March 2007 IIDE discussion paper: 200703-01
IIDE
institute for international and development economics
DISCUSSION PAPER Economic Impact of a Potential Free Trade Agreement (FTA) Between the European Union and South Korea Joseph Francois (Johannes Kepler University Linz, IIDE, and CEPR) Hanna Norberg (Lund and IIDE) Martin Thelle (Copenhagen Economics) Abstract: We analyze the effects of potential measures to liberalize trade between the European Union (EU25) and South Korea. Using a computable general equilibrium (CGE) model of world trade that incorporates the GTAP database, we evaluate two scenarios for an EU-Korea free trade agreement (FTA) and compare it to the maximum potential given by a full free trade agreement. We show that a realistic FTA scenario (called “Partial 1”) yields a total gain for the two economies of 26 percent of the potential in a full FTA. If liberalization of trade in services is taken a step further, as in our more ambitious scenario (called “Partial 2”), total gains increase to 46 percent of the total potential from a full FTA between EU and Korea. Our results show that both economies stand to gain economically from all analyzed levels of trade liberalization, but the gains are unevenly distributed. Korea will obtain two-thirds of the total gains from an EU-Korea FTA in all scenarios, basically because the Korean economy initially is more protected from international competition than the EU economy, and therefore will benefit more from increased competition. JEL Codes: F13, F15 Keywords: CGE, EU-Korea Free Trade Area
Disclaimer and thanks: This paper does not represent the official views of any institution with which the authors have ever been affiliated. This study was prepared for the European Commission DG while Norberg was with Copenhagen Economics. Cross publication note: This discussion paper was originally released as an EC short study for DG Trade, prepared with Copenhagen Economics.
Stichting IIDE, Institute for International & Development Economics www.i4ide.org
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O:I: ]#C/%D%(?#'E"%1'%F#$5" C#6-1#$%2%7:;/%2334%)?#%0#."$1'"/%@1-?%)-?"6%A)6"#'%7:;. EMD#)?!D)#?(,?+#% "##$ %#%&"##$ '()*+,(' 1234 565 565 568 I(*()=S('!=%$!?#I=,,# &5653 &5653 &5688 other primary "#)('?)P 5655 5653 &565; "+'@()+(' 5653 5655 5655 M+%+%S 5655 &5658 &5657 manufacturing ?(O?+L(' &5653 &568> &5684 ,L#?@+%S &5653 565N &5689 L(=?@() &5657 568; &568N LKMI() &5658 5659 &565> D=D()6!DKLD6!DKIL+'@+%S 5655 5653 &5654 D(?)#,@(M+,=L' 5655 5653 5653 ,@(M+,=L'6!)KII()6!=%$!DL='?+,' &5658 565> &5639 +)#%!=%$!'?((L &5657 &5659 &5697 %#%&"())#K'!M(?=L' &5654 5638 &5645 M#?#)!*(@+,L(' &5657 &56;7 &5695 (L(,?)+,=L!M=,@+%()P &5657 &5688 &567: #?@()!M=,@+%()P &5657 5639 &5694 #?@()!M=%K"=,?K)(' &5653 5654 &5635 services K?+L+?+(' 5655 5655 &5654 ,#%'?)K,?+#% 5655 5655 5658 ?)=$( 5655 5655 5653 ?)=%'D#)? 5655 5653 5689 ,#MMK%+,=?+#%' &5658 5658 568N "+%=%,+=L!=%$!I=%U+%S!'()*+,(' 5655 5655 5657 +%'K)=%,( &5658 &5658 &565N #?@()!IK'+%(''!'()*+,(' &5658 5658 563> #?@()!'()*+,(' 5655 5655 5653
-.-/0 5658 5655 &565> &565N &5689 &5659 &5653 5655 5683 5698 &5687 &5654 5653 &5654 &5694 &565> &5659 &565N &5653 5657 &568N &5678 &5697 &865> &56N9 &568N &568; &5654 5658 5653 5684 568N 5654 &565> 563> 5653 '
8 3 9 7 4 N ; > : 85 88 83 89 87 84 8N 8; 8> 8: 35 38 33 39 37 34 3N 3; 3> 3: 95 98 93 99 97 94 9N
AK!+; C"6("'-%G?#'E"%1'%K5- $=+)P!D)#$K,?' 565; &5694 563; *(S(?=IL(!#+L' &8654 &56;; 5639 #?@()!D)+M=)P!=S)+,KL?K)( &8654 &56;> &565; #?@()!D)#,(''($!"##$' &964N &86N7 &5659 I(*()=S('!=%$!?#I=,,# 3695 &96:8 56>N other primary "#)('?)P &5697 &56N; &5637 "+'@()+(' &5648 &5698 565N M+%+%S 5657 &864N 5658 manufacturing ?(O?+L(' 5685 8649 &569> ,L#?@+%S 5653 368; 565; L(=?@() 56:9 &5639 &565; LKMI() 5655 &863> 5694 D=D()6!DKLD6!DKIL+'@+%S &5685 &86;; &8658 D(?)#,@(M+,=L' &5653 &56N> 56:3 ,@(M+,=L'6!)KII()6!=%$!DL='?+,' 5688 &864> 86;9 +)#%!=%$!'?((L 56N> 56:: N6;3 %#%&"())#K'!M(?=L' 5679 &9687 46;8 M#?#)!*(@+,L(' 5647 87698 765> (L(,?)+,=L!M=,@+%()P 5634 3639 :685 #?@()!M=,@+%()P 5634 &3698 4635 #?@()!M=%K"=,?K)(' 568; &3689 86;5 services K?+L+?+(' 5655 &569N 5679 ,#%'?)K,?+#% &5659 5633 5688 ?)=$( 5658 &565; &56:4 ?)=%'D#)? 5655 &56N: 864: ,#MMK%+,=?+#%' &5659 &5675 &36;9 "+%=%,+=L!=%$!I=%U+%S!'()*+,(' 5655 &5657 &564N +%'K)=%,( &5654 &5633 &5653 #?@()!IK'+%(''!'()*+,(' &5658 &8684 &>6;7 #?@()!'()*+,(' &5659 &568N &56N>
' !+;9%N;B+%+77+G:M/% : 85 88
AK!+; 8'.O1$$"P%9#0)6%+* &86; 56; &965 896> 86> &369 &363
&567 565 569 569 &865 56> 86N N65 468 96: >63 76: 86N
56: 363 368 &865 &965 &568 565 ;69 364 8>69 8569 36> &567
3> 3: 95 98 93 99 97 94 9N
services K?+L+?+(' ,#%'?)K,?+#% ?)=$( ?)=%'D#)? ,#MMK%+,=?+#%' "+%=%,+=L!=%$!I=%U+%S!'()*+,(' +%'K)=%,( #?@()!IK'+%(''!'()*+,(' #?@()!'()*+,('
565 565 565 565 565 565 &568 565 565
&564 568 &569 &56> &56N &563 &569 &869 &569
569 568 &56: 864 &36N &56N &568 &>64 &56>
&563 568 &868 56; &963 &56> &564 &:6> &868 '
8 3 9 7 4 N ; > : 85 88
AK!+; MO1$$"P%9#0)6%+* $=+)P!D)#$K,?' 565 *(S(?=IL(!#+L' &567 #?@()!D)+%=)P!=S)+,KL?K)( &56: #?@()!D)#,(''($!"##$' &869 I(*()=S('!=%$!?#I=,,# 56;
other primary 83 "#)('?)P 89 "+'@()+(' 87 M+%+%S
'
M=%K"W
'()*+,('
?#?=L
&563 &568 &56N &563 &568 &56N &563 &569 &56; &56N &863
&568 568 &563 563 &568 568 569 569 565 563 567
&563 565 &56: &564 568 &867 568 &567 &86N &86; &568
&569 &56> 565
&564 &564 &863
&568 563 568
&56: &868 &868
84 8N 8; 8> 8: 35 38 33 39 37 34 3N 3;
manufacturing ?(O?+L(' ,L#?@+%S L(=?@() LKMI() D=D()6!DKLD6!DKIL+'@+%S D(?)#,@(M+,=L' ,@(M+,=L'6!)KII()6!=%$!DL='?+,' +)#%!=%$!'?((L %#%&"())#K'!M(?=L' M#?#)!*(@+,L(' (L(,?)+,=L!M=,@+%()P #?@()!M=,@+%()P #?@()!M=%K"=,?K)('
565 565 569 565 565 565 565 563 568 563 568 568 568
564 56> 565 &567 &56N &563 &564 569 &865 769 56; &56> &56;
568 563 563 569 &563 564 56; 367 368 867 965 365 56>
56N 865 567 &568 &56> 563 569 36: 863 46: 96> 869 568
3> 3: 95 98 93 99 97 94 9N
services K?+L+?+(' ,#%'?)K,?+#% ?)=$( ?)=%'D#)? ,#MMK%+,=?+#%' "+%=%,+=L!=%$!I=%U+%S!'()*+,(' +%'K)=%,( #?@()!IK'+%(''!'()*+,(' #?@()!'()*+,('
565 565 565 565 565 565 565 565 565
&568 568 565 &563 &568 565 565 &567 &568
569 563 &568 56; &56> 565 563 &968 &568
563 569 &568 564 &56: 565 568 &964 &568 '
8 3 9 7 4 N ; > : 85 88
+82J 8'.O1$$"P%9#0)6%+* &568 569 568
&568 &568 565 565 565 568 &563 &569 &564 &569 &564 &567 &563
3> 3: 95 98 93 99 97 94 9N
services K?+L+?+(' ,#%'?)K,?+#% ?)=$( ?)=%'D#)? ,#MMK%+,=?+#%' "+%=%,+=L!=%$!I=%U+%S!'()*+,(' +%'K)=%,( #?@()!IK'+%(''!'()*+,(' #?@()!'()*+,('
565 565 565 565 565 565 565 565 565
565 565 565 565 565 565 565 565 565
565 568 568 563 563 568 565 569 568
565 568 568 563 563 568 565 569 568 '
8 3 9 7 4 N ; > : 85 88
+82J MO1$$"P%9#0)6%+* 4 847 5 83: 757 ;
5 85 5 : : N 84N 5 8>5 3W7;9 83
5 85 5 : : N 84N 5 8>5 3W7N; 83
8 88 5 : : ; 8N7 5 8:5 3WN48 89
; 8> 9;
> 35 7>
> 35 7:
> 35 4;
:;; 4;5 4>5 34N 773 ;: 9WN37 ;97 >;8 8W799 3W8;> ;WN59 8W;;4
8W75N >38 ;N9 937 43> :3 7W;33 >49 8W57: 3W8>5 3W7:5 85WNN> 3WN44
8W75> >39 ;N4 937 43: :3 7W;8; >9: 8W5;4 3W8N4 3WN7N 85W;:; 3WNN4
8W459 >;8 >5: 977 444 :N 7W:74 >99 8W873 3W3>4 3WN:: 88W>>8 3W>>4
9; NN 8WN83 7W>:9 >7: 9>N 89> >W554 3W897 R3T3S2
N9 885 3WN3; NW:98 8W3;N N44 35: 83W374 9W47; JXT4RU
:: 8;3 9W:4N :W883 8W;43 8W538 3:8 8;W8:5 4W748 U3TV4W
337 9;; ;W>5: 89W474 3W;:8 3W38: 7>3 3>WN33 88W9;5 434TR2W
'
.#$/,'$012F,,#"H2F,2Z(#5('#Y2+;2&/#2>+4=%&0&'+,012Q+@#12 1.
Introduction
This annex provides an overview of the basic structure of the global CGE model employed for our assessment of an EU-Korea FTA.. The model is based on Francois, van Meijl, and van Tongeren (2005) and is implemented in GEMPACK -- a software package designed for solving large applied general equilibrium models. The reader can download and replicate our results, but will need access to GEMPACK to make modifications to the code or data. The model is solved as an explicit non-linear system of equations, through techniques described by Harrison and Pearson (1994). More information can be obtained at the following URL -http://www.monash.edu.au/policy/gempack.htm. The reader is referred to Hertel (1996) for a detailed discussion of the basic algebraic model structure represented by the GEMPACK code. While this appendix provides a broad overview of the model, detailed discussion of mathematical structure is limited to added features, beyond the standard GTAP structure covered in that document. The model is a standard multi-region computable general equilibrium (CGE) model, with important features related to the structure of competition (as described by Francois and Roland-Holst 1997). Imperfect competition features are described in detail in Francois (1998:). Social accounting data are based on the most recent Version 6.2 of the GTAP dataset (www.gtap.org).
2.
General structure
The general conceptual structure of a regional economy in the model is as follows. Within each region, firms produce output, employing land, labour, capital, and natural resources and combining these with intermediate inputs. Firm output is purchased by consumers, government, the investment sector, and by other firms. Firm output can also be sold for export. Land is only employed in the agricultural sectors, while capital and labour (both skilled and unskilled) are mobile between all production sectors. Capital is fully mobile within regions. All demand sources combine imports with domestic goods to produce a composite good. In constant returns sectors, these are Armington composites. In increasing returns sectors, these are composites of firm-
differentiated goods. Relevant substitution and trade elasticities are presented in Appendix Table 1.
3.
Taxes and policy variables
Taxes are included in the theory of the model at several levels. Production taxes are placed on intermediate or primary inputs, or on output. Some trade taxes are modeled at the border. Additional internal taxes can be placed on domestic or imported intermediate inputs, and may be applied at differential rates that discriminate against imports. Where relevant, taxes are also placed on exports, and on primary factor income. Finally, where relevant (as indicated by social accounting data) taxes are placed on final consumption, and can be applied differentially to consumption of domestic and imported goods. Trade policy instruments are represented as import or export taxes/subsidies. This includes applied most-favored nation (mfn) tariffs, antidumping duties, countervailing duties, price undertakings, export quotas, and other trade restrictions. The major exception is service-sector trading costs, which are discussed in the next section. The full set of tariff vectors are based on WTO tariff schedules, combined with possible Doha and regional initiatives as specified by the Commission during this project, augmented with data on trade preferences. The set of services trade barrier estimates is described below.
4.
Trade and transportation costs and services barriers
International trade is modeled as a process that explicitly involves trading costs, which include both trade and transportation services. These trading costs reflect the transaction costs involved in international trade, as well as the physical activity of transportation itself. Those trading costs related to international movement of goods and related logistic services are met by composite services purchased from a global trade services sector, where the composite "international trade services" activity is produced as a CobbDouglas composite of regional exports of trade and transport service exports. Trade-cost margins are based on reconciled f.o.b. and c.i.f. trade data, as reported in version 6.2 of the GTAP dataset. A second form of trade costs is known in the literature as frictional trading costs. These are implemented in the service sector. They represent real resource costs associated with producing a service for sale in an export market instead of the domestic market. Conceptually, we have implemented a linear transformation technology between domestic and export services. This technology is represented in Annex Figure 1. The straight line AB indicates, given the resources necessary to produce a unit of services for the domestic market, the feasible amount that can instead be produced for export using those same resources. If there are not frictional barriers to trade in services, this line has slope -1. This free-trade case is represented by the line AC. As we reduce trading costs, the linear transformation line converges on the free trade line, as indicated in the figure. The basic methodology for estimation of services barriers involves the estimation of an equation where import demand is a function of the size of the economy (GDP) and its income level (per-capita income). We have also
included dummy variables by sector, and country-specific dummies (with Hong Kong and Singapore being the base case). Our import data are on a sector basis by country with respect to the world, and are at the same level of aggregation as the CGE model data. Formally, out estimating equation is (1)'
M i, j " ai # a j # a 1 ln(GDP) j # a2 ln(PCI) j # $ j '
where Mi,j represents imports in sector i by country j, ai and a j are sector and country effect variables, GDPj represents national GDP (taken in logs), PCIj is per-capita income (again taken in logs) and $ is an error term. This is an improvement on the apporoach in Francois, ven Meijl and van Tongeren (2005) as under this approach we have several points for estimation of each national restriction index (the a j coefficient). Adjusted by the import substitution elasticity, these national coefficients provide an estimate of the trade-cost equivalent of existing barriers in services, as an average across service sectors. a j " %& ln T j ' (2)'
'(
Here, Tj is the power of the tariff equivalent (1+tj ) such that in free trade T0 =1, and & is the trade substitution elasticity relative to domestic production (taken to be the substitution elasticity from Annex Table 1). Regression results from this approach are reported in Annex Table 2, while the relevant estimates of tariff equivalents for this study are reported in the report.
5.
The composite household and final demand structure
Final demand is determined by an upper-tier Cobb-Douglas preference function, which allocates income in fixed shares to current consumption, investment, and government services. This yields a fixed savings rate. Government services are produced by a Leontief technology, with household/government transfers being endogenous. The lower-tier nest for current consumption is also specified as a Cobb-Douglas. The regional capital markets adjust so that changes in savings match changes in regional investment expenditures. (Note that the Cobb-Douglas demand function is a special case of the CDE demand function employed in the standard GTAP model code. It is implemented through GEMPACK parameter files.)
6.
Market Structure
Z?P!K&-$#0!6"'!.-5"'12X!R'-.#(1"#!2&,1"'2! The basic structure of demand in constant returns sectors is Armington preferences. In Armington sectors, goods are differentiated by country of origin, and the similarity of goods from different regions is measured by the elasticity of substitution. Formally, within a particular region, we assume that demand goods from different regions are aggregated into a composite import according to the following CES function: (3)'
0R ) q Mj ,r " .1* j ,i ,r M j ,ij,r + / i "1 ,
1/ ) j
'
In equation (3), Mj,i,r is the quantity of Mj from region i consumed in region r. The elasticity of substitution between varieties from different regions is then equal to &Mj , where &Mj=1/(1B)j). Composite imports are combined with the domestic good qD in a second CES nest, yielding the Armington composite q. (4)'
' (
q j,r " 0 2 j.M .r q Mj,r /
3j
' (
# 2 j, D,r q Dj,r
3j
1/ 3 j
,
'
The elasticity of substitution between the domestic good and composite imports is then equal to &Dj, where &Dj=1/(1-3j). At the same time, from the first order conditions, the demand for import Mj,i,r can then be shown to equal (5) '
M j,i,r
0 * j,i,r ". + ./ Pj,i,r +,
& im
0 * j,i,r ". + ./ Pj,i,r +,
&M j
%1
0 R & Mj 1% & Mj M . 1 * j,i,r Pj,i,r + E j,r / i "1 ,
'P ( M j,r
&M j
%1
'
M E j,r
where EM j,r represents expenditures on imports in region r on the sector j Armington composite. In practice, the two nests can be collapsed, so that imports compete directly with each other and with the corresponding domestic product. This implies that the substitution elasticities in equations (3) and (4) are equal. (These elasticities are reported in Annex Table 1). Z?]!/-5&'6&,1!,"-5&1.1."#! As indicated in Annex Table 1, we model manufacturing sectors and service sectors as being imperfectly competitive. The approach we follow has been used in the Michigan and the WTO assessment of the Uruguay Round. Recent model testing work indicates that this approach works “best” vis-à-vis Armington models, when tracked against actual trade patterns. (See Fox 1999, who uses the U.S.-Canada FTA as a natural experiment for model testing). Formally, within a region r, we assume that demand for differentiated intermediate products belonging to sector j can be derived from the following CES function, which is now indexed over firms or varieties instead of over regions. We have (6)'
q j ,r
0 n 4 " .1 5 j ,i ,r X j ,ji ,r + / i "1 ,
1/ 4j
'
where 5j,i,r is the demand share preference parameter, Xj,i,r is demand for variety i of product j in region r, and &j = 1/(1-4j) is the elasticity of substitution between any two varieties of the good. Note that we can interpret q as the output of a constant returns assembly process, where the resulting composite product enters consumption and/or production. Equation (6) could therefore be interpreted as representing an assembly function embedded in the production technology of firms that use intermediates in production of final goods, and alternatively as representing a CES aggregator implicit in consumer utility functions. In the literature, and in our model, both cases are specified with the same functional form. While we have technically dropped
the Armington assumption by allowing firms to differentiate products, the vector of 5 parameters still provides a partial geographic anchor for production. (Francois and Roland-Holst 1997, Francois 1998). Globally, firms in different regions compete directly. These firms are assumed to exhibit monopolistically competitive behaviour. This means that individual firms produce unique varieties of good or service j, and hence are monopolists within their chosen market niche. Given the demand for variety, reflected in equation (6), the demand for each variety is less than perfectly elastic. However, while firms are thus able to price as monopolists, free entry (at least in the long-run) drives their economic profits to zero, so that pricing is at average cost. The joint assumptions of average cost pricing and monopoly pricing, under Bertrand behaviour, imply the following conditions for each firm fi in region i: (7) ' (8)'