SESSION III: THE ECONOMICS OF PTAs: II (non-traditional effects)

1. SESSION III: THE ECONOMICS OF PTAs: II (non-traditional effects) JAIME DE MELO This version, March 2004

2. OUTLINE: SESSION III  Evaluating the welfare effects of RTAs (ex-ante) using simulation models  Non-traditional effects of RTAs (anything but TD and TC)  Location & agglomeration effects, and growth  Deep integration  Investment  Regionalism and Services Annex: welfare effects of trade policy under imperfect competition

3.  Evaluating the welfare effects of RTAs (ex-ante) • Simulation models are typically calibrated to include some sectors with CRTS and others with IRTS. • Implies imperfect competitionPAC But P.O. requires P=MC. Calibrated equilibrium under FT will not be Pareto optimal!!!! • Complicates greatly assessment of trade policy reform effects, especially if one adds the complication of discriminatory reduction in protection

4. In simulation models W (=welfare effect of trade policy change) • Under perfect competition: WC = PS + CS+ TOT • Under imperfect competition: W = WC + effects below (see mechanisms and channels in annex) • Exploitation of economies of scale (SE) if protection of sectors producing differentiated products • Pro-competitive (anti-competitive) effect if demand curve more (less) elastic • Entry (SE) or exit (SE) • Change in number of varieties of intermediates and consumer goods (costs )

5. Two examples of simulation model results from SW chp. 2 (but see box 2.1 on difficulties with simulation models) Example 1. Mercosur: Flores (97) estimates (%of GDP in parenthesis- Argentina (1.8), Uruguay (2.1), Brazil (1.3)Two examples from SW chp. 2 . Below decomposition of gains for imperfectly competitive sectors ..but these results while easy to trace if model is well-formulated (=not a black box) lack robustness to most parameter and closure rule changes

6. Welfare estimates from ex-ante simulation exercices (end) Example 2. Effect of UEMOA implementation for Senegal (Dissou 2002) Here CU has positive effect but FTA only is negative (TD), while CET which is lower than Senegal’s tariff is positive. . Note that ULT is greatest gain here! (and likely to be always the case for small countries)

7.  NON TRADITIONAL EFFECTS OF RIAs 1. Domino effect: join RIAs to avoid “being left in the cold”. Has played an important role in the case of the Europe Agreements between the EU and Central and East European Countries (See the analyis in PTA2_ECON1). • 2. Deeper integration: regionalism allows to go beyond the scope of multilateral agreements. Illustration in the case of European integration: • “four liberties” of the common market (goods, services, labor and capital). • single market: elimination of technical barriers to trade (administrative procedures, recognition of standards); can be shown that in this case regional integration is necessarily welfare improving.

8. Launch of NAFTA negotiations NAFTA put into force 3. Credibility and signaling: use of an RIA to send a signal to private and public agents that there will be no recidivism (=helps to lock in reforms as in the case of WTO accession). Would this effect be strong with EPAs? This may  uncertainty and  investment, in particular foreign direct investment, as in the case of Mexico:

9. 4Growth; Location & agglomeration effects Convergence of real income per capita? European integration was accompanied by income convergence (see below). So could South-South RIAs lead to the same outcome? Unfortunately no, just the opposite: RIAs among poor countries probably leads to income divergence. Why? Following provides one illustration of why this might be the case (but see discussion in SW chp. 5 ) Assume that countries can be ranked by comparative advantage in agricultural (vs. manufacturing) goods, which mimics the ordering by decreasing level of income (and capital) per capita:

10. France Hungary world average capital/labor ratio Armenia Azerbaidjan  Growth effects and divergence in S-S RIAs Real Income N-N RIA: Hungary steps in between France and ROW for agricultural products = France (the richest) suffers trade diversion  income convergence S-S RIA: Armenia steps in between Azerbaïdjan and ROW for manufactured products = Azerbaïdjan (the poorest) suffers trade diversion  income divergence

11. MEASURING CONVERGENCE IN INCOME PER CAPITA AVERAGE INITIAL y OF SAMPLE RELATIVE TO RICHEST II I   SAMPLE AVERAGE GROWTH (2.1%) 2.1%  0.0%  III IV CONVERGENCE CURVE 0.3 OBSERVATIONS CONTRIBUTE TO: DIVERGENCE:   (I & III) CONVERGENCE:   (II & IV)

12. INCOME PER CAPITA IN 48 US STATES: 1929-60

13. DISPERSION IN INCOME PER CAPITA IN 48 US STATES

14. DISPERSION IN INCOME PER CAPITA IN THE EC Convergence during reduction in trade barriers

15.  Agglomeration effects (II) Agglomeration is the result of the balance between Marshallian centripetal and centrifugal effects • Centripetal forces: • Knowledge spillovers • Labor pooling effects • Linkage effects: backward (= demand); forward (=supply)possibility for process of cumulative causation leading to agglomeration Centrifugal forces: • Congestion, pollution • high price of land • Other negative externalities

16.  Agglomeration effects (II) • How does trade liberal. affect balance between two forces? • Reduction in trade barriers improves market access • Increased competition reduces profitability • Cheaper intermediate imports raises profitability Any difference among modes of trade liberalization (I.e. between UTL, MTL, and PTA)? •  UTL less likely to lead to industry moving South (if it is to move South since UTL can also make Southern firms less competitive) than MTL • PTA increases locational attractiveness of members at the expense of excluded countries, but many S-S PTAs may involve economies that are too small for this effect to be significant (markets too small). See SW box 5.1 summary of simulations where N-S better than S-S for the South (gets lower intermediates from North + market access).

17.  Deep integration Goes beyond what is negotiated at the WTO W..but it takes a very, very long time!

18.  Deep integration (II) Example of EC integration and difficulty to get partial movement of people (mode IV) in the next agenda for multilateral negotiations, suggest modest hopes for ‘deep integration’ in N-S and S-S agreement • Mutual Recognition Agreements (MRA) for technical standards could give large efficiency gains. • TBTs do not create rents (which are just resource transfers) but use resources • See (again) next slide for the extra welfare gains from removing TBTs.

19. p S p1 A C D B p0 D Q0 C0 Q , C  Deep integration (III) DWL= dead weight (or efficiency) loss • 1) A tariff (that raises the price from p0 to p1) gives rise to gov’t revenue (area C) which is a rent. DWL=B+D • 2) A quota (like a tariff) gives rise to a rent that is captured by domestic residents (area C), DWL=B+D • Technical barriers to trade (TBT) : DWL= B+C+D • (see more detailed 3 country similar set-up in Matoo-Fink Annex)

20.  Investment (I) • Bilateral investment treaties (BITs) are usually agreements that are shallow or “negative”, i.e. that remove some of uncertainty that affects investment. • Exceptions are: • SMP in the EU with single market for investment and capital • NAFTA where MFN treatment in establishment and operation. Also extensive dispute settlement provisions that allow for private action against gov’ts. … but failure of OECD to get the Multilateral Agreement on Investment (MAI) signed (which would have given binding dispute settlement procedures suggest that perhaps in some cases the regional route might work…but will take time.

21.  Investment (II) •  An RIA can also help lock in good policies (see above) • An RIA can also attract FDI (see Mexican case above but also MERCOSUR in S-W tab. 4.1) • An RIA can also signal gov’ts reform intentions--- but not always as the comparison of Greece with Spain and Portugal shows

22.  Regionalism and Services The GATS Article V 1. This Agreement shall not prevent any of its Members from being a party to or entering into an agreement liberalizing trade in services between or among the parties to such an agreement, provided that such an agreement: (a) has substantial sectoral coverage [1] and (b) provides for the absence or elimination of substantially all discrimination, in the sense of Article XVII, between or among the parties, in the sectors covered under sub-paragraph (a),…  Quite similar to article XXIV with exceptions for developing countries

23.  Regionalism and Services (from Matoo-Fink) • Now a Services dimension to most RIAs. • Main conclusions: • Efficiency effects • Barriers being often prohibitive and not rent-generating, likely to have gain (no TD problem) • Also scope for increased competition and other effects + knowledge spillovers. • As usual non-preferential liberalization would be better

24.  Regionalism and Services (II) • Plurilateral vs- multilateral approach • Plurilateral approach to cooperation may dominate multilateral because: • Possibility of TOT gains at the expense of the ROW (this also applies to trade in goods • More efficient bargaining at regional level • Cooperation may be more desirable among a subset of countries than globally. ….but there are potential exceptions to these arguments (sunk costs can lead to ‘history matters’ type of situation so sequencing may be important (regional before or after multilateral; etc…)

25. Annex welfare effects of trade policy under imperfect competition Following slide decomposes the effects of a an increase in protection on welfare in an industry producing a differentiated good under IRTS  See on comments on last slide

26. Trade policy to protect oligopoly (or monopolistic competition) industry Increase in Protection Demand  Less elastic demand ‘anti-competitive’ effect Less product variety SE  (for existing firms) Consumer satisfaction  Producer costs Welfare  Profits  Welfare  SE ?? Welfare  Firm entry  SE  Welfare  SE= ‘Scale Efficiency’

27. Comments Most simulation models include all effects on previous slide except variety (only a few determine the number of varieties of products in equilibrium) • In GE what is most important is if on average, sectors with IRTS see their incentives (protection) rise with change in trade policy. If so, then SE effects will be determined by interaction of entry/exit (movements along AC curves) and shifts in AC curves). • Properly executed, each of identified effects can be isolated by calibrating model to same initial solution • But where do elasticities come from? Is economy in equilibrium?