Trade Creation & Trade Diversion and Total Trade Effects in SMART (Quantity Effects of Tariff Liberalization)

The explanatory table below shows the cost to the United States of purchasing an automobile part from various source countries, with and without tariffs. The numbers illustrate the idea of trade diversion, under which the United States could switch from buying the auto part from Asia before NAFTA (for $20.90 with a 10% tariff) to Mexico after NAFTA (for $20 with zero tariff). While the United States gains 90S on each unit from paying a lower price, it also loses $1.90 in tariff revenue from not purchasing from Asia. An initial tariff of 20% going down to zero levels will show that trade is created with Mexico. Consumers gain in US because they are now getting cars from Mexico at US $ 20 and at the same time the Mexican Producers gain. Trade creation is always welfare improving while trade diversion most of times are welfare reducing (except when Mexicans can put extra effort in providing all the car requirements of the US).

Source: Feenstra and Taylor, 2008

Trade creation (in SMART model) is defined as the direct increase in imports following a reduction on the tariff imposed on good g from country c. If the tariff reduction on good g from country c is a preferential tariff reduction (i.e. it does not apply to other countries, c ), then imports of good g from country c are further going to increase due to the substitution away from imports of good g from other countries that becomes relatively more expensive. This is the definition of trade diversion in the SMART model. For exporting countries, total trade effect is made of trade diversion and trade creation.

Equations for Trade Creation and Trade Diversion are given in Appendix Table VI. The values will depend on import demand elasticity, substitution elasticity and supply elasticity.

Simulation I: Liberalization of CSG Trade with MERCOSUR countries in 2010

The first simulation is the liberalization impacts of zero tariffs on imports of CSG from the rest of the nine MERCOSUR countries. The following are the outputs of the SMART analysis (within WITS).

The Detailed Data report is to check the raw data used for smart simulation just to make sure the dataset corresponds to expectations.

The Export View report shows the impact of the tariff reform on partner's exports to the considered market. It displays the pre value of exports (before the tariff change), the post value of exports (after the tariff change) to the considered market as well as the net value between the two, considered as the change in exports revenue

The Market View report returns all three types of effects affecting the market (trade value, tariff revenue and welfare change) by individual product code and for all products as one aggregate.

The Revenue Impact report returns individual results on the market's revenue by product code and for all products as one aggregate. The report displays the tariff revenue change between the pre and post tariff cut situation as well as the trade total effects.

The Trade Creation Effect report returns individual results on Trade Total effect by product code/partner combination and for all products as one aggregate. This report also shows the trade diversion effect among partners and trade creation effect for both the market and its partners. In SMART, beneficiaries of the tariff reduction enjoy both positive diversion effect and positive creation effect while all other partners will suffer from negative diversion effect and no trade creation effect

The Welfare Effect report returns individual results on the market's welfare by product code and for all products as one aggregate. The report displays the Total Trade Effect, which is defined as the sum of Trade Diversion effect, Trade Creation Effect and Price Effect as well as the Welfare Effect defined as the benefits consumers in the importing country derive from the lower domestic prices after the removal or reduction of tariffs.

In the SMART modeling framework, a change in trade policy (say preferential tariff liberalization) affects not only the price index/level of the composite good but also the relative prices of the different varieties. Despite the export supply elasticity, the import demand elasticity and the substitution elasticity9, it will lead to changes in the chosen aggregate level of spending on that good as well as to changes in the composition of the sourcing of that good. Both channels affect bilateral trade flows.

As mentioned above SMART reports the results of any trade policy shock on a number of variables. In particular, it reports the effects on trade flows (i.e. imports from the different sources). It also decomposes those trade effects in trade creation and trade diversion. Trade creation is defined as the direct increase in imports following a reduction on the tariff imposed on good g from country c. If the tariff reduction on good g from country c is a preferential tariff reduction (i.e. it does not apply to other countries, c ), then imports of good g from country c are further going to increase due to the substitution away from imports of good g from other countries that becomes relatively more expensive. This is the definition of trade diversion in the SMART model.

We summarize the results in Tables I through III (Simulation I). Table I gives the total trade effect (sum of price-terms of trade effect, and quantity effects-trade creation and trade diversion effects) of tariff liberalization undertaken by Ecuador in context of MERCOSUR countries (simulations) in 2010. Price effects in these simulations are zero because we assume Ecuador to be the 'small country. Colombia gains the most in terms of total trade effects followed by Argentina and Peru. Chile has negative total trade effects because Chile already has a free trade policy with most of its Latin American Partners. Total trade effect for the US is negative and relatively higher as there is trade diversion from US to MERCOSUR countries for trade in CSG goods. For saving space the trade diversion impact on all countries is not shown. The total trade effect on the World is 3111.64 1000 US $.

Table I: Trade Creation, Trade Diversion and Total Trade Effects of Tariff Liberalization with MERCOSUR Countries only for CSG Imports for Simulations Undertaken by Ecuador in 2010

Source: Author's work in WITS. Price effects are zero as we assume that Ecuador is 'small country'

SMART also calculates the impact of the trade policy change on tariff revenue, consumer surplus and welfare.

A tariff revenue change on a given import flow is computed simply as the final Ad Valorem tariff multiplied by the final import value minus the initial Ad Valorem tariff multiplied by the initial import value.

It should be noted that tariff revenue change is made of two opposite effects:

1. A tariff revenue loss at constant import value, which corresponds to a transfer from the State to

consumers and is equal to Q0*(t0-t1).

2. A tariff revenue gain through the increase in imports which enlarges the tax base and is equal to (Q1-Q0)*t.

Using SMART internal import demand elasticity values, the tariff liberalization simulation returns a negative tariff revenue change (that is revenue gain from increased imports not enough to dominate revenue loss due to tariff decrease) in most cases.

Table II below shows that the welfare effects of tariff liberalization for CSG products. This works out to be 351.76 1000 US $ while the total imports before tariff reduction is 252,746.147, 1000 US$. The revenue effect works out to be -2,276.697, 1000 US $. The total import change is 3111.634, 1000 US$ due to reduction in tariffs on imports of CSG from MERCOSUR.

Table II: Revenue and Welfare Effects of CSG Liberalization undertaken by Ecuador (Simulations Only) with MERCOSUR Countries in 2010

Source: Author's work in WITS

Table III below shows the tariff change in revenue of -3029.456 while the consumer surplus due to reduction in tariffs on CSG coming from MERCOSUR countries. This work out to be 180.812, 1000 US dollars.

Table III: Simulation Results: Consumer Surplus and Tariff Change in Revenue for Ecuador after its liberalization with MERCOSUR in Trade in CSG Products

Source: Author's work in WITS

Table IV below shows the trade creation, trade diversion and total trade effects of liberalization of CSG trade with the main suppliers of CSG goods, i.e., the US, Japan and China (Simulation 2). The highest total trade effect occurs in the US of the tune of 8023.8,1000 US$ followed by China worth 5338,1000US$ while the country which has the highest negative total trade effect is Columbia (-787.63, 1000 US$). Mexico has total negative trade effect of -379.09 ,1000 US& while Germany is the most affected country in Europe of the tune of -369.29,1000US$. The total import price change with all countries is 9702.19,1000 US$

Table IV: Trade Creation, Trade Diversion and Total Trade Effects of Tariff Liberalization of CSG Trade with China, Japan and the US for Simulations Undertaken by Ecuador in 2010

SOURCE: Author's work in WITS

Table V below gives the revenue and the welfare effects of tariff liberalization undertaken by Ecuador (simulations only) with respect to China, Japan and the US. The Welfare effect works out to be 786.20,1000US$ for Ecuador. The figure is higher (more than double) with what it were when Ecuador liberalized its trade of CSG products with the MERCOSUR countries.

Table V: Revenue and Welfare Effects of CSG Liberalization undertaken by Ecuador (Simulations Only) with China, Japan and the US in 2010

Source: Author's work in WITS

Table VI shows that consumer surplus effect is higher than when Ecuador liberalized its trade of CSG with MERCOSUR countries.

Table VI: Simulation Results: Consumer Surplus and Tariff Change in Revenue for Ecuador after its liberalization China, Japan and the US in Trade in CSG Products

Source: Author's work in WITS

Table VII indicates that Germany, Italy and Spain are the greatest gainers due to liberalization of Ecuadorian trade with EU27(Simulation 3). The total trade effect for Germany works out to be 2686.755, 1000 US$ (export surge), followed by Italy of the tune of 2035.086,1000 US$ followed by Spain of the tune of 1362.69,1000 US $. United States, Columbia and China are the countries who have the greatest trade diversion effects because of preferences given by Ecuador to EU27 countries. The total trade effect (total import surge with respect to all countries) works out to be 5601.571,1000 US $

Table VII: Trade Creation, Trade Diversion and Total Trade Effects of Tariff Liberalization of Ecuadorian CSG Trade with the EU 27 for Simulations Undertaken by Ecuador in 2010.

Source: Author's work in WITS

Table VIII shows the consumer surplus effects of liberalization equivalent to 310.696,1000 US$, an amount less than when Ecuador liberalized CSG trade with China, Japan and the US, but more than when Ecuador liberalized its trade with MERCOSUR countries

Table VIII: Consumer Sulus and Tariff Change in Revenue Effects of Liberalization of Ecuadorian CSG Trade with EU27 Countries

Source: Author's work in WITS

Table IX shows the welfare effects of liberalizing Ecuadorian CSG trade with EU27 Countries. The amount works out to be 534.350,1000 US$, less than when Ecuador liberalized its trade with China, Japan and the US, but more than when it's liberalized its trade with Mercosur Countries

Table IX: Welfare and Total Trade Effect of Liberalizing Ecuadorian CSG Trade with EU27 Countries

Source: Author's work in WITS

In Summary, SMART Analysis helps us to establish that it is better and more beneficial to liberalize Ecuadorian CSG trade with the Japan, the US and the China, followed by EU 27, the main suppliers (exporters) of CSG products rather than MERCOSUR countries