Chapter 5: The essential economics of
preferential liberalization
…the ideas of economists and political philosophers, both when they are right
and when they are wrong, are more powerful than is commonly understood.
Indeed the world is ruled by little else. Practical men, who believe themselves
to be exempt from any intellectual influences, are usually the slaves of some
defunct economist.
John Maynard Keynes, 1935
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Analysis of unilateral discriminatory liberalization
Only 3 basic elements needed to understand preferential liberalization:
-
‘Smith’s certitude’ by Adam Smith: foreign firms gain (i.e., higher
price and more exports) when tariffs against them are eliminated;
-
‘Haberler’s spillover’ by Gottfried Haberler: third nations – those
excluded from the preferences – must lose;
-
‘Viner’s ambiguity’ by Jacob Viner: preferential liberalization might
harm the preference-giving nation because .discriminatory
liberalization is both ‘liberalization’ – which removes some price
wedges and thus tends to improve economic efficiency and Home
welfare – and ‘discrimination’ – which introduces new price wedges
and thus tends to harm efficiency and welfare.
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The PTA diagram
Diagrams analyzing preferential liberalization are complex since they
require at least 3 nations in the analysis (Home, Partner and RoW).
Extend workhorse MD–MS diagram to allow for 2 sources of imports:
- aggregate (i.e., horizontal sum) export supply curves of two sources
(Partner and RoW);
- free trade equilibrium at intersection of MS and MD;
- level of imports from two sources read from each supplier’s graph.
What happens when Home imposes a tariff T on all imports?
- MS curve shifts up by T and no change in MD;
- new intersection shows the post-tariff equilibrium domestic price for
imports and new import level;
- with this border price, both import suppliers supply less.
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The PTA diagram
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Discriminatory liberalization
What happens when Home removes tariff T only from Partner?
-MS curve shifts down but only halfway between MS (free trade) and
MSMFN because liberalization affects only half imports;
-kinked MS curve with PTA, for low enough prices where only Partner
country is exporting.
New equilibrium:
-new domestic price is lower;
-Partner-based firms see border price rise, P′ – T to P′′;
-RoW firms see border price fall from P′ – T to P′′ – T;
-RoW exports fall, Partner exports rise more than RoW exports fall, so
domestic imports rise (supply switching).
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Discriminatory liberalization
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Supply-switching effects of EEC customs union
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Welfare effects
What happens when Home removes tariff T only from Partner?
-Home’s welfare changes by (A + B – C), positive or negative (Viner’s
ambiguity);
-Partner gains area D (Smith’s certitude);
-RoW loses area E (Haberler’s spillover).
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Welfare effects
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Home welfare effects
-
DCS = D + A1 + A2 + A3;
DPS = -D;
Dtariff revenue = B – A1 – C.
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Analysis of a customs union
European integration involved a sequence of preferential liberalizations
but all reciprocal = both Home and Partner eliminate T on each other’s
exports.
Assume that three goods are traded (goods 1, 2 and 3). Each country
produces all three goods, but cost structures are such that each nation
exports two of the three goods while importing the remaining one:
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Analysis of a customs union
Price and quantity effects:
-impact of Home’s discriminatory liberalization is as seen before;
-impact of Partner’s discriminatory liberalization of imports of good 2
from Home can also be seen using the same diagram:
• price of good 2 in Partner falls from P′ to P′′ but border price for Home
exporters when they sell good 2 to Partner rises from P′ – T to P′′. No
change to domestic prices in RoW since they did not liberalize, but
RoW exporters face a lower border price for their exports to Partner.
Welfare effects:
-a matter of adding up effects illustrated before.
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Analysis of a customs union
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Customs unions versus free trade agreements
A free trade agreement (FTA) is like a customs union (CU) but without
a common external tariff. This situation prompts ‘tariff cheats’:
-goods from RoW destined for Home market enter via Partner if
Partner has lower external tariff = ‘trade deflection’.
The solution is ‘rules of origin’ meant to establish where a good was
made. However, such rules are difficult and expensive to administer,
especially as world get more integrated. They often become a form of
disguised protection. Still, almost all preferential trade arrangements in
world are FTAs because CUs require some political integration.
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Frictional barriers: the 1992 Programme
Since the mid-1970s and especially since the 1986 Single European
Act, most economic integration in Europe has involved the removal of
‘frictional’ barriers to trade.
Still, frictional barriers can be conceptualized as tariffs where the tariff
revenue is thrown away. For such barriers, Smith’s certitude and
Haberler’s spillover still hold, but Viner’s ambiguity disappears.
Reciprocal preferential frictional barrier liberalization leads to:
-lower Home’s domestic and border price;
-Higher price received by Partner exporters and lower price received
by RoW exporters.
Thus, Home imports rise and Partner exports rise while RoW exports
fall. Supply switching still occurs.
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Frictional barriers: the 1992 Programme
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WTO rules
A basic principle of the WTO/GATT is non-discrimination in application
of tariffs.
FTAs and CUs violate this principle. However, Article 24 permits FTAs
and CUs subject to conditions:
- substantially all trade must be covered;
.
- intra-bloc tariffs must go to zero within reasonable period;
- In case of CU, the common external tariff must not on average be
higher than the external tariffs of the CU members were before:
• in EEC, the CU meant that France and Italy lowered their tariffs,
Benelux nations raised theirs while German tariffs were about at the
average.
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