3 Economic Benefits and Costs

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Economic Benefits and Costs REGIONAL INTEGRATION AND COOPERATION UEES LECTURE 3: Regional Integration Agreements: Economic Benefits and Costs Prepared by: Ignacio W Loor, MIBA – Economist

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OUTLINE INTRODUCTION COMPETITION AND SCALE Domestic Production Market Segmentation and Deep Integration Importers and the Terms of Trade Foreign Direct Investment TRADE AND LOCATION: THE PATTERN OF TRADE Sourcing Imports: Trade Diversion Exports and Trade Diversion Government Revenue TRADE AND LOCATION: CONVERGENCE OR DIVERGENCE? Internal and External Comparative Advantage Agglomeration Knowledge Flows Convergence or Divergence: The Balance

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INTRODUCTION Membership in a regional integration agreement has implications for almost all parts of the economy. Some sectors will face opportunities for expansion, others will contract. Some sources of income will be boosted, others will decline. Economic mechanisms that bring these changes: competition and scale effects, and trade and location effects. Larger markets permits economies of scale to be achieved and brings producers in member countries into closer contact and competition. Entrenched monopoly positions are eroded. Trade and location effects arise when the regional agreement changes the pattern of trade and the location of production. Many countries are too small to support, separately, activities that are subject to large economies of scale. INTRODUCTION

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DOMESTIC PRODUCTION Small domestic markets make it difficult to produce profitably goods that are subject to increasing returns to scale. Even if production is profitable, scale economies mean that only one of a few producers can survive, typically with monopoly power, leading to high prices. RIA combines markets, making it possible to reduce monopoly power. RIA can yield three types of gains Textbook gain from increased competition Market enlargement allows firms to exploit economies of scale Reductions in internal inefficiencies that firms are induced to make There is evidence that openness to trade reduces price-cost margins. There are arguments that suggest that the potential gains for developing countries in a RIA may be larger than they are in high-income countries. Gains are not automatic, making sure they are achieved involves careful policy design; many of these gains can also be achieved through unilateral (non-preferential) trade liberalization. COMPETITION AND SCALE

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COMPETITION AND SCALE MARKET SEGMENTATION AND DEEP INTEGRATION RIA does not necessarily secure the gains from competition, scale, and efficiency mentioned before. RIA member governments might be under pressure from industry lobbies and stop markets from being fully opened to competition. In that case, markets will be left “segmented” rather than “integrated” into a single unified market, that way gains mentioned earlier would be partially achieved. Liberalization of trade between countries can involve not just removing tariff barriers, but also removing “trade chilling” contingent protection, and other obstacles created by frontier frictions, such as frontier red-tape (excessive time consuming regulations), differences in national product standards and so on. The benefit of implementing as deep a range of measures as possible, and extending them into areas such as service trade, is that it will force firms to compete directly. It was these arguments that cause the EU to embark on the Single Market Program in 1989 – a far reaching set of measures aimed at integrating markets.

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COMPETITION AND SCALE IMPORTERS AND THE TERMS OF TRADE Terms of trade is the relative prices of a country´s export to import If RIA make markets more competitive, then this should be felt not only by firms inside the agreement, but also by firms outside that export to the RIA markets. More intense competition induce to cut prices; this is a direct source of economic gain to purchasers in the RIA. Example: Brazil membership in MERCOSUR has resulted in a significant decline in the relative prices of imports from non-member countries. United States Export Prices to Brazil and Rest of World – (1,356 commodities) United States Export Prices to Brazil and Rest of World – (1,356 commodities)

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COMPETITION AND SCALE FOREIGN DIRECT INVESTMENT RIA assist in attracting FDI. Foreign firms that want to supply their product to a particular country face a choice between importing or building a plant. Tradeoff is between the cost of tariffs and other trade barriers incurred on imports, and the production cost of the local plant. Mexico perhaps provides the best example of increasing FDI after becoming member of NAFTA. There is evidence also of increased FDI in MERCOSUR.

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TRADE AND LOCATION: THE PATTERN OF TRADE SOURCING IMPORTS: TRADE DIVERSION Trade diversion can occur only if the country has a tariff on imports from the rest of the world, and if partner country costs are out of line with costs and prices in the rest of the world. Products from different countries are not perfect substitutes, and trade faces transport costs and other barriers apart from tariffs. The fact that countries that are close may have lower costs of supply than more distant ones – natural bloc. Madani (1999) found that imports of intermediate goods from the rest of the world tend to raise growth in the Andean Pact countries, while intra-bloc imports did not have this effect. RI might have a negative effect on growth in this matter. RIA between small developing countries is likely to only generate trade diversion and no trade creation. Example: A and B are partners in a RIA. C is a non-member country. Before RIA: A import from B at $105, and from C at $100. Both pay $10 tariff, so final price for product from B is $115 and for product from C is $110. A import from C then. After RIA: Product from B don´t pay tariff, its price will be $105. A imports from B.

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TRADE AND LOCATION: THE PATTERN OF TRADE EXPORTS AND TRADE DIVERSION Is an importer country loss due to trade diversion just the other side of an exporter gain? – There may be exporter gain, but it is less than importers loss. Taking the example of countries A B and C, B export sales expand. If B is selling at cost ($105), then selling more of them does not raise income in B. If B sales above cost, the higher it can go is $110, otherwise A would buy from C. The gain per unit for an exporter country in a RIA can not exceed the gap between the price of imports from the rest of the world and costs. Returning to the example, Government has given up $10 of tariff revenue per unit. $5 per unit goes to the higher cost of producing partner (B), and the remaining $5 is divided between domestic consumers and partner country firms. It is argued that an advantage of RIA over unilateral liberalization is that firms benefit from preferential access to partner markets; but it comes only at the expense of consumers and government revenue. LDC risk losing from a RIA with developed countries because LDC typically have higher tariffs; consequently, the developed partner is likely to gain more from increased access to the LDC´s market than the LDC partner. The industrialized one can resolve this issue by unilaterally lower its tariffs.

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TRADE AND LOCATION: THE PATTERN OF TRADE GOVERNMENT REVENUE For many LDCs trade taxes are an important source of government revenue, and membership in a RIA leads to loss of tariff revenue. This arises for both, directly and indirectly reasons: Directly when tariffs on intra-RIA trade are reduced Indirectly when trade diversion occurs If government is constrained in its alternative revenue sources, than a loss of tariff revenue can be particularly damaged. Many LDCs are heavily dependent on trade taxes as a source of revenue. Intra-RIA trade volumes are typically very high in RIAs where dependency on trade taxes has been low. Countries with higher trade tax dependency have often formed RIAs with countries with whom they have relatively little trade. Countries with high trade tax dependency need to apply alternative tax systems before removing sources of trade tax revenue.

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TRADE AND LOCATION: CONVERGENCE OR DIVERGENCE? Regional Integration will lead to relocation of economic activity; industries will expand in some countries and contract in others, and as this happens demand for labor and real income levels will change. INTERNAL AND EXTERNAL COMPARATIVE ADVANTAGE To think about how industry will relocate within the RIA we look first at the comparative advantage of RIA members relative to each other, and relative to the rest of the world. Let´s suppose that two LDCs have a comparative disadvantage in manufactures relative to the rest of the world, but the disadvantage is less of one of them. What happens if these two countries form an RIA? Manufacturing production will be drawn to the country with less disadvantage, so this country will supply consumers for both countries members of the RIA. The country with less disadvantage will gain from the relocation, and the other country will suffer trade diversion. Countries with comparative advantage closer to the world average do better in a RIA than do countries with more extreme comparative advantage. A RIA between two poor countries tend to cause their income level to diverge.

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TRADE AND LOCATION: CONVERGENCE OR DIVERGENCE? AGGLOMERATION As economic centers start to develop, so “cumulative causation” mechanisms come into effect, leading to clustering (agglomeration) of economic activity and extending the advantage of locations that have a head start. Spatial clustering of economic activities is all-pervasive. Cities exist because business, workers, and consumers benefit by being in close proximity. Particular types of activity are frequently clustered, like the electronic industries of Silicon Valley, cinema in Hollywood, etc. Agglomeration arises from the interaction between centripetal and centrifugal forces. Centripetal forces encourage firms to locate close to each other: Knowledge spillovers, labor market pooling, and linkages between buyers and sellers – firms will locate where their customers are. Centrifugal forces encourage the dispersion of activity. These include congestion, pollution, or other negative externalities associated with concentrations of activity. By reducing trade barriers, membership in a RIA makes it easier to supply consumers from a few locations, favoring agglomeration and growing divergence.

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TRADE AND LOCATION: CONVERGENCE OR DIVERGENCE? KNOWLEDGE FLOWS Both the comparative advantage and agglomeration mechanisms suggest that integration may cause the performance of members of LDC RIAs to diverge. But, RIA may promote knowledge flows between member countries. Trade flows provide a powerful mechanism for the transfer of technology between countries, and thus, an increased rate of total factor productivity. For developing countries, the authors Coe, Helpman, and Hoffmaister (1997), find that productivity growth is related to the interaction between the openness of the economy (imports related to GDP) and access to foreign knowledge. An economy benefits from foreign knowledge, first, according to how open it is, and, second, according to whether it is open to those countries that have the largest knowledge stocks. This conclusion can be also highly correlated to the level of foreign direct investment.

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Source: Organisation for Economic Cooperation and Development http://www.oecdbookshop.org/oecd/index.asp?lang=EN Regional Integration and Developing Countries

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