Analytical Model

2.1. Description on the Approach

Studies on the impact of an FTA assumed implicitly that imported goods are homogeneous to domestic goods. That is, imported goods have the same quality, characteristics, and consumers’

recognition as domestic goods. If this assumption is applied to analyses, imports from one country affect directly the domestic market of the other country. That is, an increase in import indicates that total supply of the good increases by the volume of the imports. Accordingly, domestic price drops significantly and domestic production decreases substantially. This kind of approach has been criticized to overestimate the effects of an FTA.

The following figure depicts an open economy with the homogeneous-good assumption. D and S indicate domestic demand and supply. Before an FTA, domestic price is at P0 and domestic production is Q0. If the border is open to the other countries, domestic price would drop from P0 to P1 and domestic production would decrease from Q0 to Q1. Note that P1

is the price of imported goods before tariff is charged. Let P^im be the arrival price of imported goods at port. Then, P1 is the same as P^im. In a case that a price gap between domestic goods and imported goods, the price drop is very large and the production decrease is, accordingly, substantial. Therefore, the impact of an FTA on domestic industry is also significant.

오류!

However, some researchers raise a question whether imported goods can be dealt with as the same as domestic goods because imported goods are priced differently from domestic goods in the domestic market.

This approach has another drawback. In this approach, it is not easy to analyze an FTA effect with China or Japan after an FTA with the United States. Such difficulty is caused by the fact that it does not identify goods imported from the U.S. with goods imported from China or Japan. According to this model, domestic prices would fall to the level of C.I.F. prices of the U.S. goods under a free trade agreement with the U.S. After a Korea-U.S. FTA, additional FTA would not affect the Korean domestic market if C.I.F. prices of the country are higher than C.I.F.

prices of the U.S. In such a case, U.S. goods dominate the Korean market and import substitution effect from the U.S. to another country cannot happen. Thus, this approach is not appropriate for an analysis of an FTA effect.

In this study, it is assumed that imported goods are heterogeneous to domestic goods.

The heterogeneity of goods is caused by quality difference and consumers’ recognition. For example, domestic beef and imported beef are recognized as different beef by Korean consumers even though they are both beef. High prices for domestic beef (Hanwoo) are acceptable to Korean consumers because domestic beef is safer and of higher quality than imported beef. However, they do not pay high price for imported beef because they believe that imported beef is less safe and of lower quality. It is not important whether their recognition is true or not. The fact is that Korean consumers believe that imported beef is different from domestic beef and that the difference in recognition appears as the difference in price in the market. Consumer prices of domestic beef are higher by 3-4 times than U.S. beef prices.

One possible approach to handle the heterogeneity is to deal with imported goods as one of substitutes. For example, U.S. beef is one of substitutes for domestic beef, like pork or chicken.

An FTA would drop the price of the goods imported from the country in question by eliminating tariff. The drop in price of imported goods would change the relative price between domestic goods and imported goods. Domestic prices expressed in terms of imported price would be higher than before the FTA. The change in relative price would substitute some portion of domestic demand. The substitution effect would appear as a shift in demand curve, not a movement along with demand curve because the price of a substitute changes. Thus, the impact of a Korea-U.S.

FTA is measured how much U.S. beef substitutes the demand for Korea beef.

The following figures describe the changes in the market of U.S. goods, domestic goods, and goods of other countries that are exporting to Korea. In panel (a), P^us0 and P^us1 are prices of U.S. goods before and after an FTA between Korea and the U.S., respectively. D^us is demand for U.S. goods in Korea. If prices of U.S. goods fall from P^us0 to P^us1 by removing barrier to trade through an FTA, import for U.S. goods would increase from Q^us0 to Q^us1.

Q₁ Q₀ Q₂

P1

P0

S

D

Panel (b) depicts the market of domestic goods. Demand for domestic goods would shift from D0 to D1 because some portion of domestic demand is substituted by goods imported from the U.S. The shift in demand curve induces domestic price to drop and domestic production to decrease.

It depends on a cross-elasticity of demand how much domestic demand shifts. The magnitude of the shift of demand curve is directly linked to an FTA impact on domestic industry.

The bigger the cross-elasticity, the larger the shift of demand curve. The larger the shift of demand curve, the more the impact on domestic industry.

In addition, the size of cross-elasticity is dependent on the substitutability between domestic goods and imported goods. If there is a significant difference in quality between domestic goods and imported goods, little demand for domestic goods would be substituted by imported goods. Thus, a small cross elasticity is expected. However, if domestic goods and imported goods are very similar in terms of quality and consumers’ recognition, the cross-elasticity would be large.

Q1 Q0

P₁ P₀

D0

(b) Market of Domestic Goods

D1

Q^us₀ Q^us₁ P^us1

P^us0

D^us

(a) Market of U.S. Goods

Panel (c) depicts the market of goods imported from other countries. Before an FTA between Korea and the U.S., these countries exported by P^oth0 to Korea. An FTA with the U.S.

makes prices of goods imported from other countries high relative to U.S. prices. High relative price shifts demand curve from D^oth0 to D^oth1. The shift in demand curve results in a decrease in export of other countries from Q^oth0 to Q^oth1.

2.2. Demand Function

One of the features of this approach is that imported goods are classified by the origin. That is, U.S. beef is different from Australia beef or New Zealand beef. In other words, all kinds of beef imported are one of substitutes for domestic beef. Therefore, each beef price of the countries is included into demand curve of domestic beef. Demand curve is defined as follows.

Q^d=f(P, P^pork, P^chicken, P^usbeef, P^aubeef, P^nzbeef, expenditures)

where Q^d is demand for domestic beef; P is domestic beef price; P^pork and P^chicken are prices of domestic pork and chicken; P^usbeef, P^aubeef, and P^nzbeef are prices of beef imported from the United Stats, Australia and New Zealand, respectively. Expenditures indicate consumers’ expenditures on all kinds of meat.

From the demand function, the following relation can be derived using zero degree of homogeneity.

n +n^pork + n^chicken + n^usbeef + n^aubeef +n^nzbeef +n^exp = 0

In general, own elasticity (n) is negative and all cross-elasticities for domestic meat (n^pork , n^chicken) are expected to be positive. In addition, all elasticities for imported beef (n^usbeef, n^aubeef, n^nzbeef) are also likely to be positive because they are substitutes for domestic beef. If beef is not an inferior good, elasticity for expenditures (n^exp) are also positive. Thus, all elasticities are positive except own-price elasticity.

The above relation may be very useful for some goods, particularly when we have no trade data. In such a case, we cannot estimate cross-elasticities. The above relation shows that

Q^oth₁ Q^oth₀ P^oth

D^oth0

(c) Market of Goods of Other Counties

D^oth1

the value of assumed cross-elasticity should not be bigger than own-price elasticity in absolute terms. For example, if own price elasticity is -1.0, any elasticity of substitutes should be less than 1.0. In other words, it is unreasonable to assume that a cross-elasticity of imported goods is 1.2.

It is worth being noted that simultaneous equation approach is more appropriate for meat because beef, pork and chicken are usually substitutes one another. In general, the demand for meat is determined simultaneously. However, we need at least the same number of exogenous variables as the number of equations (the number of endogenous variables is the same as the number of equations), in order to use a simultaneous equation system. Unless we have sufficient number of exogenous variables, we have to face the identification problem and it is not possible to estimate each parameter of the system.

III. Measuring the Effect of an FTA