The Economics of Free Trade Areas

Institut Tadbiran Awam Negara (INTAN)
Jabatan Perkhidmatan Awam Malaysia
Institut Tadbiran Awam Negara (INTAN)
Jabatan Perkhidmatan Awam Malaysia
The Economics
of Free Trade Areas
Institut
Institut Tadbiran Awam Negara (INTAN)
Jabatan
Jabatan Perkhidmatan
Perkhidmatan Awam
Awam Malaysia
Malaysia
INTRODUCTION

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:
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–
–
–
–
–
Movement of labours
Trade in services
Investments
Flow of capital
Intellectual property protection
Others (e.g. rules of origin; anti-dumping; national treatment)
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Institut Tadbiran Awam Negara (INTAN)
Jabatan Perkhidmatan Awam Malaysia
Economic Analyisis of FTA
 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
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temporal problems.
Institut Tadbiran Awam Negara (INTAN)
Jabatan Perkhidmatan Awam Malaysia
Debates about Free Trade
 Debates go back to times even before Adam Smith (1723 – 1790)
 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)
• 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.
 Smith argued against mercantilist economics in the wealth of Nation
(1776)
• 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.
Institut Tadbiran Awam Negara (INTAN)
Jabatan Perkhidmatan Awam Malaysia
Debates about Free Trade (cont...)
 During the period of classical economics ( 1770s until 1890s) free trade
established itself as a doctrine in economics.
 Free trade was a unilateral case.
 Britain embraced “free trade“ policy in 1846 when it abolished the
protectionist Corn Laws. Three main individual players:
• 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.
 A few other countries followed: The netherlands, Spain, Austria,
Switerland.
Institut Tadbiran Awam Negara (INTAN)
Jabatan Perkhidmatan Awam Malaysia
Debates about Free Trade (cont...)
• 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.
Institut Tadbiran Awam Negara (INTAN)
Jabatan Perkhidmatan Awam Malaysia
The Gains and Losses of an Exporting Country
Before Trade
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
A+B
Producer Surplus
C
After Trade
-B
A
+ (B + D)
B+C+D
A+B+C
Total Surplus
Change
+D
A+B+C+D
The area D shows the increase in total surplus
and represents the gains from trade.
Price of
Textiles
Domestic
supply
Price
after
trade
Exports
A
B
Price
before
trade
World
price
D
C
Exports
0 Domestic quantity
demanded
Domestic
demand
Domestic quantity
supplied
Quantity of
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Textiles
Institut Tadbiran Awam Negara (INTAN)
Jabatan Perkhidmatan Awam Malaysia
The Gains and Losses of an Importing Country
Before Trade
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.
After Trade
Change
Consumer Surplus
A
A+B+D
+ (B + D)
Producer Surplus
B+C
C
-B
A+B+C
A+B+C+D
+D
Total Surplus
The area D shows the increase in total surplus
and represents the gains from trade.
Price of
Textiles
Domestic
supply
A
Price
Before trade
Price
After trade
B
D
World
price
C
Imports
0
Domestic quantity
supplied
Domestic
demand
Domestic quantity
demanded
Quantity of
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Textiles
Institut Tadbiran Awam Negara (INTAN)
Jabatan Perkhidmatan Awam Malaysia
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
Producer Surplus
Government Revenue
Total Surplus
Before Tariff
A+B+C+D+E+F
G
None
A+B+C+D+E+F+G
Change
After Tariff
A+B
- (C + D + E + F)
C+G
+C
E
+E
-(D + F)
A+B+C+E+G
The area D shows the increase in total surplus and represents the gains from trade.
Price of
Textiles
Domestic
supply
Equilibrium
without trade
A
B
Price
with tariff
Price
without tariff
C
G
Tariff
F
Imports
with tariff
𝑠
0
E
D
𝑄1
𝑠
𝑄2
Domestic
demand
𝐷
𝑄2
Imports without tariff
𝐷
𝑄1
World
price
Quantity of
Textiles
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Institut Tadbiran Awam Negara (INTAN)
Jabatan Perkhidmatan Awam Malaysia
Setting up FTAs
• 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.
Institut Tadbiran Awam Negara (INTAN)
Jabatan Perkhidmatan Awam Malaysia
Economists’ Concern about FTA Negotiations
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•
•
•
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.
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Environmental issues.
Labor standards.
Intellectual property.
Domestic economic policies.
Institut Tadbiran Awam Negara (INTAN)
Jabatan Perkhidmatan Awam Malaysia
Source of International Trade
1
Differences in labour productivity
• 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.
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Institut Tadbiran Awam Negara (INTAN)
Jabatan Perkhidmatan Awam Malaysia
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)
Manufactures
Food
Foreign
(labor abundant)
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Institut Tadbiran Awam Negara (INTAN)
Jabatan Perkhidmatan Awam Malaysia
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.
Food
production, Q F
Indifference curves
D
Food
imports
Q
Isovalue
line
TT
Cloth
exports
Cloth
production, Q C
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Institut Tadbiran Awam Negara (INTAN)
Jabatan Perkhidmatan Awam Malaysia
Source of International Trade (cont...)
2
Differences in Resource Endowment
• Named as Hecksher-Ohlin Model
• Due to different natural endowments
• Canada exports forest products to the US because
it has more forested lands.
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Institut Tadbiran Awam Negara (INTAN)
Jabatan Perkhidmatan Awam Malaysia
Source of International Trade (cont...)
3
Occurs due to Economies of Scale (increasing returns)
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•
•
•
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.
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Institut Tadbiran Awam Negara (INTAN)
Jabatan Perkhidmatan Awam Malaysia
Trade with Increasing Returns and Monopolistic
Competition
Home
(capital abundant)
Manufactures
Food
Interindustry
trade
Intraindustry
trade
Foreign
(labor abundant)
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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Institut Tadbiran Awam Negara (INTAN)
Jabatan Perkhidmatan Awam Malaysia
Indexes of Intraindustry trade for United States
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Inorganic chemicals
Power generating machinery
Electrical Machinery
Organic chemicals
Medical and pharmaceutical
Office Machinery
Telecommunications equipment
Road vehicles
Iron and steel
Clothing and apparel
Footwear
0.99
0.97
0.96
0.91
0.86
0.81
0.69
0.65
0.43
0.27
0.00
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Jabatan Perkhidmatan Awam Malaysia
Thank You !!!
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