U.S.-Korea Free Trade Agreement: Potential Economy-wide ... - USITC

General Effects of Trade Agreements
Studying the economic impact of an FTA entails investigating static effects such as trade
creation and trade diversion, as well as terms of trade (i.e., the price of exports relative to the
price of imports). In addition, issues related to scale effects and less tangible effects have to
be considered. These issues are discussed below.
Static Effects: Trade Creation and Trade Diversion
Trade liberalization can in general be undertaken in two different manners. First, trade
liberalization can be based on the MFN principle, where better market access is granted to
all or nearly all trading partners equally. The classical “gains from trade” argument asserts
that such trade liberalization will offer consumers access to more goods at lower prices, and
producers more sources for their inputs and more markets for their products (for which they
may receive higher prices). Second, trade liberalization can be done in a preferential way,
with better market access granted to one or several partners but not to others. It should be
noted that better market access can result not only from bilateral tariff removal but also from
other negotiated provisions in the areas of cross-border trade in services,
telecommunications, electronic commerce, and government procurement, all of which are
not readily quantifiable. An FTA such as the one between the United States and Korea is an
agreement in which preferential liberalization is negotiated and undertaken reciprocally
between participating countries. 1
To the extent that FTAs are designed to liberalize trade, they are likely to engender economic
gains similar to those of an MFN liberalization. Given their discriminatory nature, however,
studying the economic impact of FTAs involves additional issues that are not present in an
MFN liberalization. The traditional way to study an FTA is to categorize the FTA-induced
trade expansion into trade creation or trade diversion. 2 Trade creation improves net welfare
and occurs when partner-country production displaces higher-cost domestic production.
Trade diversion reduces net welfare and occurs when partner-country production displaces
lower-cost imports from the rest of the world. 3 The combined effect of an FTA on intrabloc
trade will then reflect trade creation as well as trade diversion. Whether the trade creation
(welfare-enhancing) or the trade diversion (welfare-reducing) effects dominate depends on
a variety of factors, including external trade barriers, cost differences, relative supply and
demand responses, and other domestic policies. Thus, the overall welfare impact of an FTA
can be empirically determined.
1 It should be noted that, although negotiated bilaterally, some FTA provisions, such as those related to
customs administration, labor, or environment, tend to be applied in a nondiscriminatory manner and are
closer to the MFN principle.
2 The seminal works on this issue are Viner, The Customs Union Issue; and Meade, The Theory of
Customs Union.
3 Losses from trade diversion occur when lost tariff revenue associated with changes in the pattern of
trade exceeds efficiency gains from the decline of the prices paid by consumers. These losses will be larger
the higher the FTA’s margin of preferences (i.e., the trade barriers facing nonmembers relative to intra-FTA
barriers).
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