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The Simple Analytics of Trade Creation and Diversion

Alan V. DeardorffUniversity of Michigan

Rishi R. SharmaColgate University

For presentation at

Conference on International Economic Integration: Firms, Workers, and Policies

Universität Tübingen May 22-23, 2019

Outline

• Background• Simplest model: horizontal supplies• Upward-sloping supplies– 3-country case, in graphs– Somewhat more general case, in

equations– 4-country case, in graphs

Background

• Viner’s (1950) trade creation and trade diversion are usually illustrated with

– Constant costs

– 2-country FTA or CU plus rest of world

• Then we’ll look at cases with

– Upward sloping supplies

– And in the last case, an FTA with pre-existing other FTA

Simplest Model• Assume– Partial-equilibrium model of trade in a good– 3 countries:

• Home, A• Partner 1, B, and • Partner 2, C

– B and C have constant costs of exporting to A, at prices PB < PC

– A has tariff, t > PC – PB

No FTA

QS0 M0

• Without FTA– Since PB+t < PC+t Home

imports only from B

FTA with low-cost country, B

QS0 M0

FTA with B• Since PB < PC+t Home still

imports only from B• Country C plays no role

a b c d

WelfareSuppliers lose –aDemanders gain +(a+b+c+d)Government loses –cCountry gains +(b+d)

Same as Free TradeD1S1 D0

QS0 D0M0

a b c d

Trade Creation

FTA with low-cost country, B

FTA with high-cost country, C

QS0 M0

FTA with C• Since PC < PB+t Home now

imports only from C

a b c d

WelfareSuppliers lose –a

Demanders gain +(a+b+c+d)

Government loses –(c+e)Country loses –e+(b+d)

Not same as Free Tradeand may be a loss, if

e>(b+d)

S1 D1D0

QS0 M0

a b c d

S1 D1D0

Trade Creation

Trade Diversion

FTA with high-cost country, C

Trade in Services• Trade in a service is not subject to tariffs, since nothing physical

crosses borders• It is subject to regulatory standards, that also raise cost, by some

amount, say “s”• Assume that FTA removes this cost through

– Harmonization of standards– Mutual recognition

• The difference is that – Tariff t is revenue to government– Regulatory cost s is a real cost, using real resources, and not a transfer

or benefit to anyone• Pictures look the same as before, except for interpretation of this

Lecture 1: Overview10

Service FTA with low-cost, B

QS0 M0

FTA with B• Since PB < PC+s Home still

imports only from B• Country C plays no role

a b c d

WelfareSuppliers lose –aDemanders gain +(a+b+c+d)Government loses 0Country gains +(b+c+d)

D1S1 D0

QS0 M0

FTA with C• Since PC < PB+s Home now

imports only from C

PCa b c d

WelfareSuppliers lose –aDemanders gain +(a+b+c+d)Government loses 0Country gains +(b+c+d)

Certain gain, but not as large as with country B

S1 D1D0

Service FTA with high-cost, C

Upward-sloping Supplies3-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

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.

!" = !$

Export Supplies of B and C

Exports to Country A

%"&, %$& P %"& + %$&

%") + %$&

Export Supplies

%"), %$)

!"#, !%#

Import Market

!"&, !%& P

!)" = !)% ')( = !)" +!)%

MFN Equilibrium

," = ,%-

!"& + !%&

!"# + !%&.)(

Export Supplies

!"#, !%# P

!("= !(%

FTA Equilibrium

!*" &(' &*'

+" = +%,

!"# + !%#

!". + !%#/('/*'

!"., !%.

Export Supplies Import Market

Trade Creation and Diversion

!"#, !%# P

!(" &)' &('

*" =*%

!"# + !%#

!". + !%#!"., !%.

/)'/('

!)"= !)%

TC & TD, another View

#$%, #'%

#)$ (*" ()"

#$% + #'%

#$- + #'%#$-, #'-

!*"!)"

TD TCTDTC

#*$= #*'

#)'2$ =2'

Welfare Effects on Country A

Export Supplies

!"#, !%#

!(" &)' &('

Tariff revenue lost fromB C

Net gain of A’s private sector

!"# + !%#

!", + !%#!",, !%,

-)'-('

TD TCTDTC

Import Market

!)"= !)%

2"= 2%

See immediately that country A• Gains from trade creation• Loses from trade diversion• As well as from lost revenue from country B

Welfare Effects on Countries B and C

!"#, !%#

!(" &)' &('

!"# + !%#

!", + !%#!",, !%,

-)'-('

TD TCTDTC

!)"= !)%

Gain by partner country B

Loss by outside country C

2"= 2%

Welfare Effects on the World

These add up, with much cancellation to yield the following:

!"#, !%#

!(" &)' &('

!"# + !%#

!", + !%#!",, !%,

-)'-('

TD TCTDTC

!)"= !)%

2"= 2%

!"#, !%#

!(" &)' &('

!"# + !%#

!", + !%#!",, !%,

-)'-('

TD TCTDTC

!)"= !)%

2"= 2%

!"#, !%#

!(" &)' &('

!"# + !%#

!", + !%#!",, !%,

-)'-('

TD TCTDTC

!)"= !)%

2"= 2%

!"#, !%#

!(" &)' &('

!"# + !%#

!", + !%#!",, !%,

-)'-('

TD TCTDTC

!)"= !)%

2"= 2%

!"#, !%#

!(" &)' &('

!"# + !%#

!", + !%#!",, !%,

-)'-('

TD TCTDTC

!)"= !)%

2"= 2%

!"#, !%#

!(" &)' &('

!"# + !%#

!", + !%#!",, !%,

-)'-('

TD TCTDTC

!)"= !)%

2"= 2%

!"#, !%#

!(" &)' &('

!"# + !%#

!", + !%#!",, !%,

-)'-('

TD TCTDTC

!)"= !)%

2"= 2%

!"#, !%#

!(" &)' &('

!"# + !%#

!", + !%#!",, !%,

-)'-('

TD TCTDTC

!)"= !)%

Loss from trade diversion

Gain from trade creation

2" =2%

!"#, !%#

!(" &)' &('

!"# + !%#

!", + !%#!",, !%,

-)'-('

TD TCTDTC

!)"= !)%

Why the Loss from Trade Diversion

C’s fall in cost

B’s rise in cost

2" =2%

!"#, !%#

!(" &)' &('

!"# + !%#

!", + !%#!",, !%,

-)'-('

TD TCTDTC

!)"= !)%

Loss from trade diversion

Gain from trade creation

2" =2%

• 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.

Four-Country Model in Equations

• 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, & = (, ), *

The Model

Exports:

Imports:

Equilibrium:

!" = $" %" − '" , ) = *, +, ,, %" ≥ '"

./ = $/ '/ − %/ , %/ ≤ '/

./ = !1 + !3 + !4

The Model

Then solution is:!" = $ + &'(' + &)() + &*(*

+ = ," + ,' + ,) + ,*

$ = &"-" + &'-' + &)-) + &*-*&. = ⁄,. +

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.)

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

Because A’s tariff on C and D does not change

∆"# = −&'(

∆"' = (1 − &')(

∆", = ∆"- = ∆"# = −&'(

The Model

From the price changes, one derives the following changes in quantities of trade:

∆"#= %&'#( > 0∆+&= %& '# + '- + ./ ( > 0

∆+-= −%&'1( < 0

∆+/= −%&'3( < 0

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

because it is reversal of trade diversion from the prior FTA.

∆"#= ∆%& − ∆"( −∆")

−∆"( as “trade diversion”

−∆") as “trade reversion”

The Model

!"#$% &"%#'()* = !& = ,-./' > 0

!"#$% 2%3%"4()* = !2 = ,-.5' > 0

!"#$% 6(3%"4()* = !6 = ,-.7' > 0

The Model

Welfare effects of new FTA

Country A (home):

Country B (new partner):

Country C (outside world):

Country D (old partner):

∆"#= ⁄&'# (# + *+ ⁄, 2 ./ − ,.1 − ,2'+

∆"+= ∆34+= 2'+ +12 ./ + .1 + .6 1 − *+ ,

∆"7= −2'7 +.12 *+,

∆"8= −2'8 +.62 *+,

Lost tariff revenue

The Model

Welfare effects of new FTA on the World

World (A+B+C+D):

∆"#= 12'() +

12 '+ − '- )

4-country case in figures

• 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

!" =!$ =!% Q

Export Supplies of B, C, and D

Export Supplies to Country B

&"', &$', &%' P

∑&* = &"* + &$* +&%*,

Export Supplies

∑&- = &"* + &$' +&%*

∑&. = &"' + &$' +&%*

/" = /$ = /%

∑&0 = &"' + &$' +&%'&"*, &$*, &%*

!"#, !%#, !&# P

Equilibrium 1: A has FTA with 1 country, D

∑!)*+

!("= !(%

!(& *(+

= !(" +!(% + !(&

!"., !%., !&.

Import Market

!"#, !%#, !&# P ∑!(

∑!)*+

!("= !(%

!(& *(+

Equilibrium 2: A has FTA with 2 countries, B & D

!)% !)"= !)&

!"-, !%-, !&-

Import Market

!"#, !%#, !&# P ∑!(

∑!)*+

!("= !(%

!(& *(+

Changes in Trade from expanding FTA to Country B

!)% !)"= !)&

∆*+∆!% ∆!&

!"., !%., !&.

Import Market

Trade Creation

!"#, !%#, !&# P ∑!(

∑!)*+

∆!" ∆*+∆!% ∆!&TD TR TC

Trade Creation (TC), Diversion (TD), and Reversion (TR)

!"1, !%1, !&1

Import Market

Trade CreationTrade Diversion Trade Reversion

!"#, !%#, !&# P ∑!(

∑!)*+

Trade Creation (TC), Diversion (TD), and Reversion (TR)

∆!" ∆*+∆!% ∆!&

TRTDTCNote that ∆!", while a gain to Country B, is the sum of TC, TD, & TR, since ∆!"= ∆*+ − ∆!% − ∆!&

!"2, !%2, !&2

Import Market

TD TR TC

!"#, !%#, !&# P ∑!(

∑!)*+

Welfare Effects on Country ATariff

revenue lost from

B CNet gain of A’s private sector

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.

!",, !%,, !&,

Import Market

∆!" ∆*+∆!% ∆!&

∆!&TR

∆!%TD∆*+

TR TCTD

!"#, !%#, !&# P ∑!(

∑!)*+

Welfare Effect on Country B

!",, !%,, !&,Net gain of B’s private sector

Import Market

QTRTDTC

TR TCTD

!"#, !%#, !&# P ∑!(

∑!)*+

Welfare Effect on Country C

Net loss of C’s private sector

!",, !%,, !&,

Import Market

QTRTDTC

TR TCTD

!"#, !%#, !&# P ∑!(

∑!)*+

Welfare Effect on Country D

!",, !%,, !&,Net loss of D’s private sector

Import Market

QTRTDTC

TR TCTD

!"#, !%#, !&# P ∑!(

∑!)*+

Welfare Effects on World

!",, !%,, !&,

Import Market

QTRTDTC

TR TCTD

I claim that these gains and losses mostly cancel out to reduce to the following:

!"#, !%#, !&# P ∑!(

∑!)*+

Welfare Effect on World

!",, !%,, !&,

Import Market

QTRTDTC

TR TCTD

!"#, !%#, !&# P ∑!(

∑!)*+

!",, !%,, !&,

Import Market

QTRTDTC

TR TCTD

!"#, !%#, !&# P ∑!(

∑!)*+

!",, !%,, !&,

Import Market

QTRTDTC

TR TCTD

!"#, !%#, !&# P ∑!(

∑!)*+

!",, !%,, !&,

Import Market

QTRTDTC

TR TCTD

!"#, !%#, !&# P ∑!(

∑!)*+

!",, !%,, !&,

Import Market

QTRTDTC

TR TCTD

!"#, !%#, !&# P ∑!(

∑!)*+

!",, !%,, !&,

Import Market

QTRTDTC

TR TCTD

!"#, !%#, !&# P ∑!(

∑!)*+

!",, !%,, !&,

Import Market

QTRTDTC

TR TCTD

!"#, !%#, !&# P ∑!(

∑!)*+

!",, !%,, !&,

Import Market

QTRTDTC

TR TCTD

!"#, !%#, !&# P ∑!(

∑!)*+

!(" !(% !(&!",, !%,, !&,

Import Market

QTRTDTC

TR TCTD

!("= !(%

!"#, !%#, !&# P ∑!(

∑!)*+

!(" !(% !(&!",, !%,, !&,

Import Market

QTRTDTC

TR TCTD

!("= !(%

!"#, !%#, !&# P ∑!(

∑!)*+

!",, !%,, !&,

Import Market

QTRTDTC

TR TCTD

!("= !(%

!(&!(" !(% !(&

!"#, !%#, !&# P ∑!(

∑!)*+

!",, !%,, !&,

Import Market

QTRTDTC

TR TCTD

!"#, !%#, !&# P ∑!(

∑!)*+

!",, !%,, !&,

Import Market

QTRTDTC

TR TCTD

!"#, !%#, !&# P ∑!(

∑!)*+

!",, !%,, !&,

Import Market

QTRTDTC

TR TCTD

!"#, !%#, !&# P ∑!(

∑!)*+

!",, !%,, !&,

Import Market

QTRTDTC

TR TCTD

!"#, !%#, !&# P ∑!(

∑!)*+

!",, !%,, !&,

Import Market

QTRTDTC

TR TCTD

!"#, !%#, !&# P ∑!(

∑!)*+

!",, !%,, !&,

Import Market

QTRTDTC

TR TCTD

!"#, !%#, !&# P ∑!(

∑!)*+

!",, !%,, !&,

Import Market

QTRTDTC

TR TCTD

4-country case

• Result:– World welfare rises with second FTA, by amount

depending on trade creation and the tariff• Recall from model:

• Here, because we’ve assumed countries B and D are the same, TR=TD

∆"#= 12'() +

12 '+ − '- )

∆"#= 12'()

4-country case

• In general, !" ≠ !$• Which is larger depends just on country size, size

both face the same price change.

• If the new partner is smaller than the old, !" > !$ , and world gain will be larger

• If new partner is bigger than old, then !" < !$and world gain will be smaller and perhaps a loss.

∆45= 12!9: +

12 !" − !$ :

Conclusion

• Analysis of FTAs shouldn’t treat each independently of FTAs that already exist

• Sequencing of FTAs can matter.

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