Great Expectations: Ex Ante Assessment of the Effects of Trade Reform

1. Great Expectations: Ex Ante Assessment of the Effects of Trade Reform Joe Francois and Will Martin 15 June 2006

2. We’ve made enormous progress • GTAP has given easy access to the data needed for global trade analysis • MAcMap 6-digit data for policy analysis • With preferences included • Able to gain key insights into policy reforms • Help highlight problems, identify opportunities • Contrast with the Uruguay Round • Hard to get data even after the Round concluded

3. Are we there yet? • Paul Krugman’s “dirty little secret” remains: the welfare measures from trade reform are very small • 0.7% of GDP in recent World Bank analysis • What sensible policy maker would stake her career on gains of 0.7% of GDP? • A month’s growth in China or India

4. But perhaps it’s OK? • Our standard measures are based on a rigorous theoretical framework • And perhaps the unmeasured gains scale up these measures proportionately? • So we might rank policies, without providing a “number”? • Alas, this is not always the case

5. Key questions • What needs to be measured? • What should we do better? • How might we do it?

6. What needs to be measured? • Some indicator of the potential for the gainers to compensate the losers? • Where might these gains come from? • Allocative efficiency changes • Process productivity changes • Product variety & quality effects • Factor market & investment effects

7. Efficiency and Productivity

8. A disturbing disconnect • Traditional trade theory, and most empirical modeling, focuses on allocative efficiency • The difference between b and e in the figure • With the PPF unchanged, except via input price • Generally small • Macro-growth literature focuses mainly on shifts in the Production Possibility Frontier • Mainly due to process productivity • Price distortions, variety & quality effects on inputs included, but no consumer gain • Sometimes large

9. What should we do better? • Welfare measures • Measures of distortions • Aggregation of distortions • Revenue replacement • Process productivity • Changes in product variety & quality • Investment, factor markets & growth

10. Welfare measures • The balance-of-trade function captures production, expenditure & tariff revenues • generalizes measures based on expenditure fn B = e(p,u) – r(p,v) – zp(p,u,v)´(p-p*) • Where e(p,u) is the expenditure fn; r(p,v) is GDP; zp=ep – rp; p* is world price • 2nd order approximation with fixed # of products yields Harberger triangles

11. Can augment B to capture • Process productivity gains • Increases in product variety • Improvements in product quality • Declines in price-cost margins & output increases at firm level • Investment and growth

12. The ubiquitous EV’s • The compensated measure of EV ΔBc = B(p1,u0) - B(p0,u0) • In applied work, usually use uncompensated EV = e(p0, u1) – e(p0, u0) • Includes income effects on distorted goods • Can differ a lot if revenues used for public goods • But quite close to a potential real GDP measure • Compensated measures internationally comparable & additive

13. Measuring distortions • Doing much better with tariff measures • Ad valorem equivalents, preferences included • Key issue now is non-tariff measures (NTMs) • Kee, Nicita and Olarreaga infer these measures from a finely disaggregated trade model • Suggest NTMs are twice tariffs in industrial-country agriculture, four times as high in non-agriculture • Would scale up the costs of protection by a factor of 9 in agriculture, 25 in non-agriculture

14. Measuring distortions (2) • Francois and Woerz find ATC quotas were far higher than we thought when rents captured by importers are included • From price comparisons, Bradford finds NTMs may be 10 times tariff barriers in the OECD • Not likely that the unmeasured benefits proportional to our measured gains from tariff cuts

15. Better data on distortions • Detailed price comparisons and surveys of exporters potentially very important • Kym Anderson’s project on agric distortions • Will provide better information on NTMs • May reduce measured protection– water in tariffs • Also some insights into the counterfactual • Is protection stochastic? • If so, benefits even if bound rate exceeds applied • Is mean protection stable, or increasing?

16. Services trade barriers • Current measures are extremely poor • Widely suspected that average barriers to services trade are larger than in goods • And many of these barriers likely create higher costs per unit than tariffs • Through rent seeking; reduction in competition; or x-inefficiency • A priority, albeit a difficult one

17. Aggregating distortions • The ubiquitous weighted-average has major problems • Averaging problem– understates costs • Weighting problem-- low weights on highly protected goods • The differences can be huge • Manole and Martin found costs with optimal aggregators 15 times those with weighted average • Some with higher average tariffs had lower costs

18. Estimated costs of protection

19. Aggregation • We have all the information we need to do better • Currently, we just throw much of it away • There are papers at this conference looking at different approaches • This is surely one area where we can do better?

20. Revenue replacement • Most trade liberalization studies assume that tariff revenues are redistributed costlessly to consumers • Alas, such lump-sum transfers rarely exist • Tariff revenues must be replaced via an alternative tax, or expenditure changes • Harrison, Rutherford & Tarr found that tariff replacement via a VAT cut the benefits of liberalization by 40%

21. Process productivity • Evidence from the firm level that liberalization increases productivity by expanding the availability and quality of intermediate inputs • Also an extensive literature on transmission of knowledge through trade • Pavcnik found productivity gains in import-competing firms through competition, exit and reallocation • The adjustment that governments often fear is a major source of gain

22. Process productivity: exports Exporting firms have higher productivity • Traditional explanations --Arrow’s learning-by-doing • But Clerides, Lach & Tybout, & Bernard & Jensen, cast doubt on this explanation • Seemed to be little increase in productivity post-export • More efficient firms self-selected into exporting • Also highlighted the fact that firms are very heterogeneous in their productivity • And that price-cost margins decline with liberalization

23. Process productivity: Heterogeneous firms Melitz (2003) provided a framework where trade liberalization with heterogeneous firms yields productivity gains • High productivity firms self-select into exports • Competitive pressure following liberalization causes exit of less-productive firms, reallocation of resources to more efficient • Some recent studies question the rejection of gains from learning-by-doing

24. Variety & quality of exports • Our traditional models assume that all export growth is at the intensive margin • Expanded exports involve more of the same products going to the same markets • Hummels & Klenow (HK 2005) find that 2/3 of export expansion is in new products • Evenett & Venables find that 1/3 of export growth in developing countries is from new markets • HK find quality upgrading on intensive margin

25. Export variety and quality • Assuming preference for variety, increases in export variety augment export demand • Shift out the export demand curve • Offset terms of trade fall implied by usual models • May help resolve old puzzles on elasticities • Quality upgrading augments these gains • Hummels-Klenow find rising intensive-margin prices in growing economies • These gains are additional to the gains from process productivity

26. Factor Markets: Labor • Desirable to include labor supply • Relevant supply elasticities are compensated, so even response by prime-working-age males nontrivial • Labor market performance is important • Simple closures like fixed consumer real wage increase the gains from libn, but are they realistic? • Doing better seems to require knowledge of countries’ institutions

27. Investment climate • Investment climate always important • In Melitz-type models, firms “die” and need to be replaced • Recent work suggests that the full gains from trade are much greater if the investment climate is supportive • Rutherford and Tarr (2002) find an 11% gain from 10% point tariff cut, with variety effects on intermediates and with domestic reinvestment • But 37% with foreign investment allowed

28. To conclude: Some key potential improvements • Improved estimates of distortions • Better aggregation of distortions • Better representation of process productivity • Heterogeneous firms & reallocation • Learning-by-doing? • Capturing changes in product variety & quality • Capturing gains associated with investment

29. Implementation • New data needs are difficult but important • Aggregation looks more straightforward • Many of the new approaches involve distributions of firm productivity, costs of exporting, elasticities of substitution • Might we be able to obtain adequate, agreed measures of these parameters • To get agreed consequences of liberalization? • An ambitious agenda, and we can surely learn a lot trying