Is trade diversion bad? 1

I was involved in a debate with Pasha on Free Trade Agreement (FTA). At any rate, we share the same idea that free trade is worth advocating for. Unilateral-by reducing tariffs regardless what other countries do is the best way; multilateral-based on reciprocity principle is the most economic sensible way.

Yet, the very question here is how we go there. From here, I think, we make a different route :D. Perhaps Pasha may propose something here.


Without any disagreement between us, I suppose, FTA (or Preferential Trade Agreement you may say) is discriminatory. Moreover, we are also concerned that FTA may end in trade creation or trade diversion. Unfortunately, studies on the last issue (trade creation vs trade diversion) are still inconclusive (not only empirical but theoretical as well).


Yet, posting here interests me. My point here : “is trade diversion bad for welfare?” I’ll use an example from this posting, hopefully café’s manager and the author do not mind with this :D. For background story, please see the posting.


Suppose North Jakarta signs free trade agreement with West Jakarta and leaves Tangerang out of deal. It would be true that free trade agreement in hat bad for North-Jakarta people only and if only: first North-Jakarta people have a unique preference (there is no substitution in consuming hat) and second, hat production requires only one factor of production (which is true in this context where hat is produced only by labor).


This may look too technical. But hopefully the graphs may help us understanding the concept of trade diversion.


Look at the graph 1, red line curves are combinations of consumption bundle consisting of clothing and hat which give the same utility for North Jakarta people. U_NJ^FT means utility level of North Jakarta in free trade condition, while U_NJ^FTA is utility level under Free Trade Agreement (FTA). Green line, NJ-T, is trade pattern between NJ and Tangerang under free trade (or in technical term we may call as production possibility frontier) while dark line is pattern between NJ and West Jakarta (WJ).


In this case, only Tangerang and WJ are the only hat producers and NJ is the only clothing producer ( I assume this). Under free trade, NJ will import hat from Tangerang since Tangerang is more efficient than WJ (from the graph we can see that Tangerang produces more hats than WJ).


Now, North Jakarta and West Jakarta agree on FTA but NJ still imposes tariff on hat from Tangerang. What happens then, North Jakarta is likely to import hat from West Jakarta, even though West Jakarta is not an efficient producer. Tariff on Tangerang shifts trade pattern between Tangerang and NJ, hence the NJ-T green line shifts and becomes NJ-T* blue dash line (means that tariff reduces demand for hat from Tangerang ).


This is what trade diversion means. FTA alters consumption from the more efficient producer to less efficient one. And it reduces possibility of producing more good. At the same time we can see clearly that utility level of North Jakarta is lower now under FTA compared to free trade (just rule of thumb, as utility curve is close to origin, it means that utility level decreases-that’s why I draw line crossing the origin) Then, we compare situation between FTA and condition when North Jakarta imposes tariff to both West Jakarta and Tangerang. How can we analyze this? When NJ levies tariff from both WJ and Tangerang, NJ still imports hat from Tangerang because, even there is tariff, Tangerang is still the most efficient producer of hats.

Look at blue dash line in T** (without any loss generality, I don’t draw a new line for WJ). It is trade pattern between NJ and Tangerang when NJ imposes tariff to both countries. Under T**, Tangerang produces more hat than condition under T* (under FTA) why? because WJ’s hat is also imposed tariff by NJ. Yet remember, under T**, Tangerang produces less than under free trade, namely, T.


Under tariff for both WJ and Tangerang, NJ imports hat from Tangerang (because Tangerang is still more efficient producer than WJ). Therefore utility level exists in intersection between blue dash line T** (tariff) and green line T (free trade). In other word, utility level under tariff coincides with utility level under free trade. You may surprise why utility level under tariff is the same as utility level under free trade. This may happen if tariff revenue is returned to this kind consumer by lump-sum method. What if tariff revenue is not returned to the consumer? Then utility level under tariff lies between free trade condition and FTA. Yet the point is still the same, utility level under FTA is lower than under tariff-to-all system (Most Favored Nations tariff) and absolutely far lower than free trade.

Some Mathematical Proof

Economist John Siegfried wrote an interesting piece for students who never took econometrics or planning to take their first econometrics class. Here's the link.

Robert Mundell on David Letterman

I found this on youtube. Nobel Laureate Robert Mundell appeared in the Late Show with David Letterman. It truly shows that economists are a unique bunch. Enjoy.

Not So Dismal After All

Here's an interesting news. Here's a quote:

"In 2006, in the first ever national assessment of economics, 79 percent
of 12th-graders nationwide performed at or above the Basic achievement
level. Forty-two percent performed at the Proficient level or higher.
On average, male students scored higher than female students, and
White and Asian/Pacific Islander students scored higher than other
racial/ethnic groups. Students from schools in large cities had lower
average scores than students from schools in other locations. Students
from families with higher levels of parental education scored higher, on
average, than their peers from families with lower levels of parental
education. Most 12th-graders reported some exposure to economics
content during high school."

Mickey Mouse Once Tried to Commit Suicide

Here's something way off the mark. As a fan of sequential art, I always find something interesting about the history of long established characters such as superman, batman, or spiderman. This time it's Mickey Mouse. During the 1930's, to capitalize on the success of the character in the cartoon movie, Walt Disney decided to also put the character in a comic strip. The strip was drawn and written by Floyd Gottfredson. One of the strip tells the story where Mickey was upset with his relationship with Minnie and decided to commit suicide, although in a comical way. You can read the whole strip right here. It goes to show how sense of humor evolves over time. Mickey Mouse used to be very funny.

Why A Chapter in Game Theory is So Important, Particularly for Partygoer Students

One day, two procrastinating economics students decided to go for a party in a campus instead of studying for exam. They knew that the next Monday is Microeconomics Analysis 1 exam (let’s say so). But it's so worthy not to be missed. This party would be getting crazy and hang out (a bit hang-over) with ladies in the next campus could be a lot of fun. A party which must be put on not-to-be missed party list. Besides, they should not worry about exam anyway. The party is on Saturday and there is a plenty of time for reviewing the materials. Since they thought they are smart students and, of course, good party goers, 6 hours on Sunday for refreshing the course is enough.

Then they went to the party. They’re right. At least the party got crazy and many were unconscious-including them. Getting hang-over….back home and oh sleeping the whole day on Sunday. After all, Shit!..no time for covering the whole materials. They just reviewed Social Welfare I and II and no much time for studying A chapter on Game-Theory. In a very decisive time, one of them realized, raised a brilliant idea and thought that they could use special consideration for delaying exam.

They would tell the Prof that they attended a seminar (or workshop…or whatever academic things) in Econ program at the neighbour university. And when they were on the way back home, there was something wrong with one of the wheels. The wheel was broken and it took a whole day for fixing it. “Mmmm it sounds reasonable….” replied another smart but artful student. They did and they were allowed to take the exam in the next week after.

What a brilliant idea. Then they would have a plenty of time for studying lovely microeconomics. The exam time was coming. They sat separately (of course this is an exam and not a study group). Both were surprised since there were only two questions.

The first question was about consumer theory which account for only 10 % of total grade. Even, there was no question about game-theory. The second question was only one sentence but significant and account for 90 % of total grade. The question is like this: “which wheel was broken?”

Well the Prof just applied one important part of a chapter in game theory, namely, Prisoner’s Dilemma. Yeah..they once again missed that part.

*Note: this is a common joke and ,of course, not a real story :D

A New Look and Blabbing...guh..Babbling

As you can see we got a new look for our blog. What do you think? By the way, did any of you ever read this blog? No? Or just skimming? No? Just looking at the pretty pictures? What pretty pictures?? Pictures that someday we might put in this blog. WHAT?? Sure, someday people won't have to write or read blogs anymore, they look at pretty pictures. Didn't the porn industry already done that?? Riiiiiiiight. Nevermind, here's Calvin and Hobbes taking a shot at economics (just click the comic for a bigger picture).