Moldeo de Moldes y Noyos

There are two significant analytical approaches to the static welfare analysis of RTAs. The first approach is the concepts of trade creation and trade diversion by Viner (1950), Meade (1955), Lipsey (1957), Johnson (1960) and Mundell (1964). The latter is Kemp-Wan’s (1976) approach on welfare-improving customs union.

3.3.1 Trade Creation and Trade Diversion

The static welfare analysis of RTAs was pioneered by Viner in 1950. In Viner’s (1950)

classic book, The Customs Union Issue, the author introduced the concepts of trade creation

and trade diversion for measuring the economic effects of CUs. Viner’s model was based on a three-country, two-good partial equilibrium framework under the assumptions of infinite supply elasticity and zero demand elasticity. Viner focused on shifts in given volume of trade and production among member and non-member countries of the RTA but excluded

consumption effects (Bhagwati, Krishna and Panagariya, 1999; Jayasinghe, 2003; Viner, 1950).

The essential contribution of the Viner’s work demonstrates that a discriminatory RTA could be harmful for both a member country and the world welfare. The RTA produces trade creation in some products and trade diversion in others. Therefore, the welfare outcome can be welfare enhancing or reducing depending on the relative magnitudes of trade creation and

trade diversion. The Vinerian conclusion is contradictory to the pre-Vinerian approach, which shows that any form of regionalism should be welfare improving and move to worldwide free trade (Bhagwati and Panagariya, 1996; Jayasinghe, 2003; Viner, 1950).

Meade (1955) initially developed a three-good, three-country general equilibrium model with vertical supply and downward sloping demand functions. Meade measured the welfare effect of RTAs on the union and individual union members under the assumption of fixed terms of trade. Meade argued that Viner’s conclusion on the magnitudes of trade creation and

diversion are inadequate to capture the welfare effects. Gains of RTA in Meade’s model are determined by not only the magnitude of trade creation, but also the amount of cost reduction because of trade creation. In the same way, losses come from both the magnitude of trade diversion and increasing cost due to trade diversion. Besides, the formation of RTAs may result in world welfare improvement or reduction, depending on the initial levels of tariff on

the goods (Bhagwati et al., 1999; Jayasinghe, 2003; Meade, 1955).

Viner’s (1950) and Meade’s (1955) studies on the effects of RTAs were descriptive and lacked of graphical analysis and formal models. Lipsey (1957) initially applied graphical analysis to analyse the effects of RTAs using a three-country, two-good general equilibrium model. Lipsey’s graphical analysis assumed that a demand curve is downward-sloped and a supply curve is horizontal. Lipsey disputed that the exclusion of consumption effects of Viner’s analysis leads to an inaccurate conclusion in welfare effects. Lipsey pointed out that after forming a union, the relative prices in the domestic markets of member countries change because of the removal of tariffs on imports among member countries. These price changes generate two important effects. First, they affect the shift in production sources from a lower- cost non-member country to a higher-cost union partner. This is called production effects of union similar to Viner’s approach. Second, the consumption effects of union, where union member countries will increase their product consumption while reduce imports from non- member countries. Lipsey concluded that the gain in consumption owing to a reduction in the import price by a union member might outweigh the loss from switching production sources

of imports from a lower-cost non-member country to a higher-cost union partner (Bhagwati et

al., 1999; Jayasinghe, 2003; Lipsey, 1957).

Johnson (1960) employed a downward sloping demand curve and constant-cost supply curve. The author agreed with Lipsey’s definition of trade creation and trade diversion which

Customs Union which consists of two parallel effects: the production effect; a reduction in the real cost of goods due to the replacement of higher-cost domestic products with lower-cost partner imports, and the consumption effect; an increase in consumers’ surplus from the replacement of higher-cost domestic products with lower-cost partner imports. In addition, the formation of the Customs Union results in a shift in the source of imports from lower-cost foreign to higher-cost partner countries. This shift represents trade diversion or economic loss of the Customs Union which comprises both production and consumption effects. The

production effect is an increase in the real cost of goods from the substitution of higher-cost partner imports for lower-cost foreign products, and the consumption effect is a reduction in consumers’ surplus from the substitution of higher-cost partner imports for lower-cost foreign products.

The net welfare effect of the Customs Union is the sum of trade creation and trade diversion effects (Johnson, 1960). The redefinition of trade creation and trade diversion by Johnson (1960) is a more direct and natural analysis of the welfare effects of the Customs Union than

Viner’s and Lipsey’s approaches (Bhagwati et al., 1999; Jayasinghe, 2003).

In addition to trade creation and trade diversion, Mundell (1964) pointed out that the welfare effects of a RTA depends on the changes in the terms of trade among members, and between the RTA members and the rest of the world. The author employed the three-goods Meade (1955) model and a neat geometric technique to examine the terms of trade effects after the formation of a RTA. The model consists of three countries and three products. Each country exports one product and imports the remaining two. Then, country 1 and country 2 form a RTA and reduce a small tariff preference for imports among them while both countries still impose tariffs on imports from country 3 as initial levels. Mundell demonstrated that a discriminatory tariff reduction granted by a member country leads to an increase in the terms of trade of the partner country with respect to both the tariff-reducing member country and the rest of the world. But the change in the terms of trade of the tariff-reducing member country with respect to the rest of the world may increase or decrease. Mundell concluded that the level of improvement in the terms of trade of the partner country is larger, the greater the member’s tariff reduction. In other words, the member’s gain from a RTA is larger, the higher the initial tariffs of the partner country (Bhagwati et al., 1999; Mundell, 1964).

DeRosa (1998) described the basic Viner model to a more general model with downward- sloped demand and upward-sloped supply functions. The model consisted of two goods and three countries. The author concluded two important implications. First, if member countries of an RTA are the least-cost exporters, the RTA will bring trade creation and will increase

welfare certainly. Second, if one or more member countries are inefficient exporters, the net welfare effect of RTA is ambiguous depending on the magnitude of gains from trade creation and tariff revenue losses from trade diversion.

3.3.2 Making a Necessarily Welfare-Improving Customs Unions (CUs)

Kemp and Wan (1976) presented an influential discussion on effects of the formation of Customs Union (CUs) that if the trade with the rest of world remains stable as it was before the formation of a CU, the welfare of the CU partners is improved while the welfare of the rest of the world is unchanged. Therefore, the formation of the RTA leads to a Pareto improvement. In the welfare analysis after removing intra-union trade barriers, Kemp and Wan assumed that the external tariff of the CU is adjusted endogenously and the external union trade flow is given at the initial level. In contrast, Viner fixes the external tariff at the initial level and the external union trade flow is adjusted endogenously (Bhagwati et al., 1999; Jayasinghe, 2003).

Kemp and Wan’s (1976) implementation confronts two significant operational problems. One has to devise the common external tariff and another one has to figure out the design of lump- sum compensation among members. In practice, the Vinerian approach provides the natural framework and clear distinction between trade creation and trade diversion. Therefore, Vinerian approach is more influential in trade policy analysis than the Kemp-Wan approach. (Bhagwati et al., 1999; Jayasinghe, 2003). Similarly, Burfisher et al. (2003) concluded that the Vinerian framework is prevalently employed to capture trade effects in the static approach because it is well established, coherent theoretical structures and comfortable to use.

3.4 Empirical Studies of the Economic Impacts of Regional Trade