Right in the Short Run

There’s been a lot of talk about the South Korea free trade agreement lately on the ‘ol econ blogs. So before RISR gets left behind, I’m going to dive in with a little story about trade diversion.

Say country Alpha produces bikes for $10 each and country Beta produces bikes for $20 each. Country Gamma, the country in which you happen to live, doesn’t make bikes, but it does apply a $20 per bike tariff to bike imports. This isn’t so bad, you say, because in this world a Gamma citizen gets Alpha bikes for $30 and Beta bikes for $40. We should find these countries, you say, because on this Earth bikes cost $200! Well I haven’t said whether the bikes are any good, perhaps they are for teh tinies (teh childrens). But I digress.

In this world of uniform tariffs, assuming Alpha and Beta produce equally good bikes, Alpha will sell bikes to Gamma, and Beta will be left out. But what happens if Beta and Gamma sign a trade deal cutting all bilaterial tariffs on bikes to $0? Suddenly Beta bikes cost $20 and Alpha bikes cost $30. Gamma citizens only buy Beta bikes now, and they save $10 to boot! Free trade yay!

Unfortunately, the economists in Gamma are sulking in the corner. They say this trade deal wasn’t actually such a good deal — that it actually may have made the world as a whole worse off! What do they know?!

It turns out these economists are right. Alpha is the most efficient producer of bikes, and under the uniform tariff, it ended up being the main producer of bikes. With the bilateral trade deal, Beta became the exporter despite its relative inefficiency. Although the consumers of Gamma gained from the deal, it’s not clear whether this gain matched losses to the Gamma government — it no longer makes money off tariffs. As this example has shown, a country may start trading with a less efficient producer as the result of a trade deal, an outcome that economists call “trade diversion.” And trade diversion stinks.

One worry is that the American focus on bilateral trade deals has been trade-diverting. But don’t listen to me — talk to the experts! Here’s Mark Thoma:

What appears on the surface to be a series of free trade agreements betweent the U.S. and other countries is really a system of insider-outsider trade with all the distortions such preferential treatment brings about

Thoma quotes a new op-ed by Martin Wolf (check the Thoma link for the full text):

Why do I object? Is such trade liberalisation not precisely what most economists interested in trade believe in? The answer to this question is “yes and no”: yes, because liberal trade is desirable, but no, because this form of liberalisation is not necessarily a move towards liberal trade. As Jagdish Bhagwati of Columbia University has argued, “free trade agreements” should, instead, be called “preferential trade agreements”. I would prefer “discriminatory trade agreements”.

In this case, the US and South Korea agree to discriminate in favour of exporters or investors based in each other’s territory. The obvious potential economic cost of such an agreement is what Jacob Viner, the great inter-war trade economist, called “trade diversion”. In other words, the partners might shift from more competitive to less competitive suppliers. In this case, however, trade diversion may be modest, since these two countries are among the world’s most competitive suppliers of a wide range of goods and services.

A more significant economic cost, however, is systemic. The number of preferential trade agreements has exploded upwards in recent years… Other countries will be desperate to avoid the adverse effects upon them. This makes probable yet another jump in the prevalence of such agreements.

And Kash Mansori at The Street Light is pretty pissed too:

[T]he Doha Round (the round of multilateral trade negotiations that is intended to finally take serious steps toward helping the developing world) is “on life support” in no small measure because the Bush administration has never seriously tried to make it work, instead focusing on small bilateral agreements that make no difference to anyone in the US except for a few individual corporations. And there are good theoretical reasons to think that a bunch of small bilateral trade deals may actually make it harder to conduct multilateral trade negotiations, putting a world-wide level playing field further out of reach than ever before.

So yes, it’s not clear whether the South Korea free trade agreement was actually in our best interest. But don’t take my word for it…