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# Summer internship report by sharad kumar

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### Transcript of "Summer internship report by sharad kumar"

1. 1. Trade DiversionIn general, trade diversion means that a free trade area diverts trade, away from a moreefficient supplier outside the FTA, towards a less efficient supplier within the FTA. In somecases, trade diversion will reduce a countrys national welfare but in some cases nationalwelfare could improve despite the trade diversion. We present both cases below. The adjoining diagram depicts the case in which trade diversion is harmful to a country that joins a FTA. The graph shows the supply and demand curves for country A. PB and PC represent the free trade supply prices of the good from countrys B and C, respectively. Note that country C is assumed capable of supplying the product at a lower price than country B. (Note: In order for this to be possible country B must have tariffs or other trade restrictions on imports from country C, or else all of Bs market would be supplied by C) We assume that A has a specific tariff tB = tC =t* set on imports from both countries B and C. The tariff raises the domestic supply prices toPTB and PTC, respectively. The size of the tariff is denoted by the green dotted lines in thediagram which show that t* = PTB - PB = PTC - PC.Since, with the tariff, the product is cheaper from country C, country A will import theproduct from country C and will not trade initially with country B. Imports are given by thered line, or by the distance D1 - S1. Initial tariff revenue is given by area (c + e), the tariff ratetimes the quantity imported.Next, assume countries A and B form a FTA and A eliminates the tariff on imports fromcountry B. Now tB = 0 but tC remains at t*. The domestic prices on goods from countries Band C are now PB and PTC, respectively. Since PB < PTC country A would import all of theproduct from country B after the FTA and would import nothing from country C. At thelower domestic price, PB, imports would rise to D2 - S2, denoted by the blue line. Also sincethe non-distorted (i.e., free trade) price in country C is less than the price in country B, tradeis said to be diverted from a more efficient supplier to a less efficient supplier.
2. 2. The welfare effects are summarized in the Table below. Welfare Effects of Free Trade Area Formation Trade Diversion Cases Country AConsumer + (a + b + c + d)SurplusProducer -aSurplusGovt. - (c + e)RevenueNational + (b + d) - eWelfareFree Trade Area Effects on:Country A Consumers - Consumers of the product in the importing country benefit from thefree trade area. The reduction in the domestic price of both imported goods and the domesticsubstitutes raises consumer surplus in the market. Refer to the Table and Figure to see howthe magnitude of the change in consumer surplus is represented.Country A Producers - Producers in the importing country suffer losses as a result of the freetrade area. The decrease in the price of their product on the domestic market reduces producersurplus in the industry. The price decrease also induces a decrease in output of existing firms(and perhaps some firms will shut down), a decrease in employment, and a decrease in profitand/or payments to fixed costs. Refer to the Table and Figure to see how the magnitude of thechange in producer surplus is represented.Country A Government - The government loses all of the tariff revenue that had beencollected on imports of the product. This reduces government revenue which may in turnreduce government spending or transfers or raise government debt. Who loses depends onhow the adjustment is made. Refer to the Table and Figure to see how the magnitude of thetariff revenue is represented.National Welfare Country A - The aggregate welfare effect for the country is found bysumming the gains and losses to consumers, producers and the government. The net effectconsists of three components: a positive production efficiency gain (b), a positiveconsumption efficiency gain (d) and a negative tariff revenue loss (e). Notice that not all ofthe tariff revenue loss (c + e) is represented in the loss to the nation. Thats because some ofthe total losses (area c) are, in effect, transferred to consumers. Refer to the Table and Figureto see how the magnitude of the change in national welfare is represented.Because there are both positive and negative elements, the net national welfare effect can beeither positive or negative. The diagram above depicts the case in which the FTA causes areduction in national welfare. Visually, it seems obvious that area e is larger than the sum of a
3. 3. and b. Thus, under these condition the FTA with trade diversion would cause national welfareto fall. If conditions were different, however, the national welfare change could be positive. Consider the adjoining diagram. This diagram differs from the one above only in that the free trade supply price offered by country B, PB, is lower and closer to country Cs free trade supply price PC. The description above concerning the pre- and post-FTA equilibria remains the same and trade diversion still occurs. The welfare effects remain the same in direction, but, differ in magnitude. Notice that the consumer surplus gain is now larger because the drop in the domestic price is larger. Also notice that the net national welfare effect, (b + d- e), visually, appears positive. This shows that in some cases, formation of a FTA that causestrade diversion, may have a positive net national welfare effect. Thus, trade diversion maybe, but is not necessarily, welfare-reducing.Generally speaking, the larger is the difference between the non-distorted prices in the FTApartner country and in the rest of the world, the more likely that trade diversion will reducenational welfare.Trade CreationIn general, trade creation means that a free trade area creates trade that would not haveexisted otherwise. As a result, supply occurs from a more efficient producer of the product. In all cases trade creation will raise a countrys national welfare. The adjoining diagram depicts a case of trade creation. The graph shows the supply and demand curves for country A. PB and PC represent the free trade supply prices of the good from countrys B and C respectively. Note that country C is assumed capable of supplying the product at a lower price than country B. (Note: In order for this to be possible country B must have tariffs or other trade restrictions on imports from country C, or else all of Bs market would be supplied by C) We assume that A has a specific tariff tB = tC =t* set on imports from both countries B and C. The tariff raises the domestic supply prices toPTB and PTC, respectively. The size of the tariff is denoted by the green dotted lines in thediagram which show that t* = PTB - PB = PTC - PC.
4. 4. Since, with the tariffs, the autarky price in country A , labeled PA in the diagram, is less thanthe tariff-ridden prices PTB and PTC, the product will not be imported. Instead country A willsupply its own domestic demand at S1 = D1. In this case the original tariffs are prohibitive.Next, assume countries A and B form a FTA and A eliminates the tariff on imports fromcountry B. Now tB = 0 but tC remains at t*. The domestic prices on goods from countries Band C are now PB and PTC, respectively. Since PB < PA country A would now import theproduct from country B after the FTA. At the lower domestic price PB, imports would rise tothe blue line distance, or D2 - S2. Since trade now occurs with the FTA, and it did not occurbefore, trade is said to be created.The welfare effects are summarized in the Table below. Welfare Effects of Free Trade Area Formation Trade Creation Case Country AConsumer + (a + b + c)SurplusProducer -aSurplusGovt. 0RevenueNational + (b + c)WelfareFree Trade Area Effects on:Country A Consumers - Consumers of the product in the importing country benefit from thefree trade area. The reduction in the domestic price of both imported goods and the domesticsubstitutes raises consumer surplus in the market. Refer to the Table and Figure to see howthe magnitude of the change in consumer surplus is represented.Country A Producers - Producers in the importing country suffer losses as a result of the freetrade area. The decrease in the price of their product in the domestic market reduces producersurplus in the industry. The price decrease also induces a decrease in output of existing firms(and perhaps some firms will shut down), a decrease in employment, and a decrease in profitand/or payments to fixed costs. Refer to the Table and Figure to see how the magnitude of thechange in producer surplus is represented.