The Economics of Free Trade Areas

Institut Tadbiran Awam Negara (INTAN) Jabatan Perkhidmatan Awam Malaysia


The Economics

of Free Trade Areas


2


At minimum FTA reflects an agreement allowing free

trade in goods among participating countries.

Practically an agreement setting up an FTA does not

restrict to trade in goods only. It also covers rules

relating to:

– Movement of labours

– Trade in services

– Investments

– Flow of capital

– Intellectual property protection

– Others (e.g. rules of origin; anti-dumping; national treatment)

INTRODUCTION

Definition.pptx

Definition.pptx

Definition.pptx


The framework of economic analysis is

not within the boundary of a country. It is

about the boundary of the world.

. Economic policy initiatives must observe

Pareto maximization principles.

– Policy measures design to improve economic

well-being of a country at the expense of

another is “bad economics”.

– “bad economics” could be tolerated only if it is in

conformity with the principles of the “second

best”;

– The second best option must only be

temporary, adopted to address specific and

temporal problems.

Economic Analyisis of FTA

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Debates go back to times even before Adam Smith (1723 – 1790)

• The wealth of a country depends on its ability to accumulate gold and bullion.

• Trade policy must gear towards enhancing exports and reducing imports.

• Exports are good, imports are bad.

Debates about Free Trade

Smith argued against mercantilist economics in the wealth of Nation

(1776)

Primarily between mercantilists and clasical economists

For two centuries, during 1500s and 1600s the thinking of mercantilists

was very dominant (especially in Britain and France)

• Contribution of Smith and others (David Riacardo, James Mills, John Stuart

Mills) put the issue of export versus import to rest from the perspective

economics (economics case).

• Mercantilist thinking is not part of mainstream economic thinking and analysis.

The Economics Case for Free Trade.pptx


During the period of classical economics ( 1770s until 1890s) free trade

established itself as a doctrine in economics.

• Richard Cobden, a textile manufacturer.

• James Wilson, the founder of the Economist (1843).

• David Ricardo, an economist as well as a member of Parliament in 1846.

Debates about Free Trade (cont...)

A few other countries followed: The netherlands, Spain, Austria,

Switerland.

Free trade was a unilateral case.

Britain embraced “free trade“ policy in 1846 when it abolished the

protectionist Corn Laws. Three main individual players:


• Unilateral free trade broke down after shortly after WW1.

• One of the reasons triggering the WW2 was protectionism and

trade wars.

• After WW2, the dominant thinking was (and still is) trade must

be reciprocal.

– You liberalize yours; I liberalize mine.

• Few economists still insist on unilateral free trade: Jagdish

Bhagwati, Paul Krugman, Arvin Panagaria, Gregory Mankiw.

Debates about Free Trade (cont...)


The Gains and Losses of an Exporting Country

International Trade in an Exporting

Country Once trade is allowed, the domestic price

rises to equal the world price. The supply

curve shows the quantity of textiles

produced domestically, and the demand

curve shows the quantity consumed

domestically. Exports from Home equal

the difference between the domestic

quantity supplied and the domestic

quantity demanded at the world price.

Sellers are better off (producer surplus

rises from C to B + C + D), and buyers are

worse off (consumer surplus falls from A +

B to A). Total surplus rises by an amount

equal to area D, indicating that trade

raises the economic well-being of the

country as a whole.

Consumer Surplus

The area D shows the increase in total surplus

and represents the gains from trade.

Before Trade After Trade Change

Producer Surplus

Total Surplus

A + B A -B

C B + C + D + (B + D)

A + B + C A + B + C + D +D

D

A

Domestic

supply

Price of

Textiles

Exports

B

C

Exports

World

price

Domestic

demand

Price

after

trade

Price

before

trade

Quantity of

Textiles

Domestic quantity

demanded Domestic quantity

supplied

0 7


The Gains and Losses of an Importing Country

International Trade in an Importing

Country Once trade is allowed, the domestic price

falls to equal the world price. The supply

curve shows the amount produced

domestically, and the demand curve

shows the amount consumed

domestically. Imports equal the difference

between the domestic quantity demanded

and the domestic quantity supplied at the

world price. Buyers are better off

(consumer surplus rises from A to A + B +

D), and sellers are worse off (producer

surplus falls from B + C to C). Total

surplus rises by an amount equal to area

D, indicating that trade raises the

economic well-being of the country as a

whole.

Consumer Surplus

The area D shows the increase in total surplus

and represents the gains from trade.

Before Trade After Trade Change

Producer Surplus

Total Surplus

A

C -B B + C

A + B + D + (B + D)

A + B + C A + B + C + D +D

D

A

Domestic

supply

Price of

Textiles

B

C

Imports

World

price

Domestic

demand

Price

After trade

Price

Before trade

Quantity of

Textiles Domestic quantity

demanded

Domestic quantity

supplied

0 8


The Effects of a Tariff A tariff reduces the quantity of imports and moves a market closer to the equilibrium that would exist

without trade. Total surplus falls by an amount equal to area D + F. These two triangles represent the

deadweight loss from the tariff.

Consumer Surplus

The area D shows the increase in total surplus and represents the gains from trade.

Before Tariff After Tariff Change

Producer Surplus

Government Revenue

A + B + C + D + E + F

C + G +C G

A + B - (C + D + E + F)

None

A + B + C + E + G -(D + F) Total Surplus A + B + C + D + E + F + G

E + E

E

A

Domestic

supply

Price of

Textiles

B

C

Imports

with tariff

World

price Domestic

demand

Price

without tariff

Price

with tariff

Quantity of

Textiles

Equilibrium

without trade

Tariff D

G

F

0

Imports without tariff

𝑄𝑠1 𝑄

𝑠2 𝑄

𝐷2 𝑄

𝐷1 9


• Based on the thinking that FTA should be

reciprocal.

• Negotiations are based on mercantilist rules.

– An increase in export is a win.

– An increase in import is a loss.

• Economists take offend of this rule.

Setting up FTAs


• It is based on mercantilist rules.

• Reflects to much the interest of business and lobbying groups

• The interest of the general public is minimal.

• To many non-trade issues creep into the negotiations.

– Environmental issues.

– Labor standards.

– Intellectual property.

– Domestic economic policies.

Economists’ Concern about FTA Negotiations


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Source of International Trade

Differences in labour productivity 1

• Named as Ricardian model of trade (standard model)

• Due to specialization of labour

• Eg. Malaysia is more efficient in producing E & E; Korea

is more efficient in producing cars.


Trade in a World Without Increasing Returns (Perfect Competition)

In a world without economies of

scale, there would be a simple

exchange of manufactures for

food.

Home

(capital abundant)

Foreign

(labor abundant)

Manufactures Food

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Food

imports

D

Q

T T

Q

F

Food

production,

Cloth

exports Q

C

Cloth

production,

Indifference curves

Isovalue

line

Production, Consumption, and Trade in the Standard Model

The economy produces at point

Q, where the production

possibility frontier is tangent to

the highest possible isovalue

line. It consumes at point D,

where that isovalue line is

tangent to the highest possible

indifference curve. The

economy produces more cloth

than it consumes and therefore

exports cloth: correspondingly,

it consumes more food than it

produces and therefore imports

food.

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15

Source of International Trade (cont...)

• Named as Hecksher-Ohlin Model

• Due to different natural endowments

• Canada exports forest products to the US because it has more forested lands.

Differences in Resource Endowment 2


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Source of International Trade (cont...)

• Production is more efficient the larger the scale of production.

• Countries specialize in producing a limited range of products.

• Trade provide bigger markets for the products.

• Eg. Commercial air crafts, Boeing and Airbus, are produced in

US and EU respectively because they require huge economies of scale

• This gives rise to intra-industry trade.

Occurs due to Economies of Scale (increasing returns) 3


Trade with Increasing Returns and Monopolistic

Competition

Home

(capital abundant)

Foreign

(labor abundant)

Manufactures Food

Interindustry

trade

Intraindustry

trade

If manufactures is a monopolistically competitive industry, Home and Foreign

will produce differentiated products. As a result, even if Home is a net

exporter of manufactured goods, it will import as well as export manufactures,

giving rise to intraindustry trade.

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– Inorganic chemicals 0.99

– Power generating machinery 0.97

– Electrical Machinery 0.96

– Organic chemicals 0.91

– Medical and pharmaceutical 0.86

– Office Machinery 0.81

– Telecommunications equipment 0.69

– Road vehicles 0.65

– Iron and steel 0.43

– Clothing and apparel 0.27

– Footwear 0.00

Indexes of Intraindustry trade for United States


Thank You !!!

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The Economics of Free Trade Areas