Saturday, September 01, 2007

Is trade diversion bad? (2)

Now we relax our first assumption. Suppose consumption on hat is closely (but not perfectly) substituted by clothing. Notice the difference in the utility curve. In the graph 2 now we have a curly utility curve because of our assumption: both goods are closely substituted.

The story is the same as before-NJ signs FTA with WJ and utility level of North Jakarta under FTA, UNJFTA, is lower than utility level under free trade, UNJFT. But look at carefully, UNJFTA curve crosses blue dash line T** (situation where NJ imposes tariff to both WJ and Tangerang). What does it mean? It clearly shows that bundle consumption in B gives the same utility level as bundle consumption in C. In other word, utility level under FTA is as good as utility level under tariff-to-all system.

From these two graphs, i conclude that: it is true FTA may create trade diversion. But is trade diversion really bad in terms of welfare? My answer is not necessarily. Trade diversion is not necessarily bad for the welfare of North Jakarta if West Jakarta efficiency in producing hat is quite close to Tangerang efficiency.

Some of you may argue, why I don’t draw blue dash line crossing point A which is the same as the graph 1. Well, I can do that but as in this case the individual preference is different from the one on the graph 1, the blue dash line crossing point A means nothing (why?).

What happen next if we, once again, take both assumptions off (there are substitution goods and more than one factor production). The result strongly proposes that trade diversion is not necessarily bad for welfare.

If so, does it mean that FTA is the best deal? The answer is surely no. This simple example only justifies the welfare of home country due to FTA where its partner’s efficiency in FTA is pretty close to other countries out of FTA. More importantly, in this case I assume that the cost of doing and cost of FTA itself are close to zero-which is in many cases unrealistic.


dede said...

Yudo, this is great. I agree with you very much that FTA is not the first best solution. Unilateral trade liberalization is the first best .Unfortunately, we are not living in first best world. But looking at the supply side problem in Indonesia, unilateral liberalization is getting harder. What should we do?

Yudo said...

Bang Dede,
Sorry for late reply after so long i haven't checked this blog. It is true that we face a problematic situation, unilateral seems to be implausible but at the same time multilateral agreements-as you write on your paper- are seemingly far from what we expect.

I think modified FTA's may work in the same nature as free trade (well to some extent :D), namely, by tailoring agreement in such way that each country is prevented from using domestic policies for countering supply side problem (domestic production). In other words, an FT agreement should allow flexibility on trade policies but disallow strongly the use of domestic policies. A feasible trade agreement, i think, is agreement which does not constraint both trade and domestic policies at the same time.

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