Understanding the Impacts of Trade Agreements on Global Welfare

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The lecture discusses the rules of origin and the potential gains or losses from trade agreements, focusing on whether the proliferation of FTAs can be harmful. It explores the concept of trade diversion and the implications of countries forming multiple FTAs. The content also includes a breakdown of countries connected by FTAs as of 2015.

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  1. Rue the ROOs: Rules of Origin and the Gains (or Losses) from Trade Agreements Alan V. Deardorff University of Michigan Lecture 5 Nankai University March 2, 2016 www.fordschool.umich.edu

  2. The Issue Can the proliferation of FTAs be harmful? Standard trade diversion suggests that Individual FTAs could lower world welfare, But if FTAs became ubiquitous, that would not happen. If every country were to have an FTA with every other country, then there would be no trade diversion. Examples: US-Singapore 2004 Singapore-Korea 2006 US-Peru 2009 Singapore-Peru 2009 Korea-Peru 2011 US-Korea 2011 2 www.fordschool.umich.edu

  3. S. Korea U.S. 2012 2009 2006 2009 Singapore Peru 3 www.fordschool.umich.edu

  4. WTO 4 www.fordschool.umich.edu

  5. 20% Countries? connected? by? FTAs? only,? as? of 2015? Argen Austr Austr Bangl Belgiu Brazil Brune Bulga Burkin Canad Chile China Colom Czech Denm Ecuad Egypt Finlan Franc Germ Greec Hong Hung India Indon Irelan Israel ItalyJapan Korea Kuwa Malay Argentina 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 Australia 0 0 0 0 0 0 2010 0 0 0 2009 2015 0 0 0 0 Austria 0 0 0 0 0 0 0 0 0 0 2003 0 2013 0 0 0 Bangladesh 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 Belgium 0 0 0 0 0 0 0 0 0 0 2003 0 2013 0 0 0 Brazil 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 Brunei? Darussa 0 2010 0 0 0 0 1992 0 0 0 2006 0 0 0 0 0 Bulgaria 0 0 0 0 0 0 0 0 0 0 2003 0 2013 0 0 0 Burkina? Faso 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 Canada 0 0 0 0 0 0 0 0 0 0 1997 0 2011 0 0 0 Chile 0 2009 2003 0 2003 0 2006 2003 0 1997 0 2006 2009 2003 2003 0 China 0 2015 0 0 0 0 0 0 0 0 2006 0 0 0 0 0 Colombia 0 0 2013 0 2013 0 0 2013 0 2011 2009 0 0 2013 2013 0 Czech? 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  6. The Issue But that is accurate only for final goods I will argue, via simple theoretical examples, that the presence of binding rules of origin (ROOs), in a world of traded intermediate inputs Can increase protection on intermediate inputs above even the tariffs on final goods. Will reduce world welfare below that of global free trade, even if every country has an FTA with every other country. May even reduce every country s welfare below what it would have achieved with no FTAs at all and positive tariffs. That is: All FTAs can be worse than No FTAs! 6 www.fordschool.umich.edu

  7. Rules of Origin Why an FTA must have ROOs Countries external tariffs differ Without ROOs, goods will enter through the lowest- tariff country ( trade deflection ) If internal transport cost is less than tariff differential ROOs specify Requirements for goods to be considered as originating either in a country or in an FTA Only trade satisfying the ROO gets a zero tariff 7 www.fordschool.umich.edu

  8. Rules of Origin Types of ROOs Substantial transformation Change of tariff heading The fewer the digits, the more restrictive. Regional value added Minimum % from inside Maximum % from outside Technical rules E.g., yarn forward for textiles in NAFTA 8 www.fordschool.umich.edu

  9. Rules of Origin Originating where? The issue of cumulation Bilateral cumulation: Inputs only within the FTA count, regardless of other existing FTAs Diagonal cumulation: Inputs from selected other countries count (such as other FTA partners) In practice, many FTAs (and all involving the U.S.) use bilateral cumulation That s most restrictive TPP has Diagonal to all members But not to non-members Relevant for China, wich has FTAs with several TPP countries 9 www.fordschool.umich.edu

  10. Why ROOs matter Some trade does not qualify, so tariffs remain in effect. Worse: Some producers will alter their choice of inputs in order to satisfy ROOs. This raises costs Examples will illustrate both 10 www.fordschool.umich.edu

  11. Why ROOs matter Outline: Partial equilibrium model of a single input & output General equilibrium example Variations on the general equilibrium example 11 www.fordschool.umich.edu

  12. Why ROOs add protection Tariff triggered by violation of a ROO applies to the full value of the final good, rather than just the cost of the imported input (That would be better, but it is never done.) Thus the $ cost of that violation, measured as a % of the cost of the input, is larger than the tariff itself. 12 www.fordschool.umich.edu

  13. Why ROOs add protection Thus a ROO is like increasing the tariff on the input. But its ad valorem effect on the input is larger than the ad valorem tariff on the output. ROOs, when binding, therefore magnify effects of existing tariffs on input trade. A partial-equilibrium example illustrates this. 13 www.fordschool.umich.edu

  14. Example 1 (Partial equil.) Suppose country B imports input from A to produce final product (output) to sell to C Initially, C has tariff t on imports B has zero tariff on input, perhaps due to FTA with A The input costs b in B, and a in A, with b>a Output costs c plus cost of the input 14 www.fordschool.umich.edu

  15. Example 1 Thus, producers in B have choice of costs: (a + c) with input imported from A (b + c) with input produced at home Assume (b + c) > (a + c) Without B-C FTA, output sells in C for (1+t)(a+c) With B-C FTA, output sells in C for (b+c) if sourced from B (1+t)(a+c) if sourced from A B will source from B if (b+c)<(1+t)(a+c) 15 www.fordschool.umich.edu

  16. A-B FTA (a + c) a (<b) Input cost = a A (a + c)(1+t) Output cost = c B Tariff = t Input cost = b C Without A-C FTA 16 www.fordschool.umich.edu

  17. A-B FTA (a + c) a (<b) Input cost = a A B-C FTA (a + c)(1+t) Output cost = c B Tariff = t Input cost = b C With B-C FTA (b + c) [if < (a + c)(1+t)] 17 www.fordschool.umich.edu

  18. Example 1 With B-C FTA and binding ROO, If (b+c) < (1+t)(a+c), then producer sources in B Define Input Protection (IP): IP, due to ROO, is maximum by which b can exceed a and still be sourced in B: IP = max{(b-a)/a | (b+c) (1+t)(a+c)} bmax + c = (1+t)(a+c) IP = (bmax-a)/a = [(1+t)(a+c)-c-a]/a = t(a+c)/a => IP = t + t(c/a) Note: IP > t 18 www.fordschool.umich.edu

  19. Example 1 IP = t + t(c/a) Thus the equivalent ad valorem protection provided by a binding ROO to an input is larger than the tariff in the FTA partner country on the output. e.g., if input is half the value of output, c=a& IP = 2t If input is 1/x the value of output, IP = xt 19 www.fordschool.umich.edu

  20. Example 1 Result: Input protection provided by ROO is larger the smaller is the input s share in value of final output. Caveat: This assumes that ROO is binding regardless of that share. That is often not the case: some ROOs bind only beyond some fraction of value added. But not all ROOs take that form. 20 www.fordschool.umich.edu

  21. Example 1 Conclusion from Example 1 FTAs with ROOs can raise protection on inputs But of course they reduce protection on outputs So can they be, on net, harmful? For that I turn to a different example, in general equilibrium 21 www.fordschool.umich.edu

  22. Example 2. (General equilibrium) 3 countries, each with same amount of labor 3 industries (but 6 goods) Goods demanded in fixed proportions (X=Y=Z) Each industry has separate input & output Constant labor requirements (a la Ricardo) Country A Country B In Out Tot In Out Tot X 1 2 X Y 2 3 Y Z 3 1 Z Country C In Out Tot X 2 Y 3 Z 1 3 1 2 1 2 3 3 1 2 22 www.fordschool.umich.edu

  23. Example 2. (General equilibrium) 3 countries, each with same amount of labor 3 industries (but 6 goods) Goods demanded in fixed proportions (X=Y=Z) Each industry has separate input & output Constant labor requirements (a la Ricardo) Country A Country B In Out Tot In Out Tot X 1 2 X Y 2 3 Y Z 3 1 Z Country C In Out Tot X 2 Y 3 Z 1 3 1 2 1 2 3 3 1 2 23 www.fordschool.umich.edu

  24. Country A Country B In Out Tot 3 1 1 2 2 3 Country C In Out Tot X 2 Y 3 Z 1 Example 2 In Out X 1 2 Y 2 3 Z 3 1 Tot 3 5 4 X Y Z 4 3 5 3 1 2 5 4 3 Comparative advantage if fragmentation not possible input and output must be produced together, 24 www.fordschool.umich.edu

  25. Country A Country B In Out Tot 3 1 1 2 2 3 Country C In Out Tot X 2 Y 3 Z 1 Example 2 In Out X 1 2 Y 2 3 Z 3 1 Tot 3 5 4 X Y Z 4 3 5 3 1 2 5 4 3 Comparative advantage if fragmentation is possible and there is multilateral free trade 25 www.fordschool.umich.edu

  26. Trade Flows: Inputs Country A Country B In Out Tot 3 1 1 2 2 3 Country C In Out Tot X 2 Y 3 Z 1 Example 2 In Out X 1 2 Y 2 3 Z 3 1 Tot 3 5 4 X Y Z 4 3 5 3 1 2 5 4 3 Comparative advantage if fragmentation is possible and there is multilateral free trade 26 www.fordschool.umich.edu

  27. Trade Flows: Inputs, Outputs Country A Country B In Out Tot 3 1 1 2 2 3 Country C In Out Tot X 2 Y 3 Z 1 Example 2 In Out X 1 2 Y 2 3 Z 3 1 Tot 3 5 4 X Y Z 4 3 5 3 1 2 5 4 3 Comparative advantage if fragmentation is possible and there is multilateral free trade 27 www.fordschool.umich.edu

  28. Trade Flows: Inputs, Outputs Country A Country B In Out Tot 3 1 1 2 2 3 Country C In Out Tot X 2 Y 3 Z 1 Example 2 In Out X 1 2 Y 2 3 Z 3 1 Tot 3 5 4 X Y Z 4 3 5 3 1 2 5 4 3 But note that some of these exports (in red) use inputs from a third country. They may not satisfy ROOs, once FTAs exist 28 www.fordschool.umich.edu

  29. Trade Flows: Inputs, Outputs Country A Country B In Out Tot 3 1 1 2 2 3 Country C In Out Tot X 2 Y 3 Z 1 Example 2 In Out X 1 2 Y 2 3 Z 3 1 Tot 3 5 4 X Y Z 4 3 5 3 1 2 5 4 3 Note: Even with ad valorem tariff, t, on all trade, if t < ~30%, result is same as with Free Trade (FT), since t is less than cost advantage E.g., B s price of X to A: 1.3(1+1.3(1)) = 2.99 < 3 29 www.fordschool.umich.edu

  30. Trade Flows: Country A Country B In Out Tot 3 1 1 2 2 3 Country C In Out Tot X 2 Y 3 Z 1 Example 2 In Out X 1 2 Y 2 3 Z 3 1 Now suppose: 3 bilateral FTAs ROOs inhibit output-trades shown by red arrows How? Depends on tariffs & ROOs. Assume: ROO content requirement > 50% and t > 50% ROO > 50% since InA/PX(InA) = 50% t > 50% raises PX(InA) > 3 = PX(InC) Tot 3 5 4 X Y Z 4 3 5 3 1 2 5 4 3 30 www.fordschool.umich.edu

  31. Trade Flows: Inputs, Outputs Country A Country B In Out Tot 3 1 1 2 2 3 Country C In Out Tot X 2 Y 3 Z 1 Example 2 In Out X 1 2 Y 2 3 Z 3 1 Tot 3 5 4 X Y Z 4 3 5 3 1 2 5 4 3 Those trades will instead be sourced within FTAs Cost rises by 1 unit; world loses. Cost for 1-unit bundle of X, Y, & Z rises 6 7 Loss of GDP due to FTAs, compared to free trade: 1/6 31 www.fordschool.umich.edu

  32. Implication (not surprising) ROOs can reduce the gains from ubiquitous FTAs below global free trade. 32 www.fordschool.umich.edu

  33. Implication? Question: Can ROOs actually cause the net welfare effect of FTAs to be negative (compared to positive tariffs and no FTAs)? In this example, No. Needed t < 30% to get free-trade welfare Needed t > 50% to induce higher-cost sourcing But with different numbers, Yes. 33 www.fordschool.umich.edu

  34. Example 3. Country A Country B In Out Tot X 20 Y 10 Z 15 Country C In Out Tot X 15 40 Y 20 10 Z 10 30 Example 2 In Out X 10 30 Y 15 40 Z 20 10 Tot 40 55 30 10 30 40 30 40 55 55 30 40 Numbers here are a different, but patterns of trade are the same. Tariff between 25% and 33% yields result E.g., t=30% 34 www.fordschool.umich.edu

  35. Example 3. Country A Country B In Out Tot X 20 Y 10 Z 15 Country C In Out Tot X 15 40 Y 20 10 Z 10 30 Example 2 In Out X 10 30 Y 15 40 Z 20 10 Tot 40 55 30 10 30 40 30 40 55 55 30 40 Check that t=30% works: (Check for X only; Y and Z are symmetric) Without FTAs B buys XIN for 1.3(10) = 13 B s cost of X = 13+10 = 23 A&C buy X from B for 1.3(23) = 29.9 < 40, 55 (A s, C s cost from self) With FTAs If B buys XIN from A for 10 B s cost of X = 10+10 = 20 If C buys X from B, it pays 1.3(20) = 26 > 25 (B s cost with XIN from C) 35 www.fordschool.umich.edu

  36. Example 3. Country A Country B In Out Tot X 20 Y 10 Z 15 Country C In Out Tot X 15 40 Y 20 10 Z 10 30 Example 2 In Out X 10 30 Y 15 40 Z 20 10 Tot 40 55 30 10 30 40 30 40 55 55 30 40 XIN from A Result of Example 3: With tariffs on all trade of 30%, consumption bundle requires 5/60 = ~8% more labor with FTAs than without. 36 www.fordschool.umich.edu

  37. Implication (surprising?) ROOs actually can cause the net welfare effect of ubiquitous FTAs to be negative for all countries, compared to no FTAs and positive tariffs. 37 www.fordschool.umich.edu

  38. Are ROOs better than this, or worse? Better? My examples all assumed that producers moved all inputs into the FTA. If they only move just enough to satisfy a ROO, then harm will be less. 38 www.fordschool.umich.edu

  39. Are ROOs better than this, or worse? Worse? I had Only two stages of production: input and output Only three goods and countries Examples in the paper show that cost rises with more stages of production, and more than three goods and countries 39 www.fordschool.umich.edu

  40. Cost rises from 9 to 11 (22%) 40 www.fordschool.umich.edu

  41. Cost rises from 8 to 11 (38%) 41 www.fordschool.umich.edu

  42. What to Do? First best: Multilateral free trade (of course) Second best: greater cumulation Specify ROOs so that inputs originating in any FTA partner qualify under other FTAs Third best: Permit within-FTA tariffs only on portion not originating, not on full value 42 www.fordschool.umich.edu

  43. What to Do? Is there hope? EU seems to use more cumulation than the US The negotiated Transpacific Partnership (TPP) does include such cumulation (to my relief, as US didn t want that) That s good, but note that TPP still doesn t have diagonal cumulation to countries outside TPP with bilateral FTAs 43 www.fordschool.umich.edu

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