Analytics of Trade Creation and Diversion: Insights from Deardorff and Sharma
Explore the simple analytics of trade creation and diversion as presented by Alan V. Deardorff and Rishi R. Sharma at the University of Michigan. Dive into the impacts of FTAs and understand the concepts through detailed graphs and equations.
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The Simple Analytics of Trade Creation and Diversion Alan V. Deardorff University of Michigan Rishi R. Sharma Colgate University For presentation at Conference on International Economic Integration: Firms, Workers, and Policies Universit t T bingen May 22-23, 2019 www.fordschool.umich.edu
To Willi Known since his year at Michigan in the 1980s Visited him and Gabi in Essen, Linz, and T bingen Have admired his work throughout Delighted to be here to honor him 2 www.fordschool.umich.edu
My Topic FTAs Willi has touched on these throughout his career, as have most of us in the trade field 3 www.fordschool.umich.edu
Outline Background 3-country case, in graphs Somewhat more general case, in equations 4-country case, in graphs 4 www.fordschool.umich.edu
Background Viner s (1950) trade creation and trade diversion are usually illustrated with Constant costs 2-country FTA or CU plus rest of world We ll look here at cases with Upward sloping supplies And in the last case, an FTA with pre-existing other FTA 5 www.fordschool.umich.edu
3-country case* Three countries, importer A, and exporters B, and C Export supply and import demands are linear Countries B and C are identical Two equilibria 0: MFN specific tariff t on exports of both B and C 1: FTA of A and B: tariff t on exports of C; zero tariff on exports of B For simplicity *Much of this is an elaboration of material in World Trade Organization, "Causes and Effects of PTAs: Is it all about preferences?", Ch. C: World Trade Report 2011, pp. 92-121. 6 www.fordschool.umich.edu
7 Export Supplies Export Supplies of B and C Exports to Country A ???+ ??? P ???,??? P ???,??? ???+ ??? ? ??= ?? Q Q www.fordschool.umich.edu
8 MFN Equilibrium Import Market Export Supplies ???+ ??? P ???,??? P ???,??? ? ?0 ???+ ??? ?? ? ??= ?? Q Q ? ? ?= ?0 ?= ?0 ?+?0 ?0 ?0 www.fordschool.umich.edu
9 FTA Equilibrium Import Market Export Supplies ???+ ??? P ???,??? P ???,??? ? ?0 ?1 ???+ ??? ? ?? ? ??= ?? Q Q ? ??1 ? ? ? ?0 = ?0 ?0 ?1 ?1 ? www.fordschool.umich.edu
10 Trade Creation and Diversion Import Market Export Supplies ???+ ??? P ???,??? P ???,??? ? ?0 ?1 ???+ ??? ? ?? ? ??= ?? TC TD Q Q ? ??1 ? ? ? ?0 = ?0 ?0 ?1 ?1 ? www.fordschool.umich.edu
11 TC & TD, another View Import Market Export Supplies ?? ?? ???+ ??? ???,??? ???,??? ? ?0 ?1 ???+ ??? ? ?? ? TD TC ??= ?? TC TD Q Q ? ??1 ? ? ? ?0 = ?0 ?0 ?1 ?1 ? www.fordschool.umich.edu
12 Welfare Effects on Country A Export Supplies Import Market Net gain of A s private sector ?? ?? Tariff revenue lost from B C ???+ ??? ???,??? ???,??? ? ?0 ?1 ???+ ??? ? ?? ? TD TC ?? = ?? TC TD Q Q ? ??1 ? ? ? ?0 = ?0 ?0 ?1 ?1 ? See immediately that country A Gains from trade creation Loses from trade diversion As well as from lost revenue from country B www.fordschool.umich.edu
13 Welfare Effects on Countries B and C Import Market Export Supplies ?? ?? ???+ ??? ???,??? ???,??? Gain by partner country B ? ?0 ?1 ???+ ??? ? Loss by outside country C ?? ? TD TC ?? = ?? TC TD Q Q ? ??1 ? ? ? ?0 = ?0 ?0 ?1 ?1 ? www.fordschool.umich.edu
14 Welfare Effects on the World Import Market Export Supplies ?? ?? ???+ ??? ???,??? ???,??? ? ?0 ?1 ???+ ??? ? ?? ? TD TC ?? = ?? TC TD Q Q ? ??1 ? ? ? ?0 = ?0 ?0 ?1 ?1 ? These add up, with much cancellation to yield the following: www.fordschool.umich.edu
15 Welfare Effects on the World Import Market Export Supplies ?? ?? ???+ ??? ???,??? ???,??? ? ?0 ?1 ???+ ??? ? ?? ? TD TC ?? = ?? TC TD Q Q ? ??1 ? ? ? ?0 = ?0 ?0 ?1 ?1 ? These add up, with much cancellation to yield the following: www.fordschool.umich.edu
16 Welfare Effects on the World Import Market Export Supplies ?? ?? ???+ ??? ???,??? ???,??? ? ?0 ?1 ???+ ??? ? ?? ? TD TC ?? = ?? TC TD Q Q ? ??1 ? ? ? ?0 = ?0 ?0 ?1 ?1 ? These add up, with much cancellation to yield the following: www.fordschool.umich.edu
17 Welfare Effects on the World Import Market Export Supplies ?? ?? ???+ ??? ???,??? ???,??? ? ?0 ?1 ???+ ??? ? ?? ? TD TC ?? = ?? TC TD Q Q ? ??1 ? ? ? ?0 = ?0 ?0 ?1 ?1 ? These add up, with much cancellation to yield the following: www.fordschool.umich.edu
18 Welfare Effects on the World Import Market Export Supplies ?? ?? ???+ ??? ???,??? ???,??? ? ?0 ?1 ???+ ??? ? = ?? ? TD TC ?? = ?? TC TD Q Q ? ??1 ? ? ? ?0 = ?0 ?0 ?1 ?1 ? These add up, with much cancellation to yield the following: www.fordschool.umich.edu
19 Welfare Effects on the World Import Market Export Supplies ?? ?? ???+ ??? ???,??? ???,??? ? ?0 ?1 ???+ ??? ? ?? ? TD TC ?? = ?? TC TD Q Q ? ??1 ? ? ? ?0 = ?0 ?0 ?1 ?1 ? These add up, with much cancellation to yield the following: www.fordschool.umich.edu
20 Welfare Effects on the World Import Market Export Supplies ?? ?? ???+ ??? ???,??? ???,??? ? ?0 ?1 ???+ ??? ? ?? ? TD TC ?? = ?? TC TD Q Q ? ??1 ? ? ? ?0 = ?0 ?0 ?1 ?1 ? These add up, with much cancellation to yield the following: www.fordschool.umich.edu
21 Welfare Effects on the World Import Market Export Supplies Loss from trade diversion ?? ?? ???+ ??? ???,??? ???,??? ? ?0 ?1 ???+ ??? ? Gain from trade creation ?? ? TD TC ??= ?? TC TD Q Q ? ??1 ? ? ? ?0 = ?0 ?0 ?1 ?1 ? www.fordschool.umich.edu
22 Why the Loss from Trade Diversion Import Market Export Supplies ?? ?? ???+ ??? ???,??? ???,??? ? ?0 ?1 ???+ ??? ? ?? ? TD TC ??= ?? TC TD Q Q ? ??1 ? ? ? ?0 = ?0 ?0 ?1 ?1 ? B s rise in cost C s fall in cost www.fordschool.umich.edu
23 Welfare Effects on the World Import Market Export Supplies Loss from trade diversion ?? ?? ???+ ??? ???,??? ???,??? ? ?0 ?1 ???+ ??? ? Gain from trade creation ?? ? TD TC ??= ?? TC TD Q Q ? ??1 ? ? ? ?0 = ?0 ?0 ?1 ?1 ? Loss is an area, product of the price change and the quantity of trade diversion, with the latter depending on the former. So the loss rises with the square of trade diversion. www.fordschool.umich.edu
The Model Four countries: Importer A Exporters B, C, and D Export supply and import demands are linear Three equilibria 0: MFN tariff t on exports of B, C, and D 1: FTA of A and D: Tariff t on exports of B and C; Zero tariff on exports of D 2: FTA of A with B, keeping FTA with D Tariff t on exports of C only Zero tariff on exports of B and D Consider only cases with ??> 0,? = ?,?,? 24 www.fordschool.umich.edu
The Model Exports: ??= ???? ??, ?? ?? ? = ?,?,?, Imports: ??= ???? ??, ?? ?? Equilibrium: ??= ??+ ??+ ?? 25 www.fordschool.umich.edu
The Model Let: ? = ??+ ??+ ??+ ?? ??= ??? ? = ????+ ????+ ????+ ???? Then solution is: ??= ? + ????+ ????+ ???? 26 www.fordschool.umich.edu
The Model With more assumptions, ?? are proportional to country size (See paper) Therefore ?? is country i s share of world economy (This is not really right, as it assumes both demanders and suppliers in proportion to population. Exporters will in fact have more firms, and thus greater weight, than importers.) 27 www.fordschool.umich.edu
The Model Effect of new FTA between A and B (in presence of A s FTA with D) Let be change from equilibrium 1 to equilibrium 2 ??= ??? Thus price in A falls by a fraction of the tariff, in proportion to size of new partner compared to world. Country B s price rises by the rest of the tariff ??= (1 ??)? Because A s tariff on C and D does not change ??= ??= ??= ??? 28 www.fordschool.umich.edu
The Model From the price changes, one derives the following changes in quantities of trade: ??= ????? > 0 ??= ????+ ??+ ??? > 0 ??= ????? < 0 ??= ????? < 0 29 www.fordschool.umich.edu
The Model As must be from market equilibrium ??= ?? ?? ?? Thus the added exports of the partner country include the new imports of country A plus the reduced exports of countries C and D. The latter trade may be said to be diverted, but we label ??as trade diversion and ??as trade reversion because it is reversal of trade diversion from the prior FTA. 30 www.fordschool.umich.edu
The Model Thus ????? ???????? = ?? = ????? > 0 ????? ????????? = ?? = ????? > 0 ????? ????????? = ?? = ????? > 0 31 www.fordschool.umich.edu
The Model Welfare effects of new FTA Lost tariff revenue Country A (home): ??= ???+ ?? ? ?0 ? 2 ?? ??? ??0 Country B (new partner): ??= ???= ?0 ?+1 1 ??? 2?? + ?? + ?? Country C (outside world): ??= ?0 ?+?? ??? 2 Country D (old partner): ??= ?0 ?+?? ??? 2 32 www.fordschool.umich.edu
The Model Welfare effects of new FTA on the World World (A+B+C+D): ??=1 2??? +1 2?? ?? ? 33 www.fordschool.umich.edu
4-country case Three countries, importer A, and exporters B, C, and D Export supply and import demands are linear Countries B, C, and D are identical Two equilibria 1: MFN tariff t on exports of both B and C Zero tariff on exports of old FTA partner D 2: New FTA of A and B: tariff t on exports of C only; zero tariff on exports of two FTA partners B and D For simplicity 34 www.fordschool.umich.edu
35 Export Supplies Export Supplies of B, C, and D Export Supplies to Country B P P ???,???,??? ???, ???, ??? ?1= ???+ ???+??? ?0= ???+ ???+??? ?2= ???+ ???+??? ? ??= ?? = ?? ??= ???+ ???+??? ??= ?? = ?? Q Q www.fordschool.umich.edu
36 Equilibrium 1: A has FTA with 1 country, D Export Supplies of B, C, and D Import Market P P ???,???,??? ???, ???, ??? ?1 ?2 ?? ? Q Q ? ? ? ?1 ?1 ?1 = ?1 ?+ ?1 ?+?1 ? ? = ?1 www.fordschool.umich.edu
37 Equilibrium 2: A has FTA with 2 countries, B & D Export Supplies of B, C, and D Import Market P P ???,???,??? ???, ???, ??? ?1 ?2 ?? ? Q Q ? ? ? ? ? ? ?1 ? ?1 ?2 ?2 ?1 = ?1 ?2 = ?2 ? www.fordschool.umich.edu
38 Changes in Trade from expanding FTA to Country B Export Supplies of B, C, and D Import Market P P ???,???,??? ???, ???, ??? ?1 ?2 ?? ? ?? ?? ?? ?? Q Q ? ? ? ? ? ? ?1 ? ?1 ?2 ?2 ?1 = ?1 ?2 = ?2 ? www.fordschool.umich.edu
39 Trade Creation (TC), Diversion (TD), and Reversion (TR) Export Supplies of B, C, and D Import Market P P ???,???,??? ???, ???, ??? ?1 ?2 ?? Trade Creation ? ?? ?? ?? ?? TC TD TR Q Q Trade Diversion Trade Reversion Trade Creation www.fordschool.umich.edu
40 Trade Creation (TC), Diversion (TD), and Reversion (TR) Export Supplies of B, C, and D Import Market P P ???,???,??? ???, ???, ??? ?1 ?2 ?? ? ?? ?? TR ?? TC ?? TD Q Q TR TDTC Note that ??, while a gain to Country B, is the sum of TC, TD, & TR, since ??= ?? ?? ?? www.fordschool.umich.edu
41 Welfare Effects on Country A Tariff revenue Export Supplies of B, C, and D lost from Import Market P P ???,???,??? ???, ???, ??? Net gain of A s private sector ?1 B C ?2 ?? ? ?? ?? TR ?? TC ?? TD ?? ?? ?? Q Q TR TC TD Note that trade reversion does not appear to affect A s welfare. I suspect this is an artifact of making export supplies from B and D the same. www.fordschool.umich.edu
42 Welfare Effect on Country B Export Supplies of B, C, and D Import Market P P ???,???,??? ???, ???, ??? ?1 Net gain of B s private sector ?2 ?? ? TC TD TR Q Q TR TDTC www.fordschool.umich.edu
43 Welfare Effect on Country C Export Supplies of B, C, and D Import Market P P ???,???,??? ???, ???, ??? ?1 ?2 ?? Net loss of C s private sector ? TC TD TR Q Q TR TDTC www.fordschool.umich.edu
44 Welfare Effect on Country D Export Supplies of B, C, and D Import Market P P ???,???,??? ???, ???, ??? Net loss of D s private sector ?1 ?2 ?? ? TC TD TR Q Q TR TDTC www.fordschool.umich.edu
45 Welfare Effects on World Export Supplies of B, C, and D Import Market P P ???,???,??? ???, ???, ??? ?1 ?2 ?? ? TC TD TR Q Q TR TDTC I claim that these gains and losses mostly cancel out to reduce to the following: www.fordschool.umich.edu
46 Welfare Effect on World Export Supplies of B, C, and D Import Market P P ???,???,??? ???, ???, ??? ?1 ?2 ?? ? TC TD TR Q Q TR TDTC www.fordschool.umich.edu
47 Welfare Effects on World Export Supplies of B, C, and D Import Market P P ???,???,??? ???, ???, ??? ?1 ?2 ?? ? TC TD TR Q Q TR TDTC www.fordschool.umich.edu
48 Welfare Effects on World Export Supplies of B, C, and D Import Market P P ???,???,??? ???, ???, ??? ?1 ?2 ?? ? TC TD TR Q Q TR TDTC www.fordschool.umich.edu
49 Welfare Effects on World Export Supplies of B, C, and D Import Market P P ???,???,??? ???, ???, ??? ?1 ?2 ?? ? TC TD TR Q Q TR TDTC www.fordschool.umich.edu
50 Welfare Effects on World Export Supplies of B, C, and D Import Market P P ???,???,??? ???, ???, ??? ?1 ?2 ?? ? TC TD TR Q Q TR TDTC www.fordschool.umich.edu
