nm1128: as always er you know if you want to discuss the essays with me come 
along you know any time or certainly i'll be in my room during s-, so-called 
surgery hours [laugh] right let's get this thing moving i'm dealing with the 
economics of er free trade areas which some of you have done i mean i'll be 
doing it a little bit more depth than we did on my other course but there's 
obviously quite a bit of overlap on this particular topic so i'm looking for 
you to do the lecture rather than me er so here's the handout i assume you've 
got all 
sm1129: 
nm1128: yes [laughter] we're doing a little bit more [laughter] i i said you're 
doing the lecture [laughter] but some people haven't had the privilege of er 
doing the E-U in developing countries so what i'm dealing with is that today 
we'll deal with the the economics of customs union and free trade agreements 
and in next week we'll deal with article twenty-four which is the W-T-O er 
article the general agreement 
on tariffs and trade article er which covers authorizes er free trade areas and 
customs union because of course they fundamentally break article one er the 
principle of non-discrimination i mean the whole purpose of a free trade area 
or a customs union is to discriminate in favour of the partner countries and 
therefore against the world er so which is entirely against the whole essence 
of the GAT the er agreements and the W-T-O so article twenty-four permits this 
major break er from the principle of non-discrimination but i'll deal with that 
next week er 'cause it's a topic which er has come to the fore particularly 
given the proliferation of er these preferential trade agreements as Bhagwati 
prefers to call them er i mean at the moment i think there's about a hundred-
and-six preferential trade agreements have been notified to the W-T-O and not 
all agreements are notified er so there's something in n-, in excess of a 
hundred-and-six preferential trade 
agreements er and the p-, as i say the previous past ten years or less have 
seen a proliferation of these agreements er i mean everybody's signing 
agreements as if there was no tomorrow er which is entirely contrary to all 
that we were saying about the Uruguay round and the move towards a rules based 
system for international trade and the principle of non-discrimination that 
underpins all of the new er international economic order so one of the 
questions really i mean one of the fundamental questions which people are 
asking themselves today is why you know why in a world in which on the one hand 
we strengthened the general agreement on tariffs and trade and we have the 
general agreement on trade and services and trade related intellectual property 
rights agreements trade related investment measures er and so on i-, 
particularly the strengthening of the di-, the er dispute settlement process 
all of that you know we we emphasized really was to underpin the 
spectacular growth of world trade that we've seen er so why at this time of all 
times do we see this huge increase in the number of preferential trade 
agreements which is fundamentally based on mercantilist philosophy isn't it i 
mean the view that you know we sign up agreements between ourselves er and keep 
out the rest of the world you know we sort of concentrate the gains from trade 
er between us at the expense of or partly at the expense of the rest of the 
world so why that's one of the big questions that we'll continue to come to to 
come back to er i don't think anybody knows the answer to that one er but we 
can at least speculate on it and of course as Bhagwati puts it as well are they 
are they obstacles to the development of a non-discriminatory free trade world 
or are they simply stepping stones which might be the apologist case if you 
like for customs unions and free trade agreement stepping stones in the sense 
that er you first of all er free up trade between 
the partner countries and maybe deepen relations between you er and having 
adjusted to that you can then go on to er free trade on a worldwide basis and 
particularly perhaps for developing countries er that might be very attractive 
rather than go suddenly for broke you know suddenly when your barriers to trade 
as we've discussed in the past have been very high very high tariff and non-
tariff barriers er and you you know rapidly take them away over a short period 
of time expose yourself to world trade that's a pretty frightening thought er 
for for any country so maybe a regional free trade agreement particularly with 
an industrialized country a large industrialized country like United States or 
a regional grouping like the E-U that might be a sort of stepping stone so you 
free trade first of all with the the big industrialized market and you adjust 
to that and then you go in to er liberalized trade on a on a worldwide basis 
and that's the sort of 
optimistic view if you like of er the role of free trade agreements er in which 
case they're stepping stones to er er final free trade or are they obstacles in 
the way that i indicated at the beginning they might be 'cause fundamentally 
they're discriminatory and the more agreements you have the more discrimination 
we have in the world and therefore we're running quite contrary to the 
fundamental principle of the W-T-O principle of non-discrimination so that's 
the big debate and we there's no answers to that one you just have to really 
make up your own minds so first of all let's go through with the basic 
economics of it i say my apologies to those who've done this before but it's 
such an important topic it comes up in all sorts of areas er so what i'm going 
to do is er put up the diagrams and then get those of you particularly well 
anyone but particularly those of you who've done E-U and developing countries 
course er to then explain the diagrams to me rather than me do 
it so let's see if we when we get this thing focused in this ghastly room that 
we have least it's not as bad as the Palmer building is it where you've got the 
the screen up one end and people are sitting up the other end i mean that is 
really truly awful okay well the starting point on the analysis of er 
preferential trade agreements really was by put up by Jacob Viner er who 
pointed out that er preferential trade agreements on the one hand freed up 
trade between the partner countries and therefore the theory of comparative 
advantage can work okay but of course it was only partial liberalization er it 
discriminated against the countries and so it was er Viner who coined the terms 
trade creation and the next diagram that we'll do trade diversion er have we 
got a spare handout oh you do right 
sm1130: 
nm1128: okay so trade creation then this is comparative advantage working mm 
but of course only between the member countries mm er this diagram here er this 
is a 
preferential trade agreement between a developing country right which is er 
labelled L-B-C here and the European Union E-U er and we're looking to see what 
happens in the developing country here er the the argument's a general one but 
er purposes of our interest let's look at the developing country side of the 
equation er now in this case here the European Union is the cheapest source of 
supply er of the imported goods okay the rest of the world the dearer source of 
supply somewhere up here so we can forget about them okay so we're simply we're 
importing from the E-U er which is the cheapest source of supply prior to the 
preferential trade agreement there is the tariff tariff is the distance between 
P-star-E-U and P-E-U here okay so that's the that's the height of the tariff er 
and prior to the preferential trade agreement we're importing M-O from the E-U 
tariffs then disappear okay and er we then er expand our imports from the E-U 
upto M-F-T-A imports under the free trade 
agreement mm okay first of all first question for you er how do consumers gain 
from this in the di-, in terms of the diagram what can you show has been the 
gain in welfare to consumers from signing the free trade agreement yeah 
sm1131: can provide them choice not very good price 
nm1128: right 
sm1131: goods 
nm1128: right 
sm1131: his prices and a wider choice of foreign goods 
nm1128: okay so they pay a lower price er than before mm and they've got a 
wider choice of goods there's something else purely analytical terms 
sm1132: C-N-D 
nm1128: sorry 
sm1132: C-N-D 
sm1133: 
nm1128: okay so they pay a a lower price for the previous level of imports M-F-
T-A er sorry M M-O right but then also what happens because the price falls 
what else happens 
sm1132: consume more 
nm1128: they they consume more that's right and there's the wider choice which 
you said we'll come back to that one later on we're just dealing with a 
particular product just now so they gain in two respects they gain that the 
previous level of imports they can buy cheaper than before mm and then 
because the goods are cheaper they move down their demand curve okay er 
consuming even more mm so the gain in the consumer surplus is this area in here 
someone just define for me what do we mean by the gain in the consumer surplus 
it's a technical term in economics what does it mean 
sm1134: does it mean how much work consumer's doing to pay er difference of how 
much 
nm1128: that's right that's right exactly that's a that's a very good 
definition of it okay so the consumer surplus er is er i mean let's er well 
let's take a price er er well someone describe to me in terms of the diagram 
what it means if it's under what you mean maybe i'll leave it to you it's the 
difference between what people will be willing to pay and what they actually 
have to pay 
sm1135: 
nm1128: sorry 
sm1135: the price that they're willing to pay s-, that should be the price P-E-
star and the that actually pays P-E-U 
sm1134: P-E-U 
sm1135: 
nm1128: right right right okay 
yes about right so so the consumer surplus then is the increase in the area 
under the demand curve okay so er that's what i-, if you take any particular 
level of imports imports M-O okay er they'd be willing to pay as you said P- E-
U-star but they actually only have to pay that okay so they gain that about 
here right and similarly all the way down the demand curve it's only the very 
last unit that's consumed all right at which the price they have to pay is just 
equal at the margin is just equal to the price er that they'd be willing to pay 
for all the intramarginal units they'd be willing to pay a higher price but 
they don't have to okay they just have to pay price P-E-U okay so the area 
under a demand curve is the consumer surplus mm and what we're measuring here 
is the increase in the consumer surplus as a consequence of er the abolition of 
a tariff area A-B-C-D okay we then divide that up okay er i think 
it pretty well speaks for itself the loss of tariff revenue of course is by the 
government in the developing country mm i er going back to what we were talking 
about this morning if Morocco er signs a free trade agreement or so in-, er 
indeed it has signed a free trade agreement with the E-U then one major impact 
on on on Morocco is that previously i think something like twenty per cent of 
government revenues in Morocco came from import duties most of those were from 
the E-U about three-quarters of its imports come from the E-U well once the 
agreement's fully in place that source of government revenue will disappear mm 
er it's a very important element it's a er a c-, a a very important cost to 
particularly to developing countries and signing free trade agreement with 
industrialized countries so that loss of government revenue is the is the size 
of the tariff P-star against P okay so that's the height of the tariff 
multiplied by the previous level of imports M-O 
mm so that's the tariff it used to be applied to imports from the E-U that's 
now disappeared so the difference between those two prices multiplied by the 
previous level of imports I-E in the area A-B is the loss of tariff revenue by 
er Morocco or where it happened to be so that element under the demand curve 
the increase in the consumer surplus A-B-C-D is made up of two components mm 
the first one's a pure transfer mm it's a transfer from the government of 
Morocco to the consumers in Moroco mm so one just cancels out the other all 
right net er there's no welfare gain in that sense all right there's a gain in 
consumer surplus but that chunk of the consumer surplus in here is just a 
decrease in government revenues and that's transferred to consumers through the 
lower price that they pay for the previous level of imports one balances out 
the other exactly er zero change in terms of welfare unless you like to say 
that well it's better off if er consumers gain er than 
if governments get their revenues but as economists we're we're very neutral in 
all those things all right er so we don't make value judgements as to whether 
governments should consume or whether private individuals or firms should 
consume point of view of the economy that's simply a a transfer er no welfare 
effect at all so the net welfare effect then is that the two tri-, the is the 
is the triangle here plus this whatever that shape is i've forgotten my 
methematics somebody tell me [laughter] er D in there er it's those two areas C-
plus-D is the net welfare gain okay so cons-, the gain and the consumer surplus 
minus this transfer element A-B so we're left with this area in here so that's 
the welfare gain unambiguously a welfare gain to the developing country from 
the er abolition of the tariffs the free trade agreement and that's what Viner 
called trade creation mm the consumers er are able to purchase er a higher 
level of imports at a lower price let's 
look a little bit further now er i've sketched in here not terribly well but i 
hope it's clear what's going on behind the scenes here because this is the 
demand for imports and the demand for imports is a residual demand mm it's the 
difference between domestic demand and domestic supply okay that's imports mm 
'cause we assume that the good is produced within Morocco within the developing 
country er as well as imported from the E-U we'll come back to that assumption 
later but that's the basic assumption it's the same product produced within the 
er Morocco and also imported so imports are the difference then between 
domestic demand all right the demand in the developing country and supply in 
the developing country mm so let's look now at this what lies behind this trade 
creation gain what are its two components then imports rise for two reasons 
what are they there's rise in imports in M-O M-F-T-A it's for two reasons what 
are they 
sm1132: [cough] the position of tariffs which creates obviously a lower price 
and er greater consumption 
nm1128: right 
okay so that's the movement down the demand curve here okay so the lower price 
we demand more of something if it's cheaper we buy more of it right that's one 
component and the second component of the rise in imports how about the left 
hand side 
sm1135: 
nm1128: right okay specifically what's happening the the tariffs taken away so 
competition 
sm1132: will destroy the er unproductive er enterprise 
nm1128: or the less efficient one 
sm1132: or the less efficient 
nm1128: the less efficient ones that's right okay so we move back down the 
supply curve in the developing country okay so we take away the tariff 
protection okay the the marginal producers then the ones that could only 
survive under tariff protection now simply go under yeah 
sm1136: i have just one question er 
nm1128: o-, 
sm1136: 
nm1128: yes i mean you're you're right but but y-, you're sort of jumping the 
gun as it were you're so you're moving ahead in the in the analysis that is 
indeed the fear okay that we we've 
talked about the infant industry arguments the reasons for protection so maybe 
you shouldn't be signing just yet that's right that's right that's right maybe 
you know i mean i i showed a pretty steep curve here all right which indicated 
that they were indeed vulnerable right i deliberately drew that supply curve 
quite steeply for precisely the reasons you've given okay but there's an awful 
lot of firms that need the tariff protection because we're dealing with a 
developing country er they're still learning by doing er things i'll be going 
onto in a moment on on economies of scale and production you know they they 
just entered the manufacturing sector fairly recently they're still feeling 
their way they're still learning skills and they're still moving down their 
long run average cost curve and so forth er and is suddenly bang the 
protection's taken away and they go straight down the supply curve here right 
yeah but we'll come onto that in a a 
moment that's a good point er so er i've got a situation here then where er the 
increase in imports is due to two forces the first one is the movement down the 
demand curve for the product in the developing country something's cheaper you 
buy more of it the second element is that the doing away with the tariff 
protection does away with the less efficient producers mm they may be infant 
industries too bad the infant never grows up all right er er and that's the 
second reason then why imports rise mm er right let's explore that a little bit 
further now er given that theory suppose you had er let's go back to last term 
now okay where we talked about the possibilities of a free trade agreement er 
well certainly er on on the other course i talked about er a free trade 
agreement between the E-U and say sub-Saharan African countries mm er so we're 
talking here about countries particularly er low levels of income low levels of 
industrialization and the 
rest given the analysis that we've got there do you think the trade creation i 
i'm lost to the fact that the E-U as i say is [cough] er you know planning to 
sign free trade agreements with various regional groupings of these countries 
er no later than two-thousand-and-eight mm two-thousand-and six two-thousand-
and-eight er given then a free trade agreement between the E-U and sub-Saharan 
African countries do you think the trade creation effects would be large or 
small 
sm1135: 
nm1128: right 
sm1135: 
nm1128: so it i-, w-, so so trade creation would be large or small 
sm1135: large 
sm1132: small 
nm1128: ah [laugh] right [laughter] you're saying small [laughter] 
sm1132: 'cause i think what they were saying that that result result packed in 
in small trade creation 
nm1128: because 
sm1132: well because the sort of fact you got a less developed country er 
nm1128: mm 
sm1132: which is 
sm1136: 
sm1132: products will what was manufacturing er everything else from the whole 
production will not be able to compete er against the E-U 
E-U of their countries producers 
nm1128: well if if it couldn't compete against it okay all right then following 
what we've just said just now 
sm1132: right yeah 
nm1128: okay there's going to be a big surge in imports 
sm1132: mm 
nm1128: that's going to wipe out the local industry okay 
sm1132: but then again we did mention earlier first term that er it's not just 
that tariffs 
nm1128: well all that yes 
sm1132: not sure whether they're er will be removed or not 
nm1128: it will oh yes i mean because all all the non-tariff barriers will be 
reduced as well as the tariffs or at least most of the non-tariff barriers all 
the import quotas import licensing everything else has to go in a free trade 
agreement i mean it is free trade all right right we can i mean we can't 
actually look at the details you have 
to say well it's not quite as simple as that but let's just keep it at that for 
the moment because that's more or less what it is but what i'm getting at here 
though is say we're talking about Chad or Mali right some very very poor 
countries er you know 
sm1136: yeah sorry 
nm1128: the industry that they've got 
sm1136: this is this is what i thought er 
nm1128: right 
sm1136: what it is about is whether the what the E-U c-, could export whether 
it is suitable for the er er African mark-, er market for Mali for example i 
mean the Mali er consumer does he really want er a car or does he really want 
nm1128: well he probably wants it [laughter] 
sm1136: well he wants a car yeah he wants a car but can he pay for it 
nm1128: yes yes 
sm1136: so that that's that's what i was going to 
nm1128: right 
sm1136: yeah 
nm1128: okay 
sm1136: so 
nm1128: and in terms of local production then what's what's what sort of goods 
are going to be produced you know manufactured goods right 
sm1132: 
nm1128: right so a lot 
of the local industry will be producing for the domestic market okay and these 
goods will be pretty basic consumer goods right fundamentally selling in terms 
of price okay they're cheap they use local materials local labour er but not 
exactly state of the art they're not beautifully designed coloured whatever 
right but they're basic essentials of life in that country er they're you might 
call them non-tradeable goods a lot of them mm er they are purely produced for 
the domestic market they might have a regional market but that's tha-, that's 
another story all right they're certainly not goods that compete with the sort 
of goods which you'd import from the E-U what sort of goods are you going 
importing from the E-U if you're Chad Mali et cetera Uganda what what sort of 
goods are you going to be importing from the E-U capital goods investment goods 
intermediate products okay not produced in the local economy on the whole 
that's the key point okay so the key word i'm 
getting round to then is that one of the important aspects of the trade 
creation effect is the degree of substitutability between domestic production 
and imported goods okay in other words my supply curve that i've got here okay 
er and i've drawn that quite steeply indicating that the degree of 
substitutability is quite small mm most of the goods you import from the E-U 
are not produced in the domestic economy so if you like the trade displacing 
effect on domestic production is also going to be quite small now it depends on 
the economy right i've talked about Chad or Mali if we're talking about Cote 
d'Ivoire er Zimbabwe Kenya er well there's going to be a greater degree of er 
overlap if you like between some domestic production anyway and imports from 
the E-U mm so if er the price of of goods fall imported from the E-U er then 
that's going to squeeze out er less efficient less desirable goods produced by 
some or er d-, domestic producers in er in the country they could only 
survive behind high tariff protection but you still got a lot of other 
production which is simply doesn't compete er with imports from the E-U that's 
important because this theory was developed by Viner in the context 
particularly of explaining er the common market all right we're going back now 
to the nineteen-fifties mm if you're talking about a free trade agreement a 
customs union i'll give you the difference between those later on er between 
industrialized countries in Europe between France and Germany and Italy right 
then the degree of substitutability between imports and domestic production is 
going to be very high mm so the trade creation effect on that side is 
potentially very powerful mm er but going to be going to be a wide range of 
goods which are produced for the domestic economy which you could just as well 
import from France or Germany or Italy mm and so er the trade creation effect 
would be very powerful er in an industrialized country but between an 
industrialized and a developing country we would expect it to be very much less 
but when you come to look at the empirical estimation of er the effects when 
you when you read the literature on on this such as it is er you will see no 
discussion at all or very little discussion about this particular point er 
nobody asked that question about er is the degree of substitutability between 
imports and domestic production high or low in particular what value does it 
have what is the elasticity of substitution absolutely no one knows mm if 
anybody finds a reference which tells you what that figure is even for one one 
developing country i'd be very grateful mm seriously grateful because part of 
my job is to try and measure these blasted things all right i've never found a 
source which is actually empirically measured the elasticity of substitution 
for imports from an industrialized country and domestic production everybody 
just assumes a number most of the of the 
literature on that is for industrialized countries not for developing countries 
and it's a very important difference the other element is the extent to which 
the decrease in price for the increased comsumption all right er and er that 
well again is an empirical fact i mean it just depends if we're talking again 
about very poor countries mm with very low levels of income er again the sort 
of comsumer goods which the E-U produces are not going to have a very big 
market there the the the rich elite will be able to buy their Mercedes or 
whatever er but er they probably buy them anyway whether the tariff was there 
or not and indeed because they're rich elites they're probably not paying their 
tariff anyway they're finding some way round it so er i don't think we need 
worry about that side of things what it will do however is make investment 
goods and intermediate goods cheaper mm than they were before mm what effect do 
you think that would have on 
the economy 
sm1136: 
nm1128: well certainly the short term effect will be a rise in imports we've 
just shown that 
sm1136: yes 
nm1128: okay we haven't looked at the export side of this yet that might also 
rise it depends what went before 
sm1136: 
nm1128: but but but but but let's but let's leave the balance of trade aside 
for the moment we're still quite a way from looking at that let's just look 
solely at the effect of doing away with the tariff and moving down the demand 
curve and this case the demand for investment goods and intermediate products 
what effect's that going to have on the economy 
sm1135: 
nm1128: sorry i'm not i i don't want to look at the export side at the moment 
okay i'm just looking at you know if if if investment goods and intermediate 
goods are cheaper what effect's it going to have 
sf1137: well it should somehow get an increased investment in the country 
nm1128: that's it that's that's what we're looking for okay so investment goods 
intermediate 
goods that you need in production all right both those factors you can buy 
capital goods cheaper and the costs of production are lower all right than they 
were before and given the height of the tariffs and non-tariff barriers okay er 
that er e-, existed before er that fall is going to be quite substantial er so 
that could be a powerful boost to investment in the economy remember one of the 
puzzles in many developing countries is that we have a basis for saving and 
investment which very often doesn't occur we can look at countries with similar 
income distributions and similar levels of per capita income but widely 
different saving and investment rates all right and we're always puzzled why 
and one of the reasons for that is the price of capital okay if the price of 
capital falls in terms of interest rates but also in terms of price of capital 
goods intermediate goods need in production then that could stimulate a a rise 
in production and just to briefly deal with 
your point er the balance of payments might deteriorate okay as we import these 
goods then production rises all right and production both of exports and of 
import substitutes to the extent that they exist er could then move the balance 
of payments the other way mm so it's a it's an empirical question 
sm1136: 
nm1128: yes i mean the-, there's a problem of financing it all that's right 
which we haven't discussed here we've just said imports rise the you know what 
you're saying to me is where does the foreign exchange come to buy it all right 
[laughter] and we just call that oh that's an adjustment problem you know 
[laughter] er but of course it's more than that you're absolutely right er so 
if this is going to work in a developing country and it's a very very useful 
point er probably with the the developing country needs aid all right er the 
government will need aid because its i-, its revenues have fallen 
quite substantially okay and it needs to change its structure of taxation from 
heavy dependence on import duties towards indirect taxes value added tax or 
something like that that's going to take time expertise et cetera right so 
they'll need aid and technical assistance to bridge them over that particular 
adjustment problem 
also we've got a rise in imports with nothing happening on the export side s-, 
in the in the short term which may be several years er that's got to be paid 
for or alternatively there's a balance of payments crisis currency devalued you 
get inflation all sorts of nasty effects could arise so again we're saying that 
you need financial assistance foreign exchange needs to come in in order to 
enable a country to buy these investment goods and er and these intermediate 
goods er then its production can expand er as production expands er and 
tradeable goods supply of tradeable goods rises so you don't need the aid 
that's the theory okay well we can squeeze quite a bit out of that diagram er 
and it is important that you understand the mechanics okay too often i think 
the the the textbooks simply throw that up there's A B C and D that's the 
consumer surplus you know blah blah blah on to the next thing 
on to trade diversion mm think of what's going on because if you if you think 
of what's going on behind the scenes here then you can say is the trade 
creation effect going to be large or going to be small and what are the 
adjustment problems for the country in terms of the government revenues and in 
terms of dealing with the rise in imports whenever we just said exports haven't 
increased any questions on that before we go on to the next one and trade 
diversion er happy okay right well that's the welfare gain okay er remember in 
this view of things the fact that you wipe out a bit of local industry er 
certainly means they're inefficient producers all right er which you know er 
shouldn't be there in the first place because they're only there under 
protection they go away that releases resources which can be more productively 
used in the rest of the economy all right that's the assumption behind it but 
they may 
just be infants that are ready to grow up 
sm1135: can we add 
nm1128: no because that's just going to effect that distance up here okay er if 
what you're saying is i mean i haven't actually marked that in because we got 
enough rubbish on this diagram that's the tariff inclusive price if there was 
such a price for the rest of the world in fact we're not importing from the 
rest of the world at all so er i'm not i'm not concerned with that no er but 
you're ju-, you're w-, what you're saying is that er instead of being up here 
the rest of the world tariff inclusive price would be up here somewhere just 
above that but that's irrelevant to the argument that doesn't affect the 
magnitude of our squares and triangles and rectangles and things underneath mm 
sm1135: 
nm1128: see 
sm1135: 
nm1128: i think what it wa-, what's con-, confusing you here is on this simple 
diagram er we import only from the E-U we're not importing anything from the 
rest of the world okay i mean i 
think what you're thinking in the back of your mind is in reality we import 
from both right er but to simplify the analysis because the E-U is the cheapest 
source of supply in the world we only import from the from the E-U there's no 
imports from the rest of the world so we don't need complicate the picture but 
that er i see your point yes in reality we do it okay let's look at the other 
side of things 
nm1128: okay 
nm1128: now er again let's go through the mechanics of this mm er whoops this 
thing it's difficult when it's this close to the screen can read that okay in 
this case it's the reverse situation to the one we had before so here the E-U 
is not the cheapest source of supply in the rest of the world on the contrary 
the tariff inclusive price P-E-U one-plus-T er is higher than the price for the 
rest of the world the rest of the world now is the cheapest the U-S Japan et 
cetera are a cheaper source of supply mm er so er at that tariff inclusive 
price for the rest of the 
world Morocco is importing M-zero mm er now that the tariff is taken away from 
imports from the E-U but not from the rest of the world mm the picture totally 
reverses okay because the rest of the world has to pay a tariff but the E-U 
doesn't okay we now import we switch our sources of imports from the rest of 
the world to the E-U the E-U now becomes the cheapest source of supply mm not 
because it's the most efficient but because the E-U doesn't have to pay a 
tariff imports from the E-U don't have to pay a tariff whereas those from the 
rest of the world do so we're discriminating against the rest of the world in 
favour of the E-U hence we switch our imports totally away from the rest of the 
world to the E-U even though the E-U is not the most efficient source of supply 
in the world right it's because either they're dearer they're less efficient 
less well designed but nevertheless they don't have to pay a tariff the rest of 
the world does and so they capture the 
market well that's a welfare loss mm er in its simplest terms a welfare loss 
because there must be something wrong with E-U goods all right otherwise we'd 
be importing from them in the first place right we've talked in terms of price 
here but remember that we've got the price and non-price characteristics of 
products and maybe they're just less well designed investment goods and 
intermediate goods they're less efficient they're not state of the art the 
latest technology that you get from the U-S or Japan er nevertheless you import 
from the E-U okay yeah the analysis is exactly the same as before er the gain 
in the consumer surplus is the area under the demand curve okay which is er A-
plus-C okay that is that wedge in there er slightly different of course because 
the loss of tariff revenue is the difference between the rest of the world's 
price er a world prices and the tariff that's the height of the tariff sorry 
that's the 
height of the tariff in here okay so we were getting this tariff revenue from 
the rest of the world plus this area up in here so the tariff revenue from the 
rest of the world before was A-plus-B okay that's the height of the tariff 
multiplied by the level of imports okay well we're losing that tariff revenue 
er part of that loss of tariff revenue is going to who where's B going to 
sm1135: 
nm1128: in where which producers are we talking about you're right 
sm1135: E-U the E-U 
nm1128: in the E-U that's right so B is a loss of tariff revenue being handed 
to E-U producers okay because they are at a higher price than the price for the 
rest of the world okay so there's a a a transfer that's a welfare loss to 
Morocco it's a transfer of tariff revenue which was being previously being 
collected from the rest of the world now going to Philips or wherever it 
happens to be the immediate right er to er either boost their 
profits or because they are higher cost source of supply whatever it is that's 
a transfer to the E-U from the government of Morocco er so we've got the gain 
and the consumer surplus okay the area under the demand curve right we've got 
the loss of tariff revenue right remember that neutral so the net effect is C 
okay that's the so the gain and the the the net welfare effect to to Morocco in 
terms of the gain in consumer surplus they're paying a lower price of increased 
quantities of imports is C the triangle mm minus the loss of tariff revenue 
which has been transferred to the E-U producers okay as we've just said so the 
net welfare effect on Morocco is the gain and the consumer surplus right minus 
the loss of tariff revenue transferred to E-U producers purely as a matter of 
geometry if you like all right the rectangle B is going to be bigger than the 
triangle C mm unless unless what 
sm1135: 
nm1128: yes back to your point i think you were making earlier that's 
right [laugh] okay unless go on spell it out 
sm1135: unless the the difference er margin between the er the rest of the 
world and the E-U 
nm1128: mm 
sm1135: is is smaller 
nm1128: yes okay right so the rest of the world was just a fraction cheaper 
than the E-U okay then that rectangle's going to be a very small area right and 
so it is technically possible that that could be a very tiny rectangle compared 
to the triangle C in which case there would be also welfare gain but none of 
the textbooks say that okay er you won't find that in a textbook for the simple 
reason i think that it's most unlikely to occur but it's technically possible 
so that's trade diversion that's a welfare loss then it's a welfare loss 
because you're transferring government revenue from Morocco to the E-U and 
transferring income from Morocco to the E-U straightforwardly right it's it's 
like A going in the reverse direction er and secondly er we weren't buying fr-, 
anything from the E-U before presumably because it was a crummy source of 
supply okay er you know it was it was dearer it was less efficient it was 
yesterday's technology it was poor design nobody wanted the blasted thing okay 
now suddenly er you're not buying from the rest of the world you're buying only 
from the E-U solely solely because of the preferential trade agreement solely 
because the E-U no longer has to pay tariffs but the rest of the world still 
has to okay that's a distortion in the market it's a distortion which is 
welfare reducing for Morocco it it's welfare reducing for the world as a whole 
of course as well 'cause they there's a loss of production so at a global level 
there's a loss of welfare borne by whoever it was that was exporting to Morocco 
before U-S Japan et cetera to the other developing countries so at a global 
level it's a loss of welfare and it's a loss of welfare to Morocco itself i 
emphasized the the the impact on 
developing countries partly 'cause that's what we're interested in but also 
because again you'll read in the literature again in mostly in the development 
literature i have to say that you needn't worry about trade diversion 'cause 
that's only a global loss of welfare okay that the costs of trade diversion are 
borne by the rest of the world all right that's nonsense okay that's complete 
and utter nonsense for the reasons that we've given mm from the straightforward 
transfer of of government revenue to the E-U and you're buying a less efficient 
product than you were before mm 
sm1135: in this case it should be better for the devloping countries 
nm1128: well that that's [laughter] 
sm1135: 
nm1128: yes i mean that's what Bhagwati so so so why do you sign the wretched 
agreements all right [laughter] er the point i-, i mean to be a-, a-, again be 
impartial on this one okay because Bhagwati hates preferential trade agreements 
so let's be neutral about all this er 
there's the the the the the the static welfare effects of the preferential 
trade agreement are there for the net effect between the positive trade 
creation on the one hand and the trade diversion effect on the other okay and 
if trade creation our previous diagram is greater than trade diversion then 
Morocco gains from the preferential trade agreement okay so it's as always it's 
plusses and minuses okay we call swings and roundabouts er it's er there's a 
gain the trade creation gain the welfare gain on the one hand and the trade 
diversion the welfare loss on the other and it's the net effect of the two mm 
so the change in welfare if you like is trade creation minus trade diversion 
okay let's look at the magnitudes of trade diversion again our E-U Morocco 
agreement mm is it going to be big or small let's gask the same question as we 
did before and we said it's the net effect what do you think or sub-Saharan 
Africa 
sm1135: 
nm1128: sorry 
sm1135: 
nm1128: 
er is trade diversion going to be big or small when you've got an African 
country on the one hand and the E-U on the other what would you expect it to be 
same logic as we used before 
sm1136: 
nm1128: sorry 
sm1136: 
nm1128: yeah you're right 
sm1136: 
nm1128: okay give yourself time 
ss: 
nm1128: so substitutability between 
sm1133: 
nm1128: sorry 
sm1133: 
nm1128: yes okay they're the ones that are in competition with each other okay 
so one of the key things is what sort of goods is Morocco or Mali or Chad 
importing from the E-U and the rest of the world do you think there'd be same 
goods or different goods rough-, probably speaking 
sm1132: should be the same 
nm1128: yeah okay we s-, we said it would be investment goods and intermediate 
products which largely weren't produced in the domestic economy it's a bit of a 
simplification that but it's not wildly different from the truth okay and 
whether they're produced in the E-U right 
whether they're produced in Germany or France or Italy or Japan or er the 
United States or Taiwan all right or or Singapore okay it's purely a matter of 
price and technology and all the rest of it okay it's going to be a similar 
sort of mix of goods produced there so what's that going to tell you about the 
elasticity of substitution be precise now er between imports from the E-U and 
the rest of the world 
sm1136: 
nm1128: yeah it's going to be very high 
sm1136: very high 
nm1128: yeah therefore the trade diversion effect will be 
sm1132: high 
nm1128: high that's the key point okay so we would expect the magnitude of the 
trade diversion effect where the agreement is between an industrialized and 
developing country we would expect trade diversion to be large because the sort 
of goods you import from the E-U will be a similar sort of mix of goods to the 
ones that you import from other industrialized countries okay no big surprise 
about that so the elasticity of substitution then 
that's the it will will be high that's the key parameter which will determine 
the magnitude of the trade diversion effect mm now surprise surprise nobody's 
been able to measure that one either [laughter] er i'm not sure why er you can 
look at there's a book everybody uses by Leamer and Stern which came out in the 
seventies on elasticities and international trade and everybody says well they 
say the figure's three so i'm going to use three er and that's the figure that 
they've had to use you know people talk about the the elasticity of subsitution 
as being three for the purposes of measuring the trade diversion effect do you 
think that would be a a sensible figure to use that we're talking about a free 
trade agreement between an industrialized and developing country given what 
we've just said you're shaking no i mean you expect it to be what slightly more 
lot more 
sm1136: 
nm1128: yeah a lot more mm a lot more okay 
again the estimates that we work with are estimates produced for trade between 
industrialized countries mm which is still possibly the relevant one to use mm 
er but given the structure of imports er being heavily concentrated in 
investment goods and intermediate goods for a developing country i would 
imagine that the elasticity of substitution for this sort of trade agreement 
would be higher than the elasticity of substitution for an agreement say 
between Britain and France but you know we could debate about that debate about 
that anyway so going back to this then trade creation what conclusion did we 
draw about that magnitude 
sm1136: low 
nm1128: fairly low we wouldn't expect it to be very great right but the 
differences in levels of income in structures of production et cetera okay 
between the E-U and the developing country and trade diversion high so without 
doing any numbers at all all right simply looking at the at the determinants of 
trade 
creation and trade diversion we're going to say that trade diversion will be 
greater than trade creation okay in which case welfare will decline and it's 
going to be g-, going to take an awful lot of persuading to er tell us 
otherwise the only question then is how big [laughter] er you know er how big 
is the loss of welfare going to be okay everybody happy with the static 
Vinerian model yes 
sm1136: sign this 
nm1128: yes well that's [laughter] that's exactly the thing i was just going to 
say [laughter] i obviously led into it quite well er why do they sign it mm er 
why why do you sign it and really the lest of the of of the lecture and 
probably b-, a bit of next week going to be trying to explore why that's what 
economists have done ever since 
sm1136: 
nm1128: yes i mean we-, the-, the-, there's various er things we'll be through 
that's right where it's the sort of long runs so people say that's a static 
effect okay that's the once and for all effect but there's other beneficial 
gains to investment and blah blah blah and we'll be doing that that's right but 
that's the starting point okay why sign it i've given you a th-, a third 
diagram there which er is taken from Bhagwati 'cause i think it's a useful one 
er it's a variation on the er on on the model because one of the magnitudes of 
this er effect is going to er is going to depend also on the share of the E-U 
in the total imports of the developing country mm that's clearly going to be 
very important but haven't said anything about that we've just talked about the 
magnitude of the tariff change but clearly the magnitude of the trade creation 
effect will be larger the larger the share of the E-U in total imports of the 
developing country mm and conversely the trade diversion effect okay er will be 
er smaller the smaller the share of imports from the rest of the world other 
things we need in the E-U a caveat 
so we've implicitly i think er in our previous models assumed that the share of 
the E-U was quite significant that's why you're signing the agreement okay 
you're basically it's the developing country signing a free trade agreement 
with its major trading partner mm and that's the usual pattern what we're 
looking at here is the case where the opposite's true where the developing 
country is signing a free trade agreement with an industrialized country that's 
a minor trading partner an example would be the Caribbean countries signing a 
free trade agreement with the E-U okay Caribbean countries fundamentally their 
trade is with the U-S Canada and other Latin American countries and the E-U 
account for a very small proportion maybe ten per cent at most of total imports 
nevertheless the Caribbean is heading on the route of signing a free trade 
agreement with the E-U round about two-thousand-and-six two-thousand-and-eight 
i mean it's terribly complicated er 
political dynamite all round for obvious reasons the U-S are not exactly going 
to be jumping for joy er and [laugh] the Caribbean can't er can't really er 
afford to upset the U-S so not quite sure but if they want to preserve their 
preferential access for their exports of sugar and for bananas which are 
terribly important to these countries they'll have to sign a free trade 
agreement that's the that's the big dilemma they're faced with 
sm1136: 
nm1128: sorry the banana war again yes no yes there'll be another one 
[laughter] so this is an agreement then between er the Caribbean countries and 
the E-U with the E-U counting a maybe only a small proportion of imports well 
as i put here er it's a question of price-takers and price-makers all right 
that we talked about last term er here fundamentally prices are set by the U-S 
okay that's the big source of supply okay and E-U producers simply er sell er 
in in the market at the price set 
by the U-S suppliers okay they have they're such a small proportion of the 
market that they have no influence on price okay common sense assumption okay 
let me see what what happens in this case well again we've got free er w-, er 
er free trade imports from er the E-U er here and imports from the rest of the 
world call that United States okay but the difference in this case is that 
because the U-S is the major source of supply it's the price-maker perfectly 
elastic supply okay the Caribbean however is a distant market er for E-U 
producers substantial transport costs only a small proportion of their export's 
going there so transport costs would be a significant proportion of total cost 
so the supply curve will be anything but perfectly elastic er it'll be fairly 
steep re-, reflecting the fact that they command only a small proportion of the 
market price is set here so the U-S sets the price in the Caribbean market the 
E-U suppliers provide m-, move up their supply curve until they 
hit point B okay and er at that point which is set by the U-S er price plus the 
tariff okay er then that determines imports from the E-U O-Q-one okay and then 
the rest of imports come from the U-S now let's take the tariff away from er 
imports from the E-U but not from the U-S okay free trade agreement with E-U mm 
er in that case then we show the effect of that by an output movement of the E-
U supply curve okay er in which case imports from the E-U expand from Q-one out 
to Q-two okay the important thing to note is that nothing happens to the 
internal price levels in the Caribbean 'cause they're set by U-S suppliers so 
it's U-S supply plus the tariff so it's the tariff inclusive U-S price which 
sets the domestic price level in the Caribbean mm what the E-U exporters do is 
simply maximize profits with price is set by the U-S suppliers so imports from 
the U-S expand from Q-one out to Q-two mm er there's a loss of tariff revenue 
to the Caribbean governments of A- C- G-E 
okay that area in there where they previously collected the tariff now that's 
being lost and guess who's getting it 
su1138: 
nm1128: no the E-U okay that got to be the U-S are still paying the tariffs 
excuse me er the but but the E-U suppliers aren't paying the tariff mm 
nothing's happened to the domestic price level 'cause they're price-takers okay 
so that loss of tariff revenue goes straight into the pockets of the E-U 
exporters very nicely thank you mm er and that's it there is no gain for the 
consumers because nothing happens to the price er the internal price level of 
the Caribbean doesn't fall because the E-U er previously was accounting for 
maybe ten per cent of imports now goes up to fifteen per cent of imports but 
it's not going to affect price okay you still get eighty-five per cent of of 
imports coming from the U-S that's what determines the internal price level in 
the Caribbean so the price-makers of the U-S exporters the E-U exporters 
are price-takers mm they can't influence price they're too small to do so so 
they simply clean up in terms of the of not having having to pay the tariff 
they previously had to they simply boost their profits er no gain in consumer 
surplus straightforward deterioration in the terms of trade from the Caribbean 
against the E-U er straightforward transfer of government revenue from the 
Caribbean governments and people to the E-U producers full stop end of story 
that's the price of continuing to get access for your exports of sugar and 
bananas and you can measure it [laughter] get to make the right assumptions 
when i i actually went through this one when we because er as you know there's 
er all the er will be up to about two-thousand-and-six two-thousand-and-eight 
the trade negotiations er going on er with the commission er over there that 
will be starting quite soon and i went through that analysis er with the and 
the with people over the the within the 
the commission er there was a [laughter] it wasn't favourably received 
[laughter] er people were unhappy with the idea that the price wouldn't change 
er but that's the reality i mean it's an empirical question okay but if you 
account for only ten or fifteen per cent of the market and the Caribbean group 
very helpfully told me well actually that was a bit high it's about seven or 
eight per cent actually you know in many countries then you're a price-taker 
you don't influence price and that's what the whole analysis hinges on er so 
that's er by way of er a variation of a theme yeah 
sm1132: one question the role of the U-S company in that last model 
nm1128: yes is to get very upset you know 
sm1132: as a price-ma as a price-maker i mean how i mean how how will the U-S 
respond 
nm1128: well they get very upset [laughter] yes i mean er it's obviously it's 
it's crowding out er imports from the U-S that's right yeah that's it 
sm1132: so is there anything the U the U-S will do in that situation 
nm1128: yes i mean that's the that's the big 
issue that's the dilemma which the Caribbean countries are faced with 
sm1132: how 
nm1128: because at the at the currently they have er under the Caribbean Basin 
Initiative they have preferential access to the U-S market principally for 
clothing i mean that's the key one for them really er you know i can't imagine 
the U-S standing by and continuing to allow them that preferential access while 
their exporters are saying but we're losing market share 
sm1132: so isn't the isn't rea-, to the er Caribbean countries in this example 
are better off sticking with the price-maker than rather 
nm1128: and but then if they don't sign the free trade agreement they lose 
their exports of sugar and and bananas and that cause large scale unemployment 
in Jamaica and in the er you know the er er Windward Islands 
sm1132: but then again if if if that happens then the U-S might retaliate say 
well you know 
nm1128: yeah 
sm1132: to import from 
nm1128: yeah 
sm1132: Indonesia or somewhere else 
nm1128: and then the so so the guys in the in the in in 
the sugar and banana plantations do all right but the guys in the clothing 
industry are unemployed 
sm1136: 
nm1128: [laughter] yeah that's the dilemma they've got 
sm1136: 
nm1128: right 
sm1136: 
nm1128: yeah 
sm1136: 
nm1128: mm 
sm1136: 
nm1128: well that is well th-, yes that is exactly what the Caribbean and and 
and CARICOM in particular the Caribbean community which is a free trade 
agreement in fact it's it's moving over to a customs union there and they're 
physically signing i mean some of those hundred-and-six agreements i mentioned 
were between CARICOM er and various Latin American countries 'cause they see 
that as being their future 
sm1136: 
nm1128: yes 
sm1136: 
nm1128: yeah yeah that's right that's right so er better off building up your 
trade with Latin America yes i mean i a-, again it's an example of of the 
patterns of trade not being determined so much by purely economic 
considerations as by a colonial heritage 
er that's why their export in sugar and bananas to Europe er in a free trade 
situation they may or may not be doing so probably wouldn't er free trade 
probably sugar will be coming from India or from Brazil or somewhere like that 
where a a very low cost producer well it's from Australia are a very low cost 
producer not from the Caribbean i mean that's a reflection of the fact that 
were British colonies er i'm not saying that market er 
but and that's created a dilemma and similarly with clothing you see the 
clothing industry in Jamaica which is a quite an important source of employment 
for them that live there is principally because of the Caribbean Basin 
Initiative it's because of preferences in the U-S market without those 
preferences again in a free trade situation the clothing would come from Asia 
not from Jamaica i mean Jamaica then says well what the heck are we going to 
produce but but you've got the answer i mean the answer is that it'll be other 
things which of course we don't know about because they don't exist but er the 
obvious trade pattern would be towards Latin American countries that have a 
different resource base a different level of income a different stage of 
technology so the two economies are complementary to each other and that's the 
future for these countries' problems but that gets us away from here anyway 
that's just er a variation on the on the i mean th-, th-, the 
the previous models assume that the partner country in the trade agreement was 
a price-maker okay this is a case where the partner country's a price-taker 
with the rest of the world determining the price and that alters the analysis 
okay so why sign the damn thing [laughter] you know [laughter] er and that's er 
as i say that's the question which everybody has er you know really teased 
their brains about er you have to look to the so-called dynamic arguments okay 
i don't like the term dynamic because we've nicked it off thermodynamics or 
physics or something like that er growth enhancing i think is more accurate 
okay er phrase so it's a growth enhancing effects of a free trade agreement 
what might they be 'cause remember trade creation and trade diversion are once 
and for all static effects okay they just have a once and for all impact and 
that's it okay fundamentally what we're talking about here is accelerating the 
growth of these countries okay it's a continuous 
process so okay trade diversion might be greater than trade creation all right 
but that's just a once and for all cost if you like mm er is there something 
about the free trade agreements that has a continuous effect on increasing 
output year by year more rapidly than would otherwise have occurred if you 
hadn't signed the free trade agreement and those who favour free trade 
agreements say those are the really important things those growth enhancing 
effects they're the really important ones but they're difficult to measure 
rather fortunate that perhaps but er the other ones are difficult to measure 
anyway so the first one then obvious one is er economies of scale okay 
basically the argument is a simple one er the developing country has access to 
a wider market so previously if you imagine producers simply selling in the 
home market the home market's small 'cause you're a small country small size of 
population and you've got a low level of per capita G-N-P 
so er the effect of that is er er to mean that if that's the long run average 
cost curve er then you know it you're probably this is cost output your small 
size of the domestic market producing a P-A just producing er a production for 
the for the for the home market er means that you're operating at quite high 
average cost of production you then sign a free trade agreement gives you 
access to this huge E-U market i don't know how many million people there are 
i've forgotten how many there are in the E-U 
sm1132: two-hundred-and-forty something like that 
nm1128: right 
sm1136: three-hundred-and 
nm1128: yeah 
sm1136: 
nm1128: yeah three-hundred-and-fifty-million people okay and instead of your 
population of twelve-million [laughter] er so you don't need too many of that 
three-hundred-and-fifty-million people to buy your goods to be able to move 
somewhere out here okay er so you may er having free access unrestricted access 
to this huge market enables you to increase exports expand productions way 
above the constraint of the er 
domestic market and you move down your long run average cost curve okay and 
that makes you even more competitive of course than you were before and so 
exports expand even more so you get a a virtuous process if you're moving down 
if you expand your exports you're moving down the long run average cost curve 
because you're more efficient than you were before producing a lower average 
cost than before you sell more output and so you go on moving down the average 
cost curves in that way 
sm1132: i'm sorry just er one point is the assumption here that er we have free 
er trade agreement just between the developing countries and for example the E-
U er but what what if we say well got er free trade 
nm1128: mm 
sm1132: you know w-, with the whole world then obviously do we have still 
economies of scale then that is the question 
nm1128: well then it gets complicated for the reasons that you've indicated 
because everybody else has got a free trade agreement all right er so 
you've just got free trade i mean ultimately then you've just got world free 
trade in which case comparative advantage should work on a on a world basis all 
right and provided you've got a comparative advantage in this product the same 
argument should hold mm i mean the only difference is that this might hold for 
a product in which you don't have a comparative advantage on a worldwide level 
all right but you do in terms of trade with E-U so if you just had a an 
agreement between Morocco and E-U nothing else in the world all right Morocco 
can move down its long run average cost curve say for clothing it's an 
important industry in Morocco okay mm er because it doesn't have to compete 
with Asia and the rest but if the E-U signs agreements up with all the Asian 
countries and Eastern Europe and everybody else okay then that might not hold 
you had to have a comparative advantage at a world level so er i mean in a 
sense you see what what i'm saying is 
that er a preferential trade agreement can create a false comparative advantage 
mm because you have free access to the E-U but the rest of the world doesn't 
okay then you're more competitive but it's a false comparative advantage mm and 
as more agreements are signed you might well find that you've committed 
yourself to produce clothing but then you're left high and dry because you're a 
high cost producer just that the Caribbean countries er had a false comparative 
advantage in selling bananas in the U-K market or sugar cane in the U-K market 
only because they have preferential access to to to Britain but Australia 
Brazil er Ecuador in the case of bananas and so on er didn't mm so it created a 
false comparative adavantage they built up these industries and now when we've 
got free trade virtually on those products er they can't survive without 
preferences 
sm1132: so basically as the for example the European Union er signs more and 
more trade agreements 
nm1128: yes 
sm1132: which it's which is in the process of doing so now 
nm1128: yes that's right 
sm1132: with the Caribbean with Eastern Europe and other countries er 
nm1128: that's right 
sm1132: and so so basically that preferential er lose 
nm1128: margin 
sm1132: er it loses it's er significance 
nm1128: absolutely absolutely that's right that's right er yes i mean it's er 
yes i mean it whi-, which of course er those who say therefore free trade 
agreements are stepping stones to multilateral trade liberalization might exa-, 
you know say well that's exactly what i'm saying mm that they're just stepping 
stones to world free trade i shall point out at the end it's not quite as 
simple as that 'cause the agreements differ in their content and that creates 
barriers to trade but that's getting a-, that's jumping the gun a bit but 
that's right we're talking as if it was the only 
agreement in the world mm er obviously if it isn't then that that reduces the 
gains to Morocco or wherever it happens to be but then we move over more to 
just global or multilateral trade liberalization getting closer to that perhaps 
okay so the first dynamic gain might be economies of scale you move down your 
long run average cost curve the second one the familiar one to us from any 
trade liberalization er greater competition mm 
to the extent that imports compete with domestic production we're back to that 
argument again the elasticity of substitution between domestic production and 
imports if that's small then that argument's not terribly important er but it's 
still going to e-, exist a wider choice of goods okay previously you'd all 
sorts of barriers to trade i mean many developing countries in the past anyway 
simply prohibited a whole range of imported goods so as to conserve foreign 
exchange for so-called essentials mm er free trade widens choice that's a 
a welfare gain in itself increase in foreign direct investment people 
particularly emphasize this gain here and er the two terms here investment 
creation and investment deflection er investment creation somebody tell me 
about that 
sm1135: er it's like 
sm1135: the share of the market 
nm1128: right okay so we've got two forces working just like the trade aspect 
okay first of all let's again go back to our agreement between E-U and Morocco 
mm now er er previously we had barriers to trade between the two countries er 
let let's assume that was the case er now we've a situation where there's no 
barriers to trade at all a producer of say clothing in France where labour 
costs are high mm can now close down that factory relocate it in Morocco where 
labour costs are much lower er and then export er the output back into France 
again so that the er the manufact-, the the the clothing manufacturer can now 
serve the domestic market in France much more cheaply than they could before er 
as a result of the 
preferential trade agreement mm so er that's one gain from the free trade 
agreement yeah 
sm1135: so the [cough] there would be in er inves-, investment diversion from 
the 
nm1128: in the sense of 
sm1135: in the sense of maybe er an investor will move er and then the export 
nm1128: yes that was the case i was i was i was going though just now 
sm1136: 
nm1128: well it's i-, er er it's normally called in-, in-, investment 
deflection that one 
sm1136: 
nm1128: okay er but it's it's a bit i mean it depends which as you say which wh-
, which standpoint you view it from er but if you're viewing it from the E-U 
point of view it's investment deflection okay er in the case of the er say the 
United States okay that was previously selling goods in the you know that that 
was exporting goods to Morocco mm but now a trade diversion against it okay it 
may wish to retain its market share in Morocco okay in which case it replaces 
its exports by investment in a plant which will produce the goods previously 
exported and that's called investment creation right it's called i-, it's the 
creation of 
investment because investment is taking the place of exports as a way of 
servicing the market so yeah 
sf1137: 
nm1128: yes previously i mean let's say they were selling say agricultural 
machinery to Morocco and they were exporting that from the U-S to Morocco now 
because of o-, of trade diversion the-, the-, they they've lost the market the 
market was big enough then they might say we want to retain our market share by 
jumping the tariff wall in in Morocco if there's still place for it and setting 
up an assembly plant for the combine harvesters the tractors in in Morocco and 
in s-, and and and and continuing to retain its market share 
sf1137: 
nm1128: right 
sf1137: 
nm1128: i-, i-, i-, investment deflection yeah 
sf1137: invest deflection 
nm1128: yeah investment deflection is France er closing down a factory in 
France and setting up a clothing factory in Morocco it's deflecting investment 
from investment in the home country to investment in in Morocco 
sf1137: 
other word for deflection 
nm1128: these are the technical terms that are used in the literature 
sm1135: de-investment 
nm1128: sorry 
sm1135: de-investment 
nm1128: yes i mean i-, it's ca-, it's called deflection because it's simply in-,
in-, investment taking place in a different geographical location mm but the 
total amount of investment hasn't increased all right it's just been deflected 
to a different geographical location hence the word deflection [laughter] not a 
not that i mean if you can imagine sort of investment flowing in into France 
over the years then the preferential trade agreement's signed and it's closed 
off there and it's deflected off down towards Morocco okay that's whereas the 
other case is creation of investment that didn't exist before okay you're not 
closing anything down in the United States necessarily i mean they'll probably 
sell the factory somewhere else what you're doing is in-, instead of servicing 
the market through exports you now 
service it through investment in a production facility so it's i-, it's 
creation of investment that didn't exist before 
sf1137: but it is the U-S would have to look what to do with 
nm1128: yes but we don't ask that question that's right [laughter] 'cause 
that's the rest of the world and the rest of the world's very big all right er 
and Morocco's very small so we needn't bother about that question that's all 
we're saying so er whoops the the the first case er we-, well i mentioned here 
anyway the the the investment deflection can be quite important i i didn't pick 
clothing by accident er 'cause it's the one in which you very often see this er 
where er particularly the the labour intensive stages of the production process 
could often be relocated from the industrialized country to the developing 
country that's what the U-S is doing in Jamaica talked about the Caribbean 
Basin Initiative agreement er this is what France indeed has done in Morocco 
all right and that is what Egypt is hoping will happen er if it signs a free 
trade agreement er with the E-U that there'll be this outward processing er 
will take place on quite a large scale whether that's beneficial or not for the 
country is another question we talked about that under on direct investment but 
that would be a clear case of investment deflection mm investment creation 
would be the U-S coming in to Egypt because they er they're they're losing 
their market and it's a big market for the U-S yeah 
sm1132: just one question say you're a policy maker in Morocco or in the 
Caribbean and er you've done your analysis you've looked at the gains you have 
and of free trade agreements well i've got on one side er er trade creation the 
other hand i've got trade diversion but i also have dynamic er dynamic gains 
along with that 
nm1128: right 
sm1132: er i mean you have nothing to measure you have [laughter] 
nm1128: no that's right 
sm1132: you know how do you how do you decide this case and it's very difficult 
nm1128: yeah 
sm1132: it's a very difficult choice 
nm1128: er 
sm1132: to make 
nm1128: yeah i mean you just have to in the end you have to trust your 
judgement er all you can do however is analyse the situation okay and what this 
does is provide you with a framework of saying are these things going to be 
important okay let's go back to the Morocco case all right er Morocco actually 
had already had preferences with the E-U okay so at the stimulating an effects 
on its exports were zero 
okay because they already had preferential access under a bilateral agreement 
so Morocco could say forget that economies of scale okay because we've we we 
reaped those in the past all right er er and we're not being given any more 
preferences greater competition er well the goods that we import from E-U 
compete to a limited extent with domestic production but not a lot so that's 
not going to be great wider choice of goods similar sort of argument er maybe a 
little bit more than we did before because we had but we're already dismantling 
barriers to trade anyway you know er so that's not going to be great increased 
foreign direct investment er well what's changed you know er the only thing 
that's changed that may be important is that my tariffs on importing goods 
setting up a production facility in Morocco er the er er i-, i-, er it's 
certainly i-, it's more profitable to set up a production facility in Morocco 
than it was before if a French er clothing manufacturer was setting 
up a factory in Morocco all the machinery and the intermediate goods would have 
to pay duty previously er but er they they no longer have to do so er but the 
duties usually are not terribly high on these products in developing countries 
it's consumer goods that carry the very high tariffs i mean it may be tariffs 
of you know ten per cent or so so it might make a difference er but not a a 
dramatic amount and am i going to get investment from the rest of the world i'm 
a tiny little market right if this is Brazil that's signing an agreement okay 
then sure i mean as soon as as er as the Mercasor agreement was signed American 
investment poured in er to retain market share very big market Brazil er b-, t-,
er er er er Morocco what's its population did we say 
sm1133: 
nm1128: sorry 
sm1133: 
nm1128: is it as much as that 
sm1132: i don't think it's that much 
sm1133: 
sm1132: it's even less than that 
nm1128: mm yes it's pretty small 
sm1133: 
nm1128: and and Tunisia's 
what about twelve-million 
sm1135: 
nm1128: yeah yeah yeah so we've we've got a small er a small market so thi-, 
this is the way you'd go through it yeah 
sm1135: 
nm1128: right 
sm1135: 
nm1128: yes if you 
sm1135: 
nm1128: mm 
sm1135: the er access to er Moroccan or Egyptian market 
nm1128: mm 
sm1135: 
nm1128: that's right so y-, but you you have to i mean going through the point 
y-, y-, d-, you already had preferential access before so you ask the question 
how much has it increased all right 
sm1135: yeah potential 
nm1128: yeah now one key thing though is that you you may have had preferences 
before but they were unilateral preferences a free trade agreement is a a 
binding agreement mm a legally binding agreement of indefinite duration and 
that might give the investors greater confidence than they had under the 
previous thing so that might be a big plus and these are the questions i mean 
what this does is provide a framework for asking a whole series of questions 
that's i can forget about that 
one that's not going to be terribly big that's going to be small this one might 
be big it might not we have to look at that more carefully and that's what it 
does and then at the end of the day you make a judgement but the big question 
too is all of these things i've mentioned here you could get from unilateral 
trade liberalization at least a lot of it anyway mm er i mean you wouldn't nes-,
i mean you wouldn't get the so much the investment creation investment 
deflection effects that wouldn't tell us very much but the other ones economies 
of scale greater competition wider choice of goods er we'd all i would all get 
if i simply lowered my barriers to trade with the world as a whole and there'd 
be no trade diversion cost mm so again we come back and think why the hell did 
we sign the agreement right er okay there might be this er investment creation 
investment deflection effects to the extent that they're important er as i say 
i would 
think fundamentally that depends how big an economy you are mm if you're a 
small economy i wouldn't expect it to be terribly great may be wrong er 
Mauritius might be an example where it was quite substantial mm er where you 
know it's it's the third largest exporter of woollen clothes in the world and 
it's a tiny little island and that's largely because of preferences so yeah we 
got to be careful with that one i-, i-, it could be important er but er so so 
maybe that's important but in terms of stimulating foreign direct investment 
because duties on imports of capital goods and intermediate goods have come 
down well liberalize to the world as a whole mm so investors can then buy 
capital goods and intermediate goods at world prices mm not simply er at 
whatever price the E-U exporter sells them to you so we still got really we 
still haven't really answered the question why sign the agreement we've got the 
gains from trade but why not just get 
those on a non-discriminatory basis through unilateral trade liberalization why 
do it in a in a discriminatory way we've still got that puzzle well er next 
week i'll go through some new thinking and er to explain why some of the what 
those gains might be i've hinted at one of them already that is in an uncertain 
world binding yourself in to a free trade agreement provides you with a bit 
more certainty so if i engage in unilateral trade liberalization and it's or 
maybe with other countries er negotiate reciprocal tariff reductions in the W-T-
O er there's always the danger of going back to the nineteen-thirties all right 
there's always the W-T-O has been weakened by the Seattle er situation that 
we've talked about before okay maybe it's not quite such a strong organization 
that we thought it was okay maybe if there was serious unemployment in the 
industrialized countries the whole agreement would just be torn up and we'd be 
back to the er er discrimination and er barriers to trade 
of the nineteen-thirties you know that's not improbable but if i lock myself in 
to the E-U or to United States through a free trade agreement maybe that gives 
me a bit more certainty okay it's a i-, it's a it's a legally binding agreement 
you'd build up institutional arrangements which link you in with the other 
country so when push comes to shove all right if we if we did have a bit of a 
recession in the u-, in the E-U or or United States they'll discriminate 
against other people er not against me at least not in the first instance all 
right so bit more certainty then perhaps yeah 
sm1132: 
nm1128: well it yeah i mean in the case of Eastern European agreements it's 
heavily political all right you're trying to reinforce the overthrow of 
communism er democratic governments as long as 
they're not communist governments er and so on that's right so i mean that was 
a heavy political element in that one that was the top of the of the agenda and 
the E-U was willing to pay quite a high price to maintain that with the other 
dev-, o-, other developing countries not really willing to pay a price and that 
in a sense is part of the of of also of the puzzle the developing countries in 
effect i mean from what we've said have to pay quite a high price upfront right 
at the beginning for these agreements okay that's the welfare loss there's the 
rising unemployment as industries close down that are competing with imports 
from the E-U there's the loss of government revenue you know there's a lot of 
upfront costs for the developing country from the agreement really not much 
cost for the industrialized country mm so why do they sign why do developing 
countries sign these agreements with industrialized countries hinted at one of 
them and that's that's increased certainty i think that figures quite 
prominently but there's other aspects as well that we'll talk about next week 
to do with timing consistency problems signalling all sorts of other things 
that we talk about any final points okay well i'll carry on doing the theory 
and then we'll talk a bit more about actual agreements next week and then we'll 
get on to talk about article twenty-four and er how it i-, its weaknesses and 
how it needs to be reformed hopefully in a Seattle type row whatever it's going 
to be called [laugh] thank you