Q Q
!"#, !%#
&'
!(" &)' &('
*
!"# + !%#
!", + !%#!",, !%,
-)'-('
TD TCTDTC
Export Supplies Import Market
!)"= !)%
!(%
-' -'
2"= 2%
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22
Welfare Effects on the World
These add up, with much cancellation to yield the following:
Q Q
!"#, !%#
&'
!(" &)' &('
*
!"# + !%#
!", + !%#!",, !%,
-)'-('
TD TCTDTC
Export Supplies Import Market
!)"= !)%
!(%
-' -'
2"= 2%
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23
Welfare Effects on the World
These add up, with much cancellation to yield the following:
Q Q
!"#, !%#
&'
!(" &)' &('
*
!"# + !%#
!", + !%#!",, !%,
-)'-('
TD TCTDTC
Export Supplies Import Market
!)"= !)%
!(%
-' -'
2"= 2%
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24
Welfare Effects on the World
These add up, with much cancellation to yield the following:
Q Q
!"#, !%#
&'
!(" &)' &('
*
!"# + !%#
!", + !%#!",, !%,
-)'-('
TD TCTDTC
Export Supplies Import Market
!)"= !)%
!(%
-' -'
2"= 2%
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25
Welfare Effects on the World
These add up, with much cancellation to yield the following:
Q Q
!"#, !%#
&'
!(" &)' &('
*
!"# + !%#
!", + !%#!",, !%,
-)'-('
TD TCTDTC
Export Supplies Import Market
!)"= !)%
!(%
-' -'
2"= 2%
=
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26
These add up, with much cancellation to yield the following:
Welfare Effects on the World
Q Q
!"#, !%#
&'
!(" &)' &('
*
!"# + !%#
!", + !%#!",, !%,
-)'-('
TD TCTDTC
Export Supplies Import Market
!)"= !)%
!(%
-' -'
2"= 2%
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27
These add up, with much cancellation to yield the following:
Welfare Effects on the World
Q Q
!"#, !%#
&'
!(" &)' &('
*
!"# + !%#
!", + !%#!",, !%,
-)'-('
TD TCTDTC
Export Supplies Import Market
!)"= !)%
!(%
-' -'
2"= 2%
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28
Welfare Effects on the World
Q Q
!"#, !%#
&'
!(" &)' &('
*
!"# + !%#
!", + !%#!",, !%,
-)'-('
TD TCTDTC
Export Supplies Import Market
!)"= !)%
!(%
Loss from trade diversion
Gain from trade creation
-' -'
2" =2%
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29
Q Q
!"#, !%#
&'
!(" &)' &('
*
!"# + !%#
!", + !%#!",, !%,
-)'-('
TD TCTDTC
Export Supplies Import Market
!)"= !)%
!(%
Why the Loss from Trade Diversion
C’s fall in cost
B’s rise in cost
-' -'
2" =2%
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30
Welfare Effects on the World
Q Q
!"#, !%#
&'
!(" &)' &('
*
!"# + !%#
!", + !%#!",, !%,
-)'-('
TD TCTDTC
Export Supplies Import Market
!)"= !)%
!(%
Loss from trade diversion
Gain from trade creation
-' -'
2" =2%
• Loss is an area, product of the price change and the quantity of trade diversion, with the latter depending on the former.
• So the loss rises with the square of trade diversion.
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Four-Country Model in Equations
31
• Four countries: – Importer A– Exporters B, C, and D
• Export supply and import demands are linear• Three equilibria
– 0: MFN tariff t on exports of B, C, and D– 1: FTA of A and D:
• Tariff t on exports of B and C; • Zero tariff on exports of D
– 2: FTA of A with B, keeping FTA with D• Tariff t on exports of C only• Zero tariff on exports of B and D
• Consider only cases with !" > 0, & = (, ), *
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The Model
32
Exports:
Imports:
Equilibrium:
!" = $" %" − '" , ) = *, +, ,, %" ≥ '"
./ = $/ '/ − %/ , %/ ≤ '/
./ = !1 + !3 + !4
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The Model
33
Let:
Then solution is:!" = $ + &'(' + &)() + &*(*
+ = ," + ,' + ,) + ,*
$ = &"-" + &'-' + &)-) + &*-*&. = ⁄,. +
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The Model
34
• With more assumptions, !" are proportional to country size– (See paper)
• Therefore #" is country i’s share of world economy– (This is not really right, as it assumes both
demanders and suppliers in proportion to population. Exporters will in fact have more firms, and thus greater weight, than importers.)
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The Model
35
Effect of new FTA between A and B (in presence of A’s FTA with D)
Let ∆ be change from equilibrium 1 to equilibrium 2
Thus price in A falls by a fraction of the tariff, in proportion to size of new partner compared to world.
Country B’s price rises by the rest of the tariff
Because A’s tariff on C and D does not change
∆"# = −&'(
∆"' = (1 − &')(
∆", = ∆"- = ∆"# = −&'(
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The Model
36
From the price changes, one derives the following changes in quantities of trade:
∆"#= %&'#( > 0∆+&= %& '# + '- + ./ ( > 0
∆+-= −%&'1( < 0
∆+/= −%&'3( < 0
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The Model
37
As must be from market equilibrium
Thus the added exports of the partner country include the new imports of country A plus the reduced exports of countries C and D. The latter trade may be said to be “diverted,” but we label
and
because it is reversal of trade diversion from the prior FTA.
∆"#= ∆%& − ∆"( −∆")
−∆"( as “trade diversion”
−∆") as “trade reversion”
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The Model
38
Thus
!"#$% &"%#'()* = !& = ,-./' > 0
!"#$% 2%3%"4()* = !2 = ,-.5' > 0
!"#$% 6(3%"4()* = !6 = ,-.7' > 0
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The Model
39
Welfare effects of new FTA
Country A (home):
Country B (new partner):
Country C (outside world):
Country D (old partner):
∆"#= ⁄&'# (# + *+ ⁄, 2 ./ − ,.1 − ,2'+
∆"+= ∆34+= 2'+ +12 ./ + .1 + .6 1 − *+ ,
∆"7= −2'7 +.12 *+,
∆"8= −2'8 +.62 *+,
Lost tariff revenue
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The Model
40
Welfare effects of new FTA on the World
World (A+B+C+D):
∆"#= 12'() +
12 '+ − '- )
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4-country case in figures
41
• Three countries, importer A, and exporters B, C, and D
• Export supply and import demands are linear
• Countries B, C, and D are identical
• Two equilibria
– 1: MFN tariff t on exports of both B and C• Zero tariff on exports of old FTA partner D
– 2: New FTA of A and B:
• tariff t on exports of C only;
• zero tariff on exports of two FTA partners B and D
For simplicity
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42
P
!" =!$ =!% Q
Export Supplies of B, C, and D
Q
Export Supplies to Country B
&"', &$', &%' P
∑&* = &"* + &$* +&%*,
Export Supplies
∑&- = &"* + &$' +&%*
∑&. = &"' + &$' +&%*
/" = /$ = /%
∑&0 = &"' + &$' +&%'&"*, &$*, &%*
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43
P
Q
Export Supplies of B, C, and D
Q
!"#, !%#, !&# P
Equilibrium 1: A has FTA with 1 country, D
∑!(
∑!)*+
!("= !(%
!(& *(+
= !(" +!(% + !(&
!"., !%., !&.
/
Import Market
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44
P
Q
Export Supplies of B, C, and D
Q
!"#, !%#, !&# P ∑!(
∑!)*+
!("= !(%
!(& *(+
Equilibrium 2: A has FTA with 2 countries, B & D
!)% !)"= !)&
*)+
!"-, !%-, !&-
.
Import Market
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45
P
Q
Export Supplies of B, C, and D
Q
!"#, !%#, !&# P ∑!(
∑!)*+
!("= !(%
!(& *(+
Changes in Trade from expanding FTA to Country B
!)% !)"= !)&
∆*+∆!% ∆!&
*)+
!"., !%., !&.
/
Import Market
∆!"
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Trade Creation
46
P
Q
Export Supplies of B, C, and D
Q
!"#, !%#, !&# P ∑!(
∑!)*+
∆!" ∆*+∆!% ∆!&TD TR TC
Trade Creation (TC), Diversion (TD), and Reversion (TR)
!"1, !%1, !&1
2
Import Market
Trade CreationTrade Diversion Trade Reversion
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47
P
Q
Export Supplies of B, C, and D
Q
!"#, !%#, !&# P ∑!(
∑!)*+
Trade Creation (TC), Diversion (TD), and Reversion (TR)
∆!" ∆*+∆!% ∆!&
TRTDTCNote that ∆!", while a gain to Country B, is the sum of TC, TD, & TR, since ∆!"= ∆*+ − ∆!% − ∆!&
!"2, !%2, !&2
3
Import Market
TD TR TC
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48
P
Export Supplies of B, C, and D
Q
!"#, !%#, !&# P ∑!(
∑!)*+
Welfare Effects on Country ATariff
revenue lost from
B CNet gain of A’s private sector
Note that trade reversion does not appear to affect A’s welfare. I suspect this is an artifact of making export supplies from B and D the same.
!",, !%,, !&,
-
Import Market
Q
∆!" ∆*+∆!% ∆!&
∆!&TR
∆!%TD∆*+
TC
TR TCTD
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49
P
Export Supplies of B, C, and D
Q
!"#, !%#, !&# P ∑!(
∑!)*+
Welfare Effect on Country B
!",, !%,, !&,Net gain of B’s private sector
-
Import Market
QTRTDTC
TR TCTD
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50
P
Export Supplies of B, C, and D
Q
!"#, !%#, !&# P ∑!(
∑!)*+
Welfare Effect on Country C
Net loss of C’s private sector
!",, !%,, !&,
-
Import Market
QTRTDTC
TR TCTD
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51
P
Export Supplies of B, C, and D
Q
!"#, !%#, !&# P ∑!(
∑!)*+
Welfare Effect on Country D
!",, !%,, !&,Net loss of D’s private sector
-
Import Market
QTRTDTC
TR TCTD
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52
P
Export Supplies of B, C, and D
Q
!"#, !%#, !&# P ∑!(
∑!)*+
Welfare Effects on World
!",, !%,, !&,
-
Import Market
QTRTDTC
TR TCTD
I claim that these gains and losses mostly cancel out to reduce to the following:
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53
P
Export Supplies of B, C, and D
Q
!"#, !%#, !&# P ∑!(
∑!)*+
Welfare Effect on World
!",, !%,, !&,
-
Import Market
QTRTDTC
TR TCTD
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54
P
Export Supplies of B, C, and D
Q
!"#, !%#, !&# P ∑!(
∑!)*+
Welfare Effects on World
!",, !%,, !&,
-
Import Market
QTRTDTC
TR TCTD
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P
Export Supplies of B, C, and D
Q
!"#, !%#, !&# P ∑!(
∑!)*+
Welfare Effects on World
!",, !%,, !&,
-
Import Market
QTRTDTC
TR TCTD
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56
P
Export Supplies of B, C, and D
Q
!"#, !%#, !&# P ∑!(
∑!)*+
Welfare Effects on World
!",, !%,, !&,
-
Import Market
QTRTDTC
TR TCTD
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P
Export Supplies of B, C, and D
Q
!"#, !%#, !&# P ∑!(
∑!)*+
Welfare Effects on World
!",, !%,, !&,
-
Import Market
QTRTDTC
TR TCTD
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58
P
Export Supplies of B, C, and D
Q
!"#, !%#, !&# P ∑!(
∑!)*+
Welfare Effects on World
!",, !%,, !&,
-
Import Market
QTRTDTC
TR TCTD
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P
Export Supplies of B, C, and D
Q
!"#, !%#, !&# P ∑!(
∑!)*+
Welfare Effects on World
!",, !%,, !&,
-
Import Market
QTRTDTC
TR TCTD
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60
P
Export Supplies of B, C, and D
Q
!"#, !%#, !&# P ∑!(
∑!)*+
Welfare Effects on World
!",, !%,, !&,
-
Import Market
QTRTDTC
TR TCTD
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61
P
Export Supplies of B, C, and D
Q
!"#, !%#, !&# P ∑!(
∑!)*+
Welfare Effects on World
!(" !(% !(&!",, !%,, !&,
-
Import Market
QTRTDTC
TR TCTD
!("= !(%
!(&
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62
P
Export Supplies of B, C, and D
Q
!"#, !%#, !&# P ∑!(
∑!)*+
Welfare Effects on World
!(" !(% !(&!",, !%,, !&,
-
Import Market
QTRTDTC
TR TCTD
!("= !(%
!(&
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63
P
Export Supplies of B, C, and D
Q
!"#, !%#, !&# P ∑!(
∑!)*+
Welfare Effects on World
!",, !%,, !&,
-
Import Market
QTRTDTC
TR TCTD
!("= !(%
!(&!(" !(% !(&
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64
P
Export Supplies of B, C, and D
Q
!"#, !%#, !&# P ∑!(
∑!)*+
Welfare Effects on World
!",, !%,, !&,
-
Import Market
QTRTDTC
TR TCTD
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65
P
Export Supplies of B, C, and D
Q
!"#, !%#, !&# P ∑!(
∑!)*+
Welfare Effect on World
!",, !%,, !&,
-
Import Market
QTRTDTC
TR TCTD
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66
P
Export Supplies of B, C, and D
Q
!"#, !%#, !&# P ∑!(
∑!)*+
Welfare Effect on World
!",, !%,, !&,
-
Import Market
QTRTDTC
TR TCTD
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67
P
Export Supplies of B, C, and D
Q
!"#, !%#, !&# P ∑!(
∑!)*+
Welfare Effect on World
!",, !%,, !&,
-
Import Market
QTRTDTC
TR TCTD
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68
P
Export Supplies of B, C, and D
Q
!"#, !%#, !&# P ∑!(
∑!)*+
Welfare Effect on World
!",, !%,, !&,
-
Import Market
QTRTDTC
TR TCTD
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69
P
Export Supplies of B, C, and D
Q
!"#, !%#, !&# P ∑!(
∑!)*+
Welfare Effect on World
!",, !%,, !&,
-
Import Market
QTRTDTC
TR TCTD
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70
P
Export Supplies of B, C, and D
Q
!"#, !%#, !&# P ∑!(
∑!)*+
Welfare Effect on World
!",, !%,, !&,
-
Import Market
QTRTDTC
TR TCTD
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4-country case
71
• Result:– World welfare rises with second FTA, by amount
depending on trade creation and the tariff• Recall from model:
• Here, because we’ve assumed countries B and D are the same, TR=TD
∆"#= 12'() +
12 '+ − '- )
∆"#= 12'()
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4-country case
72
• In general, !" ≠ !$• Which is larger depends just on country size, size
both face the same price change.
• If the new partner is smaller than the old, !" > !$ , and world gain will be larger
• If new partner is bigger than old, then !" < !$and world gain will be smaller and perhaps a loss.
∆45= 12!9: +
12 !" − !$ :
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Conclusion
• Analysis of FTAs shouldn’t treat each independently of FTAs that already exist
• Sequencing of FTAs can matter.
73
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