The Economics of TTIP. A Theoretical Investigation of Environmental effects of international free trade agreements

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Abstract

Free Trade Agreements have been at the centre of an inamed debate, with eco-nomic benets being questioned and rising complaints about fairness of the playing eld for the sides involved. Environmental drawbacks are often asymmetrically di-vided among the parties, resulting in problematics of environmental dumping. At the eve of the new Transatlantic Trade and Partnership Agreement, this work proposes to analyse the possible drawbacks due to environmental externalities, investigating how FTAs may be the tool through which economic agents make counterproductive decisions. As the burden of externalities may be overlooked, the well-being of the consumers from the partner countries can turn out to be lowered from a policy involuntarily incentivising them. In order to assess what are the crucial elements to take into account, a Comparative Advantage model is built to simulate the possible outcomes of an FTA.

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Acknowledgements

I wish to take this chance to thank my supervisor Simone d'Alessandro for his constant support and helpfulness; all this work has been made easier by the open and passionate collaboration I received from him. More importantly, I became interested in the very subject of this work as an important step on the path of my personal development, to which he contributed by providing valuable academic and intellectual stimulus. Therefore, this is but another chance to thank him for the support received throughout this master course in Economics.

I shall also thank my family, as they not only sponsored my studies, but promoted and encouraged me to aim for the new objective hiding beyond the accomplish-ments, believing in my possibilities often more than I did.

I am also grateful beyond measure that I was able to walk this path with such a good company of colleagues and friends. The reciprocal assistance has been vital, although it is the support at large that I consider to have been the most precious. Thus, I thank Andrea C., Elena, Eleonora and Marco and for walking with me to this day, avouring days of studying with what I will cherish as good memories. A special mention goes also to Andrea P., Asya and Tommaso, with whom I shared many adventures, in many dierent places. Of similar mindsets and inclinations, you made me enjoy moments to be treasured and retraced.

Luckily, I found many sources of warmth in these years that made my experience at the university warmer. I thank my friends from Salerno, that I name myself grateful for being too many to name, for the hearty comfort in days of harsh study.

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iii

I could make very close friends in Pisa, too. I would also like to thank Dario and Enrica for making my days in this town even more pleasant to be lived.

As life is not only amusement, I am thankful to the association Banca del Tempo di Pisa and to the Stop TTIP Committee of Pisa, and to their members more importantly, for I hope to be matured thank to the activities organised together. Finally, I am thankful for all the relief and encouragement that was always waiting for me in proving times. I would like to thank Sara, my loving half, for sustaining my ambitions and my will every time it was needed, and for pushing me to always do my best. To her I dedicate this work.

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Chapter 1 TTIP among multilateral

agreements

1.1 An introduction to the relevant issues

The Transatlantic Trade and Investment Partnership (TTIP, hereafter) is the last of a large number of bilateral and multilateral agreements that have been signed in order to promote international trade liberalisation. To current date the US government has signed Free Trade Agreements for a total of 14 Free Trade Areas and even more partner countries. As regards the EU, apart from its intrinsic ob-jective of trade liberalisation in Europe, the European Commission has proposed and signed 4 FTAs with countries from dierent continents2. It should be noted that an international agreement strictly related to the TTIP is the Comprehen-sive Economic and Trade Agreement (CETA) already negotiated with Canada and waiting to become legally binding after a legal review and the completion of the ratication process. These agreements allow for both tari and non-tari measure reduction among the countries involved, the latter representing the normative dis-crepancies and the approval procedure on the imported goods or services. Indeed, national legislation may demand that some requirements are satised in order for the good or service to be traded within the country's territory.

As will be shown in detail later in this work, non-tari measures (NTMs) 1

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2 1.2. A closer look at Non-Tari Measures are the focus of the TTIP, as the taris faced by the signatories candidates are already at a low level. Non-tari measures are typically regulations enacted by a State to reduce or otherwise minimise the risk of any harm in matters of Safety, Health, Environment, Investors, and Consumers. SHEIC measures, as the Centre for European Policy Studies report (Pelkmans et al., 2014) names them, have an important role to play, as they may be a tool to x for market failures.

1.2 A closer look at Non-Tari Measures

In this perspective, SHEIC regulation is introduced as a corrective measure and thus represents an asset for the legislator's country. Impact assessments forecasts and international trade models usually deal only with the cost side of such regu-lation, as they may burden international rms with higher costs leading to ine-ciency in the goods and services market. This is the case of the economic forecasts and analyses on which this work will be built, although the author recognises the corrective value of SHEIC regulation. However, in order to properly comment on the economic aspects of NTMs and related international agreements, regulation will be regarded as a cost for international rms throughout the work.

Whenever a country enacts a regulation identiable as a NTM (xed prices, new standards, certications, etc. . . ), it is likely that the cost to export goods and services to this country will rise. A useful consideration is provided by the same CEPS report, as it highlights that the raise in cost deriving from a regulative barrier would be overrated if it were to be evaluated from a domestic market perspective. Indeed, although it might require a 10% nominal increase in costs relatively to the case of absence of such regulation, national and international rms could have already abided to some extent to the new standards set by the legislator. This would make for a lower-than-proportional increase in costs for international rms willing to export to the country under consideration. With this specication in mind, together with a fundamental uncertainty regarding the choice of a correct estimation of the quantitative eects of a regulation, it becomes evident that all analyses regarding the NTMs are unlikely to be perfectly accurate. This is also the reason why economic research recently focused on a correct evaluation of NTMs

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3 1.3. The Transatlantic Trade and Investment Partnership (TTIP) and their role in international trade. It should be specied that the burden of estimating the cost equivalence of the enactable NTMs was borne by (Francois et al., 2013a), that also provided for some estimations of the economic eects.

1.3 The Transatlantic Trade and Investment

Part-nership (TTIP)

The TTIP is a treaty undergoing negotiations between the United States of Amer-ica and the European Union. Negotiations began in July 2013, and the partnership is expected to become eective from 2027, upon the approval of the EU govern-ments and the European Parliament. Information regarding the content of such a Partnership has been made available rst and foremost through leaks of secreted documents and afterwards by a disclosure of the mandate of the negotiations, fol-lowing the request of the European Union Ombudsman. However, as the mandate only reveals the guiding principles underlying the TTIP future negotiations, infor-mation made available to citizens comes mainly from leaked documents. Indeed, the institutions that produced forecasts of the eect of the TTIP could only make a guess on what the actual details of the treaty will be, analysing a likely situation. The reference studies that will be referred to in this work are the ones that are commonly seen as constituting the basic theoretical framework: Francois et al. (2013a), Francois et al. (2013b), citetfontagne2013transatlantic, and Felbermayr et al. (2013). However, we will also comment on a study by Capaldo (2014), as it has gained increased attention, and on the CEPS report (Pelkmans et al., 2014), that provides useful insights on the reference studies and on relevant aspects regarding CGEs models and other international agreements.

1.3.1 The civic society response and the ICE

As has been the case for other notorious Free Trade Agreements, TTIP has gained much antagonism from the side of civic society and associations. Every citizens

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4 1.3. The Transatlantic Trade and Investment Partnership (TTIP) group in the eld of Environment, Health, Labour rights and also some political parties have raised to speak against the agreement. The reason is the one most intrinsic in the nature of TTIP: the reduction of NTMs, that will translate into a weakening of standards in the above mentioned elds. Renown activist groups active in both EU and US, such as Global Project, Greenpeace, labour syndicates large and small, WWF, WWOOF, Friends of the Earth, ATTAC, the Occupy movements, and many more, with an uncountable number of local groups and committees.

Indeed, as the legislative reduction is to take eect on such a broad range of societal aspects, many were the voices the came together, resulting in the European Citizens' Initiative (ECI). This tool would challenge the European Commission to deal with the subject of the ECI and may translate into legislative change. However, a given number of signatures across the EU must be collected, thus a petition was started all over Europe to both inform and collect as many signatures as allowed by the one year time span of an ECI. So far the minimum number of signatures has been collected, and more than two millions and a half joined the campaign to ask the European Commission to reconsider. The campaign is not proceeding smoothly, though, with the petition being invalidated by the European Commission on the grounds of illegitimacy. The argument was that no ECI could be accepted on what was not a legal act, but merely an internal preparatory act, i.e. the mandate to negotiate. The European campaign has thus deposited a lawsuit at the European Court of Justice, demanding to acknowledge the validity of the ECI, as the mandate to negotiate is consider to be a proper legal act that could be translated into eective legislation. As of now, no response has been given to the lawsuit, but after the rejection of the ECI little room is left for a dialogue between the parties, although it might be noted that little dialogue has ever been conceived in the designing of TTIP.

1.3.2 The roundtables and the left home

In fact, in order to know the opinion of European citizens, many roundtables and talks where organised by the European Commission. To current date and

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5 1.3. The Transatlantic Trade and Investment Partnership (TTIP) knowledge, up to 560 meetings were organised, with the dierent sectors being represented in varying measure. Nonetheless, what troubles campaigners and the activist groups is that only 26 out the 560 meetings were held with representatives of civic societies, and then one would need to sum up for NGOs, trade unions, and consumers organisations. Also among the sectors involved there has been a huge divergence in the numbers: while less than 20 meetings included members of the public sphere (Public Adminitration, Standard Setters, etc. . . ), more than 120 were the meetings including representatives of corporations dealing in the Agribusiness. This dierence is made more notable by comparing this gure with the 6 meeting in which Farmers representatives were invited to share their view on TTIP.

Furthermore, not even the business sector has been wholly represented, with no participation of Small and Medium Enterprises (SMEs) representatives. Indeed, whenever TTIP was sponsored as benecial for SMEs by the business world, it was from interest groups such as Business Europe, although they represents big businesses in Europe. In addition, when trade associations had the chance to ask the Directorate General for more information regarding the TTIP, the same business groups prompted questions concerning the presumed benets of TTIP for SMEs, for which the case [of said benets] remains hypothetical.

1.3.3 The unheard call for transparency

As has already been hinted, no public documentation regarding the state of nego-tiations or even information on which are the points under discussion have been made available. The secrecy of the negotiations has blown the horn of both aware-ness and sturdier antagonism, igniting suspicions also among the lines of the euro-deputies, as the important number of amendments and the postponement of the relative voting has recently shown. Notwithstanding the recurrent commitments to further transparency expressed by Members of the European Parliament (MEPs), no steps forward have been taken after the disclosure of the mandate to negoti-ate. However, this leaves little space for an inherent, informed Impact Assessment on the subject of TTIP, making the production of forecasts something more than

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6 1.4. A review of current literature on TTIP an experts guess. This could also be the reason why so few studies have been published until now, and would thus urge on the proponents of TTIP to conform with their transparency commitments, fostering academic debate and production on the issues involved.

1.4 A review of current literature on TTIP

The scarce availability of information goes to the merit of the research centres and foundations that took up the task of providing an economic analysis of the potential benets of TTIP. Although the articles and studies will be reviewed with a critical perspective, their work is nonetheless appreciated by the author, for it supplied vital material for debate and further research.

1.4.1 The CEPR Study

The main reference study regarding the TTIP is the one commissioned by the European Commission Directorate General for Trade to the Centre for Economic Policy Research (Francois et al., 2013b). This study analyses the benets from the reduction in Tari Barriers and more importantly in Non-Tari Barriers (NTB). As the existing Tari Barriers are recognised as already being at a low level, the study focuses on NTBs, strongly advocating in favour of the partnership with its forecasts. Indeed, the CEPR estimated that families would benet from the TTIP, obtaining as much as 545 euros per year as an increase in their disposable income. Moreover, employment could receive a boost evaluated in several million jobs freshly available for the European labour force.

However, doubts were cast on the credibility of the forecasts, especially as re-gards the eects on employment. On the one hand, the CEPR (Francois et al., 2013b) states in its own report that gures regarding occupation should be read with caution, as labour is not the main focus of the proposed model so that ac-curacy of employment estimates is expressly not to be relied upon. On the other hand, occupation gures are usually a hot political and economic issue, eagerly dis-cussed in the media without neither a deep analysis of the underlying assumptions

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7 1.4. A review of current literature on TTIP of the model nor a contextualisation of the results. In this way, a controversial result could be misused or become a dangerous tool of propaganda, moving the attention away from the more accurate or reliable estimates. Unsurprisingly, the CEPR result has rapidly become popular, also leading following studies to high-light any dierence of their results in terms of occupation (Capaldo, 2014). The stand of the European Union on this regard is ambiguous: while the European Commissioner for Trade Cecilia Malmstroem relies on the CEPR results to reject the need of a protection fund for laid down workers following a negative impact of TTIP in employment, the European Commission has recently taken its distance from such incautious interpretation, deeming the only study that estimated the creation of more than a million jobs to be unreasonable and inconsistent, its estimates being unrealistically high.

Indeed, as can be read from the study, the model used by the CEPR takes the employment as xed, eliciting the number of new jobs by the value created from the increased trade. This conclusion is not only farfetched, but it is also weakened by the absence of any inequality and redistribution consideration. The 545 euros gure, for instance, is merely an average, failing to duly relate the value created to the actual share that would enrich European families and closing both eyes on how equally this would occur, both in terms of cross-country and within-country dierences. In addition, the forecast GDP increase amounts to a 0.5% and relates to the 10-years span from 2017 to 2027, that put into yearly terms, represents roughly a 0.05% change. This may be even more surprising when recalling that this gures belong to the ambitious scenario, i.e. one in which NTBs would be shrunk by 25% and Tari Barriers would be nullied, while less optimistic scenarios yielded even more modest gures. Indeed, the work has the merit of designing multiple scenarios, to catch the possible states of the world and enhancing the robustness of the estimation in case these all point to the same results.

The CEPR divides the possible states of the world into two dierent categories: Limited Scenarios and Comprehensive Scenarios, the rst ones only representing a specic NTM to be cut while the second ones presenting the possibility to reduce all NTMs, although with varying extent. Among the limited scenarios can be found the Taris Only one, that would see no Non-Tari Measure to be reduced, while

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8 1.4. A review of current literature on TTIP Tari Measure would be almost eliminated (98% reduction). The Services Only scenario represents the case of a cut of the cost deriving from NTMs only in the services sector, while taris would remain untouched, and the Procurement Only scenario represents the case of a cut only in public procurement related NTMs. The Comprehensive Scenarios instead include two degrees of NTMs liberalisation, but in both cases all NTMs are reduced at some extent. In the less ambitious scenario, NTMs are to be cut by 10% on both goods and services and by 20% for public procurement, while 98% of taris would be removed. In the ambitious scenario, the taris are totally removed, with NTMs reductions of 25% on goods and services and 50% for public procurement. In the Limited Scenarios, the gains in GDP for EU and US are estimated to be no more 0.1 per cent and 0.04 per cent, respectively, while all other countries (except for China) would suer a loss ranging from 0.01 and 0.04 per cent. The results for the ambitious scenarios have already been showed to be slightly higher, not beyond 0.5 per cent even when considering the cumulative benets in the long-run.

Thus, the results conrm that an overtly ambitious scenario, coming from a reduction of as much as 25 per cent of NTMs (national SHEIC legislation), would lead at most to the equivalent of a modest 0.05 per cent yearly gain in GDP, with likely negative eects on countries that are not involved in the signature of the TTIP. Nonetheless, the CEPR goes as far as including in the Comprehensive Scenarios benets for third parties as well, i.e. for countries that will not be part of the TTIP. Indeed, the CEPR work assumes that a xed share (10 or 20 percent) of the benets of signatory countries in terms of cost reduction would simply spill-over to third countries. However, as these benets would derive from a normative alignment of such countries, thus leading them to eectively become part of the agreement to an extent, it is not easy to estimate how these countries would be likely to respond and the economic consequences of such policy alignment. Finally, even if third parties would like to counteract to the TTIP by means of enacting new international trade legislation, separate FTAs among these countries could not be excluded. This specication of the spillovers oered by the CEPR is at most a useful scenario to be compared together with alternative possible states in terms of policy responses, with the 10-20 per cent of positive spillovers probably

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9 1.4. A review of current literature on TTIP representing an optimistic cooperative alternative.

1.4.2 The Ecorys Studies

In addition to providing the most successful estimation of the benet of the NTMs reduction in terms of costs, Ecorys published three studies between the 2009 and the 2012. Indeed, in the rst of their publications (BV et al., 2009), Ecorys oered what became the benchmark measure for NTMs analysis, as all the models here reviewed have built their calculations on these estimations. However important this task has been, the Ecorys works lack specication on the characterisation of the NTMs. As already mentioned, since NTMs are derived from regulatory heterogeneity and other qualitative factors, it is not trivial to decide how these factors are to be transformed into a qualitative measure. Thus more specication could have allowed for a more insightful account of the extent of NTMs reduction actionability and improved the likelihood of the scenarios selected.

Concerns arise also when considering the quantitative estimation, since BV et al. (2009) includes only two scenarios (in addition to the baseline one): the Limited scenario and the Ambitious scenario. The results are signicantly dierent between the two, with the EU estimated gain in GDP of 18,7 billion euros in the Limited scenario being more than doubled in the Ambitious scenario: 44, 4 billion euros (Short Run estimations). Similar dierences may be observed for the US estimated benets, ranging from 7,8 billion euros in the Limited scenario to the 18,9 billion euros in the Ambitious one. Moreover, a comparison with the single-scenario BV et al. (2199) report would also highlight some major inconsistencies, weakening any clear-cut conclusion that is possibly derived from the study. For instance, the US estimate for the terms of trade in the Ambitious scenario is -0.15% and -0.23% in the Short Run and Long Run respectively, while in the following report it is estimated in a gain of 0.1%, independently of the horizon considered. Finally, Ecorys used aggregate data to obtain EU estimated gains and benets, but only assessed national impacts for Netherlands. This leaves the topic of trade diversication open, as possible diversion of trade paths between EU member states to the US is not accounted for, although it might possibly impact on terms

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10 1.4. A review of current literature on TTIP of trade, national employment, and GDP of some of the european partners.

Finally, as regards the eect of TTIP on third countries, Ecorys does not show clear-cut results in its works, while hinting that both EU and US might gain in terms of volume of trade relatively to third countries, thus likely weakening the position of the latter as a by-product of the trade agreement.

1.4.3 The CEPII Study

The analysis conducted from the Centre d'Études Prospectives et d'Informations Internationales (CEPII) is similar to the ones seen so far in its results and also in the methodologies used to derive such results. Overall, the TTIP is found to be slightly benecial to both the US and the EU, although with varying magnitude between the US and the EU and among the European member States (Fontagné et al., 2013). Indeed, while the forecast regarding the GDP would see the US improving its position by 0.3% by 2025, just as much as the average performance of the EU states, benets for the specic European countries range from 0.2% to 0.4%. Furthermore, the sectoral position varies also between the two macro-areas. For instance, the gains in the agricultural sector are estimated to be around 1.9% of GDP for the US, while the EU would suer a loss of 0.8% of GDP in this sector, compensated by higher gains in both the Industrial and the Services sectors relatively to the US.

Interestingly, the CEPII study is the only one that produced autonomous esti-mation and quantications of the NTMs and the eect on GDP of their removal, after the publication of the Ecorys study (BV et al., 2199). Indeed, multiple sce-narios were envisaged in the work, diering on the scale and application of NTMs reduction: I) Taris Only; II) Reference; III) Targeted NTMs Cut; IV) Harmon-isation Spillovers; V) Alternative (Ecorys) NTM reduction. The rst scenario assumes that no NTM reduction is actionable and estimates the eects of reduc-tion of Tari Measures only. The reference scenario represents the calculareduc-tions done by the authors of the CEPII study, while the last represents the calculations by Ecorys. A normative alignment with third parties is assumed in the Harmon-isation Spillovers scenario, enhancing the results in terms of exports volume and

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11 1.4. A review of current literature on TTIP GDP increase. Finally, a more thoughtful enactment of the NTMs reduction is implemented in the Targeted NTMs Cut scenario, with the sectors bearing the highest barriers being more aected from the cost reduction than the others. The rationale for this procedure would be to promote international trade precisely in those sectors that are currently suering from the highest cost due to national regulation. The results for this scenario are slightly better relatively to the Refer-ence and the Ecorys ones, while harmonisation spillovers are still the most crucial contingency in order to obtain the best forecast result, for both US and EU.

Indeed, alike the CEPR study analysed beforehand, also the CEPII includes normative alignment are as a desirable and likely (although to unknown extent) eect of an international agreement between the two macro-areas. However, the most optimistic forecast does not exceed the ones made by the CEPR, as the Harmonisation Spillovers scenario result would bring to an increase of 0.5% of the GDP for both partners. Thus, the only dierence insofar with the CEPR result is to be found in the time horizon, as the dierence with the baseline scenario is now computed in 2025, compared to 2027 milestone of the previously analysed study.

1.4.4 The Bertelsmann Foundation Study

Although making no direct assumption on regulation alignment and on spillover eect on third parties, the Bertelsmann Foundation study (Felbermayr et al., 2013) is the one reporting the highest estimates of the gain from a free trade agreement. Indeed, while due to the lack of alignment and the magnitude of the trade deal under negotiations Canada would suer a loss of GDP of 9%, in the authors' cal-culations the US would benet by a huge 13% gain in GDP, with the EU obtaining a slightly less incredible result of a 5% benet in GDP. These results were driven from the assumption that once the barriers have been removed, the signatories would interact as if they were replicating the eects of previous agreements such as the EU creation itself and the NAFTA. This assumption has been deemed de-manding also from the CEPS (Pelkmans et al., 2014) in its report, as it would imply that the trade ows variations following dierent and historical agreements such as the NAFTA and the EU would equally be the results of the signature of the

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12 1.4. A review of current literature on TTIP TTIP. This assumption weights also on the spillovers estimation, as the economic reaction of third parties (external to the free trade agreement) has been derived econometrically, too. Thus, economic impacts following the NAFTA are reected in the impact of the TTIP for non-signatory countries. The features of a specic country, time and previous economic situation (globalisation level, employment legislation, previous international agreements) are thus not taken into account, making for a comparison that lacks substantial contextualisation.

Moreover, the study was criticised also for the few scenarios included in the study: Taris Only and Liberalisation. The scenarios foreseen in Bertelsmann Foundation's work could be unable to properly depict the full variety of possibil-ities for the TTIP to be implemented, especially as regards the NTMs reduction actionability. Indeed, as the Liberalisation scenario would see trade ows to be increased by an econometrically-derived measure built on past agreements, the re-sults are detached from any degree of reduction of NTMs. In this perspective, the study is unable to supply any consideration on the relevance of the scale of NTM reduction as the Taris Only scenario is not aected either, consisting in NTMs to be untouched while Tari Measures would be eliminated.

This is not the only dierent feature of the Bertelsmann Foundation's study with respect to the ones we have analysed so far. The dataset used for the esti-mation has a dierent level of aggregation, using country data instead of summing up into macro areas. This allows for an improved specication of the eects of the trade agreement, with country-specic data and the possibility to compare the performance of every country, with some European states exchanging places as commercial partners of the US. However, the relevance for every country in terms of volume of trade following the liberalisation is dependent on the magnitude of the variation of economic variables (such as GDP) as this in turn relies on an arguable methodology of estimation.

Jeronim Capaldo, from the Tufts University, provided additional insight on the partnership, especially considering that his work represents a methodologi-cal breakthrough with respect to the preceding studies (Capaldo, 2014). Indeed, Capaldo chose to use the United Nations Global Policy Model (GPM, hereafter),

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13 1.4. A review of current literature on TTIP with the most signicant features being the presence of a Keynesian eective de-mand, income distribution eects on the economic activity, and an econometric employment level estimation. The dierent tools used to derive the projections led Capaldo to signicantly dierent results, to the point of reaching dierent policy implications. Indeed, all previous studies we have mentioned until now had been optimistic, although to varying extent, towards the eect of the TTIP, while Ca-paldo's conclusion is that it would be detrimental to some economies. In CaCa-paldo's forecasts there would be winners and losers, with some countries gaining in terms of net exports, GDP and employment, while other would be negatively aected both in the short and long run. More specically, all EU economies are found to suer a loss in terms of net exports, to the benet of the US and non-signatory countries. Moreover, Capaldo prospects the risk of a greater nancial interdepen-dency due to an increase in asset prices to sustain positive growth rates, since consumption will supposedly be stagnating (both in his baseline scenario and in his forecasts). This would lead to widespread European instability, according to Capaldo, as the EU lacks a scal authority to enact a scal policy to stimulate the economy.

In addition, perhaps urging to respond to the discussion following the incredible CEPR results, Capaldo focused on employment, and in particular on the job losses forecast in his work. The negative result for employment, quantied in an overall 600'000 jobs lost, comes from a longitudinal analysis of the correlation between the GDP growth rate and the rate of employment, with data provided by the Interna-tional Labour Organisation (ILO). On this regard, it could be said that Capaldo econometrically derived an Okun's Law from the ILO data and then applied to the GDP estimates of the GPM model. Although the time span selected for the estimate might be very wide, it could still leave some crucial variables that would also aect employment out of the regression. Moreover, the work presents only one possible scenario in addition to the baseline, sapping its capacity to represent the various possible futures ahead. The alternative scenario, i.e. the introduction of TTIP, could not be implemented by means of a NTMs reduction, as the GPM model does not include trade costs. The scenario was instead implemented through the variation in terms of each country's share in the import market, based on the

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14 1.5. The CEPS, Raza, and the methodological debate results from previous studies. However, this model has been mostly criticised on a methodological grounds dierent from the ones analysed so far. As all the models require simplications and make some assumptions in order to produce estima-tions, the methodologies used by the authors presented so far will be discussed separately, with the support of the CEPS report.

1.5 The CEPS, Raza, and the methodological

de-bate

The Centre for European Policies Studies (CEPS) produced an insightful review of selected studies on TTIP and on preceding FTAs that are comparable in magnitude and features. This was done with the aim of evaluating the impact assessments produced to current date and to compare their methodologies, assumptions and ndings. The report starts with a comment on the European Commission's Impact Assessment, i.e. the CEPR study (Francois et al., 2013b). Although it is deemed powerful and appropriate by the CEPS, a larger set of analysis and tools is consid-ered necessary to establish a solid debate, and thus encourages the production of more Impact Assessments (IAs). In this perspective, it would be desirable if dif-ferent methodologies contributed to the debate, in order to make any projection's results robust to both its assumptions and estimation errors.

A part from the dierentiation argument, it useful to spend a few words on the features of the models of the aforementioned studies, highlighting their sim-ilarities and their dierences, and how they shaped dierent results. Indeed the CEPS has shown in the same report in which it comments on the TTIP IA that modelling choices have proven decisive to determine the results in previously anal-ysed studies. The case provided is the EU-South Korea FTA IA, required by the European Commission and produced by two institutions: Copenhagen Eco-nomics (EcoEco-nomics, 2007) and the CEPII/ATLAS. The two centres shared the same database for their projections, although the two models dier as regards any other aspect, with each one choosing a dierent model and scenarios. The results were signicantly dierent on some aspects, to the point that one study would nd

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15 1.5. The CEPS, Raza, and the methodological debate a positive eect on a specic sector, while the other would nd a negative eect on the same sector. Overall, the two studies suggested that a EU-Korea FTA would be benecial to both partners, although this shows how modelling choices may shape the related results. We worked on the insightful analysis carried on by Raza et al. (2014), graphically presenting the methodological dierences among the four main reference studies, but including Capaldo's study into the framework for comparison.

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16 1.5. The CEPS, Raza, and the methodological debate

Table 1.1: Overview of the studies on TTIP, based on work by Raza & Troester (2014)

Ecorys

(2009) CEPII(2013) CEPR(2013) Bertelsmann(2013) Capaldo(2014) Basic Assumpions

Model CGE-GTAP CGE-MIRAGE CGE-GTAP _{gravity model}Simulation of GPM Data GTAP₇ GTAP GTAP₈ _speciedNot UNCTAD/ILO NTMs Ecorys CEPII Ecorys ifo (no cost-drivenNA

impacts) Forecast Period 2008-2018 2015-2025 2017-2027 10-20years 20252015 No. of Scenarios 7 5 5 3 1 Taris reduction 100% of goods 75% of services 100% _100%98 100% NA (Reduction included in the trade volume variation) NTM reduction in reference scenario 25% 25% 25% Reduction corresponding to trade creation eect NA (Reduction included in the trade volume variation) Main ndings

(dierent scenarios, percentage changes compared to baseline scenario within forecasting period) EU GDP 0.35 0.72 0.0 0.5 0.02 0.48 0.52 1.31 NA (Bloc specic variations) US GDP 0.14 0.31 0.0 0.5 0.01 0.39 0.35 4.82 0.36 EU

bilateral exports speciedNot 49.0 0.69 28.0 5.7 68.8 Not specied EU total exports 0.91 2.07 7.6 0.16 5.91 (extra-EU only) Not

specied Not specied EU

real wages 0.34 0.78 NA 0.29 0.51 speciedNot

Not specied (Bloc-wise results on Empl. Income) Unempl. rate in EU-OECD countries (avg.) Unchanged

(assumption) (assumption)Unchanged (assumption)Unchanged

-0.42 (deep liberalisation scenario) Not specied (Empl. loss quantied in 583'000 units) Third

parties spillovers NA speciedNot

-0.04 0.1 (country-specic results) Mostly negative (No normative alignment included) 0.1

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17 1.5. The CEPS, Raza, and the methodological debate As can be noted by looking at table 1.1, few dierences may be found in the upper part of the table showing the methodological dierences as reected by the basic assumptions. This remarks a similarity in the structure of the model that although allowing for a clearer comparison of the results among the related studies it shows how narrow the perspective has been until now and actually makes the comparison less informative. A few but signicant dierences can be found when looking at the methodological choices of the Bertelsmann Stiftung and Capaldo and comparing them with the rst three studies. Indeed, the latter ones have all used the same CGE model (with the CEPII using the MIRAGE variant) and the same GTAP dataset, with the most updated version available at the time. Moreover, their scenarios are very similar, as they all produce projections according to an NTMs reduction of 25%. The results that can be seen in the lower part of the table reect this similarity, with the gures being equally negligible (although with a somewhat remarkable relative dierence) with respect to GDP increases and with the only meaningful dierence laying in total bilateral exports, where there is a notable divergence. Indeed, while the CEPII predicts an increase of 49 per cent, the CEPR study holds that the range of bilateral export should stay between a 0.69% minimum change up to a maximum of 28%. By moving to considering the Bertelsmann Stiftung contribution, we can see how it provides even more diverging results, as its range for bilateral export is 5.7% to 68%. This conrms total bilateral exports to be a critical point to assess in the scenarios, although it is a vital one to predict the impact of TTIP on GDP of both EU and US. Indeed, the ranges for bilateral exports are proportional to the ones of GDP forecasts, and are likely to be their drivers, with their most ambitious scenario forecast (the one including Harmonisation Spillovers) of 0.5% for both partners being slightly greater than the gures projected by the ambitious scenario of CEPR, 0.48% for EU and 0.39% for the US. Once again, the Bertlesmann Stiftung gure positions itself atop other estimates, with GDP increases reaching up to 1.31% for the EU and 4.82% for the US.

This can be easily understood by recalling that the projections were drawn from the assumption that the variations in relevant gures would have followed the path of previous free trade agreements. We would argue that the analyses

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18 1.5. The CEPS, Raza, and the methodological debate provided by CEPR, CEPII, and Ecorys have far too much in common, in both methodologies and results, to be considered as distinct studies and opinions on the matter. One possibility could have been to build on the work of Ecorys attempting to consider a more realistic behaviour of the labour market or introducing an industrial perspective, which could have prompted interesting results concerning the concentration of rms and change in their size. The updating of the dataset, as useful as it can be, has proven to lead to little variation in the results and the consideration for policy analysis.

Although the scheme highlights eciently the few dierences among the rst four studies and the very large ones between them and Capaldo's study, these divergences should be further detailed to characterise the dierent choices made. We shall tackle the most controversial and relevant methodological divergence: the models used to assess the impact of TTIP on EU, US and third countries. As can be seen from the graphical analysis, almost all major works used some version of a Computable General Equilibrium model, while Capaldo used the United Nations GPM model and the Bertelsmann Foundation used a gravity model. We shall then attempt to characterise these models and assess their advantages and their faults, and how these have weighted on the nal conclusions drawn by the related institutions.

1.5.1 The CGE models critical issues

The Computable General Equilibrium models gained widespread appreciation and use thanks to the comprehensive analysis that they allow. Indeed, perhaps the most notable quality of CGE models is the possibility on the side of the analysts to obtain both sector and regional results, allowing for a high degree of depth. For instance, the version used by the CEPR accounted for 20 sectors and 11 re-gions, among which the EU and the US along with other geographical/economical aggregates. This approach is capable both to encompass policy options, imple-menting them directly into the model, and to deliver sector-specic results, and hence to study the eect of a more sectoral policy proposal. This level of detail is enriched by a wide and precise dataset, such as the GTAP used in the models of

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19 1.5. The CEPS, Raza, and the methodological debate Ecorys, the CEPR and the CEPII, with dierent versions depending on the period of publication of the studies. Moreover, CGE models assume that there are as many varieties of a product as there are regions, and the representative consumer demands all varieties and decides his own bundle of goods by comparing relative prices.

Indeed, the theoretical framework of the models lies on neoclassical microeco-nomics theory and thus on the representative agent assumption. As regards the industrial side of economies, the basic structure of CGE models does not account for markets with imperfect competition nor for the role of the government and public procurement, yet Francois et al. (2013b) introduced both features into the analysis, and is recognised as an exception on this regard. Notwithstanding the notable merits of such complex models, especially when further complexity is im-plemented in the pursue of adherence to reality, we ought to keep in mind the critical points at their foundations possibly undermining even the most compre-hensive and rened structure.

Prices

One of the assumptions we nd most troubling in CGE models is exibility of prices, that is wages and capital interests rates. In particular, exibility of wage rates would imply that the employment market is always in equilibrium and that all laid o workers are absorbed by the economic system by means of reallocation. Equivalently, shall workers be laid o in numbers, the real wage would immediately drop and the new level of employment determined by the equivalence of demand and supply of labour. Combining this notion with the one of xed labour supply, i.e. the representative household oers always the same level of labour, indepen-dently of the wage, we obtain that in case of a signicant lay-o the wage would fall just as much as to keep the level of employment constant.

The same goes for capital, that is assumed to be easily moved from one sector to the other, with no sector-specic constraints. Moreover, the interest rate on capital is the same among the regions, as it represents the price of renting capi-tal from households. Should such price be higher in a specic country, it would

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20 1.5. The CEPS, Raza, and the methodological debate signal a higher demand from the rms, drawing capital from households of other countries and thus pushing the price back towards a general equilibrium in capital market prices. This assumption makes the modelled world particularly sensitive to the introduction of nancial NTBs relaxation, as this would presumably aect interest rates in all countries. Financial instability is a likely consequence of such NTM reduction, and the volatility of interest rates may endanger the small GDP positive forecasts, beyond being undesirable in itself. It should recalled that nan-cial instability, high international linkage, and capital market deregulation have all been cited by some as igniting factors of the recent crisis. These considerations are relevant since "modelling assumptions [. . . ] largely drive the results", as com-mented by the CEPS (Pelkmans et al., 2014) report itself. Thus, their removal would signicantly undermine the estimates and, more importantly, it would make the choice of the assumptions crucial, as the results might be chosen in the process. Employment

As already hinted above, the labour supply in CGE models is xed, thus xing the level employment itself and making the model unt for any estimation on this regard. As wage rates are exible and the employment market is always in equilibrium, there is virtually no unemployment in CGE models. The positive forecasts on GDP following the signature of the TTIP leads in these models to a higher labour demand in the expanding industries as a consequence of increased production and trade. Hence, the result would be the raise in the level of wages, with no foreseen change in the level of employment.

However, in CGE models any variation of the employment level can be com-puted by other means in an a posteriori analysis. One could be willing to transform the wage raise into a comparable increase in the employment level, or otherwise use the GDP increase to estimate the number of jobs that may be sustained with that amount. Indeed, the CEPR chose the latter method, and estimated the em-ployment level variation from the GDP estimates and using data on the average number of jobs sustained in the EU for every billion of euros, leading to the already discussed ever-too-positive result of several millions new jobs created. This exer-cise is generally accepted in the economics literature whenever unemployed workers

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21 1.5. The CEPS, Raza, and the methodological debate are abundant and wages are sticky, as is the case in Europe. Nonetheless, this a posteriori translation of a wage raise or a GDP increase into an increased employ-ment relies on the shaky ground represented by insisting that employemploy-ment has no role in the determination of the GDP.

In our perspective, CGE modelling ignores the demand-side eects of employ-ment, and overlooks some malfunctioning mechanisms in the reallocation of the labour force. Beyond an already signicant frictional unemployment, there is the oversimplication of the labour force and thus an overestimation of its mobility that might seriously put into question the GDP creation. In particular, workers are not identied as the sector-specic and complex resource that they are, but are instead gured as free to move from one sector to another and from one rm to the other with no transition costs and waiting times. In fact, workers would not be willing (or capable) of moving so easily and even so they would need some time in order to be hired again. Moreover, the expansion of the winning sectors could take some time, too, for instance to install new plants. In addition, in the expanding sectors there might be a shifting paradigm advantaging the capital over the labour input, if the ratio was not already relatively high with respect to the contracting sectors.

If the combined eect of frictions, paradigm shift (or anyway a higher capital-to-labour ratio), and an already high unemployment rate showed to be signicant enough to push the unemployment rate higher still, although it would otherwise be a temporary shock, it might not merely hinder the GDP growth, but rather start a downward spiral through a wage-consumption-unemployment connection. Indeed, by reducing the household's purchasing power, consumption would fall and drag labour demand down for a new increase in unemployment. Social welfare would decrease even if the case that equilibrium in the goods market is reached, with all goods produced by the rms being bought by the representative agent. This comes from considering that a reduction in the demand of goods reduces the total surplus available for sharing. This vicious circle, if started, would lead to negative projections of GDP, not positive, unless employment can be somehow supported at its original level even if some sectors will be contracting. However, government subsidies to unemployed workers would not represent an ultimate solution, as their

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22 1.5. The CEPS, Raza, and the methodological debate burden would weigh on the government budget.

On this regard, it may be relevant to remind that Cecilia Malmstroem pub-licly denied the possibility of a European fund for laid o workers, since CEPR estimates for employment did not suggest that there is any risk of increased unem-ployment. From the discussion so far on CGE models and employment predictions, our opinion is that incautious forecasts on sensible variables are more dangerous when provided in an Ocial Report, as they are likely to be weighted more than the authors would have anticipated. A research institution invested of the role of advisor by a policy-maker such the EU should not venture in perilous statements, as decisions are likely to be taken on their ground. We take this chance to under-ling that any CGE estimate concerning employment level or unemployment rate are to be taken with caution, as this models are hardly the proper instrument for this purpose.

1.5.2 The GPM critical issues

The appropriateness of the GPM for international trade policies

The UN GPM model chosen by Capaldo has been criticised by the European Center for International Political Economy (Bauer and Fredrik, 2015), addressing the model as unt to analyse international trade. Indeed, the GPM model has never been used for this task, as it does not allow for direct estimation of some relevant variables. In our analysis of the GPM model, we had the chance to consider how NTMs reduciton could not be implemented directly in the model, but had to be accounted via the indirect eects on the share of each country's GDP in the import market. This could be regarded as a contradiction, since Capaldo indirectly uses the results of a CGE model to reach diverging conclusions. However, it must be noted that most of the harsh critics moved to Capaldo by the ECIPE were otherwise lacking convincing power, and inamed a discussion which continued with Capaldo's successive publication in May 2015.

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23 1.5. The CEPS, Raza, and the methodological debate Depth of analysis

When comparing Capaldo's model to the CGE models of previous studies it is apparent how both results and the database used lack some specicity, at least in relative terms. Indeed, no explicit mention has been done as regards some crucial variables as bilateral exports and sector-specic gains. Moreover, no EU level of aggregation is present, xing the depth of geographical detail to the bloc level, taking out of the analysis and interesting perspective. As the most relevant result obtained through the analysis base on the GPM is an employment contraction, it would have been even more interesting to include sectoral data, so to investigate which would be the contracting sectors and which would be the expanding ones.

1.5.3 The gravity model critics

The gravity model builds a relationship between the economic mass of two coun-tries and their geographical distance with the amount of trade that occurs between them. The economic mass is to be interpreted as overall economic activity of the country, and their distance was sometimes interpreted not only in the strict ge-ographical meaning but also in a distance in terms of relative factor abundance, for instance. Although no theoretical explanation has been deemed satisfying in order to justify such relation, gravity models for trade have been shown to have a signicant empirical power as many trade ows might be explained by means of a gravity trade ow.

The most relevant criticism moved to gravity models for trade is the failure to duly incorporate the NTMs into their structure and hence failing to represent the importance of the degree of their actionability. Instead, the mechanism dierenti-ating the alternative scenario from the baseline one is an econometrically derived from previous agreements. This makes the study blind to the specic features of the TTIP, among which the magnitude of the two economic entities. Moreover, the specication on the linkages among the variables is so omitted, making the projections little more that an econometric exercise. Finally, the high distance in both geographical and normative terms between the signatories is likely to play a

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24 1.6. What are the main points of this work part in the extraordinary results obtained by the study, distrusted also by the EU and CEPS. This tool was thereby found to be inappropriate for the purpose, and possibly misleading on the impact of the TTIP.

1.6 What are the main points of this work

Although the studies conducted so far have contributed to the debate on TTIP, in our opinion there is more perspective to be attained by diversifying the analytical tools and in any case by enlarging the current literature. Indeed, as the TTIP has the potential to impact signicantly on a large set of economic variables, a part from other relevant topics, it would be advisable not to take any binding decision before it has not been extensively informed. This goes in contrast with the line of action of the European Commission until now, represented by the erce defence of the CEPR study results as a beacon of light on the prospect of the TTIP signature, and the scarce information made available on the details of the agreement. As the CEPS testies, the mere mandate does not allow for a specic analysis of what will be the actual contents of the agreement, and only permits to make predictions blind to the European Commission negotiating aims. Moreover, no information apart from the already mentioned mandate has been made available to the civil society, so that citizens self-information, contribution, and research activities have been seriously sagged.

We thus propose more transparent negotiations, at least in what details are known to be the object of discussion, and an open request by the European Com-mission to provide for new forecasts, hopefully with methodologies varying among each other. This work is an attempt to make up in some measure for the little heterogeneity and small number of the scientic contributions.

1.6.1 Complexity versus Simplicity

It should be underlined that we do not consider precedent literature as totally inadequate and not useful as a tool for policy makers. In fact, all the studies

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25 1.6. What are the main points of this work cited in this work have given a useful perspective on the matter, and defended their methodological choices with some reasonable arguments. For instance, the incapacity of CGE models to account for employment is counterbalanced by a complex specication of the variables and their connections. Analogously, the lack of a clear relation of NTMs reduction and GDP and net exports eects is the drawback of the GPM, whereas it can supply an unemployment analysis.

As it has been argued from the authors of the studies presented, no model is perfect, and it is very hard to encompass the behaviour of all economic variables, let alone other socially relevant variables. The argument we wish to bring forward is that specic problems might be better tackled by specically designed models, in order to be able to include all most relevant variables and possibly be bound to fewer assumptions. As the TTIP is indeed an ambitious agreement, it involves too many aspects of the economy and of citizens well-being to possibly analyse all of them in an exhaustive way. On the one hand, this would denitely enhance the comprehension of the relations among the economic aspects concerned, allowing for a holistic representation and a general understanding of the overall framework. On the other hand, a theoretical approach aimed to address specically one issue could be able to deliver a better understanding of it, especially since the aspect chosen for this work has not been suciently investigated in previous literature. Indeed, we will investigate the environmental eects of free trade agreements from a theoretical perspective, suggesting that if negative production externalities are not accounted for in the decision to open the economy to free trade, welfare might be reduced as a result.

1.6.2 The externality argument

As the US have a higher CO2/GDP ratio than EU, it may be argued that environ-mental externalities in the latter area have been better internalised, so that rms are more incentivised to control their emission levels. This becomes relevant when the net export change favours a nation with a relatively environmentally ine-cient production, since it would lead to an equilibrium in which a market failure, i.e. the environmental externalities, is not correctly faced by market regulation.

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26 1.6. What are the main points of this work If the lower costs of the US exports is attributable to externalities being less in-ternalised than in the EU, the conclusion that a GDP increase following a trade internationalisation is good in itself becomes questionable.

This hypothesis seems highly realistic, as we recall that NTMs reduction are to be achieved at the expense of SHEIC national regulations, including norms protecting the environment. On this regard, environmental organisations all over the EU and US are worried of the damages to the environment that they con-sider likely to follow the signature of the TTIP. To make a bad situation worse, the TTIP negotiations have undergone some round tables with what groups were acknowledged to be stakeholders by the European Commission, but this did not include any environmental organisation. It must be underlined that this way of conduct cannot be pardoned by means of naiveté as environmental organisations were among the strongest contesters of previous similar agreements such as the NAFTA. If production externalities are found to oset gains in consumption fol-lowing a free trade agreement, than the signature of the TTIP would lead to a lower social welfare. We propose a theoretical analysis built on Comparative Ad-vantage Theory, and our results will show that social welfare can indeed be lowered by a FTA in certain circumstances.

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Chapter 2 A comparative advantage model of

the environmental eects of the

TTIP

2.1 An overview of Comparative Advantage

mod-els

The model we propose in this work is based on the concept of Comparative Ad-vantage rstly introduced by Ricardo (Ricardo et al., 1819). The original model considers two country producing two dierent goods, and shows how even in the case of absolute advantage in production for one of the two countries, benets are to be enjoyed by both sides if international trade occurs. This conclusion relies on the consideration that relative opportunity costs dier between the countries involved as long as the national proportions of the inputs required for the goods are not the same. This is a very mild assumption, as countries would likely need dierent measures of inputs in order to produce outputs and these dierences can hardly keep the relative opportunity costs equal.

The model has later been developed by more recent works, resulting in the Heckscher-Olin factor proportions to identify the product of export of each

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28 2.1. An overview of Comparative Advantage models try (Heckscher and Ohlin, 1991), and in the generalisations brought forward by Deardor (1998), Dixit and Norman (Dixit and Norman, 1980). In all extensions and applications by these authors, Comparative Advantage has been used to show that free trade is an overall positive measure, economically harming some agents while favouring others, although eventually leading to national gains. Externalities have usually been a counter-argument to this clear-cut conclusion, pointing to the possibility that free trade might be detrimental to the welfare of consumers. As Fletcher (2011) underlines, externalities are a characterisation of a misspecication of prices, and since Comparative Advantage is no dierent from other free market economies' theories on its dependence on prices as a correct measure of the value of goods, it follows that it would suggest suboptimal policies.

Indeed, whenever consumers are not aware of the negative externalities of pro-duction and thus their optimal consumption bundle is not informed of the social damage that it induces, diverging standards on environment, for instance, would lead to an over-importing of the good. The exporting country would most likely suer more heavily from the negative externality connected with the production, and although one might think that gains from trade might oset such damages, the consumption choice would still be suboptimal. Drawing again from Fletcher's analysis, whenever diverging environmental standards exist free trade [. . . ] posi-tively encourages [such problems], as skimping on pollution control is an easy way to grab a cost advantage.

Of a dierent mind, Deardor (1998) looks positively at pollution havens, insisting that Comparative Advantage theory might well justify how populations exporting polluting goods accept the burden of the production externalities. In-deed, in his perspective these cases represent populations that are more willing than populations elsewhere to bear the costs of pollution in exchange for other things. Then that location has a comparative advantage in polluting activities, and this is exactly where these should be located. This would imply that popu-lations exporting goods with relatively high negative externalities are not simply ignoring the higher cost they need to suer in order to sustain their enhanced consumption, but such populations are rather willingly accepting this cost. Unre-alistic as it might be, this is the only defence that Deardor brings to Comparative

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29 2.1. An overview of Comparative Advantage models Advantage theory, a part from the consideration that the above mentioned prob-lems exist only as long as polluters are insuciently regulated, that is far from being a rare situation also in rich countries.

Indeed, Deardor suggests a production tax to oset the damage done by the polluting industries, that is similar to the cost that rms need to suer in US and EU to abide by SHEIC regulation. Reducing such cost is the aim of the TTIP agreement and equals to step back from the attempt to correctly limit the social damage of negative externalities. In addition, it seems to the author that Deardor is missing a crucial feature of negative externalities: their trans-boundary nature, bringing the production externality from one country to the other, although sometimes to a somewhat reduced extent. Pollution havens may be a short-run temptation, whether the populations of the related countries are conscious or not of the trade-o involved, but most environmental externalities tend not to persist in a single location, but rather to diuse along the globe.

Moreover, he concludes that however undesirable negative externalities may be, the fault lies on the incorrect policy, not on the free trade agreement that made it possible to exploit the dierent legislation. One might agree with his clarication, yet it still holds that if countries have diverging environmental standards (in line with the previous examples), free trade agreements allowing consumers to make counter-productive decisions regarding their consumption bundles are surely not the best policy to be enacted. We would like to underline that TTIP would not simply allow for free trade among EU and US though, erasing existing Tari Measures on goods and services, as these have already been said to be currently negligible. As TTIP represents a more comprehensive alignment of legislation, the risks involved are higher than as commonly considered in Comparative Advantage models.

While in the standard case the free trade agreement would lead to an over-production of the polluting good, with both countries maintaining their respective environmental taxes or protection, with TTIP the normative tools designed to limit such production of negative externalities would be cut. The reduction in NTMs, i.e. the weakening of SHEIC standards, would be higher in those countries with a

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30 2.2. An introduction to the proposed modelisation better internalisation of the production externalities. With no detailed information on how the normative alignment is to become eective (by a Most Favoured Nation mechanism, standard legislation implemented in all partner countries, etc. . . ), it is hard to take into consideration the impact of production externalities. In the model we propose, Comparative Advantage is used in an innovative way to illustrate how free trade agreements may be inconvenient at given conditions.

2.2 An introduction to the proposed modelisation

As already seen, Comparative Advantage usually includes in the analysis two coun-tries and two goods, yet the academic world pushed the model to more realism, attempting to implement more dimensions on both variables. Indeed, the model has henceforth been applied to cases in which more than two countries traded the two consumption products and in cases in which more than two goods were traded by two countries. However, extensions of the model to include cases of three or more countries trading three or more goods led to weaker results.

In this application of the Comparative Advantage model two countries and three goods are considered, hence falling in the safe net oered by previous eco-nomic literature. Nonetheless, the nature of one of these three goods is particular, and complicates the analysis. In addition to two normal generic goods x and y, we included also the negative production externality z on which the utility function will inversely depend on. All products are assumed to be supplied only in positive quantities, and the externality to be a by-product bounded to the production of the two utility-augmenting goods. To simplify the analysis, with no loss of gener-ality, we will assume that y is more externality-intensive than x for both countries. A sketch of autarchy terms of trade among products is represented in 2.2 in a pairwise trade-o perspective for generic countries A and B.

In the rst graph of 2.2 we can observe the trade-o that country A must accept in order to switch the consumption of the two goods x and y, thus also setting the limit quantities of these goods in the graphs on its right. As can be seen, the graphs on the right are positively sloped, as any increase in one of the consumption goods

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31 2.2. An introduction to the proposed modelisation Figure 2.1: Country A

Figure 2.2: Country B

will result in an increase in the production of negative externalities. Thus, no production limit would result from this relation (except for any specic limit level that could be imposed on externalities), and we derive these quantities from the national constraint on its capacity, i.e. labourers or other production capacity factors, as they are reected in the consumption goods trade-o. Let us now look at the dierences between the two countries: maximum quantities aordable by country B are higher than maximum quantities of A, thus conferring it an absolute advantage over both consumption goods. However, in our example we assumed that country B is also relatively less ecient in terms of externality production. Indeed, the graphs suggest that the slope of the two curves on the right for this country are steeper than the ones of country A. In fact, our argument is that dierent legislation across countries may enable them to tackle the externalities ineciency to a dierent extent.

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32 2.3. A connection between externalities and SHEIC legislation

2.3 A connection between externalities and SHEIC

legislation

The country with the laxer legislation may benet from lower normative barrier to production, either in terms of production caps or taxation indirectly aecting the total quantity produced. This dierence in terms of both Tari and Non-Tari Measures may allow for an absolute cost advantage in the consumption good that is aected by the legislation. This mechanism is especially relevant when comparing a couple of countries with similar production technologies, as the EU and the US could be considered, or anyway with a more remarkable dierence in their Tari and Non-Tari Measures. In order to see how this dierence in NTMs, when translated into a Comparative Advantage, can turn out to be socially harmful in the event of a free trade agreement, we will now investigate the consumption choices of the two countries and their utility. Firstly, the optimal consumption bundle is shown in 2.3 as the tangency point between the production frontier and the highest achievable indierence curve.

The maximisation process applied by the consumers of each country is assumed to include national externalities, although ignoring international ones. Nonetheless their eects are felt across borders, so that their exclusion from the maximisation process does not preclude the utility function to be aected. In particular, the indierence curves represented above are tangent to a three-dimensional line that also denes the optimal level of national z. However, we have already had the chance to state that if not all externalities are taken into consideration during the optimisation process, the choices will be sub-optimal. Such a behaviour is thought to be realistic, as consumers are hardly aware of the externalities involved in pro-duction processes that have occurred abroad. In this exercise, we will consider the case in which every nation is blind to the foreign level of externalities, resulting in the utility function attaining a lower level than the one supposedly achieved by the optimal bundle. Indeed, national utility is reduced by an amount proportional to the unconsidered (foreign) level of z, the exact measure of which depends on the utility function chosen. In 2.4, we provided one of the possible graphical represen-tations, although a generic decrease in the country's utility is to occur as long as

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33 2.3. A connection between externalities and SHEIC legislation

Figure 2.3: Optimal consumption bundles