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Csilla A. Lakatos
Beyond Trade in Goods: The Role of Investment and Knowledge Capital in Applied
Trade Policy
Doctor of Philosophy
Terrie L. Walmsley
Thomas W. Hertel
Roman M. Keeney
Marinos Tsigas
Terrie L. Walmsley
Thomas W. Hertel
Kenneth A. Foster 02/04/2011
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Beyond Trade in Goods: The Role of Investment and Knowledge Capital in Applied Trade Policy
Doctor of Philosophy
Csilla A. Lakatos
02/04/2011
BEYOND TRADE IN GOODS: THE ROLE OF INVESTMENT AND
KNOWLEDGE CAPITAL IN APPLIED TRADE POLICY
A Dissertation
Submitted to the Faculty
of
Purdue University
by
Csilla Lakatos
In Partial Fulllment of the
Requirements for the Degree
of
Doctor of Philosophy
May 2011
Purdue University
West Lafayette, Indiana
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ii
ACKNOWLEDGMENTS
I beneted greatly from the support of many people. To all of them, I am greatly
indebted. First of all, I would like to acknowledge my adviser, Dr. Terrie Walmsley.
I greatly appreciate her guidance and patience throughout my studies. Thank you
for always being approachable and your patience during our long-distance phone
conversations. Special thanks to Prof. Thomas W. Hertel for his suggestions and
insights regarding the policy relevance of this dissertation. In addition, I would like
to thank Prof. Hertel and Dr. Walmsley for giving me the opportunity to be a part
of the team at the Center for Global Trade Analysis: I learnt a tremendous amount
during the last four years. I thank Dr. Marinos Tsigas and Dr. Roman Keeney,
members of my dissertation committee for providing helpful suggestions. I appreciate
Dr. Tsigass assistance with the data for this research.
To David for the encouragement, support and understanding that kept me going
during all these years. Your yes, you can attitude has been a constant source of
inspiration that helped me become who I am today.
Finally, none of this would have been possible without the help of my parents.
Although more than 5,000 miles away, their support allowed me to make my dreams
come true.
iii
TABLE OF CONTENTS
Page
LIST OF TABLES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . v
LIST OF FIGURES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . vii
ABBREVIATIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ix
ABSTRACT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xi
CHAPTER 1. OVERVIEW . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
CHAPTER 2. INVESTMENT CREATION AND DIVERSION EFFECTS OF
THE ASEAN-CHINA FREE TRADE AGREEMENT . . . . . . . . . . . . . . . . . . . . . . . . 5
2.1 Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
2.2 ASEAN-China Economic Relations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
2.3 Modelling Framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
2.3.1 Design Decisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
2.3.2 GDyn: a Short Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
2.4 Bilateralizing Investment in GDyn . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
2.4.1 GDyn-CE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
2.4.2 GDyn-CET . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
2.4.2.1 The elasticity of transformation. . . . . . . . . . . . . . . . . . . . . . . 29
2.5 Simulation Design . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
2.6 The Economic Impact of ACFTA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
2.6.1 Rates of Return and Total Investment . . . . . . . . . . . . . . . . . . . . . . . . . 35
2.6.2 Investment Creation and Diversion . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
2.6.3 Welfare Impacts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
2.7 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48
CHAPTER 3. KNOWLEDGE CAPITAL: A FACTOR OF PRODUCTION . . . 55
3.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55
3.2 Literature Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59
3.3 Description of the Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62
iv
Page
3.4 The Translog Production Function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
3.5 Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68
3.5.1 R&D Versus Intangibles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72
3.5.2 Econometric Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74
3.6 Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75
CHAPTER 4. CROSS-RETALIATION AT THE WTO: IMPACTS OF A NO
DEAL IN THE US-BRAZIL COTTON DISPUTE . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
4.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
4.2 Dispute DS267 - US Subsidies on Upland Cotton . . . . . . . . . . . . . . . . . . . . . . 81
4.3 The Economics of Retaliation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87
4.4 Modeling Framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92
4.4.1 Quantifying Intellectual Property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93
4.4.1.1 International accounting standards . . . . . . . . . . . . . . . . . . . 93
4.4.1.2 Royalty services in Input-Output accounting . . . . . . . . 95
4.4.2 Royalty Services in the GTAP Model . . . . . . . . . . . . . . . . . . . . . . . . . . 98
4.5 US-Brazil Trade Relations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
4.6 Simulation Design . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102
4.7 Impacts of a No Deal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 107
4.7.1 Impact on Trade Flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108
4.7.2 Impact on Consumers and Producers . . . . . . . . . . . . . . . . . . . . . . . . . . 113
4.7.3 Welfare Impacts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114
4.8 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119
CHAPTER 5. SUMMARY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121
LIST OF REFERENCES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124
APPENDICES
Appendix A: Derivation of the Cross-Entropy Minimization . . . . . . . . . . . . . . . . . . 130
Appendix B: List of Products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133
Appendix C: Monopolistic Competition Extension in GTAP . . . . . . . . . . . . . . . . . 136
VITA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137
v
LIST OF TABLES
Table Page
2.1 Bilateral China-ASEAN FDI Inows, 1996-2004 ($mil) . . . . . . . . . . . . . . . . . . . . . 11
2.2 Elasticities of Transformation of Investment in the Literature . . . . . . . . . . . . . . 30
2.3 Modality for the Reduction and Elimination of Taris . . . . . . . . . . . . . . . . . . . . . . 32
2.4 Taris Applied and Faced by China in 2001 (%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
2.5 Cumulative % Change in RORGE(GDyn-CE) and RORGA(GDyn-CET) . 51
2.6 Cumulative % Change in Total Investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52
2.7 Cumulative Welfare Changes, 2001-2020 ($mil) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
2.8 Cumulative Changes in Equity Income, 2001-2020 ($mil) . . . . . . . . . . . . . . . . . . . 53
2.9 Cumulative Changes in Bilateral Equity Income, 2001-2020 ($mil) . . . . . . . . . 54
3.1 Composition of the Wealth Nations ($ per capita in 2000) . . . . . . . . . . . . . . . . . . 56
3.2 Overall Regression Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73
4.1 Budgetary Transfers to the US Cotton Sector ($mil) . . . . . . . . . . . . . . . . . . . . . . . . 83
4.2 The Composition of the Royalties Sector in the US Input-Output Table . . 97
4.3 The Evolution of Trade Flows (US$mil) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103
4.4 Sectoral and Regional Aggregation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104
4.5 Initial and Retaliatory Taris on US Exports Applied by Brazil (% AVE) 105
4.6 Volume Changes in Private Consumption ($mil) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115
vi
Table Page
4.7 Volume Changes in Output ($mil) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116
4.8 Equivalent variation ($mil) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 118
vii
LIST OF FIGURES
Figure Page
2.1 ASEAN-China Trade Flows, 1995-2008 ($mil) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
2.2 ASEAN-China FDI Flows, 1995-2008 ($mil) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
2.3 Cumulative % Change in RENTAL and PCGDS . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
2.4 Cumulative % Change in RORGE(CE) and RORGA(CET) . . . . . . . . . . . . . . . . 38
2.5 Cumulative % Change in Total Investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
2.6 Bilateral Ownership in 2005 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
2.7 Bilateral Ownership in 2010 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
3.1 Investment in Intangibles as % of Gross Capital Formation: 1980-2007 . . . . 57
3.2 Cost Share of Knowledge Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64
3.3 Relationship Between log(Y) and log(K) by Region-Sector Pairs . . . . . . . . . . . 64
3.4 Parameter Estimates by Sector-Region Pairs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70
3.5 Allen Partial Elasticities of Substitution by Sector-Region Pairs . . . . . . . . . . . 72
4.1 World Price of Cotton (nominal $cents/lb) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82
4.2 Major Cotton Producers and Exporters (billion bales) . . . . . . . . . . . . . . . . . . . . . . 82
4.3 Reciprocity Compensation for a WTO Inconsistent Export Subsidy . . . . . . . 91
4.4 US-Brazil Bilateral Trade Flows ($bil) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103
4.5 Changes in US-Brazil Exports . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111
viii
Figure Page
4.6 Volume Changes in Bilateral Exports ($mil) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112
ix
ABBREVIATIONS
ACFTA ASEAN-China Free Trade Agreement
AES Allen Partial Elasticity of Substitution
ASEAN Association of Southeast Asian Nations
BIT Bilateral Investment Treaty
CE Cross Entropy
CES Constant Elasticity of Sustitution
CET Constant Elasticity of Transformation
CGE Computable General Equilibrium
DSB Dispute Settlement Body
EU27 European Union 27 Member Countries
FDI Foreign Direct Investment
FTA Free Trade Agreements
GATS General Agreement on Trade and Services
GATT General Agreement on Taris and Trade
GDP Gross Domestic Product
GDyn Dynamic GTAP model
x
GSM Export Credit Guarantee Program
GSP Generalized System of Preferences
GTAP Global Trade Analysis Project
HIC High Income Country
HS Harmonized Commodity Description and Coding System
IMF International Monetary Fund
IPR Intellectual Property Rights
LDP Loan Deciency Payments
LIC Low Income Country
MFN Most Favoured Nation
MIC Middle Income Country
NAICS North American Industrial Classication System
NFI Net Foreign Income
OECD Organisation for Economic Cooperation and Development
R&D Research and Development
SCM Agreement on Subsidies and Countervailing Measures
SIC Standard Industrial Classication
SNA System of National Accounts
SUR Seemingly Unrelated Regression
TRIPS Agreement on Trade Related Aspects of Intellectual Property
Rights
WTO World Trade Organization
xi
ABSTRACT
Lakatos, Csilla Ph.D., Purdue University, May 2011. Beyond Trade in Goods: The
Role of Investment and Knowledge Capital in Applied Trade Policy. Major Profes-
sors: Terrie Walmsley and Thomas W. Hertel.
International trade relations have long surpassed the traditional concept of ex-
change in goods. Trade related aspects of intellectual property rights and investment
measures are among the emerging trade policy issues of the 21st century. The goal
of this dissertation is to shed light on certain aspects of the role of investment and
knowledge capital/intellectual property in applied trade policy.
Essay 1 focuses on highlighting investment creation and diversion impacts of the
preferential reduction of barriers to trade. More specically, we focus on investment
creation and diversion eects within the framework of the free trade agreement be-
tween China and ASEAN countries in a dynamic computable general equilibrium
setting. We nd clear evidence of investment diversion from the regions not signatory
of the free trade agreement, however overall investment creation impacts dominate
investment diversion eects and thus result in a welfare improvement for the world
as a whole.
xii
Essays 2 and 3 are aimed to lay the foundations for quantifying knowledge capital
and intellectual property in applied empirical analysis.
In Essay 2, knowledge capital is obtained from rm level data on intellectual prop-
erty assets and is measured by the value of copyrights, patents, licenses, trademarks
and trade names, blueprints or building designs. We provide statistical evidence that
knowledge capital is an input in production and we analyze substitution possibilities
between knowledge capital and the other factors of production. Second, this work lays
the foundation for quantifying knowledge capital in a computable general equilibrium
framework.
Finally, Essay 3 examines the role of intellectual property in the context of the
dispute settlement process at the WTO. A signicant contribution of this essay lies
in the method used for quantifying trade related intellectual property. In line with
international accounting standards, we model royalty services as a separate interme-
diate industry (subject to increasing returns). We explore the economy wide impacts
of a no deal in the US-Brazil upland cotton dispute. As awarded by a WTO dis-
pute settlement panel, Brazil would have been entitled to $591 million in retaliatory
sanctions in goods sectors and $238 million in intellectual property sanctions. We
nd that Brazils retaliation plan would have led to welfare gains for all countries
except the US. Most importantly however, had Brazil not been allowed to retaliate in
the form of suspension of intellectual property rights, the impact of trade retaliation
alone would have been negative for both Brazil and the US, a case of shooting oneself
in the foot to shoot at the other persons foot.
1
CHAPTER 1. OVERVIEW
International trade relations have long surpassed the traditional concept of ex-
change in goods. If the subjects covered by international trade agreements and
treaties give any indication of emerging trade policy issues, then there are few trends
that become apparent. First, in the context of multilateral GATT (General Agree-
ment on Taris and Trade) negotiations the rst seven rounds covered only liberal-
ization of trade in goods, while the eighth round (the Uruguay Round) introduced
substantial changes to the domain of GATT by including services trade, investment,
intellectual property rights and dispute settlement. In addition, The Uruguay Round
is thus considered to have three pillars: GATS (General Agreement on Trade in
Services), TRIMS (Agreement on Trade Related Investment Measures) and TRIPS
(Agreement on Trade Related Intellectual Property Rights). In addition to the mul-
tilateral framework, an increasing number of preferential trade agreements include
provisions on services trade and trade related aspects of investment and intellectual
property.
This dissertation consists of three self-contained essays that address three distinct
topics concerning the role of investment and knowledge capital/intellectual property
in applied trade policy.
2
Essay 1 (Chapter 2) focuses on highlighting investment creation and diversion
impacts of the preferential reduction of barriers to trade. The pioneering work of
Viner (1950) rst challenged the universal desirability of bilateral trade agreements
by drawing attention to the possibility of signicant trade diversion impacts of such
agreements: if the trade creation eects are smaller than those of trade diversion,
the preferential agreement will be welfare reducing. Similarly to this framework we
distinguish between investment creation and diversion eects and simulate the im-
plementation of the free trade agreement between China and the ASEAN (ACFTA)
countries in a dynamic general equilibrium framework. As a rst step, we adapt the
dynamic GTAP model to take account of bilateral ownership of investment. Two
versions of the model are considered: the rst version is an example of applied mod-
els of investment demand, while the second is a model of investment supply. The
two versions help us determine the sensitivity of results with respect to the choice of
specication of investment behaviour. Our results show that ACFTA would boost the
economies of the liberalizing regions and increase rates of return. As a result, total
investment in both ASEAN countries and China increase. We place special emphasis
on investment creation and diversion eects of ACFTA and nd clear evidence of
investment diversion eects in regions not signatory to the preferential agreement.
Nevertheless, overall investment creation impact dominate investment diversion ef-
fects resulting in a positive welfare improvement for the world as a whole.
Changing focus, Essay 2 (Chapter 3) draws attention to the importance of knowl-
edge capital in production. Despite theoretical advance (new growth theory), empir-
3
ical analysis concerning knowledge capital is scarce to non-existent. Most economic
models tend to ignore knowledge capital as a factor, including it in the residual or
referring to more comprehensive concepts such as technological change, innovation,
spillovers or research and development. Here, knowledge capital is obtained from rm
level data on intellectual property assets and is measured by the value of copyrights,
patents, licenses, trademarks and trade names, blueprints or building designs. We
provide statistical evidence that knowledge capital is an input in production and we
analyze substitution possibilities between knowledge capital and the other factors of
production. Second, this work lays the foundation for quantifying knowledge capital
in a computable general equilibrium framework.
Finally, Essay 3 (Chapter 4) explores the role of intellectual property in interna-
tional trade relations focusing on the dispute settlement process at the WTO. Dispute
DS267, US subsidies on upland cotton, was initiated in 2002 by Brazil alleging that
various provisions of the US cotton programme were in violation of WTO obligations.
After almost eight years of litigation, a WTO arbitration panel granted Brazil the
right to impose trade sanctions against the US and the possibility for cross-retaliation
in the form of suspension of intellectual property rights. The day before Brazil was to
start imposing retaliatory sanctions, the parties reached a deal. This chapter explores
the economic costs of a no deal in the US-Brazil cotton dispute with special empha-
sis on intellectual property retaliation. The framework developed here is unique in
the sense that it provides the possibility for quantifying intellectual property related
issues. As awarded by a WTO dispute settlement panel, Brazil would have been
4
entitled to $591 million in retaliatory sanctions in goods sectors and $238 million in
intellectual property and services sanctions. We nd that Brazils retaliation plan
would have led to welfare gains for all countries except the US. Most importantly
however, had Brazil not been allowed to retaliate in the form of suspension of intel-
lectual property rights, the impact of trade retaliation alone would have been negative
for both Brazil and the US, a case of shooting oneself in the foot to shoot at the other
persons foot.
5
CHAPTER 2. INVESTMENT CREATION AND DIVERSION EFFECTS OF
THE ASEAN-CHINA FREE TRADE AGREEMENT
2.1 Background
At the ASEAN-China summit in November 2001, China proposed the establish-
ment of a free trade area with ASEAN countries
1
. The agreement (ACFTA) was
signed in November 2002 and the free trade area came into eect on 1 January 2010.
ACFTA became the worlds third largest free trade area in volume after the Eu-
ropean Union and the North American Free Trade Area. China and ASEAN had
a combined GDP of $6.6 trillion, population of 1.9 billion and total trade of $4.3
trillion in 2008. Although before the 1990s there was no ocial relationship between
China and ASEAN as a block, between 1995-2008 bilateral trade between China and
ASEAN increased more than tenfold. By 2009, China was ASEANs second largest
trading partner (with 11.6% of total trade), while ASEAN was Chinas forth largest
(10.1% of total trade)
2
. In addition, ASEAN is a key investor in China, FDI ows
1
Association of Southeast Asian Nations that include Brunei, Cambodia, Indonesia, Laos, Malaysia,
Myanmar, the Philippines, Singapore, Thailand and Vietnam.
2
Source: ASEAN Trade Statistics Database and Ministry of Commerce of China
6
reached $5.46 billions, while FDI ows from China to ASEAN amounted to $1.4
billion in 2008.
ACFTA is expected to deepen regional integration and to have signicant impacts
on intra-regional trade and investment. On the one hand, ASEAN will benet from
Chinas economic growth and investment potential through access to an expanding
and diversied market. On the other hand, the increased access to the natural resource
and raw material intensive economies of ASEAN countries will benet China. As
a drawback, ASEAN manufacturers are expected to face higher competition from
cheaper Chinese exports on both domestic and international markets.
There are few studies that quantify the economic impacts of ACFTA. ASEAN Sec-
retariat (2001) used the comparative static GTAP model and estimated that ACFTA
will increase real GDP of ASEAN and China by 0.9% and 0.3%, respectively. The
same study found that exports from China to ASEAN will increase by 55.1%, while
exports from ASEAN to China will expand by 48% as a result of the ACFTA. Tsi-
gas and Wang (2010) modify the comparative static GTAP model to include explicit
modeling of transnational supply chains and export processing zones in China. They
found that CAFTA leads to an increase of welfare of $1.3 billion and $2.9 billion for
China and ASEAN, respectively. Jiang and McKibbin (2008) quantify the impacts
of the free trade area of the Asia-Pacic (among which the ASEAN-China FTA is
one) using a suite of CGE models such as APG-cubed (a dynamic global model),
the comparative static GTAP model and CERD (a static model for China). They
7
found that Chinas benets increases along with the increase in the coverage of the
free trade areas.
With the exception of Jiang and McKibbin (2008) all of these studies are limited
to capturing the comparative static eects of the removal of barriers to trade. An
important drawback of comparative static analysis is that it neglects dynamic eects.
Indeed, the eect of trade policies are not immediate and a number of eects are linked
with capital accumulation over time (Baldwin, 1992). In the context of ACFTA it
becomes important to take into consideration dynamic eects especially given that
the removal of taris will be implemented gradually over the course of 10 years.
The objectives of this chapter are twofold.
First, we aim to highlight investment creation and diversion eects of the FTA be-
tween China and ASEAN in a dynamic general equilibrium framework. The concepts
of investment creation and diversion rst dened by Kindleberger (1966) evolved
in parallel with those of trade creation and diversion (Viner, 1950). Later Bald-
win, Forslid, and Haaland (1996) described investment creation as the incentives to
increase investment within the integrating region and investment diversion as the
negative eects on investment outside the region. More specically, discriminatory
liberalization lowers the price of capital goods and shift production to countries sig-
natory of the free trade agreement. The rental price of capital increases as industries
expand. Investment in these countries increases as a response to higher rates of re-
turn. We expect to observe signicant investment creation and diversion eects as a
results of this FTA due to the fact that China and ASEAN are important recipients
8
and origins of global capital ows. Investment creation and diversion as used in this
chapter follows that of Baldwin, Forslid, and Haaland (1996).
Second, we present and compare two alternative views/models of investment which
yield dierent investment creation and diversion eects. As a rst step, we adapt the
dynamic GTAP model to take account of bilateral ownership of investment. Two
versions of the model are considered. The rst version is an example of applied
models of investment demand, while the second is a model of investment supply. The
two versions are based on dierent assumptions in their determination of cross-border
investment. We simulate the implementation of ACFTA and we focus on the welfare
impacts of investment creation and diversion.
2.2 ASEAN-China Economic Relations
Despite the fact that China shares a common border with three (Laos, Myanmar
and Viet Nam) of the ten ASEAN member countries, before the 1990s there was
no ocial relation between China and ASEAN as a group. Economic relations were
boosted starting with the signing of the ASEAN-China Framework Agreement of
Comprehensive Economic Cooperation in November 2002 with the target of creating
ACFTA in 2010. The Framework Agreement resulted in successive agreements cover-
ing dierent areas of economic integration: Agreement on Trade in Goods (November
2004), Agreement on Trade in Services (January 2007) and the Agreement on Invest-
ment (August 2009).
9
As of January 1, 2010 ACFTA came into eect. Under this framework, China and
six ASEAN countries (Brunei, Indonesia, Malaysia, Philippines, Thailand and Singa-
pore) eliminate taris on 7,000 product categories covering 90% of traded goods. The
other four ASEAN nations (Cambodia, Myanmar, Laos and Viet Nam) are expected
to join by 2015.
In 2008, ASEAN-China merchandise trade totalled $175.38 billion, 13.15 times
the value of that in 1995 ($13.32 billion). ASEANs exports to China grew from $6.2
billions in 1995 to $85.55 billions in 2008, while imports from China increased from
$7.12 billions in 1995 to $89.83 billions in 2008 (see Figure 2.1). By 2009, China was
ASEANs second largest trading partner (with 11.6% of total trade), while ASEAN
was Chinas forth largest (10.1% of total trade)
3
.
The composition of ASEAN-China trade is concentrated in key manufacturing
sectors. ASEANs top 5 export commodities to China in 2008 included sound and
television equipment (HS
4
85), nuclear reactors and machinery (HS 84), mineral fuels
and oils(HS 27), rubber (HS 40) and animal or vegetable fats (HS 15) covering 67.5%
of total exports to China. On the other hand, the top 5 import commodities from
China were sound and television equipment (HS 85), nuclear reactors and machinery
(HS 84), iron and steel (HS 72), mineral fuels and oils (HS 27) and articles of iron and
steel (HS 73) covering 66.1% of total imports from China. We note that the structure
ASEANs imports from China and that of exports to China is very similar given that
of 3 of the top 5 commodity categories traded are identical.
3
Source: ASEAN Trade Statistics Database and Ministry of Commerce of China
4
Harmonized Commodity Description and Coding System
10
Along with trade, bilateral investment between ASEAN and China has gradually
expanded since the signing of the Framework Agreement, although it constitutes only
a modest share of the two regions total FDI inows. In 2008, FDI ows from China
to ASEAN countries totalled $1.49 billion - a more than eight-fold increase from $0.16
billion in 1995. Chinese FDI accounted for only 2% of total ASEAN FDI (see Figure
2.2). On the other hand, ASEAN is a net investor in China with FDI ows totalling
to $5.46 billion in 2008 (5% of total FDI inows to China).
Table 2.1 details the evolution of bilateral FDI ows between China and ASEAN
countries. We nd that in 2004 the main destinations of Chinese FDI to ASEAN were
Indonesia ($0.29 billion), Singapore ($0.21 billion) and Myanmar ($0.1 billion). On
the other hand, among ASEAN countries Singapore was by far the most signicant
foreign direct investor in China ($2 billion) in 2004, followed by Malaysia ($0.35
billion) and Thailand ($0.17 billion).
1
1
Table 2.1: Bilateral China-ASEAN FDI Inows, 1996-2004 ($mil)
China -> ASEAN
1996 1997 1998 1999 2000 2001 2002 2003 2004
Brunei 12.4 14.1 15.8 0.2 0.2 3.0
Cambodia 2.9 49.2 26.2 33.0
Indonesia 8.0 -44.0 -1.2 -2.8 -1.5 -0.4 294.6
Lao PDR 0.4 2.7 2.8 1.1 9.1 11.8 1.3 1.8 0.1
Malaysia 6.5 23.0 3.4 1.2 -1.0 16.9 13.2 1.8 2.0
Myanmar 2.2 0.4 2.6 0.5 4.8 108.1
Philippines 3.1 5.8 216.4 64.9 0.1 -0.2
Singapore 84.5 14.6 84.2 -27.4 -7.1 91.5 -170.9 131.7 212.6
Thailand 3.9 -7.8 5.1 -2.1 7.2 -2.5 20.9 23.8 -3.8
Viet Nam 3.1 28.1 1.7 7.0 21.0 24.2 9.4 1.5 85.6
ASEAN 116.1 88.9 288.0 43.5 26.4 143.9 -71.9 186.6 735.0
ASEAN -> China
1996 1997 1998 1999 2000 2001 2002 2003 2004
Brunei 0.1 1.8 0.2 0.1 17.4 52.6 96.1
Cambodia 7.4 5.5 2.9 2.5 1.9 9.3 13.7 12.5 20.7
Indonesia 93.5 80.0 68.8 129.2 146.9 159.6 121.6 150.1 104.5
Lao PDR 0.2 0.4 1.1 3.1 1.0 5.2 0.4 4.3
Malaysia 460.0 381.8 340.5 237.7 202.9 263.0 367.9 251.0 385.0
Myanmar 0.6 2.7 5.1 11.0 2.3 2.3 16.8 3.5 8.8
Philippines 55.5 155.6 179.3 117.3 111.1 209.4 186.0 220.0 233.2
Singapore 2247.2 2606.4 3404.0 2642.5 2172.2 2143.6 2337.2 2058.4 2008.1
Thailand 328.2 194.0 205.4 148.3 203.6 194.2 187.7 173.5 178.3
Viet Nam 1.5 1.5 14.1 0.1 0.6 1.5 2.5 3.3 1.1
ASEAN 3194.0 3428.0 4223.2 3288.8 2844.6 2984.0 3255.9 2925.4 3040.5
Source: ASEAN Statistical Yearbook and China External Economic Statistical Yearbooks
12
2.3 Modelling Framework
Traditionally, trade policy analysis has been at the core of the classic CGE exer-
cise, but with the growing importance of cross-border investment ows applied general
equilibrium models are increasingly focusing on adopting mechanisms for modeling
international investment, in general, and FDI, in particular. Incorporating interna-
tional capital mobility in CGE models requires explicit tracking of capital stocks,
ownership and wealth and the corresponding welfare eects of these.
With the importance of foreign capital ows being highlighted yet again during
the recent global nancial crisis, it is clear that more attention needs to be given
to its impact. However despite this, existing trends in the literature show diverging
and often contradictory specications of international investment. Perfect mobility of
capital across national boundaries has long been challenged in the literature. Among
the most well-known, Feldstein and Horioka (1980) proposed a savings-investment
correlation as a measure of international capital mobility and found that changes
in domestic savings are almost fully passed through into domestic investment - an
indicator of imperfect capital mobility. Further, French and Poterba (1991) somewhat
similarly to Feldstein and Horioka note the empirical regularity according to which
countries tend to allocate a signicant share of their portfolio to their domestic assets
and label their discovery the home bias puzzle of investment. Under-diversication
can be explained by transaction costs, discriminatory taxes, dierences in preferences
across countries. In the GDyn model, used here, an attempt is made to reconcile
the empirical ndings in the literature with the theory of perfect capital mobility by
13
0
20000
40000
60000
80000
100000
1995 2000 2005
ASEAN>China ASEAN5>China
1995 2000 2005
BCLMV>China
China>ASEAN China>ASEAN5
0
20000
40000
60000
80000
100000
China>BCLMV
Figure 2.1.: ASEAN-China Trade Flows, 1995-2008 ($mil)
Source: ASEAN Statistical Yearbook 2008. BCLMV refers
to Brunei, Cambodia, Laos, Myanmar and Viet Nam
0
1000
2000
3000
4000
5000
1995 2000 2005
ASEAN>China ASEAN5>China
1995 2000 2005
BCLMV>China
China>ASEAN China>ASEAN5
0
1000
2000
3000
4000
5000
China>BCLMV
Figure 2.2.: ASEAN-China FDI Flows, 1995-2008 ($mil)
Source: ASEAN Statistical Yearbook 2008. BCLMV refers
to Brunei, Cambodia, Laos, Myanmar and Viet Nam
14
assuming imperfect mobility on the short and medium run, and perfect mobility only
in the long run.
2.3.1 Design Decisions
When considering the specication of capital mobility in a CGE model, there are
four main types of decisions that have to be made:
the extent to which capital is mobile across sectors;
the extent to which capital is mobile across borders;
whether capital accumulation is described as a part of an intertemporal or
recursive optimization
5
;
and whether the investment is driven by demand or supply.
The choice of the exact specication should depend on the objectives of the modeling
exercize taking into consideration the nature of the shocks, the time period and the
characteristics of the underlying economies.
First, if capital is specied as being sector specic, sectoral rates of return will
dier and will depend on the supply and demand characteristics of the sector. If
capital is chosen to be perfectly mobile across sectors, there is a rate of return that
clears the aggregate market for capital. As argued by Devarajan and Oerdal (1989)
sectorally xed capital reects the short run. In this case, sectoral rates of return are
endogenous and adjust in order to clear any dierences between demand and supply
5
The same categories have been described in a comprehensive survey by Islam (1999).
15
of sectoral capital. The reason for this is that to date the dynamic GTAP model has
had a more medium to long run focus.
Second, if capital is assumed to be perfectly mobile across borders there is one
aggregate international market for capital that is cleared by a unique international
rate of return. In this approach, it is required that total supply of capital is known
a-priori. On the other hand, if capital mobility is imperfect the specication will make
use of an exogenously dened elasticity (or convergence parameter as referred to in
GDyn) that describe the responsiveness of capital ows to rate of return dierentials.
Before proceeding, we rst need to dierentiate between mobility of physical cap-
ital and mobility of capital referring to the movement of funds for investment that
through investment in the current period become capital in the next period.
Physical capital mobility is not seen as actual movement of capital by a change
in geographic location. Instead, the two alternative theories are: mobility of physical
capital through trade
6
and mobility through depreciation. Mobility of physical capital
is not the main objective of the analysis in this paper and therefore by capital mobility
we refer to the mobility of resources hereafter.
Third, in the context of a multi-period dynamic optimization process capital mo-
bility could be modeled using either a forward looking or recursive dynamic speci-
cation. In recursive dynamics, agents are assumed to be myopic and the current
period decisions are based entirely on current period variables. The forward looking
6
Analogous with the theory that trade in factors is seen as a substitutes for trade in goods Mundell
(1957).
16
specication assumes perfect foresight and relies heavily on (and is sensitive to) the
projected path of state variables.
After deciding on the exact combination of sectoral, regional and intertempo-
ral mobility of capital used in a model, the next step is to specify the mecha-
nism/functional form of investment allocation. Applied models can be divided into
two main categories: investment demand models and investment supply models.
Applied models of investment demand distribute investment given the amount of
savings where the specication of investment demand
7
is more or less closely related
to the theoretical model of Nickell (1978). Regional demand for investment is deter-
mined in an optimization framework where the rm acts as a prot maximizer, while
equilibrium is achieved either by the adjustment of an endogenous interest rate or
adjustment of the current account. Examples of such models are for example Jung
and Thorbecke (2003), Bourguignon, Branson, and De Melo (1989) and Fargeix and
Sadoulet (1994).
Despite the fact that investment demand models are built on strong theoretical
foundations, Lemelin and Decaluwe (2007) show that the implied demand elasticity of
investment in these models is often too high and can result in unstable models. In this
sense, investment demand models exhibit high uctuations with respect to changes
in relative protability Bourguignon, Branson, and De Melo (1989) and possibly
allow for negative investment (disinvestment) - a feature that could generate strange
welfare results. In addition, investment demand models are calibrated on bilateral
7
For a review of these models see Lemelin and Decaluwe (2007).
17
investment ows data: it has been argued in the literature that investment ows, as
opposed to stocks, are volatile and highly dependent on current economic conditions
(Boumellassa, Gouel, and Laborde, 2007)
8
.
In the second category there are models that determine investment based on a
specication more or less closely related to a theory of investment supply. The capital
owners goal is to maximize the net of his wealth subject to diversication constraints.
Total wealth is distributed across destinations (sectors and regions) as a function
of relative rates of return subject to the diversication constraints imposed by a
constant elasticity of transformation function (CET). The CET allocation determines
the allocation of regional capital stocks and investment. In these models investment is
allocated to regions with the highest rates of return and at the same time taking into
account investors preferences for a given mix of diversication. Investment decisions
based solely on the evolution of relative rates of return could lead to an increased
volatility in the allocation of investment across regions. Examples of such models are
Petri (1997), Bchir et al. (2002) and Lejour, Veenendaal, and Verweij (2006).
The current version of GDyn is fundamentally an investment demand model as
global savings are allocated to regional investment based on demand for investment
in the region, through the gradual equalization of rates of return, rather than invest-
ment being determined by the preferences of the regional household (or savers) for
a diversied portfolio. Unlike standard demand models, the GDyn model does not
8
Large take-overs, especially in relatively small countries could highly inuence the yearly recorded
investment ows data.
18
suer from the problems described above due to the inclusion of errors in expectation
and the gradual equalization of rates of return (discussed in detail below).
For the purposes of this paper we extend the GDyn model to take account of
bilateral ownership. We consider two versions of GDyn corresponding to a specica-
tion based on investment demand and investment supply, GDyn-CE and GDyn-CET,
respectively. GDyn-CET allocates regional investment based on the CET assump-
tion so widely used in the literature, while GDyn-CE uses an adaptive adjustment
process and cross-entropy techniques to determine investment and balance the cross-
ownership matrix.
Before turning to the detailed description of these two models, we provide an
overview of the current version of the GDyn model.
2.3.2 GDyn: a Short Review
GDyn extends the standard, comparative static version of the GTAP model (Her-
tel, 1997) by introducing international capital mobility, endogenous capital accumula-
tion and adaptive expectations theory of investment in a recursive dynamics setting.
GDyn is a real assets model, i.e. investment is associated with equity: the regional
households (shareholders) own equity in the rm equal to the value of physical capital
and earn income (dividends) corresponding to their ownership share - there are no
nancial markets and no dierentiation between debt and equity
9
. The model keeps
9
In this sense, we can already assert that GDyn in its current version and after introducing the
necessary modications is suitable for accomodating modeling of greeneld FDI.
19
track of gross ownership positions and income ows associated with them and thus
compared to the comparative static version the GTAP model is augmented to improve
the representation of balance of payments relationships.
Despite the advantages oered by perfect foresight models, the solution procedure
chosen for the GDyn is a recursive one in which investors are allowed to have errors
in their expectations, i.e. a novel adaptive expectations specication of investors
behaviour. Compared to perfect foresight models the dynamic GTAP model oers
greater empirical realism, exibility in data specication and lower computational
complexity.
GDyn inherits the treatment of savings of the comparative static GTAP model.
As implemented by Hertel (1997), the representative household allocates regional
income that would maximize the per capita utility based on a Cobb-Douglas utility
function. Real saving is a single commodity that is dened as savings deated by the
price of savings. The Cobb-Douglas specication keeps the budget shares constant,
implicitly assuming a constant marginal propensity to save of the household.
10
Capital goods are a production sector and their supply is determined by a Leontie
type production technology. On the other hand, capital is a value added component
and is a direct input into production of all goods (except capital goods) governed
by a CES type allocation. Capital is assumed to be perfectly mobile across sectors
determining a single rental rate across sectors that clears the market.
10
Golub and McDougall (2006) develop a version of the dynamic GTAP model in which the saving
rate in each region is endogenous and is a function of the ratio of wealth to income.
20
As in most recursive dynamic models, each periods equilibrium determines the
level of global savings and, implicitly, the aggregate amount of investment expenditure
available in that specic period. International capital mobility is modeled using a
disequilibrium approach that reconciles investment theory with empirical ndings.
The disequilibrium approach adopted here is described by two mechanisms in the
model: rst, there is a gradual convergence of the expected rate of return leading
to the equalization of expected rates of return in the long run; and second, errors
in expectations with respect to the actual rate of return are eliminated over time.
Investors are assumed to respond to expected rates of return as opposed to actual
rates of return when making investment decisions allowing for errors in expectations.
For instance, when investment in the base data is low despite high actual rates of
return it is assumed to be due to errors in expectations; investors are assumed to
behave adaptively and over time these errors are eliminated and the expected rate of
return will converge toward the observed rate of return.
The GDyn model in its current form does not make use of portfolio allocation the-
ory in determining gross ownership positions, i.e. investors reactions are based only
on (expected) rates of return and hence the GDyn model is an investment demand
driven model. Moreover, domestic households hold equity directly in domestic rms,
the lack of availability of bilateral data on foreign assets, precludes the representative
household from holding equity directly in foreign rms. This lack of bilateral data
on foreign assets and liabilities compels many CGE modelers to employ a somewhat
articial representation of foreign investment. The GDyn model overcomes this prob-
21
lem through the adoption of a ctional entity called the global trust. The global
trust collects the saving of all the regional households and allocates this to regional
investment on their behalf. The mechanism that the GDyn model uses to determine
the composition of the cross-ownership matrix over time is cross-entropy minimiza-
tion. The choice of the cross-entropy allocation of wealth is motivated by the fact
that this type of specication is able to reproduce some of the empirical ndings of
the investment literature such as the home bias of puzzle of investment (French and
Poterba, 1991).
The use of the global trust, however, could lead to the distortion of foreign asset
holdings. While each regions representative household may hold a dierent propor-
tion of their ownership in domestic and trust assets, all households are assumed to
hold the same distribution of foreign assets across countries (including some indirect
ownership of domestic assets). As a result of changes in the relative rates of return
across regions the representative households are expected to rebalance their portfolio
of foreign asset holdings and dierent regions might dier in their propensity to re-
balance their portfolios across foreign assets. The use of the global trust assumes that
all households rebalance their portfolios in the same way. However, in response to a
strong and negative change in the US rate of return China may respond by invest-
ing more in East Asia and Australia, while Americans might invest more in Europe
and the Middle East. While the average response produced by the global trust, an
increase in investment everywhere outside of the US, might be correct on average, it
is interesting to see how each countrys portfolio adjusts in response to the shock.
22
2.4 Bilateralizing Investment in GDyn
This section describes two versions of the GDyn model that account for bilateral
ownership of investment.
The data of bilateral FDI stocks that serves as a base of this modeling exercise has
been built by CEPII, France and is documented in Boumellassa, Gouel, and Laborde
(2007): contrary to other data sources, this database is fully consistent, balanced and
suitable for use in CGE work. The development of this database now allows us to
replace the global trust and calibrate the model on actual bilateral investment data.
We build two new versions of the dynamic GDyn model corresponding to two
main specications of investment behaviour.
The rst version (referred to as GDyn-CE) retains the dynamic mechanisms of
GDyn for determining regional investment but alters the cross-entropy approach used
to track bilateral ownership. This version could be mainly included in the family of
applied models of investment demand: investment demand is determined within an
optimization framework where the rm acts as a prot maximizer. Investment in each
period adds to the capital stocks, while the composition of the regional wealth matrix
is updated such as to match the change in the regional savings and investment.
The second version (referred to as GDyn-CET) is an example of the applied models
of investment supply: the capital owners goal is to allocate a given investment budget
in such a way as to maximize the present value of his net worth. Total wealth is
distributed across destinations (sectors and regions) as a function of relative rates
of return subject to the diversication constraints imposed by a constant elasticity
23
of transformation function (CET). The CET allocation determines the allocation of
regional capital stocks and investment.
2.4.1 GDyn-CE
GDyn-CE oers the advantage that it requires minimum adjustments to the
present version of GDyn and the associated database. GDyn-CE preserves the dy-
namic mechanisms and the adaptive expectations theory of the standard GDyn model,
but alters the cross-entropy approach to track bilateral ownership of capital.
The GDyn-CE model with bilateral ownership of capital does not make use port-
folio allocation theory in determining gross ownership positions, instead investors
reactions are based only on (expected) rates of return as in the standard GDyn
model. It is these mechanisms that determine regional (not bilateral) investment. The
cross-entropy minimization approach of the standard GDyn model to preserve initial
wealth-allocation between domestic and foreign (trust) ownership is now extended to
preserve bilateral allocations. Thus the cross-entropy minimization approach acts as
a quasi-portfolio diversication rule given the equalization of rates of return in the
long run.
In GDyn-CE regional investment is determined by the dynamic mechanisms re-
tained from the standard GDyn based on the interaction between actual, expected
and target rates of return. Investment further determines capital stocks and conse-
quently wealth in domestic rms. Savings on the other hand determine total wealth
24
accumulated by the household. Finally, cross-entropy determines bilateral ownership
of capital.
The use of the cross-entropy approach (combined with rates of return) employed
in GDyn-CE can be motivated with the following reasons:
in the short and medium run the model allows for dierences in rates of return,
thereby stopping the concentration of investment in the region with the highest
rate of return;
the entropy allocation rule preserves the so-called home bias puzzle of in-
vestment; according to this empirical regularity countries tend to allocate a
signicant share of their portfolio to their domestic assets (French and Poterba,
1991);
in order to avoid negative values for both gross foreign assets and liabilities:
no matter what the exogenous shock to income/wealth variables, cross-entropy
minimization keeps the initial shares positive during the simulation.
Cross-entropy minimization in GDyn-CE is the mechanism that keeps the com-
position of the cross-ownership matrix in GDyn close to its base year structure. The
underlying assumption is that the initial composition of the wealth matrix is the op-
timal one. Households have chosen this initial composition given their preferences in
the diversication and risk dispersion. As previously pointed out, the cross-entropy
mechanism is suitable in reproducing empirical observations such as the home-bias
of investment, portfolio diversication and for its properties in keeping original posi-
tive shares positive along the simulations.
25
Cross-entropy minimization in its most general form can be dened as the min-
imization of the degree of divergence between two partitions of a given total value
(initial sh o
rs
and updated sh
rs
) subject to dierent constraints:
min CE =

s
sh
rs
log
sh
rs
sh o
rs
In this specic case we can dene:
sh
rs
=
W
rs

r
WH
r
sh o
rs
=
W o
rs

r
WH o
r
where W 0
rs
and W
rs
are the bilateral cross-ownership matrices in period t and t +1,
respectively and WH
r
and WH o
r
are total wealth of household r in period t and
t + 1, respectively. r represents the owner, while s the location of the equity.
The cross-entropy minimization could be summed up with:
min

s
_
W
rs
log
W
rs
W o
rs
_
s.t.

s
W
rs
= WH
r

r
W
rs
= WF
s
26
In percentage change form
11
the solution to the above minimization would be the
following (the detailed derivation of the solution to the cross-entropy minimization
problem is presented in the Appendix):
w
rs
=
r
+
s
(2.1)

s
W
rs
w
rs
= WH
r
wh
r
(2.2)

r
W
rs
w
rs
= WF
s
wf
s
(2.3)
Equation 2.1 is the one determining the dynamic bilateral cross-ownership matrix in
GDyn, while Lagrangian multipliers
r
and
s
are determined by Equations 2.2 and
2.3.
Please note that considering the fact that cross-entropy minimization entails an
optimization based on shares, the system of equations will become overdetermined
and singular if solved for all n shares. Therefore we just solve for n 1 shares.
2.4.2 GDyn-CET
Many of todays well known CGE models such as MIRAGE (Bchir et al., 2002),
FTAP (Hanslow, Phamduc, and Verikios, 2000), WorldScan (Lejour, Veenendaal, and
Verweij, 2006), use the CET investment supply-type specication of Petri (1997) for
cross-border investment in general, or FDI in particular. Petri rst used the extended
Armington assumption and dened cross-border investment as an isoelastic supply
11
Percent change variables are presented in lower case.
27
function implying that investment decisions are dierentiated by country of origin and
characterized by imperfect substitution between preferences for investing in dierent
countries.
Investment supply is driven by the value of total wealth to be allocated across
destinations and acts as a portfolio diversication problem: the households wealth
(or in other words the value of its portfolio) is allocated at the beginning of each
period subject to a diversication constraint.
As dened by Equation 2.4, wealth in period t equals wealth in period t 1 in
addition to savings of period t.
w
t
= w
t1
+s
t
(2.4)
The allocation of wealth across regions is the following: wealth of region r is allocated
by a separable nested CET function optimization in which the household maximizes
its total wealth subject to the diversication constraints.
max w
r
=

s
ror
rs
k
rs
s.t. k
r
=

s
_

1/r
rs
k
r+1
r
rs
_r+1
r
where
r
0 is the elasticity of transformation
12
in the rth market, ror
rs
is the rate of
return to investor from market r in market s, k
rs
represents the stock of investment
12
As shown by Shumway and Powell (1984) in a CET the elasticity of transformation should be
negative.
28
of investor from market r in market s and
rs
is a preference parameter calibrated
on the initial database.
Note that wealth is valued at the price that the market pays to investors for
capital stocks, i.e. the rate of return. More correctly, wealth should be valued at the
price of capital goods (as it is dened in the standard GDyn and GDyn-CE). The
solution to the above optimization expressed in wealth share terms is shown below in
Equation 2.5:
K
rs
ror
rs
K
r
rora
r
=
w
rs
w
r
=
_
ror
rs
rora
r
_
1r
(2.5)
In GDyn-CE savings determine total wealth owned by the household (similarly to
GDyn-CE). Total wealth determines the bilateral ownership matrix based on relative
rates of return
13
according to the CET specication. The cross-ownership matrix im-
plicitly determines wealth in domestic rms that consequently determines the change
in capital stocks and investment.
It is important to underline that Equation 2.5 determines both the allocation of
investment across regions and the change in investment in GDyn-CET, compared to
GDyn-CE where investment is determined by the elimination of errors in expectations
over time and the allocation of investment across regions is determined by the cross-
13
In GDyn-CE this rate of return corresponds to the gross rate of return.
29
entropy. In addition, in GDyn-CE investors respond to expected rates of return, while
in GDyn-CET to actual rates of return.
2.4.2.1. The elasticity of transformation
The CET function specied in Equation 2.5 denes the interactions of prices (in this
case rates of return) to be characterized by a single parameter -
r
, parameter that
denes the sensitivity of relative investment, capital stock or wealth (depending on the
exact specication) with respect to changes in relative rates of return. Considering the
fact that
r
plays a crucial role in the outcome of policy experiments, it is important
to dwell on how it is dened in the context of existing CGE models that have a CET
specication.
We have surveyed the literature with respect to econometric estimates of the
elasticity of transformation of investment with respect to changes in relative rates of
return. Our main ndings are the following:
rst, econometric evidence
14
on developed countries shows that the implied
elasticity of FDI with respect to the after-tax rate of return is close to unity.
second, estimated coecients of rate of return to investment have been found
to be statistically insignicant for Sub Saharan African countries/developing
countries, i.e. caeteris paribus, a higher rate of return has no signicant impact
on FDI ows - Asiedu (2002).
14
For a survey see Swenson (1994), Slemrod (1990).
30
Table 2.2 provides examples of the elasticity of transformation of investment used
in CGE models in the literature
15
.
Table 2.2: Elasticities of Transformation of Investment in the Literature
Model
DART 4
FTAP 1.4
Lee and van der Mensbrugghe 4
WorldScan 5
Note that elasticities of transformation of investment with respect to changes in
relative rates of return reported in Table 2.2 are higher than supported by econometric
evidence. However, if
r
= 1 then the CET reduces to a simple Cobb-Douglas
specication with xed shares and underestimate changes in total investment. In
addition,
r
1 is likely to exhibit what could be referred to as the small shares
problem of the CET (Kuiper and van Tongeren, 2006). More specically, a CET
supply function will tend to underestimate trade/investment creation no matter how
signicant reduction in barriers to trade: if there are little or no trade/investment
ows in the initial data the impact of liberalization on these ows will be insignicant.
In GDyn-CET, we chose to set the value of elasticity of transformation of wealth
(not investment) with respect to changes in relative rates of return to
r
= 2. Note
that the CET function specied in GDyn-CET describes changes in bilateral owner-
ship as a function of relative rates return, as opposed to investment as a function of
relative rates of return dened in the CGE models mentioned previosly. This choice
15
Based on Springer (1998), Hanslow, Phamduc, and Verikios (2000), Lee and Van der Mensbrugghe
(2001), Lejour, Rojas-Romagosa, and Verweij (2008).
31
allows us to directly compare GDyn-CE and GDyn-CET and also minimizes modi-
cations to the standard GDyn. As a consequence the elasticity of transformation of
wealth
r
= 2 is not directly comparable with the elasticity of transformation of in-
vestment reported in Table 2.2. In addition,
r
= 2 in this specication is equivalent
to
r
> 1 in the alternative specication.
16
In the next section we compare the economic impact of ACFTA obtained with
GDyn-CE and GDyn-CET.
2.5 Simulation Design
The simulations cover the period 2001-2020 comprised of eight intervals
17
. The
model is calibrated on the GDyn 6 database
18
with 2001 as the base year. Regions
have been aggregated into 14 composite ones: China, Indonesia, Malaysia, Philip-
pines, Singapore, Thailand, Viet Nam, Rest of ASEAN, Japan, Rest of East Asia,
North America, EU 27 countries, Australia/New Zealand and Rest of the World
19
.
The sectoral aggregation is built around 3 sectors: agriculture, manufactures and ser-
vices. The dynamic baseline used here contains variables concerning the evolution of
16
Since the specication used in GDyn-CET is on wealth and not investment, an elasticity of 2 will
lead to larger changes in investment than an elasticity of 2 with respect to investment. Thus, while
an elasticity with respect to investment of 4 might give reasonable results, an elasticity of wealth
with respect to wealth could easily lead to negative investment implied by wealth changes.
17
2001-2005, 2006-2007, 2008-2009, 2010, 2011, 2012-2013, 2014-2015, 2016-2020.
18
The GDyn database is the standard GTAP database augmented with foreign income variables and
GDyn specic parameters (Ianchovichina, Walmsley, and McDougall, 2010)
19
Abbreviated with CHN, IDN, MYS, PHL, SGP, THA, VNM, XSE, JPN, EAS, NAM, EU27, AUN
and ROW, respectively.
32
some macroeconomic aggregates (GDP and population) and labor supply documented
in Walmsley (2006).
To simulate the eect of the FTA between ASEAN and China we gradually re-
duce and eliminate applied MFN taris rates according to the Modalities for Tari
Reduction and Elimination for Tari Lines Placed in the Normal Track as summa-
rized in Table 2.3 below
20
. The dynamic nature of the model allows us to gradually
implement the elimination of barriers to trade precisely as dened in the modalities.
Accordingly, by 2010 full tari liberalization is achieved between ASEAN countries
and China
21
.
Table 2.3: Modality for the Reduction and Elimination of Taris
2005 2007 2009 2010
X 20% 20 12 5 0
15% X < 20% 15 8 5 0
10% X < 15% 10 8 5 0
5% < X < 10% 5 5 0 0
X 5% Standstill 0 0
Source: Annex 1 of the China-ASEAN Framework Agreement
X = Applied MFN taris
In 2001 China applied higher taris on ASEANs imports (11.6%) than ASEAN
applied on Chinese imports (6.7%)
22
. Table 2.4 details the composition of taris faced
and applied by China across sector and individual ASEAN countries. The highest
20
Annex I of the Agreement on Trade in Goods of the Framework Agreement on Economic Cooper-
ation between ASEAN and China, 29 November 2004.
21
Sensitive products and the special modalities dened for Viet Nam, Cambodia, Lao PDR and
Myanmar are not considered here.
22
Ad valorem equivalent tari rates have been calculated using bilateral trade weights.
33
Table 2.4: Taris Applied and Faced by China in 2001 (%)
Faced taris IDN MYS PHL SGP THA VNM XSE
Agriculture 5.2 17.7 13.7 0.4 26.5 22.0 19.2
Manufacturing 7.4 5.1 5.4 0.0 11.0 21.0 7.1
Overall 6.6 6.7 5.9 0.0 11.1 19.9 7.9
Applied taris IDN MYS PHL SGP THA VNM XSE
Agriculture 14.0 14.2 22.2 33.4 13.8 20.5 20.7
Manufacturing 11.4 10.6 9.3 11.1 18.2 10.9 5.8
Overall 11.4 10.3 10.1 10.6 16.7 12.7 7.2
Source: GTAP v6 database
taris to Chinese imports are applied by Viet Nam (19.9%) and Thailand (11.1%).
On the other hand, the average protection rate applied by Singapore is close to zero.
Overall, the agricultural sector is more protected than manufacturing. For instance,
Thailand applied 26.5% on agricultural products originating from China and a lower
11% on manufactures. Agricultural imports to Malaysia from China faced 17.7%
taris while manufacturing products 5.1%.
China applied the highest taris on imports originating from Thailand (16.7%).
The remaining ASEAN countries face relatively homogeneous protection ranging from
10.1% to 11.4%. The lowest taris (7.2%)are applied to imports from the composite
ASEAN region XSE that include Brunei, Cambodia and Laos. As in ASEAN, in
China the agricultural sector in more protected than manufacturing with respect
to ASEANs imports. For instance, taris applied to agricultural products from
Singapore face a 33.4% tari while manufacturing 11.1%.
34
2.6 The Economic Impact of ACFTA
In this section, we discuss the impact of the elimination of barriers to trade be-
tween ASEAN and China. We begin with a description of the impacts on rates of
return, capital accumulation and investment before turning to the investment creation
and diversion eects of trade liberalization. We provide an analysis of the outcome of
ACFTA with the two versions of GDyn described above. The section concludes with
the analysis of long run welfare eects of ACFTA.
Results are reported as cumulative percent changes relative to the baseline: using
this approach we are able to isolate the impact of the policy shock. The liberalization
shocks have been implemented in the rst four periods corresponding to 2005, 2007,
2009 and 2010 as required by the modalities described in Table 2.3 above.
Overall, we nd that the impact of the elimination of barriers to trade between
China and ASEAN countries on variables such as rate of return, investment and
bilateral ownership is small. This can be explained by two main factors: rst, taris in
the 2001 database are low in agriculture and manufacturing and second, liberalization
of the services sector trade, or more specically construction, would have the most
35
important impact on the price of capital goods
23
, but services trade liberalization is
not considered here.
2.6.1 Rates of Return and Total Investment
Figure 2.3 provides a comparative depiction of the evolution of rental price of
capital (RENTAL) and price of capital goods (PCGDS) as a result of the reduction
of barriers to trade
24
. We nd that the rental price of capital increases in all liber-
alizing regions. By 2010 (the last year in which tari shocks are implemented) we
nd a surge in the rental price in Viet Nam (4.3%), Thailand (3.1%) and Singapore
(1.89%). Rental price of capital in China increases by a modest 0.7%. This increase
is mainly due to the increased demand for capital by industries, but in particular by
manufacturing industries, that expand as a result of trade liberalization.
The impact of liberalization on the price of capital goods is smaller. By 2010,
it increases by 1.02% in Thailand, 0.69% in Singapore and 0.21% in China. On the
other hand, it declines in Viet Nam (-0.12%) and Rest of ASEAN (-0.74%). Changes
in the price of capital goods can be explained by the price of intermediates (domestic
or imported) used as inputs in the formation of the capital goods. While the price
imported intermediates purchased by capital is declining, the increased demand for
domestic intermediates fuels the rise in the price of domestic intermediates. The share
23
Construction represents on average 60% of the inputs in the capital goods sector
24
Results have been reported for GDyn-CE as dierences with respect to variables such as rental
price, price of capital goods, rates of return between GDyn-CE and GDyn-CET are small.
36
of domestic versus imported intermediates determines the overall increase or decline
in the price of capital goods.
The combined eect of the change in rental price and that of the price of capital
goods determines the actual rate of return. A rst look at Figure 2.3 indicates that we
should expect the biggest change in rate of return for Viet Nam, Thailand, Singapore
and Malaysia. These expectation are conrmed by Figure 2.4. Accordingly, trade
liberalization under ACFTA appears to have the largest impact on actual rates of
return in Viet Nam, Thailand and Malaysia. By 2010, the increase in actual rate of
return in these countries reaches 4.94%, 1.85% and 1.18%, respectively (a detailed
evolution of the rates of return is also presented in Table 2.5).
Figure 2.4 also compares the evolution of actual and expected rates of return in
GDyn-CET and GDyn-CE. It is important to make this distinction as investment
in the two models is determined by dierent rates of return. Thus, in GDyn-CET
total investment is a function of actual rates of return as described in Equation 2.5.
More specically, in GDyn-CET the dynamic mechanisms are no longer active in
dening total regional investment demand, instead investment is determined by the
CET allocation. The errors in expectations merely adjust to ensure that regional
investment from both the CET and the dynamic mechanisms are equal. On the other
hand, in GDyn-CE investors react to changes in expected rate of return.
According to Figure 2.4 there are important dierences between actual and ex-
pected rates of return for Viet Nam, Thailand and Malaysia. Note that changes in
37
actual rate of return are higher than in the expected rate of return, pointing to the
fact that total investment in GDyn-CET should be more volatile than in GDyn-CE.
Figure 2.5 and Table 2.6 compare the evolution of total investment for GDyn-
CE and GDyn-CET. As pointed out before, dierences between total investment in
the two models will be more pronounced the bigger the dierence between expected
and actual rates of return. Overall, changes in total investment in GDyn-CET are
higher than in GDyn-CE. Both models reect the increase in total investment in
all liberalizing regions (except in Rest of ASEAN) and a decrease in the rest of the
regions.
In GDyn-CE, by 2010 we nd the most signicant increase in investment for Viet
Nam (16.08%), Thailand (5.7%) and Malaysia (3.2%). In GDyn-CET investment
increases by 17.96% in Viet Nam and 3.47% in Malaysia. By 2020, the dierences
between the two models are more pronounced explained by the fact that in the long
run there is a convergence toward steady state
25
in GDyn-CE but not in GDyn-CET.
2.6.2 Investment Creation and Diversion
In economic theory, the universal desirability of preferential trade agreements
has been rst challenged in Viner (1950) by drawing attention to the possibility of
signicant trade diversion impacts of such agreements. Trade diversion occurs if the
free trade area diverts trade away from a more ecient supplier non-signatory of the
25
Steady state occurs if there is no change in the normal rate of growth of capital stock (KHAT).
The normal rate of growth is the rate at which the capital stock can grow without aecting the rate
of return.
38
2
0
2
4
AUN
2005 2010 2015 2020
CHN EAS
2005 2010 2015 2020
EU27 IDN
JPN MYS NAM PHL
2
0
2
4
ROW
2
0
2
4
2005 2010 2015 2020
SGP THA
2005 2010 2015 2020
VNM XSE
PCGDS
RENTAL
Figure 2.3.: Cumulative % Change in RENTAL and PCGDS
Source: Authors simulations
1
0
1
2
3
4
5
AUN
2005 2010 2015 2020
CHN EAS
2005 2010 2015 2020
EU27 IDN
JPN MYS NAM PHL
1
0
1
2
3
4
5
ROW
1
0
1
2
3
4
5
2005 2010 2015 2020
SGP THA
2005 2010 2015 2020
VNM XSE
RORGA
RORGE
Figure 2.4.: Cumulative % Change in RORGE(CE) and RORGA(CET)
Source: Authors simulations
39
0
5
10
15
20
25
AUN
2005 2010 2015 2020
CHN EAS
2005 2010 2015 2020
EU27 IDN
JPN MYS NAM PHL
0
5
10
15
20
25
ROW
0
5
10
15
20
25
2005 2010 2015 2020
SGP THA
2005 2010 2015 2020
VNM XSE
CET
CE
Figure 2.5.: Cumulative % Change in Total Investment
Source: Authors simulations
agreement toward a less ecient supplier signatory of the agreement. If trade creation
eects are smaller than those of trade diversion, the preferential agreement will be
welfare reducing.
Similarly to this framework we distinguish between investment creation and invest-
ment diversion eects of preferential trade agreements. The concepts of investment
creation and diversion rst dened by Kindleberger (1966) evolved in parallel with
those of trade creation and diversion. As in Baldwin, Forslid, and Haaland (1996), we
refer to investment creation as being the incentive to increase investment within the
area covered by the preferential agreement and to investment diversion as the negative
impact on investment not covered by the preferential agreement. More specically,
discriminatory liberalization lowers the price of capital goods and shift production to
40
countries signatory of the free trade agreement. The rental price of capital increases
as industries expand. Investment in these countries increases as a response to higher
rates of return. We will thus observe investment creation and diversion. In some
cases there may be pure creation eects (an increase of investment relative to total
investment in the world), while in other cases investment creation may add to total
investment in the world.
We have already discussed the evolution of total investment, but for determining
the welfare impact of investment creation and diversion it is important to further
analyze bilateral changes in investment. The variable that is a proxy to bilateral
investment in GDyn is bilateral ownership.
Figures 2.6 and 2.7 depict changes in bilateral ownership in 2005 and 2010 for
both GDyn-CE and GDyn-CET. Shades of red represent an increase in ownership
while shades of blue a decrease, the more pronounced the changes the darker the
shade. Note however, that light blue is associated with a small increase in ownership.
We start with the analysis of changes in bilateral ownership in 2005 depicted in
Figure 2.6. First, note that real savings in all liberalizing countries increase: by
2005 real savings in Thailand increase by 0.79%, in Philippines by 0.61% and in Viet
Nam by 0.46% (dierence between GDyn-CE and GDyn-CET in terms of changes
in savings are very small). The two models provide comparable results, however the
magnitude of changes in terms of bilateral ownership are dierent. A rst look at the
results from the two models shows that changes in ownership are more concentrated
in GDyn-CET.
41
In GDyn-CET investors allocate more to regions with higher relative rate of return,
diverting away from the rest of the regions. All countries increase ownership of capital
stocks in Viet Nam, Thailand and the Philippines. More specically, by 2005 we nd
the highest increase in the ownership of capital stocks of all regions in Viet Nam
ranging from 0.07% increase in the domestic ownership of Viet Nam to 0.24% in the
ownership of EU27.
In GDyn-CE, the mechanisms described in Equations 2.1, 2.2 and 2.3 determine
the bilateral allocation of ownership. For instance, in Viet Nam we found that total
savings increase by 0.46%, while total investment 0.37%. Based on Equation 2.3, all
regions would want to increase investment in Viet Nam by 0.37% including Viet Nam.
Nevertheless, we know that the share of domestic ownership in the total portfolio is
very high and this drives the increase in domestic ownership down to 0.02%. At the
same time, other regions are able to invest more in Viet Nam (Australia/New Zealand
and East Asia increases ownership in Viet Nam by 0.38%).
By 2010, depicted in Figure 2.7, dierences between the two models are more
pronounced. Consequently, in GDyn-CET we nd that all regions concentrate more
investment in Viet Nam as relative rates of return in this country increase. Similarly,
in GDyn-CE investors increase ownership in the countries with high expected rates
of return but in this case the constraints imposed by Equations 2.2 and 2.3 lead to
better diversication than in GDyn-CET that allocates total savings on relative rates
of return.
42
The next section discusses the welfare impacts of ACFTA with emphasis on the
welfare eects due to investment creation and diversion.
2.6.3 Welfare Impacts
Understanding where welfare benets and losses arise can provide insight not only
into the overall impact of trade liberalization, but also into how dierent stakeholders
in an economy are aected. In this specic case, our goal is to isolate the welfare
gains and losses that arise due to investment creation and diversion as a result of the
ASEAN China FTA.
In comparison to the static GTAP model, national accounts in GDyn have been
extended to include international income payments. GDyn dierentiates between
asset ownership and asset location, i.e. the income generated by assets in a given
region accrues not only to the domestic household but also to foreign shareholders in
accordance with their share of ownership. Thus, in addition to the standard welfare
decomposition components (allocative eciency, terms of trade, technical change,
investment/savings eect), in GDyn we also consider the eect of net income from
the ownership of capital endowments (see Chapter 6 in Ianchovichina, Walmsley, and
McDougall (2010)).
Welfare decomposition in GDyn is based on a comparative static simulation that
shows the dierence between welfare eects in the baseline and the policy simulation
at a given point in time. Thus, for instance, if we refer to equivalent variation associ-
ated with a given policy shock, in GDyn this would represent the dierence between
43
Origin
D
e
s
t
i
n
a
t
i
o
n
AUN
CHN
EAS
EU27
IDN
JPN
MYS
NAM
PHL
ROW
SGP
THA
VNM
XSE
A
U
N
C
H
N
E
A
S
E
U
2
7
I
D
N
J
P
N
M
Y
S
N
A
M
P
H
L
R
O
W
S
G
P
T
H
A
V
N
M
X
S
E
CE
A
U
N
C
H
N
E
A
S
E
U
2
7
I
D
N
J
P
N
M
Y
S
N
A
M
P
H
L
R
O
W
S
G
P
T
H
A
V
N
M
X
S
E
CET
0.4
0.2
0.0
0.2
0.4
Figure 2.6.: Bilateral Ownership in 2005
Source: Authors simulations
Origin
D
e
s
t
i
n
a
t
i
o
n
AUN
CHN
EAS
EU27
IDN
JPN
MYS
NAM
PHL
ROW
SGP
THA
VNM
XSE
A
U
N
C
H
N
E
A
S
E
U
2
7
I
D
N
J
P
N
M
Y
S
N
A
M
P
H
L
R
O
W
S
G
P
T
H
A
V
N
M
X
S
E
CE
A
U
N
C
H
N
E
A
S
E
U
2
7
I
D
N
J
P
N
M
Y
S
N
A
M
P
H
L
R
O
W
S
G
P
T
H
A
V
N
M
X
S
E
CET
5
0
5
10
Figure 2.7.: Bilateral Ownership in 2010
Source: Authors simulations
44
the expenditure required to obtain the policy simulation level of utility evaluated at
baseline prices and the level of utility of the baseline. In this specic case, we calculate
the dierence between the welfare eects between the baseline and the policy simu-
lation at the end of our simulations in 2020. A benet of using a comparative static
simulation to calculate welfare eects is that the use of a discount rate is not required
to cumulate welfare over time. On the other hand, a drawback of this method lies in
the fact that while two countries could achieve the same welfare eects, we have no
information about the timeline of these eects.
The welfare impacts
26
of ACFTA are summarized in Table 2.7. Over 19 years sim-
ulated here, we nd welfare gains of $18.01 billion for the world as a whole as a result
of ACFTA. The main beneciaries are EU27 ($6.74 billion), North America ($5.93
billion), Malaysia ($3.56 billion) and China ($3.15 billion). Other ASEAN coun-
tries such as Singapore, Thailand, Indonesia and Philippines also gain from ACFTA.
On the other hand, we nd welfare losses for Viet Nam (-$1.21 billion) and Rest of
ASEAN (-$0.32 billion).
While total welfare results give an indication of the absolute level of the welfare
gain associated with the policy shock, this measure does not consider the relative
size of dierent countries. In order to give a better indication of the welfare gain or
loss associated with ACFTA, we calculate welfare eects relative to GDP
27
. While
in terms of absolute welfare gains the main gainers were shown to be EU27 and
26
Welfare impacts have been calculated with GDyn-CE. Welfare decomposition in GDyn is described
in detail by Ianchovichina, Walmsley, and McDougall (2010)
27
GDP in 2020 in the baseline.
45
North America, the order changes when we consider welfare eects relative to GDP.
Our results show that Malaysias welfare gain accounts for 1.81% of its GDP in
2020, followed by Singapore (0.3%), China (0.15%), Thailand (0.12%) and Indonesia
(0.03%). In contrast, welfare losses for Viet Nam account for -1.9% of its GDP in
2020. Finally, EU27 and North America gain only slightly 0.06% and 0.03% relative
to 2020 GDP.
All liberalizing countries, except the Rest of ASEAN (a composite region of
Brunei, Cambodia, Lao and Myanmar) benet from an increase in allocative e-
ciency. Among these countries, Thailand ($2.52 billion) and China ($2.08 billion) are
the main gainers. We nd signicant contributions to national welfare arising from
changes terms of trade. For Malaysia, Singapore and Thailand there are important
improvement in terms of trade as a result of falling import prices (-0.09%, -0.10% and
-0.02%, respectively) and increasing export prices (0.66%, 0.53% and 0.74%, respec-
tively). Viet Nam and China suer from deteriorating terms of trade as their export
price index falls more than that of the import price.
Finally, we consider the impact of net foreign income (NFI) from the ownership of
capital endowments on welfare. Net foreign equity income represents the dierence
between income receipts paid to domestic capital by the rest of world (including the
domestic household) and income payments to foreign factors of production in the do-
mestic economy (Chapter 6 in Ianchovichina, Walmsley, and McDougall (2010)). As
shown in Table 2.7, net foreign equity income has signicant impact on overall welfare
results. The contribution of NFI to welfare is negative for all liberalizing countries
46
(except China and Malaysia), reecting that the change in equity payments exceed
the change in equity receipts of the household. More specically, over the 2001-2020
period considered here we nd a net equity income surplus for China ($1.45 billion)
and Malaysia ($1.57 billion), while Thailand, Viet Nam and Indonesia experience
signicant net income decits (-$3.64, -$1.65 and -$1.7 billions, respectively). Other
countries such as EU27 and North America benet from ACFTA with a surplus of
net equity income of $8.62 and $8.23 billion, respectively. For these countries, the
positive impact of net income surplus surpasses the losses in allocative eciency and
terms of trade leading to an increase in overall welfare. This is an interesting result
that one could not get with the comparative static GTAP model.
Table 2.8 further decomposes the changes in net equity income reported in Table
2.7 into three components: the contribution to welfare of changes in capital used in
region (domestic rms), changes in income from foreign equity (income receipts) and
changes in ownership of domestic capital (income payments)
28
. On the one hand,
we nd that income receipts from the ownership of equity in domestic rms increase
substantially in all ASEAN countries (except Viet Nam and Rest of ASEAN) and
China, underlined by the empirical regularity that households invest an important
share of their savings domestically. On the other hand, income receipts from the
ownership of foreign capital decrease in all liberalizing countries, except in Malaysia,
i.e. overall, domestic households invest less in the rest of the world. Finally, income
28
Negative income payments in Table 2.8 show an increase in the absolute value of payments, while
positive values reect a decrease. Negative income receipts reect a decrease in the absolute value
of receipts, while positive income receipts show an increase.
47
payments to foreign equity holders in a region increase for all ASEAN countries and
China (reected by the negative impact on welfare) as foreign countries invest more in
the liberalizing regions. The cumulative impact of these three components determine
the overall impact of net foreign income on welfare.
While the decomposition of changes in net equity income presented in Table 2.8
is useful in determining the evolution of total income receipts and payments, it does
not provide any information on the impact of investment creation and diversion on
welfare on a bilateral level. Table 2.9 allows us to further decompose cumulative
income payments and receipts into source/destination specic components.
As a result of investment creation and diversion eects discussed above, we nd
dominantly positive equity income changes in the rst half of Table 2.9 and negative
income changes in the second half: all regions tend to invest more in ASEAN and
China, diverting investment away from the rest of the regions. For instance we nd
that equity income receipts of China from the domestic household increase by $7.02
billion. On the one hand, as a result of investment creation between ASEAN and
China, there are signicant positive changes in equity income receipts of China from
Indonesia ($2.36 billion) and Viet Nam ($1.5 billion). On the other hand, as a result of
investment diversion with the non-liberalizing regions, we nd a -$7.8 billion decrease
in Chinese equity income receipts from EU27 and -$1.03 billion from North America.
The overall impact of trade liberalization on net equity income in China is positive
($1.45 billion).
48
A dierent example is Thailand. While income receipts from equity in the do-
mestic household increase by $1.86 billion, this increase is not sucient to oset the
decrease in income receipts and the increase in income payments to EU27 ($2.22
billion) and Japan ($2.12 billion). As a result, the overall impact of investment cre-
ation/diversion on net equity income is negative (-$3.62 billion).
EU27 and North America gain signicantly from investment/diversion eects of
trade liberalization between ASEAN and China. For instance for EU27 countries
income receipts from abroad decrease, but this is oset by the considerable decrease
in income payments.
To sum up, the impact of investment creation/diversion eects on net foreign
income in ASEAN as a whole are negative (-$7.12 billion), in China are positive (-
$1.45 billion) and for the world as a whole we nd a positive welfare eect ($17.13
billion). Overall, ACFTA leads to a welfare increase of $18.04 billion over 2001-2020.
2.7 Conclusion
The ASEAN-China free trade agreement went into eect January 1, 2010 and
became the worlds third largest FTA by trade volume after the European Economic
Area and the North American Free Trade Agreement. ACFTA is expected to deepen
regional integration and to have signicant impacts on intra-regional trade and invest-
ment. While there are studies that quantify the economic impact of ACFTA, most of
these studies are limited to capturing comparative static eects of trade liberalization.
This chapter focuses on highlighting the impacts of the reduction of barriers to trade
49
in a dynamic general computable equilibrium framework. In the context of ACFTA
it becomes important to take into consideration dynamic eects especially given that
the removal of taris has been implemented gradually over the course of 10 years.
For the purposes of this paper we develop and compare two alternative views/models
of investment. As a rst step, we adapt the dynamic GTAP model to take account
of bilateral ownership of investment. Two versions of the model are considered. The
rst version is an example of applied models of investment demand (GDyn-CE), while
the second is a model of investment supply (GDyn-CET). The two versions allow us
to better represent the distribution of gains associated with the bilateral ownership
of capital.
Our results show that ACFTA would boost the economies of the liberalizing re-
gions and increase rates of return. As a result, total investment in both ASEAN
countries and China increase. We place special emphasis on investment creation and
diversion eects of ACFTA. We found clear evidence of investment diversion eects
in regions not signatory to the preferential agreement.
Finally, we focus on the welfare gains of ACFTA. The overall size of welfare gains
add up to $18.01 billion for the world as a whole. The main beneciaries are EU27
($6.74 billion), North America ($5.94 billion), Malaysia ($3.56 billion) and China
($3.15 billion). Other ASEAN countries such as Singapore, Thailand, Indonesia and
Philippines also gain from ACFTA. On the other hand, we nd welfare losses for Viet
Nam (-$1.21 billion) and Rest of ASEAN (-$0.32 billion).
50
Welfare decomposition in GDyn allows to consider the eect of net income from
the ownership of capital and thus highlight the welfare impacts of investment creation
and diversion. We nd that the eect of ownership on overall welfare is negative in
all liberalizing regions (except China and Malaysia) reecting that the increase in
capital stock is largely nanced from overseas mainly by EU27 and North America.
51
Table 2.5: Cumulative % Change in
RORGE(GDyn-CE) and RORGA(GDyn-CET)
RORGE - GDyn-CE
2005 2007 2009 2010 2011 2013 2015 2020
CHN 0.01 0.03 0.08 0.14 0.19 0.23 0.22 0.12
IDN 0.02 0.04 0.09 0.15 0.20 0.24 0.25 0.18
MYS 0.01 0.04 0.15 0.26 0.36 0.41 0.37 0.15
PHL 0.05 0.08 0.19 0.26 0.29 0.29 0.25 0.11
SGP 0.03 0.07 0.14 0.24 0.35 0.42 0.37 0.16
THA 0.05 0.15 0.32 0.47 0.64 0.77 0.73 0.35
VNM 0.03 0.17 0.63 1.04 1.40 1.57 1.35 0.31
XSE 0.00 0.00 0.01 0.02 0.03 0.05 0.07 0.09
JPN 0.00 0.00 0.01 0.01 0.02 0.03 0.04 0.06
EAS 0.00 0.00 -0.01 -0.01 -0.01 0.00 0.01 0.05
NAM 0.00 0.00 0.01 0.01 0.02 0.03 0.04 0.06
EU27 0.00 0.00 0.01 0.01 0.02 0.03 0.04 0.06
AUN 0.00 0.00 0.00 0.01 0.01 0.02 0.04 0.06
ROW 0.00 0.00 0.01 0.01 0.02 0.03 0.04 0.06
RORGA - Gdyn-CET
2005 2007 2009 2010 2011 2013 2015 2020
CHN 0.04 0.11 0.26 0.47 0.41 0.29 0.19 0.01
IDN 0.08 0.12 0.37 0.56 0.53 0.48 0.41 0.21
MYS 0.05 0.18 0.72 1.18 1.03 0.75 0.51 0.05
PHL 0.20 0.18 0.77 0.70 0.65 0.53 0.39 0.05
SGP 0.09 0.22 0.33 0.74 0.66 0.55 0.52 0.56
THA 0.17 0.70 1.00 1.85 1.75 1.54 1.30 0.51
VNM 0.14 0.99 3.20 4.94 4.55 3.51 2.34 -0.16
XSE 0.00 -0.03 -0.17 -0.66 -0.85 -0.91 -0.31 0.72
JPN 0.00 0.00 -0.01 -0.01 0.00 0.01 0.02 0.04
EAS -0.01 -0.02 -0.05 -0.09 -0.08 -0.06 -0.04 0.02
NAM 0.00 0.00 0.00 -0.01 0.00 0.01 0.01 0.04
EU27 0.00 0.00 0.00 0.00 0.01 0.01 0.02 0.04
AUN 0.00 -0.01 -0.01 -0.02 -0.02 0.00 0.02 0.05
ROW 0.00 0.00 0.00 -0.01 0.00 0.01 0.01 0.04
Source: Authors simulations
52
Table 2.6: Cumulative % Change in Total Investment
GDyn-CE
2005 2007 2009 2010 2011 2013 2015 2020
CHN 0.12 0.38 1.07 1.99 2.28 2.68 2.86 2.71
IDN 0.18 0.30 0.82 1.25 1.47 1.89 2.28 2.98
MYS 0.12 0.44 1.84 3.20 3.59 4.12 4.38 4.30
PHL 0.59 0.68 2.35 2.50 2.73 3.08 3.28 3.31
SGP 0.28 0.78 1.54 3.46 3.86 4.36 4.59 4.56
THA 0.46 1.74 3.23 5.70 6.68 8.35 9.58 10.64
VNM 0.37 2.61 9.74 16.08 18.21 20.69 21.22 18.10
XSE -0.01 -0.04 -0.08 -0.03 -0.01 0.05 0.11 0.24
JPN -0.03 -0.10 -0.22 -0.37 -0.38 -0.37 -0.34 -0.27
EAS -0.03 -0.09 -0.26 -0.46 -0.53 -0.63 -0.68 -0.70
NAM -0.01 -0.04 -0.10 -0.17 -0.19 -0.22 -0.24 -0.25
EU27 -0.02 -0.05 -0.12 -0.21 -0.24 -0.26 -0.26 -0.24
AUN -0.02 -0.07 -0.17 -0.29 -0.31 -0.33 -0.32 -0.27
ROW -0.02 -0.05 -0.11 -0.20 -0.22 -0.26 -0.28 -0.29
GDyn-CET
2005 2007 2009 2010 2011 2013 2015 2020
CHN 0.11 0.34 0.95 1.76 1.98 2.23 2.25 1.88
IDN 0.18 0.30 0.84 1.30 1.55 2.03 2.47 3.29
MYS 0.13 0.46 1.99 3.47 3.91 4.55 4.91 4.98
PHL 0.56 0.67 2.09 2.34 2.61 3.09 3.44 3.76
SGP 0.22 0.57 1.03 1.96 2.19 2.66 3.21 4.85
THA 0.45 1.68 3.08 5.30 6.27 8.15 9.90 12.37
VNM 0.39 2.76 10.66 17.96 20.94 24.91 26.40 23.96
XSE -0.01 -0.08 -0.40 -1.39 -2.11 -3.34 -3.26 -0.87
JPN -0.03 -0.09 -0.20 -0.31 -0.29 -0.27 -0.26 -0.24
EAS -0.03 -0.08 -0.22 -0.37 -0.43 -0.52 -0.60 -0.72
NAM -0.01 -0.04 -0.09 -0.14 -0.15 -0.16 -0.19 -0.24
EU27 -0.02 -0.05 -0.11 -0.16 -0.16 -0.17 -0.19 -0.23
AUN -0.03 -0.07 -0.16 -0.25 -0.26 -0.26 -0.26 -0.22
ROW -0.01 -0.04 -0.10 -0.15 -0.16 -0.17 -0.19 -0.23
Source: Authors simulations
53
Table 2.7: Cumulative Welfare Changes, 2001-2020 ($mil)
Allocative Terms of Investm. Net foreign Total
eciency trade -savings income
CHN 2081.4 -388.6 12.7 1452.9 3158.4
IDN 690.2 856.7 281.4 -1701.0 127.3
MYS 515.9 1610.5 -138.2 1575.0 3563.2
PHL 745.1 94 47.6 -862.4 24.3
SGP 224.7 1356.1 115.6 -752.0 944.4
THA 2525.1 1345.6 93.4 -3642.8 321.3
VNM 942.4 -356.5 -147.4 -1651.4 -1212.9
XSE -54.7 -109.2 -44.4 -114.4 -322.7
JPN -1219.8 -804.3 57.1 1189.5 -777.5
EAS -638.5 -1349.7 -103 1222.5 -868.7
NAM -1350.9 -844.4 -99.1 8234.3 5939.9
EU27 -1508.1 -486.7 113.2 8629.5 6747.9
AUN -128.5 -57.2 0 285.9 100.2
ROW -2011.8 -884.9 -72.7 3237.5 268.1
Source: Authors simulations
Results are reported for GDyn-CE
Table 2.8: Cumulative Changes in Equity Income, 2001-2020 ($mil)
Domestic Income Income Total
rms receipts payments
CHN 7023.5 -5493.6 -77.0 1452.9
IDN 963.6 -5.0 -2659.6 -1701.0
MYS 1549.6 52.8 -27.4 1575.0
PHL 171.9 -41.6 -992.7 -862.4
SGP 742.0 -282.3 -1211.7 -752.0
THA 1864.0 -590.1 -4916.7 -3642.8
VNM -134.4 -6.0 -1511.0 -1651.4
XSE -21.0 -2.1 -91.3 -114.4
JPN -1458.8 2612.6 35.7 1189.5
EAS -680.9 485.8 1417.6 1222.5
NAM 2197.2 777.4 5259.7 8234.3
EU27 4523.0 -1342.2 5448.7 8629.5
AUN 31.3 106.0 148.6 285.9
ROW 332.1 579.5 2325.9 3237.5
Source: Authors simulations
Results are reported for GDyn-CE
5
4
Table 2.9: Cumulative Changes in Bilateral Equity Income, 2001-2020 ($mil)
CHN IDN MYS PHL SGP THA VNM XSE JPN EAS NAM EU27 AUN ROW
CHN 7023.5 2365.9 0.1 9.1 82.5 496.2 1509.0 -88.9 -34.5 -598.1 -1030.5 -7808.5 -13.7 -382.2
IDN -5.0 963.6 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
MYS 39.8 0.0 1549.6 0.0 437.7 0.0 0.0 0.0 -0.2 -65.8 -68.2 -233.7 -3.5 -53.3
PHL -0.5 0.0 0.0 171.9 0.0 0.0 0.0 0.0 -0.6 -1.1 -25.9 -12.9 -0.1 -0.5
SGP 2.5 0.0 0.1 0.0 742.0 0.8 0.0 0.0 -0.9 -58.5 -7.4 -178.7 -6.2 -34.0
THA -2.5 0.0 0.0 0.0 -1.2 1864.0 0.0 0.0 -1.9 -7.9 -173.9 -378.2 -1.0 -23.5
VNM -6.0 0.0 0.0 0.0 0.0 0.0 -134.4 0.0 0.0 0.0 0.0 0.0 0.0 0.0
XSE 0.0 0.0 0.0 0.0 0.0 0.0 0.0 -21.0 0.0 0.0 -0.3 -1.7 0.0 -0.1
JPN 31.0 28.9 14.7 64.5 171.8 2129.8 0.7 133.7 -1458.8 -155.7 -941.1 1345.1 -37.8 -173.0
EAS 0.1 0.0 0.0 0.0 23.1 2.3 0.0 0.2 0.4 -680.9 -1.9 464.5 -0.8 -2.1
NAM 0.4 0.6 0.4 6.2 19.1 44.6 0.3 2.9 0.4 -2.0 2197.2 702.6 -0.6 2.5
EU27 17.0 263.9 12.0 912.0 474.0 2228.7 0.8 42.5 1.3 -527.6 -3021.6 4523.0 -84.8 -1660.4
AUN 0.1 0.1 0.0 0.5 0.8 2.5 0.2 0.3 0.0 -0.1 6.8 94.1 31.3 0.7
ROW 0.1 0.2 0.1 0.4 3.9 11.8 0.0 0.6 0.3 -0.8 4.3 558.7 -0.1 332.1
Source: Authors simulations
Results are reported for GDyn-CE
55
CHAPTER 3. KNOWLEDGE CAPITAL: A FACTOR OF PRODUCTION
3.1 Introduction
Classical economic theory pioneered by Adam Smiths The Wealth of Nations in
1776 describes land/natural resources, labor and capital as the factors of production
that dene a nations wealth. Indeed, in an agriculture intensive economy, land is the
key resource, while in an industrial economy capital and labor are the main means
of production. More recently, new growth theory developed in the 1980s increasingly
focused attention on the rising knowledge intensity of economic activities and coined
the concept - the knowledge-economy. Findings of a recent study by the World
Bank (2006), that estimates the composition of the wealth of nations for 2000, are
striking: intangible capital
1
is by far the most important form of wealth and represents
78% of total wealth of the world; 80% of the total wealth of high income countries
and 59% of the wealth of low income countries (Table 3.1).
New growth theory emphasizes that investment in knowledge and specialization
in knowledge-intensive activities are the determining factors of long run sustainable
economic growth. As pointed out by Romer we now know that the classical suggestion
1
Intangible capital in this study is measured as a residual: the dierence between total estimated
wealth and the sum of natural and produced resources
56
that we can grow rich by accumulating more and more pieces of physical capital like
fork lifts is simply wrong.
Table 3.1: Composition of the Wealth Nations ($ per capita in 2000)
Natural
Capital
Produced
Capital
Intangible
Capital
LIC 1,925 1,174 4,434
MIC 3,496 5,347 18,773
HIC 9,531 76,193 353,339
World 4,011 16,850 74,998
Natural
Capital %
Produced
Capital %
Intangible
Capital %
LIC 25% 16% 59%
MIC 13% 19% 68%
HIC 3% 17% 80%
World 4% 18% 78%
Source: World Bank (2006)
Meanwhile, there is overwhelming evidence that points to the shift from resource-
based to knowledge-based economies. In OECD countries, the share of high-technology
production and exports has more than doubled over the last decade, it is estimated
that more than 50% of the GDP of major OECD economies are knowledge based
(OECD, 1996). Figure 3.1 illustrates the increasing importance of intangible invest-
ment as a share of total gross capital formation for selected OECD countries. From
a policy point of view it is thus important to provide incentives for the creation,
diusion and use of knowledge to sustain long run growth.
The concept of knowledge capital was initially used in business economics to refer
to know-how, experience, information and skills of the employees of an organization.
57
2
4
6
8
10
AUS
1980 1990 2000
AUT CAN
1980 1990 2000
DEU
FIN FRA GBR
2
4
6
8
10
ITA
2
4
6
8
10
1980 1990 2000
KOR NLD
1980 1990 2000
NZL USA
Figure 3.1.: Investment in Intangibles as
% of Gross Capital Formation: 1980-2007
Source: OECD STAN database
Knowledge capital has become a part of the trade and endogenous growth literature
with seminal articles from Romer (1986), Grossman and Helpman (1990), Adams
(1990) and on the multinational rms theory from Markusen (2004). Empirical stud-
ies of knowledge capital are scarce, mainly due to data limitations. These studies focus
on single country analysis or a limited set of developed countries (usually OECD).
Most of these studies proxy knowledge capital using R&D expenditures (Ekholm,
Forslid, and Markusen, 2007; Romer, 1990), patent counts, data on actual innova-
tions, while others such as Santis and Anderton (2004) proxy knowledge capital with
58
Tobins Q using a stock market index.
2
Among all proxies, using R&D expenditure
is the most common choice. Although R&D could be considered as an appropriate
measure of knowledge capital, it could lead to double counting as R&D expenditure
is embedded in both capital equipment and labor expenditure. As a result, there is
likely to be a downward bias in the estimate of knowledge capital proxied by R&D
expenditure.
Previous literature hypothesizes that knowledge capital is an additional input into
production in addition to labor and capital or rather a part of technology. Griliches
(1986) estimates a Cobb-Douglas production function with knowledge capital proxied
by research and development expenditures for 1,000 US manufacturing rms. He nds
cross-sectional coecients on knowledge capital that are positive and statistically
signicant. On the other hand, Cummins (2004) starts from the assumption that
intangible capital is not a distinct input but rather the glue that creates value from
the rest of the factors.
The question arises: is knowledge capital an input in production and if yes, how
much explanatory power does it have? How does production vary with cross-country
and sectoral endowment dierences of knowledge capital? We use a rm level dataset
that directly quanties knowledge capital as an input to build empirical and testable
research questions with respect to the importance of knowledge capital in the pro-
duction process.
2
Tobins Q reects the dierence between the market value of a rm and the value of its total assets,
which in this context is a proxy of the unmeasured contribution of intangible/knowledge capital.
59
For carrying out the econometric analysis, we specify a three input translog pro-
duction function. Knowledge capital is quantied based on Compustat
3
rm level
data on intangible assets and it is measured by the value of copyrights, patents,
licenses, trademarks and trade names, blueprints or building designs.
The objectives of this chapter are therefore two-fold. First, we provide statistical
evidence that knowledge capital is an input in production and we analyze substitution
possibilities between knowledge capital and the other factors of production. Second,
this work lays the foundation for quantifying knowledge capital in computable general
equilibrium framework.
The following sections provide an overview of the relevant literature, description
of the data used, the econometric estimation and a detailed analysis of the results.
3.2 Literature Review
Knowledge capital as a factor distinct from the traditional ones of labour, physical
capital, land and natural resources has materialised over the years in mainstream
economic theory.
Initially, knowledge capital was identied as a part of the endogenous growth liter-
ature with the seminal articles of Solow (1956, 1957) as a part of an aggregate growth
model with exogenous technical change. Subsequently, Romer (1990, 1986) identied
knowledge as a separate input in production with increasing marginal productivity.
3
Compustat is a database of nancial, statistical and market information on publicly traded com-
panies published by Standard & Poors.
60
Arrow (1999) identied incorporate technological knowledge as an input of produc-
tion and emphasized its unique economic characteristics such as: knowledge is costly
to develop but after it can be used repeatedly at no additional cost and thus it is a
xed cost and a source of increasing returns.
Later, knowledge capital became a part of theoretical trade literature with Gross-
man and Helpman (1990, 1991) that examine the link between trade regimes and
knowledge spillovers. The multinational rms theory as pioneered by Carr, Markusen,
and Maskus (2001) and Markusen (2004) describes knowledge based assets as the main
reason rms undertake foreign direct investment.
Despite theoretical advance, empirical analysis concerning knowledge capital is
scarce to non-existent. Most economic models tend to ignore knowledge capital as
a factor or include it in the residual. There is nonetheless a considerable body of
empirical literature that concerns more comprehensive concepts such as technologi-
cal change, innovation, spillovers or research and development. Data limitations in
quantifying an intangible resource such as knowledge has forced applied researchers
to approximate knowledge capital with R&D expenditures. For instance, studies
such as Coe and Helpman (1995), Bayoumi, Coe, and Helpman (1999), Lejour and
Nahuis (2005) examine the linkages between technological change, openness and R&D
expenditures.
As emphasised by Freeman (1994) it is often unsatisfactory to use R&D expen-
diture statistics as a surrogate for all those activities at the level of the rm which
61
are directed towards knowledge accumulation, technical change and innovation. We
have measures of capital-intensity, energy-intensity, but not of knowledge intensity.
A recent study (World Bank, 2006) estimates the composition of the wealth of
nations in 2000 and points out that most of a countrys wealth, on the world level
78%, is captured by intangible capital (Table 3.1). Intangible capital is an estimate
of all assets not incorporated in produced and natural capital (land and natural
resources). This residual thus measures skills and know-how of the labor force, social
capital, governance and the rule of law. It has also been shown that the importance
of produced and intangible assets rises relative to natural assets as a country gets
richer.
Given the wide coverage of the concept of intangible or knowledge capital, it is
dicult to nd a comprehensive denition of it. Zambon (2003) denes intangible
assets as non-physical sources of expected future benets; Lev (2001) as a claim to
future benets that does not have a physical or nancial embodiment. One common
element of all denitions revolves around the non-physical nature of intangibles and
depending on the study they cover intangible assets that are easy to identify and
measure or those that are less visible.
According to Zambon (2003) intangible assets can be classied into three main
categories: intellectual property, separately identiable intangible assets and non-
separately identiable intangible assets. The rst category concerns intangible assets
with legal or contractual property rights such as trademarks, licences, patents, soft-
ware. Information systems, network, administrative structures and technical knowl-
62
edge are intangible assets that can be included in the second category. Finally, the
third category includes assets that would fall under the denition of goodwill, i.e. the
value of the advantage or reputation a business has acquired over its tangible assets
such as management expertise, geographic position.
This papers contribution is that it is the rst that uses the value of intellectual
property assets (copyrights, patents, licenses, trademarks and trade names, blueprints
or building designs) to proxy knowledge capital instead of R&D expenditures.
3.3 Description of the Data
The dataset used in the econometric estimation has been built combining data
from Standard&Poors Compustat North America (for US and Canadian rms) and
Compustat Global Fundamentals (for other 98 countries). The resulting dataset
describes 9,147 publicly traded individual rms for 2007.
Output (Y) is measured as net sales or value added; physical capital (C) is listed
as Compustat item Property, plant and equipment-Total (net); labor (L) is Sta
expense-Total; and knowledge capital (K) is approximated by Compustat variable
Intangible assets-Total. Intangibles assets in Compustat are a measure of the value
of patents, copyrights, trademarks and trade names, blueprints or building designs,
licenses, operating rights, covenants not to compete, design costs, subscription lists,
distribution rights and agreements, easements, engineering drawings, excess of cost
or premium on acquisition and franchise costs.
63
To measure the importance of knowledge capital in production compared to the
traditional capital and labor inputs, we start by considering the knowledge intensity
of economic activities as shown in Figure 3.2. The horizontal dotted line represents
the overall average share of knowledge capital in total costs across sectors and re-
gions. We nd that the share of knowledge as dened above represents 24% of total
costs, compared to 45% physical capital and 31% labor. Among sectors, on average
knowledge capital plays the most important role in services, while across regions on
average knowledge capital represents a more signicant share of value added in high
income countries (HIC) compared to middle income (MIC) and low income countries
(LIC). In addition, the length of the interquartile box for high income countries also
points toward the signicance of knowledge capital in production.
Further, Figure 3.3 presents bivariate scatter plots of the log of output versus the
log of knowledge capital represented for each region-sector pair. In each case we nd a
signicant and positive relationship, suggesting that output increases with knowledge
capital. Overall, the magnitude of the response of output to changes in knowledge
capital is bigger in high income countries and the services sector.
We proceed with the description of the theoretical framework framework used in
the econometric estimation.
64
0.2
0.4
0.6
0.8
HIC LIC MIC
AGR
HIC LIC MIC
MAN
HIC LIC MIC
SER
Figure 3.2.: Cost Share of Knowledge Capital
Source: Authors calculations based on Compustat data
log(K)
l
o
g
(
Y
)
5
0
5
10
15 10 5 0 5 10
AGR
HIC
MAN
HIC
15 10 5 0 5 10
SER
HIC
AGR
LIC
MAN
LIC
5
0
5
10
SER
LIC
5
0
5
10
AGR
MIC
15 10 5 0 5 10
MAN
MIC
SER
MIC
Figure 3.3.: Relationship Between log(Y) and log(K)
by Region-Sector Pairs
Source: Authors calculations based on Compustat data
65
3.4 The Translog Production Function
Consider the production function of the form:
Y = f(X; i, r) (3.1)
where Y is output and X is a vector of inputs comprised of physical capital (C), labour
(L) and knowledge capital (K). In addition to inputs, the production function may
also vary by the industry and the country in which the rm operates.
Suppose the production function (3.1) is approximated by a translog form:
ln Y =
0
+

i
ln X
i
+ 1/2

ij
ln X
i
ln X
j
, i, j = K, C, L (3.2)
The translog (or transcendental logarithmic) production function (Christensen,
Jorgenson, and Lau, 1973) specied above is an appealing functional form mainly
due to its empirical tractability and because of its properties as a exible functional
form. It has often been used to examine the substitution between factors of production
(Brynjolfsson and Hitt, 1995; Dewan and Min, 1997; Griliches and Ringstad, 1971;
Tzouvelekas, 2000), relative productive eciency (Kim, 1992; Lau and Yotopoulos,
1971) and other methodological issues (Tzouvelekas, 2000).
Given its exible nature, the translog imposes no a priori restrictions on the
structure of production, the value of the elasticities of substitution or returns to
scale. We impose restrictions that yield a production function that respects the
66
assumptions of homogeneity, constant returns to scale and symmetry. This implies
that the following restrictions on the parameters of the translog are imposed:

i
= 1;

ij
= 0;
ij
=
ji
(i = j) (3.3)
One may denote the marginal product of knowledge capital as:
f
K
=
Y
X
K
(
K
+

Kj
ln X
j
), j = K, C, L (3.4)
Assuming that both input and output markets are competitive, the rst order
conditions of prot maximization are:
f
i
= p
i
, i = K, C, L (3.5)
where p
i
is the price of the i
th
input relative to the price of output. Substituting (3.5)
into (3.4) results in the equality:
Y
X
i
X
i
Y
=
ln Y
ln X
i
=
p
i
X
i
Y
, i = K, C, L (3.6)
Thus, dierentiating the translog production function (3.2) with respect to input
i results in the cost share equation:
S
i
=
i
+

ij
ln X
j
, i = K, C, L (3.7)
67
As shown by Kim (1992), the translog production function could not be eciently
estimated without considering the cost share equations that contain important infor-
mation about the structure of production, i.e. the rst order conditions that approx-
imate inverse input demand equations. As a result, the translog parameters should
be determined by jointly estimating (3.2) and (3.7).
This framework allows us to analyze input substitution possibilities where the
elasticities vary with the values of relative input shares. We calculate Allen partial
elasticities of subsitution (Allen, 1971) directly from the production function:

ij
=

i
f
i
X
i
X
i
X
j

|F
ij
|

|F|
(3.8)
where

F is the determinant of the bordered Hessian matrix and

F
ij
is the cofactor in
F
ij
of the bordered Hessian (Berndt and Christensen, 1973; Humphrey and Moroney,
1975).
The three-input translog specied above further yields elasticities dened as:

ij
=

|G
ij
|

|G|
(3.9)
where

|G| is the determinant of
G =
_

_
0 S
K
S
C
S
L
S
K

KK
+S
2
K
S
K

KC
+S
K
S
C

KL
+S
K
S
L
S
C

KC
+S
K
S
C

CC
+S
2
C
S
C

CL
+S
C
S
L
S
L

KL
+S
K
S
L

CL
+S
C
S
L

LL
+S
2
L
S
L
_

_
68
Note that while knowledge capital and physical capital as measured here are stock
variables, while labor and output ow variables. Estimating the translog production
function as dened above could lead to a downward bias for the estimate of labor and
conversely, an upward bias in the estimates for knowledge and physical capital. In
order to correct for this bias we revise the production function presented in Equation
3.1:
Y = f(g(C), h(K), L) (3.10)
g(C) = C (3.11)
h(K) = K (3.12)
The form of the production specied in Equation 3.2 and the derived share equa-
tions in Equation 3.7 do not change. As a result, the set of equations consisting of
the production function (equation 3.2) and two of the cost share
4
equations (equation
3.7) were estimated using a SUR (seemingly unrelated regression) system using SAS
package SYSLIN. The results of this are provided in the following section.
3.5 Results
Parameter estimates for the sample as a whole and for selected aggregate sec-
tor/region pairs are reported in Figure 3.4 below.
For the sample as a whole all coecients are statistically signicant at a 99%
level. Knowledge capital has the lowest output elasticity among the three inputs
4
Factor shares sum to unity by construction.
69
into production: a 1% increase in knowledge capital inputs leads to an increase of
0.06% in value added (a relatively inelastic response), while the output elasticities of
physical capital and labor are slightly higher, 0.45 and 0.49, respectively. In addition
we note an interesting pattern with respect to the elasticity of knowledge capital to
output: output elasticity of knowledge is shown to be positively related with the level
of development. For instance, we observe the highest output elasticity of knowledge
capital in the services sector of high income countries (0.12) and the services sector of
middle income countries (0.15), while the lowest is in the services and manufacturing
sectors of low income countries.
Note that if
ij
=0, the translog is reduced to a Cobb-Douglas specication and
thus the elasticity
ij
=1. Further,
ij
< 0 and i = j results in a negative Allen partial
elasticity.
70
All
HIC_AGR
HIC_MAN
HIC_SER
LIC_AGR
LIC_MAN
LIC_SER
MIC_AGR
MIC_MAN
MIC_SER
0.0 0.2 0.4 0.6
C
0.0 0.2 0.4 0.6
K
0.0 0.2 0.4 0.6
L
All
HIC_AGR
HIC_MAN
HIC_SER
LIC_AGR
LIC_MAN
LIC_SER
MIC_AGR
MIC_MAN
MIC_SER
0.04 0.02 0.00 0.02
CC
0.04 0.02 0.00 0.02
KK
0.04 0.02 0.00 0.02
LL
All
HIC_AGR
HIC_MAN
HIC_SER
LIC_AGR
LIC_MAN
LIC_SER
MIC_AGR
MIC_MAN
MIC_SER
0.04 0.02 0.00 0.02
KC
0.04 0.02 0.00 0.02
KL
0.04 0.02 0.00 0.02
LC
Figure 3.4.: Parameter Estimates by Sector-Region Pairs
Source: Authors calculations
The Allen Partial Elasticities of Substitution (APES) have become a widely used
method for expressing the relationship between inputs. Negative APES reect com-
plementarity, while positive sign indicates substitutability between inputs. As a result
of the symmetry restrictions imposed on the production function APES are symmet-
71
rical as well (
ij
=
ji
). In addition, the sign of own price Allen Elasticities should
all be negative indicating a downward sloping demand curve.
In Figure 3.5 we report the estimated Allen partial elasticities of substitution both
for the overall sample and separately for each aggregated region/sector pair of our
aggregation.
For the overall sample, indeed we nd that the own price Allen elasticities for
knowledge capital, physical capital and labor are negative but highest for labor (
LL
=-
1.08), followed by knowledge capital (
KK
=-0.40) and capital (
CC
=-0.17). Own
price AES estimated by region/sector pairs provide interesting insights with respect
to substitution possibilities in dierent sectors and regions. For instance, we nd the
highest
KK
in the manufacturing sector of middle income countries (-8.35) and the
manufacturing sector of low income countries (-9.30). Own price APES of labor
LL
is highest in agriculture in middle income countries.
For the sample as a whole and the level of aggregation used in Figure 3.5 we nd
that all cross-price Allen elasticities are positive, indication of the substitutability
between factors (the only exceptions are manufacturing and agriculture in low in-
come countries where knowledge capital and labor are shown to be complements).
For the overall sample, we nd that the elasticities of substitution between factors
are similar. Thus we nd that knowledge capital and physical capital are the most
substitutable
KC
=1, followed closely by
LC
=1.01 and
KL
=0.98. A further look
at the regional/sectoral disaggregation shows that we nd the highest substitution
between knowledge capital and labor in the manufacturing sector of middle income
72
All
HIC_AGR
HIC_MAN
HIC_SER
LIC_AGR
LIC_MAN
LIC_SER
MIC_AGR
MIC_MAN
MIC_SER
12 10 8 6 4 2 0
sCC
12 10 8 6 4 2 0
sKK
12 10 8 6 4 2 0
sLL
All
HIC_AGR
HIC_MAN
HIC_SER
LIC_AGR
LIC_MAN
LIC_SER
MIC_AGR
MIC_MAN
MIC_SER
0 1 2
sKC
0 1 2
sKL
0 1 2
sLC
Figure 3.5.: Allen Partial Elasticities of Substitution by Sector-Region Pairs
Source: Authors calculations
countries (
KL
=2.55) while the highest substitution between knowledge capital and
physical capital are in the manufacturing sector of low income countries (
KC
=1.19).
3.5.1 R&D Versus Intangibles
Among all proxies, using R&D expenditures is the most common choice for approx-
imating knowledge capital in empirical work. As mentioned above, R&D expenditures
could be considered as an appropriate measure of knowledge in the production pro-
cess, however due to double counting it could lead to a downward bias on the impact
of knowledge capital.
73
As in the dataset described above we have information available on R&D expen-
ditures at the rm level, we proceed by comparing estimates obtained using R&D
expenditure and intangible capital as dened above.
First, we nd that for both proxies estimates are statistically signicant at 95%
level (see Table 3.2). Second, the signs of the coecients are the same in the two cases.
Importantly, note that
K
is signicantly dierent for the two models: increasing
R&D expenditure by 1% leads to an increase of 0.01% in value added, while increasing
intangible capital stocks by 1% results in a 0.06% increase in value added. This
dierence could arise due to the issue of double counting or due to the fact R&D
expenditures are a ow measure, while intangibles are a stock (see more discussion
on ow versus stock proxies in the next subsection).
Table 3.2: Overall Regression Results
Intangibles R&D expediture
Estimate Std.Err. Estimate Std.Err.

0
1.918 0.015 1.800 0.028

K
0.066 0.004 0.010 0.008

C
0.447 0.008 0.578 0.012

L
0.487 0.008 0.412 0.015

KK
0.008 0.001 0.001 0.002

CC
-0.014 0.001 -0.013 0.002

LL
0.001 0.002 0.010 0.002

KL
-0.011 0.001 -0.012 0.002

KC
0.003 0.002 0.011 0.002

LC
0.010 0.001 0.002 0.001
Source: Authors simulations
74
3.5.2 Econometric Issues
The translog production function could not be eciently estimated without con-
sidering the cost share equations that approximate inverse input demand equations
(Kim, 1992). As a result, we estimate a system of three equations consisting of
the production function and two (and not three) share equations. In such a multi-
equation model errors in dierent equations might be correlated. Ecient estimation
is achieved taking into consideration the cross-equation covariance matrix using SUR
techniques Zellner (1962). Estimates obtained suing this method are invariant to the
choice of the omitted share equation.
Due to the lack of availability of information on prices, such as the sector and
region specic rate of return to physical and intangible capital, we estimate a direct
production function, and not a more desirable dual prot or cost function. As pointed
out by Yotopoulos, Lau, and Lin (1976) there can be signicant dierences between
estimates obtained from the production function directly (the primal) and indirect
estimates of obtained from the prot or cost function (the dual). While estimates
of the dual are consistent and asymptotically ecient, the estimates of the primal
production function are inconsistent due to simultaneous equation bias (endogeneity).
As pointed out by Yotopoulos (1967), the problem with the empirical estimation
of production functions arise from the lack of availability on data on capital services.
More specically, output and labor are usually measured as a ow, while capital (and
in this case intangible capital as well) is measured by capital stock. As shown by
Shashua, Melnik, and Goldschmidt (1974), the use of a stock variable instead of ow
75
will result in an upward bias of the contribution of that variable, however the bias
has been shown to be rather small, around 10%.
Finally, a more general problem of econometric studies of cross-section type is the
potential endogeneity of the independent variables: if any of the explanatory variables
is correlated with the error term then the econometric estimation will potentially
produce inconsistent and biased estimates.
3.6 Conclusions
This paper was aimed at quantifying the impacts of knowledge capital on pro-
duction and demand of other factors using an econometric framework. Compared
to other studies that proxy knowledge capital with R&D expenditures, we measure
knowledge capital directly based on rm-level data on intangible assets.
We specify a three input translog production function in which knowledge capital
is measured as the value of copyrights, patents, licenses, trademarks and trade names
etc. For the sample as a whole we nd that a 1% increase in knowledge capital inputs
leads to an increase of 0.06% in value added (a relatively inelastic response). At
a more disaggregated level, we nd that the output elasticity of knowledge capital
increases with the level of development. More specically, the output elasticity of
knowledge capital is higher in developed countries (high income and middle income)
than in developing countries (low income countries). Further, the output elasticity
of knowledge capital is shown to be systematically higher in the services sector com-
pared to manufacturing and agriculture. We thus nd the highest output elasticity
76
of knowledge capital in the services sectors of middle income (0.15) and high income
countries (0.11) - signicantly higher than the sample average. Overall, these nd-
ings suggest that high and middle income countries and the services sectors are better
positioned to take advantage of improvements in knowledge capital.
A key result that emerges from our analysis of the Allen Partial Elasticities of
substitution is that knowledge capital is a net substitute for both physical capital and
labor. All cross-price Allen Partial Elasticities are close to unity. The substitution
possibilities are slightly dierent across regions and sectors. Interestingly, we nd
that in low income countries knowledge capital and labor are complements, while in
middle and high income countries they are substitutes. From a policy point of view
this an important nding and reects the fact that in developed countries investment
in knowledge capital leads to the increase in the knowledge intensity of the economy,
while in developing countries this is not the case.
Finally, this work lays the foundation for quantifying knowledge capital in a more
comprehensive computable general equilibrium framework.
77
CHAPTER 4. CROSS-RETALIATION AT THE WTO: IMPACTS OF A NO
DEAL IN THE US-BRAZIL COTTON DISPUTE
4.1 Introduction
In September 2002, the government of Brazil initiated consultations with the
United States under the dispute settlement procedures of the World Trade Organi-
zation (WTO) claiming that various provisions of the US cotton programme were in
violation of WTO obligations (WTO, 2002). The contested measures included cer-
tain domestic and export subsidies provided to US producers, users and exporters of
upland cotton
1
.
After unsuccessful consultations, in September 2004 a WTO Dispute Settlement
Panel found in favour of Brazil (WTO, 2004). Following a failed appeal in March 2005,
the US was required to implement changes in its policies of the cotton programme.
Later, in December 2007 a compliance panel arrived at the conclusion that the US had
not fully complied with previous WTO recommendations. As a result, at the Dispute
Settlement Body (DSB) meeting in March 2009, Brazil claimed the right to impose
$2.5 billion in retaliatory sanctions against the US in the form of the suspension
1
Upland cotton is dened as raw upland cotton and primary processed forms of such cotton including
upland cotton lint and cottonseed (WTO, 2004).
78
of tari concessions and cross-retaliation in the form of suspension of intellectual
property obligations under the Agreement on Trade Related Aspects of Intellectual
Property Rights (TRIPS).
Finally, in September 2009 the Panel granted Brazil the right to impose sanctions
worth $294.7 million (2006 base-year). In 2008 gures, this was equivalent to $829
million in sanctions against the United States. In April 2009, Brazil published a list
of 102 US products that would be subject to retaliatory taris worth $591 million
and a list of 21 proposed intellectual property sanctions up to $238 million.
The WTO dispute settlement mechanism allows for countermeasures to be im-
posed against a member country that has been proved to be in violation of WTO
rules and obligations. According to the WTO dispute settlement rules, retaliation
should be equivalent to the level of damage and should concern the same sector
whenever practicable.
Cross-retaliation as a concept has not been directly dened in any of the WTOs
dispute settlement articles, but it refers to the situation where the initiating country
suspends concessions or other obligations under a sector or an agreement that are
not the subject of the dispute. Cross-retaliation is an instrument that is authorized
in cases where the complaining country is able to prove that retaliation in the same
sector or agreement where the violation occurred is not practicable or eective.
Intellectual Property Rights (IPR) cross-retaliation entails the right of (devel-
oping) countries to suspend their obligations under TRIPS if conventional methods
prove to be inecient. When compared to traditional market access retaliation, the
79
suspension of IPR has proved to be an eective negotiating instrument for developing
countries to enforce compliance with the decisions of the Dispute Settlement Body
(DSB).
In the specic case of the US-Brazil cotton dispute, Brazil argued that the suspen-
sion of concessions exclusively under trade in goods was not practicable or eective
since higher trade barriers to Brazilian imports of U.S. goods would impose additional
costs on the Brazilian economy. Brazil pointed out that 95% of Brazils imports from
the U.S. comprise of capital goods, intermediate goods and other essentials for the
Brazilian economy. In addition 86% of the imports of consumer goods correspond to
medical supplies, food and automotive products.
The US-Brazil cotton case is not without precedence as cross-retaliation under
TRIPS has been authorized twice by the WTO Dispute Settlement Body. The rst
request for the suspension of intellectual property rights came from Ecuador against
the European Community (EC) claiming that the ECs banana trading regime was in
violation of certain aspects of the General Agreement on Taris and Trade (GATT)
and the General Agreement of Trade in Services (GATS). The arbitrators found in
favour of Ecuador and permitted the suspension of obligations of TRIPS. In this case,
the parties reached a settlement agreement before Ecuador was to start implementing
the retaliation. The second dispute settlement case involving a request for the suspen-
sion of concessions under TRIPS was initiated by Antigua and Barbuda against the
US. Antigua claimed that US restrictions on cross-border gambling services were in
violation of GATS. The WTO arbitrators ruled in favour of Antigua and authorized
80
suspension of TRIPS obligations by Antigua. Up to the present, Antigua has not yet
imposed sanctions nor has a settlement been reached with the US.
With respect to the US-Brazil cotton dispute, on April 6, 2010, the day before
Brazil was to start imposing retaliatory sanctions, a deal with the US was reached.
The deal entailed $147 million a year for setting up an assistance fund for the cotton
industry in Brazil while US negotiators agreed to reevaluate the possibility of imports
of fresh beef from Brazil.
The fact that in none of these disputes IPR cross-retaliation has actually been
implemented proves that the simple threat of IPR retaliation is serious enough to
convince parties to reach an agreement. Apart from the pressure of entertainment
and pharmaceutical industries on the national governments, it is expected that the
economic costs of the suspension IPR concessions may be substantial and widespread
across the economy.
This paper examines those economic costs by exploring the economic impact of a
no deal in the US-Brazil cotton dispute using a global computable general equilibrium
framework, the GTAP model (Hertel, 1997). As awarded by a WTO dispute settle-
ment panel, Brazil would have been entitled to $591 million in retaliatory sanctions
in the goods sectors and $238 million in intellectual property and services sanctions.
While quantifying the impacts of trade retaliation does not pose any challenges,
implementing IPR retaliation requires us to modify the underlying model. The frame-
work we develop is unique in the sense that it provides the possibility for quantifying
81
intellectual property related issues in a framework that is consistent with international
accounting standards
2
and general equilibrium.
4.2 Dispute DS267 - US Subsidies on Upland Cotton
Dispute DS267 initiated in September 2002 by Brazil (a major cotton exporter),
found prohibited and actionable subsidies on upland cotton
3
imposed by US produc-
ers, users and exporters of upland cotton. Brazil claimed that these subsidies were
in violation of certain provisions of the Agreement on Subsidies and Countervailing
Measures (SCM), the Agreement on Agriculture and Article III:4 of GATT 1994.
Cotton subsidies have proved to be a sensitive issue not only in dispute settlements,
but also in the current round of multilateral WTO negotiations
4
. The cotton market
in developed countries is subject to signicant subsidies that have resulted in the
continued decrease in world cotton prices (see Figure 4.1) to the detriment of cotton
producers in the developing world.
In 1999 - the reference year of Brazils complaint to the Dispute Settlement Body, -
assistance to cotton producers was highest in the United States ($3.4 billion) followed
by China ($1.53 billion) and Greece ($0.59 billion). In the same year, the United
States was the third biggest cotton producer with $16.9 billion bales after China
2
System of National Accounts (SNA) 1993.
3
According to the SCM Agreement, subsidies can be categorized as prohibited (e.g. export subsidies
and local content subsidies) and actionable (e.g. production subsidies) that are not prohibited but
subject to dispute settlement or countervailing action.
4
Four West African cotton exporters (Benin, Burkina Faso, Chad and Mali) referred to as the Cotton
Four (C-4) have introduced the Cotton Initiative demanding that the Doha Development Agenda
include cutting cotton subsidies and taris (WTO, 2003).
82
40
50
60
70
80
90
100
1980 1990 2000
World_price
IndexA
Memphis
Figure 4.1.: World Price of Cotton (nominal $cents/lb)
Source: USDA Cotton Outlook. Index A is an av-
erage of the cheapest ve types of cotton; Memphis
quotes are based on middling 1-1/32 inch cotton
0
5
10
15
1970 1980 1990 2000 2010
Exports
0
10
20
30
1970 1980 1990 2000 2010
Production
BRA
CHN
IND
PAK
USA
Figure 4.2.: Major Cotton Producers and Exporters (billion bales)
Source: USDA Cotton and Wool Yearbook 2010
83
Table 4.1: Budgetary Transfers to the US Cotton Sector ($mil)
1992 1999 2000 2001 2002
Coupled payments 866 1,840 820 2,609 947
Direct payments 1,017 616 574 473 617
Countercyclical payments 0 613 612 654 1,309
Crop insurance payments 26 169 161 262 194
Step 2 payments 102 165 260 144 72
TOTAL 2,012 3,404 2,429 4,144 3,140
Source: WTO (2004)
(17.6 billion bales) and India (12.1 billion bales), but the largest exporter (6.75 billion
bales), followed by China and Pakistan (Figure 4.2).
Cotton subsidies in the United States were introduced with the Agricultural Ad-
justment Act in 1933 as a part of the commodity programs
5
. Main categories of
cotton subsidies in the U.S. include:
Price based payments (marketing loan payments) provide support when market
prices fall below loan rates. Dierent forms include loan deciency payments
(LDPs), marketing loan gains (MLGs) and commodity certicates.
Step 2 programme is a special marketing loan provided to exporters and end-
users of upland cotton in case domestic prices exceed world prices.
Decoupled or direct payments (production exibility payments) are annual pay-
ments unrelated to production or market prices aimed at supporting producers
based on historical acreage and yields.
5
Other covered commodities include wheat, feed grains, rice, soybeans and other oilseeds.
84
Crop insurance is annual crop yield or revenue insurance coverage for losses due
to natural disasters or market uctuations.
Countercyclical payments (formerly known as deciency payments) are auto-
matic payments that make up for the dierence between lower market prices
and a target price.
Measures contested by Brazil in DS267 included domestic and export subsidies
to US upland cotton producers during 1999-2002; subsidies mandated to be provided
during 2002-2007; marketing loans; loan deciency payments; commodity certicates;
direct payments; countercyclical payments; i.e. virtually every type of domestic or
export support measure to the US cotton industry. Further, Brazil alleged that
Step 2 payments (described above) functioned as WTO prohibited export subsidies.
Step 2 payments have been declared to the WTO as amber-box
6
domestic support
payments and consequently not subject to any limitations concerning export subsidies.
Brazil also claimed that export credit guarantees
7
(previously not considered as export
subsidies by the US) functioned as export subsidies as well.
Brazil argued that these measures caused serious prejudice to the interests of
Brazil (WTO, 2002) since the use of these measures lead to: 1) a signicant decline
in the price of upland cotton in Brazil and everywhere else during 1999-2002; 2) an
increase in the world market share of the US for upland cotton in 2001 and 3) a
decrease/displacement of Brazilian exports of cotton to the rest of the world. Finally,
6
The amber-box contains domestic support measures considered to distort production and trade
that countries agreed to reduce but not eliminate.
7
Insurance policy that protects an exporter against default by an importer.
85
Brazil argued that the US was not eligible to be exempt from the dispute settlement
process under the peace clause of the Agreement on Agriculture as total subsidies
provided to the cotton industry were in excess of the 1992 benchmark (see Table 4.1).
The dispute settlement panel (WTO, 2004) and the Appellate Body (WTO, 2005)
of the DSB arrived at the conclusion that export credit guarantees and the Step 2
programme qualied as prohibited export subsidies in violation of WTO commitments
and called for the their withdrawal without delay.
As the US did not comply with rulings of the Panel within the given timeline, in
March 2009 Brazil claimed the right to impose $2.5 billion in retaliatory sanctions
against the US: $300 million compensation for the US Step 2 programme, $1.2 billion
for the export credit guarantee programme, and the remaining $1 billion for the
marketing loan and countercyclical payments. In addition Brazil claimed the right to
suspend intellectual property obligations under TRIPS. Finally, in September 2009
the Panel granted Brazil the right to impose trade sanctions worth $294.7 million
(2006 base-year) and the right to engage in IPR cross-retaliation.
In 2008 gures, Brazil would have been entitled to $829 millions in retaliatory
sanctions against the US, composed of:
$591 millions in retaliatory taris in goods sectors and
$238 millions in intellectual property and services sanctions
8
With respect to trade retaliation, Brazil released a list of 102 U.S. products that would
be subject to higher taris. The exact list is presented in Table B.1 in the Appendix.
8
Note that, originally, there was no monetary value given for IPR cross-retaliation.
86
As direct retaliation, cotton and cotton products face the highest tari increase from
6% to 100% for raw cotton, and from 26% to 100% for certain cotton products. Cross-
retaliatory taris cover a wide range of sectors from agricultural products, processed
food to electronics. Taris on agricultural products such as wheat and certain fresh
fruits (cherries, pears and plums) increased from 10% to 30%. Several food sectors
were also aected: taris on ketchup doubles from 18% to 38% and on sugar-free
chewing gum from 16% to 36%.
Concerning IPR retaliation, in February 2010 the Brazilian Government issued
Provisional Measure No. 482 containing details about the implementation of the IPR
retaliation. The document denes the following measures that could be undertaken:
suspension of intellectual property rights, limitation of intellectual property rights,
change of measures for the implementation of standards of protection of intellectual
property rights, change of measures for obtaining and maintaining intellectual prop-
erty rights and temporarily blocking the remittance of royalties or compensation on
the exercise of intellectual property rights.
On the day before Brazil was to start imposing retaliatory sanctions worth $829
millions, a preliminary deal with the US has been reached on April 6, 2010. Finally,
on June 17, 2010 the parties signed a Framework Agreement that requires the US
to set up an assistance fund to help Brazilian farmers worth $147.3 million per year
while the US agreed to establish a limit on trade distorting cotton subsidies.
87
4.3 The Economics of Retaliation
Article 22 of the Dispute Settlement Understanding (WTO, 1995) governs the
Compensation and the Suspension of Concessions of the dispute resolution process
of the WTO and it can be summarized by four main principles:
Parties are given the choice between compensation (undertaken by the respon-
dent in the form of lowering trade barriers) and retaliation (by the complainant
in the form of retaliatory taris or suspension of other WTO obligations). As
pointed out by Anderson (2002), retaliation is usually preferred to compensation
as it asserts more pressure on the respondent to comply with WTO obligations.
The level of retaliatory measures should be equivalent to the harm caused by
the WTO inconsistent measure to the complainant.
The complainant should rst seek to suspend concession in the same sector in
which the violation occurred. If this proves to be not practicable or eective,
retaliatory measures can target other sectors.
Retaliatory measures should be temporary and applied until the respondent
complies with WTO obligations.
In the specic case of DS267, Brazil had initially sought $2.5 billion in retaliatory
sanctions against the US, but was awarded only a small fraction, $294.7 million by
WTO arbitrators.
Figure 4.3 below provides an illustration of the theoretical framework for how
reciprocal compensation is determined by WTO arbitrators in case of a WTO incon-
sistent export subsidy.
88
Suppose Figure 4.3 describes a domestic and international market for cotton (in a
partial equilibrium setting). There are two trading countries, Brazil and the United
States. The supply (S
BRA
and S
USA
) and demand (D
BRA
and D
USA
) curves for the
two countries are shown in panels A and C, respectively. At the initial equilibrium
price P
0
Brazil has excess demand and the US has excess supply. The international
market is described in panel B: at this initial equilibrium Brazils import demand
curve is M
BRA
and the export supply curve of the US is X
USAo
. Brazil imports
cotton from the US of Q
0
.
Assume that the US introduces Step 2 and export credit guarantees for cotton, -
measures determined by the WTO panel to function as prohibited export subsidies.
As a result of the export subsidy, US cotton producers export more leading to a down-
ward shift in the export supply curve to X
USA
1
. Excess supply in the international
market for cotton causes prices to fall to P
1
. At the same time, domestic cotton
prices in the US increase to P
2
. At the new equilibrium, Brazil imports Q
1
. As a
result of the export subsidy, the market of the US increases and world cotton prices
fall hurting Brazilian cotton producers.
As pointed out above, based on the principle of equivalence, retaliation by Brazil
has to equal the damage caused by the prohibited export subsidy. More specically,
permissible Brazilian retaliation should correspond to the volume of distorted trade
(Q
1
Q
0
) at the original export price P
0
, represented by the shaded area in Figure
4.3 (Bown and Ruta, 2008).
89
Now assume that Brazil choses to retaliate by introducing prohibitive taris
against US exports. Equation 4.1 denes the value of permissible retaliation under
the principle of equivalence (Bown and Ruta, 2008):
P
0
[Q
0
Q
1
] = P
0
(
Ret
)[Q
0
Q
Ret
(
Ret
)] (4.1)
or more specically, the value of distorted trade at initial prices (the left hand side of
the equation) has to equal the value of trade lost due to retaliatory taris
Ret
(the
right hand side of the equation).
While Equation 4.1 ensures equivalence between the harm caused to the reporting
country and the permissible retaliation in terms of value of trade, it does not by
any means ensure equivalence in terms of welfare eects (Anderson, 2002). More
specically, the net loss of export earnings is not equivalent with net welfare eects
(except by coincidence) given that welfare is a more comprehensive measure that
includes not only terms of trade eects, but allocative eciency, technological change
eects, etc. Traditional trade retaliation has often been referred to as equivalent to
shooting oneself in the foot (especially in the case of developing countries). It is
thus not an eective and credible threat as it leads to a decline in welfare in the
retaliating country (Subramanian and Watal, 2000) and is therefore unlikely to be
implemented.
On the other hand, cross-retaliation under TRIPS in the form of suspension of
intellectual property obligations has proved to be both benecial for the retaliating
90
country and is a credible threat in forcing countries to comply with WTO obligations
as it does not aect negatively the retaliating countrys welfare.
9
1
S
BRA
M
BRA
X
USA
0
D
BRA
P
2
P
2
P
0
P
0
P
1
P
1
Q
BRA
P
BRA
a. Brazil c. United States

b. International
X
USA
1
P
2
P
0
P
1
Q
1
Q
0
S
USA
D
USA
Q
USA
P
USA
Figure 4.3.: Reciprocity Compensation for a WTO Inconsistent Export Subsidy
Source: Bown and Ruta (2008)
92
4.4 Modeling Framework
The framework we use for carrying out the analysis is the comparative static
GTAP model. With respect to trade retaliation, this model is ready for implementing
the policy shocks
9
. However, for implementing IPR retaliation the model needs to be
modied.
As a rst step, we identify the channels of impact of IPR retaliation.
From the consumers point of view, IPR retaliation could lead to desirable con-
sequences: as opposed to trade retaliation where the consumer carries the burden
of the price increase for imported goods, the suspension of obligations under TRIPS
could lead to an increase in consumer welfare by increasing access to pharmaceutical
products, education, entertainment etc. through reduced price.
Finally, IPR retaliation will also have an impact on the remittance of royalties
to right holders. For instance in the case of the US-Brazil dispute, Brazil threat-
ened to suspend the transfer of royalty payments to Pzer and other pharmaceutical
companies.
9
Although the model could be further improved to endogenously match the exact amount of retali-
ation.
93
The following subsections describe the international accounting standards for
quantifying intellectual property and we present the extended GTAP model with
explicit treatment of the royalty services sector.
4.4.1 Quantifying Intellectual Property
The increasing knowledge-intensity of economic activities over the years has led
to increased interest in quantifying intellectual property, intangibles and innovation
and their impact on the economy. In spite of this interest, issues with data avail-
ability, quality and measurement of intellectual property has prevented such analysis
from being carried out. The following subsections give further details on the inter-
national accounting standards for quantifying intellectual property and describe how
intellectual property is present in Input-Output accounting and trade data.
4.4.1.1. International accounting standards
The United Nations System of National Accounts 1993 introduced important method-
ological changes with respect to the measurement of intellectual property in macroe-
conomic accounts. Accordingly, SNA 1993 states that it is necessary to distinguish
between income received from licencing or leasing-type transactions and income from
the purchase or sale of intellectual property assets.
10
We thus dierentiate between
the use of intellectual property related assets (recorded under services-royalties and
10
Previously all intellectual property transactions have been recorded as income ows.
94
license fees) and the purchase or sale of intellectual property related assets (recorded
in the intangible assets category of the capital account).
In line with these recommendations, the IMFs Balance of Payments database
contains two entries with respect to royalty payments:
In the current account under trade in services: inclusion of this item under
services, rather than under income, is in accordance with the SNA treatment of
such items as payments for production of services for intermediate consumption
or receipts from sales of output used as intermediate inputs. Royalties and
license fees in this case refers to receipts (exports) and payments (imports) for
the authorized use of trademarks, copyrights, patents, processes, techniques,
designs, manufacturing rights, franchises, etc.
In the capital account referring to income payments or receipts from the sales
of intangible assets such as trademarks, copyrights etc.
To sum up, the purchase of all the rights of ownership of intellectual property
assets is an income ow, while the purchase of the right to use intellectual property
is recorded as a service transaction.
Note that the treatment of royalties and implicitly that of intellectual property
(knowledge capital) transactions is very dierent from how traditional capital inputs
and the associated foreign investment/foreign income are treated in the System of Na-
tional Accounts. Thus, the contribution capital inputs to the production is treated
as capital service, a component of value added, while royalties are treated as inter-
mediate service input. Further, international capital mobility is not associated with
95
movement across borders, as opposed to royalties that are recorded as international
services transactions. Finally, income from change in ownership are recorded in the
capital account for both.
4.4.1.2. Royalty services in Input-Output accounting
As international accounting standards require payments for the use of intellectual
property or royalties to be treated as payments for a service, we should nd that
Input-Output accounts describe the supply and use of royalties as a sector. Indeed,
at the most disaggregated level (498 industry detail), the United States Input-Output
accounts, separately identies and describes the supply and use of the royalty services
sector
11
. In the North American Industrial Classication System (NAICS) royalty and
licensing income received by industries is described as a primary activity, separated
from the rest of the activities. NAICS 533, Lessors of non-nancial intangible assets,
is the industry that rents intellectual property such as trademarks, patents, brand-
names to the other industries.
We could not nd Input-Output tables of other countries that separately identify
this sector, thus the IO table of the US will serve as a base for the disaggregation of
the GTAP sectoral classication to include a royalty services sector. According to the
GTAP database conventions, we have to dene the supply of the royalty services sector
and separately identify the domestic and imported royalty services usage of royalty
11
I thank Marinos Tsigas for generously providing the US Input-Output table at the most disaggre-
gated level.
96
services by other sectors. Given that we use the US IO table to disaggregate both
the supply/use structure and the output structure of the royalties sector in Brazil, it
is possible that we overestimate the share of royalties in total Other business services
in Brazil.
For disaggregating trade ows we complement the information from the IO tables
with royalty services data from external data sources such as the BEA International
Transactions Accounts, EUROSTAT and the National Bank of Brazil.
Table 4.2 reports the top 15 shares in the composition of the supply and use
of the royalty services sector of the US as found at the most disaggregated level.
We nd that sectors that consume most royalty services are oil and gas extraction
(25.3%), pharmaceutical and medicine manufacturing (4.7%) and food and drinking
services (4.2%). These sectors correspond to GTAP sectors Oil (OIL) and Gas (GAS),
Chemical, rubber and plastic products (CRP) and Trade (TRD), respectively. On the
other hand, in the supply of the royalties sector non-comparable imports
12
(45.2%),
monetary authorities and depository credit intermediation
13
(18%) and management
consulting services (8%) are the most signicant inputs. These sectors correspond to
GTAP sectors Recreational and other services (ROS), Financial services (OFI) and
Other business services (OBS), respectively.
12
Noncomparable imports include expenditures on personal and business travel while abroad by U.S.
residents, royalties and license fees paid to foreign residents etc. This sector has no direct domestic
counterpart.
13
Establishments primarily engaged in accepting deposits and in lending funds from these deposits
and performing central bank operations.
9
7
Table 4.2: The Composition of the Royalties Sector in the US Input-Output Table
Use Supply
Sector %* Sector %*
Oil and gas extraction 25.3% Noncomparable imports 45.2%
Pharmaceutical and medicine manufacturing 4.7% Monetary authorities and depository credit intermediation 18.0%
Food services and drinking 4.2% Management consulting serv. 8.0%
Retail trade 3.7% Couriers and messengers 5.9%
Automobiles 3.3% Nondepository credit intermediation and related activities 4.8%
Hotels 2.4% Business support services 3.4%
Wholesale trade 2.2% Management of companies and enterprises 1.9%
Telephone apparatus manufact. 2.0% Civic, social, professional and similar organizations 1.9%
Broadcast and wireless communications equipment 2.0% Services to buildings and dwellings 1.5%
Soft drink and ice manufact. 1.6% Paperboard container manufacturing 1.2%
Petroleum reneries 1.4% Paper and paperboard mills 1.1%
Home health care services 1.4% Coated and uncoated paper bag manufacturing 0.9%
Cigarette manufacturing 1.3% Other computer related serv. 0.9%
Semiconductor machinery manufact. 1.3% Employment services 0.8%
Motor vehicle parts manufact. 1.3% Securities, commodity contracts, investments 0.7%
Source: BEA U.S. Input-Output Data
*% of total use and supply, respectively.
98
4.4.2 Royalty Services in the GTAP Model
Based on our ndings described above, we decide to model royalty services as
a separate industry, similar to any other production sector in the standard GTAP
model. There is however one dierence: while all other sectors are subject to constant
returns, the royalty services sector is described by monopolistic competition.
Why monopolistic competition? Royalty services refer to goods (intellectual
property) that have the properties of club goods: they are excludable but nonri-
valrous in consumption. Assuming that royalty services are imperfect substitutes in
consumption, they have the character of monopolistic competition: there will be an
ineciency loss due to pricing above marginal cost, but producers are able to make
positive prots by appropriating part of the surplus (Spence and Owen, 1977).
Note that we do not describe the market for the purchase and sale of intellec-
tual property (capital account), but only the purchase and sale of use of intellectual
property (services trade). Implicitly we assume that IPR retaliation concerns royalty
payments for the current use of intellectual property assets.
We build on Swaminathan and Hertel (1996) that describes a version of the GTAP
model with monopolistic competition. Nevertheless, our specication diers in that
Armington preferences are kept and complemented with an additional Krugman love
of variety nest where the consumer dierentiates between horizontally dierentiated
varieties described by CES preferences. Consequently, we assume that varieties by
origin are not equally substitutable, or more specically the consumer dierentiates
between domestic and imported varieties.
99
All equations describing the monopolistic competition extension are listed in the
Appendix as implemented in the model in linearized percent change form.
On the supply side, following Dixit and Stiglitz (1977) and Krugman (1979) we
specify a market in which the royalty services sector is dened by monopolistic com-
petition consists of N identical rms, each producing a dierent variety using the
same technology and cost structure (symmetry assumption). The prot maximising
rms set price above marginal cost according to the Lerner formula that describes
markup behaviour:
P
irs
= MC
ir
/(1 +PE
irs
) (4.2)
where PE
irs
is the perceived elasticity of demand of rm i in region r in market s;
MC
ir
is marginal cost of variety i in region r. Following the Chamberlinian large
group hypothesis we assume away strategic interactions and nd that markup is
constant as the elasticity faced by the rm reduces to the Dixit-Stiglitz elasticity of
substitution between varieties
irs
.

irs
=
P
irs
MC
ir
=

irs

irs
1
(4.3)
With free entry and exit (long run equilibrium), the endogenous number of rms is
determined by the zero prot condition. Due to the symmetry assumption, industry
output is dened as the product between the number of rms and the output per rm
100
in the industry. Output per rm adjusts in order to equalise the rms xed costs
with the excess sales revenue over variable costs.
Y
i,r
= n
i,r
y
i,r
(4.4)
The framework described above is inherently static and short run in nature, that is
the suspension of IPR rights do not impact R&D incentives and there is no formation
of new knowledge. This limitation could be overcome by introducing dynamic features
to describe the formation of new knowledge, however we consider that a comparative
static framework is suitable for the carrying out the analysis at hand. The underlying
assumption would imply that the suspension of IPR rights does not impact on R&D
incentives in the two countries, a reasonable assumption given that royalty payments
are waived only temporarily.
4.5 US-Brazil Trade Relations
Before proceeding with the analysis of the outcome of our policy experiments, we
briey look at US-Brazil trade relations.
Brazil does not have a preferential trade agreement with the United States, unlike
the rest of Latin America
14
and thus trade preferences between the two countries are
governed by the Generalized System of Preferences (GSP).
14
Chile and Peru have bilateral trade agreements with the US, while FTAs with Panama and
Columbia have already been signed but not yet implemented.
101
In 2009, Brazil was the 10
th
largest export market for the US with 2.5% of total
exports, while the United States was the 2
nd
most important destination for Brazil-
ian exports after China, with 10.2% of total exports. A rst look at the historical
evolution of trade ows in Figure 4.4 shows that bilateral trade ows follow the
macroeconomic growth trends of the two countries: there is a fall in trade due to the
introduction of Brazils currency devaluation in 2001 and later growth in exports due
to Brazils export promotion policy. The US is a net exporter of services to Brazil,
but since 2001 it has been the net importer of goods from Brazil.
US exports to Brazil are capital good intensive, the top three export categories
being machinery (gas turbines, computers and engine parts), electrical machinery
(integrated circuits, radio and television) and industrial chemicals. On the other
hand, Brazils main exports to the US are aircrafts and machinery.
Last, we focus our attention on royalty trade ows. Table 4.3 shows that since
1960 the US has been a net exporter of royalty services to the rest of the world with
exports growing at a higher rate than imports, while Brazil has been a net importer
of royalty services.
In terms of bilateral trade, royalty services constitutes an increasingly important
part of total services trade between the US and Brazil. Exports of royalty services
from the US to Brazil accounted for 14.8% of the total services exports in 2009,
while imports of royalty services of the US from Brazil represent a much smaller
1.3% of total imports of services of the US from Brazil. In 2007 (the base year of
102
our simulations), US royalty exports to Brazil amounted to $1,381 million, while US
imports were $7 million (BEA International Transactions Accounts).
4.6 Simulation Design
The model described above is calibrated using version 8 pre-release 1 of the GTAP
database which has a base year of 2007. The 112 regions of the full database have
been aggregated into 10 composite ones while the 57 sectors have been originally
aggregated into 21 sectors described in Table 4.4. Finally, we disaggregated other
business services (OBS) into royalty services (ROY) and business services (OBO)
using SplitCom, a set of programs developed by Horridge (2005) to facilitate the
addition of a sector to the GTAP database.
The implemented policy shocks correspond to the two main two areas of retali-
ation granted to Brazil by the DSB: rst, countermeasures in trade in goods (trade
retaliation) and second, countermeasures on intellectual property rights (IPR retali-
ation).
With respect to trade retaliation, we refer the list of 102 U.S. products subject
to higher duties published by the Brazilian government (see Table B.1) to dene the
level of retaliatory taris. We use TASTE (Horridge and Laborde, 2008) to aggregate
product level (HS8) retaliatory taris into sectors that correspond to the level of
aggregation dened above
15
. Results of the aggregation are presented in Table 4.5
15
Note that the sectoral aggregation has been developed such as to keep the maximum level of
information about the new tari structure as allowed by the GTAP database
103
Table 4.3: The Evolution of Trade Flows (US$mil)
1960 2004 2009
Exports Imports Exports Imports Exports Imports
United States (total)
Goods 19,650 14,758 819,870 1,485,501 1,068,499 1,575,443
Services 6,290 7,674 338,707 282,420 502,298 370,262
Royalty services 837 74 56,715 23,266 89,791 25,230
Brazil (total)
Goods 1,269 1,293 96,475 62,835 152,995 127,705
Services 186 490 12,583 17,261 27,728 46,973
Royalty services 1 22 112 905 433 2,512
US-Brazil bilateral trade
Goods .. .. 13,849 21,249 26,092 20,221
Services .. .. 4,892 1,852 12,729 4,881
Royalty services .. .. 679 40 1,892 67
Source: BEA U.S. International Transactions Accounts Data and Balance of Payments of Brazil
15
20
25
30
2000 2002 2004 2006 2008
Goods
0.0
0.5
1.0
1.5
2000 2002 2004 2006 2008
Royalties
2
4
6
8
10
12
2000 2002 2004 2006 2008
Services
Exports
Imports
Figure 4.4.: US-Brazil Bilateral Trade Flows ($bil)
Source: BEA U.S. International Transactions Accounts Data
104
Table 4.4: Sectoral and Regional Aggregation
Sectors Description
AGR Agriculture
V F Vegetables, fruit and nuts
PFB Plant-based bers
MIN Mining
FOOD Food products
VOL Vegetable, oils and fats
MIL Dairy products
OFD Other agricultural products
B T Beverages and tobacco products
TEX Textiles
WAP Wearing apparel
MANUF Manufactures
CRP Chemical, rubber, plastic products
FMP Metal products
MVH Motor vehicles and parts
OTN Transport equipment nec
ELE Electronic equipment
OME Machinery and equipment nec
OMF Manufactures nec
ROY Royalty services
OBO Other business services
SERV Services
Regions Description
USA United States
BRA Brazil
SAM Rest of South America
EU27 EU27 countries
CHN China
IND India
ASIA Rest of Asia
AFR Africa
AUN Austarlia and New Zealand
ROW Rest of the World
below. As expected, we nd highest retaliatory taris in the plant based bers sector
(cotton) with an increase from 9.17% to 99.93%
16
. Further, US exports of other
agricultural goods to Brazil would be subject to a 334.69% hike of import duties,
16
Aggregated taris have been calculated using bilateral trade weights.
105
Table 4.5: Initial and Retaliatory Taris on
US Exports Applied by Brazil (% AVE)
Initial Retaliatory % Dierence
AGR 1.96 8.52 334.69
V F 11.15 24.08 115.96
PFB 9.17 99.93 989.75
MIN 0.36 0.42 16.67
FOOD 12.8 13.01 1.64
VOL 11.5 16.28 41.57
MIL 22.52 33.34 48.05
OFD 13.42 20.27 51.04
B T 21.78 21.83 0.23
TEX 14.93 19.84 32.89
WAP 20.11 31.09 54.60
MANUF 7.28 7.39 1.51
CRP 9.68 10.29 6.30
FMP 17.55 18.38 4.73
MVH 15.57 16.15 3.73
OTN 3.54 3.59 1.41
ELE 9.76 10.19 4.41
OME 12.5 12.93 3.44
OMF 18.58 20.5 10.33
Source: TASTE (Horridge and Laborde, 2008)
followed by vegetable oils with 115.96% increase in taris. In addition, Brazil would
impose signicant retaliatory duties in manufacturing sectors such as wearing apparel
(54.6% increase) and other foods (51.04% increase). Overall, we nd that 21 of the
42 GTAP goods sectors are impacted by increased taris.
Implementing intellectual property retaliation on the other hand is not straight-
forward. As pointed out previously, the modelling framework used here is short run
in nature: the suspension of IPR obligations do not impact R&D incentives and we
exclude dynamic eects due to the temporary nature of the shock.
106
As a short run eect, Brazilian rms and consumers are entitled to refuse payment
of royalties and license fees to US intellectual property holders. By assumption,
IPR retaliation would entail a decline of royalty services exports from US to Brazil
implemented as a decline in the fob export price of royalties. Note that the amount
of IPR retaliation awarded to Brazil amounted to $231 millions, or 17.23% of $1,381
million total royalties exports from US to Brazil. Consequently, the corresponding
shock is a -17.23% decline in the export price of royalties from US to Brazil.
To implement IPR retaliation, we need to introduce adjustments to the model
closure. As a rst step, we exogenize the fob export price of royalties from the US
to Brazil while any resulting rents accrue to the representative household. As in
McDonald and Walmsley (2008) we use rents similar to export tax equivalents to
be able to track these rent associated with IPR retaliation and to dierentiate them
from tari revenues. In this specic case, rents associated with IPR retaliation are
negative and borne by the US representative household.
Further, we set the elasticity of substitution between domestic and imported roy-
alty services (ESUBD) and the elasticity of substitution between imported royalty
services (ESUBM) equal to zero. As shown in the equations below, setting these
elasticities to zero implies the following changes:
ESUBD
ROY
= ESUBM
ROY
= 0
qgd
ROY,r
= qgm
ROY,r
= qg
ROY,r
qpd
ROY,r
= qpm
ROY,r
= qp
ROY,r
qfd
ROY,i,r
= qfm
ROY,i,r
= qf
ROY,i,r
qxs
ROY,r,s
= qim
ROY,s
107
where qpd
ROY,r
, qpm
ROY,r
and qp
ROY,r
represent private demand for domestic, im-
ported royalties and total private demand in region r, respectively; qgd
ROY,r
, qgm
ROY,r
and qg
ROY,r
represent government demand for domestic, imported royalties and to-
tal government demand in region r, respectively; qfd
ROY,i,r
, qfm
ROY,i,r
and qf
ROY,i,r
represent rms demand for domestic, imported royalties and total rms demand in
region r and sector i, respectively; qxs
ROY,r,s
export sales of royalties from region r
to regions s and qim
ROY,r
aggregate imports of royalties in region r.
The underlying assumption for the Leontief technology implemented above is that
royalties are usually paid on a per unit basis, that is if the demand of goods using
royalties inputs increases then the import quantity of royalties should increase as well.
Finally, the quantity of royalty exports is endogenous and allowed to respond
to the price decline: we assume that given that Brazilian rms already have the
IP, reducing the export price of royalties will increase the supply of goods that use
royalties as an input. Consequently, Brazil pays more royalties to the US although
at a lower price.
4.7 Impacts of a No Deal
On the day before Brazil was to start imposing retaliatory sanctions worth $829
million against the US, the parties reached a preliminary agreement on April 6, 2010
and signed a Memorandum of Understanding two weeks later. Although Brazil ini-
tially claimed that the harm caused by prohibited domestic and export cotton sub-
sidies in the US is equivalent to $2.5 billion, the nal Framework Agreement signed
108
on July 16, 2010 awarded Brazil $147 million a year assistance fund for the Brazilian
cotton industry, only a small fraction (5%) of Brazils initial claim.
This section discusses the impacts of a no-deal between Brazil and the US on trade
ows, producers, consumers and overall welfare.
4.7.1 Impact on Trade Flows
Figure 4.5 depicts changes in percentage and volume between the US and Brazil,
for both trade and IPR retaliation.
It is no surprise that imposing higher import taris on US exports by Brazil leads
to a decrease in trade between the two countries. As argued before, the sectors most
impacted by retaliatory taris are cotton (PFB), agriculture, fruits and vegetables
and the textile industry. Indeed, we nd that as a result of trade retaliation exports
of cotton from US to Brazil almost disappear (-93.3%). Other US exports to Brazil
impacted most signicantly are wearing apparel (-47.2%), raw milk (-45.2%), fruits
and vegetables (-32.9%) and agriculture (-27.1%).
In volume terms, trade retaliation changes the ordering of the most signicantly
impacted sectors. Exports of chemicals (CRP) from US to Brazil decrease by -$170.1
million, followed by machinery (OME) with -$125.6 millions and electronics with -
$43.8 millions. Although, in percentage terms we nd an almost 100% decrease in
US exports of cotton (PFB) to Brazil, this translates to a -$41.1 million decrease.
109
The impact on trade retaliation on Brazilian exports is moderate. Thus we nd a
decrease of manufacturing (MANUF) to the US by -$8.3 million followed by exports
of machinery (OME) with a fall of -$4.5 million.
Interestingly, we note that trade retaliation conform to the list of 102 products
subject to higher taris published by the Brazilian government leads to a decrease
of -$555.05 million in the exports from US to Brazil in the goods sector - an amount
that is very close to that awarded to Brazil by WTO arbitrators of $591 million
17
.
As shown in Figure 4.5, the impact of the IPR retaliation on US-Brazil trade ows
is relatively small. First of all, exports of royalties from US to Brazil increase by $1.79
million: as a result of the lower export price sell more units of the goods that use IP
as an input and thus pay more royalties to the US. Most negatively impacted exports
from Brazil to the US are manufactures that fall by -$14.49 million, of machinery
by -$7.63 million and that transportation equipment by -$5.11 million. On the other
hand, exports from US to Brazil increase mainly in sectors such as machinery and
equipment by $5.43 million, transportation equipment by $3.2 million and chemicals
by $3.16 million.
Figure 4.6 details changes in the volume of bilateral exports between all countries.
Apart from the changes in bilateral exports between US and Brazil already discussed
above, we nd that while Brazil imports less from the US, it imports from more from
all other regions (most signicantly from EU27 by $136.6 million and the rest of South
America by $73.4 million). At the same time, Brazil exports less not only to the US,
17
Dierences would arise also due to that fact that the amount awarded by the WTO refers to 2008,
while we calibrate our model on 2007 data.
110
but to all other regions. The case of the US is exactly the opposite: while it exports
less to Brazil, it exports more and imports less from all other regions.
To sum up, this section does not bring forward any surprises with respect to the
impact of trade retaliation on trade ows. However, it is interesting to see that the
impact of the trade retaliation on trade ows resulting from this CGE framework is
very close to the retaliatory amount awarded by WTO.
1
1
1
PFB
TEX
ELE
WAP
OTN
OME
OMF
FMP
MIL
CRP
FOOD
VOL
MVH
MANUF
ROY
SERV
OBO
OFD
AGR
B_T
V_F
MIN
0.8 0.6 0.4 0.2
BRA>USA
PFB
WAP
MIL
ROY
V_F
AGR
TEX
VOL
OFD
OMF
FMP
CRP
ELE
MVH
OME
FOOD
MIN
MANUF
OTN
B_T
OBO
SERV
80 60 40 20 0
USA>BRA
ipr
trade
(a) % changes
PFB
TEX
ELE
WAP
OTN
OME
OMF
FMP
MIL
CRP
FOOD
VOL
MVH
MANUF
ROY
SERV
OBO
OFD
AGR
B_T
V_F
MIN
0.8 0.6 0.4 0.2
BRA>USA
PFB
WAP
MIL
ROY
V_F
AGR
TEX
VOL
OFD
OMF
FMP
CRP
ELE
MVH
OME
FOOD
MIN
MANUF
OTN
B_T
OBO
SERV
80 60 40 20 0
USA>BRA
ipr
trade
(b) Volume changes ($mil)
Figure 4.5.: Changes in US-Brazil Exports
Source: Authors simulations
Result represent changes for trade and IPR retaliation implemented separately.
1
1
2
Origin
D
e
s
t
i
n
a
t
i
o
n
AFR
ASIA
AUN
BRA
CHN
EU27
IND
ROW
SAM
USA
A
F
R
A
S
I
A
A
U
N
B
R
A
C
H
N
E
U
2
7
I
N
D
R
O
W
S
A
M
U
S
A
600
400
200
0
200
400
600
(a) Trade retaliation
Origin
D
e
s
t
i
n
a
t
i
o
n
AFR
ASIA
AUN
BRA
CHN
EU27
IND
ROW
SAM
USA
A
F
R
A
S
I
A
A
U
N
B
R
A
C
H
N
E
U
2
7
I
N
D
R
O
W
S
A
M
U
S
A
150
100
50
0
50
100
150
(b) IPR retaliation
Figure 4.6.: Volume Changes in Bilateral Exports ($mil)
Source: Authors simulations
113
4.7.2 Impact on Consumers and Producers
Although retaliation is aimed at impacting trade ows, it has an indirect impact
on all agents of the domestic economies of participating countries such as producers,
consumers and government.
Accordingly, Tables 4.6 and 4.7 depict changes in the volume of private consump-
tion and output by sector for the US and Brazil decomposed into the impact of both
trade and IPR retaliation.
Overall, consumers in the US are negatively impacted as private consumption falls
by -$338.3 millions mainly driven by the signicant fall in consumption of services of -
$224.8 millions. As shown in Table 4.6, IPR retaliation hurts US consumers more than
trade retaliation, most importantly with respect to services where trade retaliation
leads to a fall in consumption by -$53.2 million while IPR retaliation results in a fall
of services consumption of -$171 million.
On the other hand, consumers in Brazil benet from retaliatory measures against
the US. More specically, in Brazil private consumption of most goods and services
increases adding up to an overall $148.9 million: consumption of services increases the
most by 85.8 million. If we decompose these changes into changes by origin (domestic
and imported goods), we nd that Brazilian consumers increase their consumption
of domestic goods, while that of imported goods decreases. Further, as depicted in
Table 4.6, the overall positive impact on Brazilian consumers result from the positive
impact of IPR retaliation that overcome the negative impacts of trade retaliation.
More specically, we note that trade retaliation decreases private consumption of most
114
goods and services most signicantly that of other foods (-$4.03 million). In contrast,
IPR retaliation positively impacts private consumption in Brazil most signicantly
that of services ($89.2 million).
The impact of Brazils retaliation plan on output is dierent. Overall, manufac-
turing (MANUF), food and agriculture and transport equipment are among the most
negatively impacted in Brazil while total output decreases by -$174.4 million. On the
other hand, total output in the US increase by $171.3 million.
We note that trade retaliation increases the price of imported intermediates in
Brazil and as a result output decreases. As shown in Table 4.7, trade retaliation
negatively impacts the output of several sectors in Brazil most importantly that of
services ($-38.4 million) and manufactures ($-33.1 million).
Finally, we focus on the impact of IPR retaliation on output in Brazil. We start by
looking at the share of royalties in the cost structure of rms. As shown in Table 4.7
royalties represent a signicant share in the cost of services (60%) and other business
services (10%) and thus we expect these sectors to be the most signicantly impacted
by IPR retaliation. Indeed, we nd that IPR retaliation increases the output of both
services ($150 million) and other business services ($12.71 million). The output of
most other sectors are negatively impacted in Brazil.
4.7.3 Welfare Impacts
It has been pointed out that authorizing trade retaliation as a remedy against a
prohibited trade barrier (export subsidies in this case) seems somewhat of a dilemma
115
Table 4.6: Volume Changes in Private Consumption ($mil)
Trade retaliation IPR retaliation
USA BRA USA BRA
AGR 0.04 -0.46 -1.06 1.39
V F 0.00 -0.13 -0.01 0.16
PFB 0.61 -2.71 -0.05 0.16
MIN -0.01 0.00 -0.01 0.00
FOOD -0.39 -0.73 -3.34 4.80
VOL -0.06 -0.25 -0.13 1.17
MIL -0.17 -0.55 -1.43 2.20
OFD -3.10 -4.03 -5.84 9.33
B T -1.53 -0.37 -2.71 2.40
TEX -1.29 -1.21 -1.67 1.22
WAP -4.72 -1.73 -4.58 3.14
MANUF -8.66 -0.40 -10.00 6.04
CRP -6.06 -3.48 -7.05 7.63
FMP -0.48 -0.13 -0.55 0.68
MVH -8.68 -1.71 -8.93 8.71
OTN -0.81 -0.06 -1.12 0.52
ELE -3.78 -1.19 -3.18 4.29
OME -4.45 -0.87 -4.87 2.54
OMF -4.83 -0.68 -4.28 2.86
ROY -0.06 0.08 -0.05 5.12
OBO -1.03 -0.86 -3.20 20.28
SERV -53.21 -3.38 -171.61 89.23
Total -102.68 -24.85 -235.66 173.83
Source: Authors simulations
in the context of an organization (WTO) whose overall objective is trade liberalization
(Bown and Pauwelyn, 2010). Moreover, equivalence between the damage and the
retaliation as awarded by the WTO does not guarantee equivalence in terms of welfare
eects (Anderson, 2002).
116
Table 4.7: Volume Changes in Output ($mil)
Trade retaliation IPR retaliation Share of ROY
USA BRA USA BRA in total costs
AGR -15.25 0.12 6.16 -29.25 0.03
V F -1.17 2.29 0.60 -0.71 0.00
PFB -26.71 21.47 0.32 -0.64 0.00
MIN 26.25 -14.53 4.53 -14.32 0.03
FOOD 10.75 -19.61 1.89 -21.74 0.01
VOL -0.66 -2.25 1.14 -6.32 0.00
MIL -3.27 2.64 -1.13 2.06 0.00
OFD -21.37 10.15 -1.02 5.23 0.05
B T 0.69 -1.33 -2.03 2.37 0.01
TEX -27.79 14.75 7.50 -7.17 0.01
WAP 2.00 0.19 1.75 1.58 0.00
MANUF 79.17 -33.18 48.29 -95.11 0.05
CRP -99.69 55.43 56.32 -50.19 0.03
FMP 12.34 3.49 14.88 -18.39 0.01
MVH 27.35 -12.13 17.06 -15.58 0.01
OTN 41.61 -11.34 26.20 -29.13 0.01
ELE 32.54 2.19 41.63 -7.56 0.01
OME 24.59 22.74 77.28 -56.72 0.01
OMF 2.33 4.64 5.13 0.23 0.02
ROY -0.58 -0.72 1.77 2.67 0.01
OBO 10.95 -5.56 5.93 12.71 0.10
SERV -23.37 -38.44 -193.54 150.61 0.60
Total 50.72 0.98 120.65 -175.39
Source: Authors simulations
This subsection is aimed to explore the overall welfare impacts of Brazils retali-
ation plan. In addition we are able to isolate the eects of trade retaliation and with
those of IPR retaliation.
Table 4.8 presents the welfare eects in terms of changes in equivalent variation
decomposed into the impact of trade retaliation, IPR retaliation and overall impact
of Brazils retaliation plan.
117
Overall welfare impacts of Brazils retaliation plan for the world as a whole are
negative (-$66.18 million). We nd that the only loser is the US (-$431.1 million),
whereas Brazil gains $245.7 million in terms of welfare. The rest of the regions welfare
gain adds up to $119.2 million, with the Rest of the World and ASIA being the main
beneciaries. A closer look at the decomposition of total welfare
18
shows the main
driver of the USs welfare losses are signicant deterioration of its terms of trade
(-$380.3 million), adding to a small loss of allocative eciency (-$9.9 million) and
negative capital goods eect (-$39 million). For Brazil on the other hand there are
signicant contributions to the increase in national welfare arising from improvement
in terms of trade ($300.4 million), but there is an allocative eciency loss (-$32.3
million).
Is trade retaliation equivalent with shooting oneself in the foot from the point
of view the retaliating country? Results show that indeed, trade retaliation results
in a welfare loss of -$30.5 million for Brazil. This loss is mainly determined by a
signicant allocative eciency loss counterweighted by a small gain of terms of trade.
In the meantime, trade retaliation results in welfare losses in the US as well (-$125.8
million) resulting from deterioration of terms of trade. All other regions benet from
trade retaliation against the US, with EU27 and the Rest of the Wold being the main
beneciaries.
We nally turn to the impacts of IPR retaliation. First, note that the rents used
to exogenize the export price and quantity of US royalty exports to Brazil directly
18
For detailed description of welfare decomposition in GTAP see Hu and Hertel (2001).
118
impact the welfare of the representative households in the US and Brazil, respectively.
More specically, as the US representative household bears the impact of negative
rents of the IPR retaliation of $-287.4 million equivalent with 0.002% of total income.
Compared to trade retaliation that hurt both the complainant and the respondent,
we nd that IPR retaliation benets Brazil (welfare gain of $276.2 million) but hurts
the US (welfare loss of -$305.2 million). There are signicant improvements in terms
of trade in Brazil mainly due to the fall in the price of royalties imported from the US.
On the other hand, terms of trade in the US deteriorate by $288.5 million governed
by the fall in the export price of royalties to Brazil.
To sum up, if Brazil had not been allowed to retaliate in the form of suspension
of intellectual property rights, the impact of trade retaliation alone would have been
negative, a case of shooting oneself in the foot to shoot at the other persons foot.
Table 4.8: Equivalent variation ($mil)
Trade retaliation IPR retaliation Total
USA -125.80 -305.28 -431.08
BRA -30.52 276.21 245.70
SAM 11.86 -1.41 10.45
EU27 21.97 -3.26 18.71
CHN 12.01 3.76 15.77
IND 3.97 1.17 5.14
ASIA 20.13 4.45 24.58
AFR 5.71 0.38 6.09
AUN 3.15 1.75 4.90
ROW 26.64 6.92 33.56
Total -50.88 -15.31 -66.18
Source: Authors simulations
119
4.8 Conclusion
The Framework Agreement that went into eect June 21, 2010 secured a deal
between the US and Brazil in the nine year long upland cotton dispute, a deal that
would avert the imposition of countermeasures against the US worth $829 million.
This paper explored the impacts of a no deal between the US and Brazil. As
awarded by a WTO dispute settlement panel, Brazil would have been entitled to
$591 million in retaliatory sanctions in goods sectors and $238 million in intellectual
property and services sanctions.
While trade retaliation does not pose any challenges with respect to quantifying its
impacts in an applied general equilibrium framework, implementing IPR retaliation
required us to modify the underlying model.
The framework we develop is unique in the sense that it provides the possibility for
quantifying intellectual property related issues in a framework that is consistent with
international accounting standards and computable general equilibrium modelling.
The overall impact of Brazils retaliation plan has a negative impact on world
welfare. However, we nd that the only loser is the US (-$431.08 million), whereas
Brazil gains $245.7 million in terms of welfare. The welfare eects of the retaliation
plan are close but not equal to the $829 million awarded as retaliatory amount by
the WTO to Brazil (the gain of Brazil and the absolute value of the loss of the US
amounts to $676.7 million or 81% of the amount awarded by the WTO). Finally, had
Brazil not been allowed to retaliate in the form of suspension of intellectual property
120
rights, the impact of trade retaliation alone would have been negative for both Brazil
and the US, a case of shooting oneself in the foot to shoot at the other persons foot.
121
CHAPTER 5. SUMMARY
The goal of this dissertation was to shed light to on certain aspects of the role of
investment and knowledge capital/intellectual property in applied trade policy.
Chapter 2 examined investment eects of the preferential reduction of barriers
to trade. More specically, we focused on investment creation and diversion eects
within the framework of the free trade agreement between China and ASEAN coun-
tries in a dynamic computable general equilibrium setting. Discriminatory liberal-
ization lowers the price of capital goods and shifts production to countries signatory
of the free trade agreement. The rental price of capital increases as industries ex-
pand. Investment in these countries increases as a response to higher rates of return
and as a result investment creation and diversion eects arise. While there exists
a number of studies that quantify the economic impact of ACFTA, most of these
studies are limited to capturing comparative static eects of trade liberalization. We
nd clear evidence of investment diversion from the regions not signatory of ACFTA,
however overall investment creation impacts dominate investment diversion eects
and thus result in a welfare improvement for the world as a whole. From a policy
point of view, this chapter highlights the necessity for the coordination of trade and
investment policy measures.
122
Chapters 3 and 4 are aimed to lay the foundations for quantifying knowledge cap-
ital and intellectual property in applied empirical analysis. Despite the overwhelming
evidence that points to the shift from resource-based to knowledge-based economies,
empirical studies of knowledge capital are scarce mainly due to data limitations.
In Chapter 3 knowledge capital is assumed to be a factor production measured
by the value of copyrights, patents, licenses, trademarks and trade names, blueprints
or building designs. We specify a three input translog production function with la-
bor, physical capital and knowledge capital as factors. Results of the econometric
estimation show that a 1% increase in knowledge capital inputs leads to an increase
of 0.06% in value added (a relatively inelastic response). In addition, a more disag-
gregated analysis shows that level of development is positively related with higher
output elasticity of knowledge.
Chapter 4 examined the role of intellectual property in the context of the dispute
settlement process at the WTO. A signicant contribution of this chapter lies in the
method used for quantifying trade related intellectual property. In line with inter-
national accounting standards, we model royalty services as a separate intermediate
industry (subject to increasing returns). We explored the economy wide impacts of
a no deal in the US-Brazil upland cotton dispute. As determined by a WTO Panel,
Brazil would have been entitled to $829 millions in retaliatory sanctions against the
US, composed of $591 millions in retaliatory taris and intellectual property sanctions
up to $238 millions. To implement trade retaliation, we refer to the list of 102 U.S.
products that would be subject to higher taris released by the Brazilian government.
123
As direct retaliation, cotton and cotton products face the highest tari increase from
6% to 100% for raw cotton, and from 26% to 100% for certain cotton products. Cross-
retaliatory taris cover a wide range of sectors from agricultural products, processed
food to electronics. As a result of trade retaliation, we nd that exports of cotton
from US to Brazil almost disappear, while other sectors such as wearing apparel, raw
milk, fruits and vegetables are impacted signicantly. IPR retaliation is assumed to
directly impact royalty services trade. Traditional trade retaliation has often been
referred to as being equivalent with shooting oneself in the foot (especially in the
case of developing countries) as it is not an eective and credible threat and it leads
to a decline in welfare in the retaliating country. Indeed, we nd that has Brazil not
been allowed to retaliate in the form of suspension of intellectual property rights, the
impact of trade retaliation alone would have been negative for both Brazil and the
US.
Although Chapters 3 and 4 tackle apparently separate issues, there is a common
underlying feature: the role of knowledge capital in applied empirical analysis. On
the one hand, Chapter 3 provides statistical evidence that knowledge capital is a
factor of production, in addition to the traditional labor and physical capital. On the
other hand, in Chapter 4 we only consider payments for the use of knowledge capital
(royalties) modelled as a separate intermediate input into production. Future work
could potentially combine these two aspects that would allow us to tackle dynamic
features such as long-run analysis and knowledge capital formation.
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124
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APPENDICES
130
Appendix A: Derivation of the Cross-Entropy Minimization
min CE =

s
sh
rs
log
sh
rs
sh 0
rs
In this specic case we can dene:
sh
rs
=
W
rs

r
WH
r
sh 0
rs
=
W 0
rs

r
WH 0
r
where W 0
rs
and W
rs
are the bilateral cross-ownership matrices in period t and t +1,
respectively and WH
r
and WH 0
r
are total wealth of household r in period t and
t + 1, respectively. r represents the owner, while s the location of the equity.
Substituting the shares from above:
CE =

s
_

_
W
rs

r
WH
r
log
_
_
_
W
rs

r
WH 0
r
W 0
rs

r
WH
r
_
_
_
_

_
Multiply by

r
WH
r
and expand the above expression:
CE

r
WH
r
=

s
_
W
rs
log
W
rs
W 0
rs
_

s
_

_
W
rs
log

r
WH
r

r
WH 0
r
_

_
CE

r
WH
r
=

s
_
W 0
rs
log
W
rs
W 0
rs
_

r
WH
r
log

r
WH
r

r
WH 0
r
_

_
131
Since

r
WH
r
and

r
WH 0
r
are given, rewrite the above equation:
FHHLD = CE +

r
WH
r
log

r
WH
r

r
WH 0
r
FHHLD

r
WH
r
=

s
_
W
rs
log
W
rs
W 0
rs
_
Thus the cross-entropy minimization could be summed up with:
min F = FHHLD

r
WH
r
=

s
_
W
rs
log
W
rs
W 0
rs
_
s.t.

s
W
rs
= WH
r

r
W
rs
= WF
s
The Lagrangean could be written as the following:
L[W
rs
,
r
,
s
] =

s
_
W
rs
log
W
rs
W 0
rs
_
+
r
_
WH
r

s
W
rs
_
+
s
_
WF
s

r
W
rs
_
The rst order conditions are the following:
L
W
rs
= log
W
rs
W 0
rs

r

s
= 0
L

r
= WH
r

s
W
rs
= 0
L

s
= WF
s

r
W
rs
= 0
132
Solving the F.O.Cs we get:

r
+
s
= log
W
rs
W 0
rs

s
W
rs
= WH
r

r
W
rs
= WF
s
In percentage change form the solution to the above minimization would be the
following:
w
rs
=
r
+
s

s
W
rs
w
rs
= WH
r
wh
r

r
W
rs
w
rs
= WF
s
wf
s
133
Appendix B: List of Products
Table B.1: List of US Products Subject to Increased Taris
Nr. HS8 Code GTAP HS8 Code Description Current Retaliatory
1 1001.90.90 WHT Wheat and meslin 10% 30%
2 0802.21.00 V F Fresh or dried hazelnuts 6% 26%
3 0802.31.00 V F Fresh or dried walnuts 10% 30%
4 0802.32.00 V F Fresh or dried walnuts 10% 30%
5 0806.20.00 V F Dried grapes 10% 30%
6 0808.20.10 V F Fresh pears 10% 30%
7 0809.20.00 V F Fresh cherries 10% 30%
8 0809.40.00 V F Fresh plums 10% 30%
9 5201.00.20 PFB Cotton, not carded 6% 100%
10 5201.00.90 PFB Other types of cotton 6% 100%
11 9102.11.10 OME Wrist-watches 20% 40%
12 0504.00.13 OAP Guts of swine 8% 28%
13 0402.10.10 MIL Milk and cream 28% 48%
14 0404.10.00 MIL Whey and modied whey 28% 48%
15 1502.00.11 CMT Fats of bovine 6% 26%
16 1507.90.90 VOL Other soya-bean 10% 30%
17 1514.11.00 VOL Low erucic acid 10% 30%
18 1514.19.10 VOL Low erucic acid 10% 30%
19 4011.10.00 CRP New pneumatic tyers 16% 32%
20 4011.20.90 CRP Other new pneumatic tyers 16% 32%
21 0303.51.00 OFD Frozen Herrings 10% 30%
22 2005.20.00 OFD Potatoes, prepared 14% 34%
23 2009.90.00 OFD Mixtures of juices 14% 34%
24 2103.20.10 OFD Tomato ketchup 18% 38%
25 2103.90.91 OFD Preparations for 18% 38%
26 2106.10.00 OFD Protein concentrates 14% 34%
27 2106.90.30 OFD Food supplements 16% 36%
28 2106.90.50 OFD Sugar-free chewing gum 16% 36%
29 2106.90.90 OFD Other food preparations 16% 36%
30 2303.20.00 OFD Beet-pulp 6% 26%
31 7113.19.00 OFD Articles of jewellery 18% 36%
32 9021.10.20 OFD Splints 4% 14%
33 9021.39.80 OFD Other articial parts of body 14% 28%
34 2202.90.00 B T Other non-alcoholic beverages 20% 40%
35 5203.00.00 TEX Cotton, carded or combed 8% 100%
36 5208.21.00 TEX Plain woven fabrics 26% 100%
37 5209.32.00 TEX Woven fabrics of cotton 26% 100%
134
Nr. HS8 Code GTAP HS8 Code Description Current Retaliatory
38 5703.20.00 TEX Carpets 35% 60%
39 5903.90.00 TEX Textile fabrics 26% 48%
40 6303.92.00 TEX Curtains, incl. drapes 35% 60%
41 6307.90.10 TEX Other made-up textiles 35% 60%
42 6307.90.90 TEX Other made-up textiles 35% 60%
43 6116.10.00 WAP Gloves 35% 60%
44 6203.42.00 WAP Mens or boys trousers 35% 100%
45 6204.62.00 WAP Womens or girls trousers 35% 100%
46 4908.90.00 PPP Other transfers decalcomanias 16% 32%
47 2905.11.00 CRP Methanol 12% 22%
48 2929.10.21 CRP Isomer mixtures 14% 28%
49 3003.90.55 CRP Medicaments 14% 28%
50 3004.20.19 CRP Medicaments 8% 14%
51 3004.20.79 CRP Other medicaments 8% 14%
52 3004.39.39 CRP Medicaments 8% 14%
53 3004.40.90 CRP Other medicaments 8% 14%
54 3004.90.49 CRP Other medicaments 8% 14%
55 3005.10.90 CRP Other adhesive dressings 0% 12%
56 3006.10.90 CRP Other sterile surgical catgut 12% 22%
57 3303.00.20 CRP Toilet waters 18% 36%
58 3304.10.00 CRP Lip make-up 18% 36%
59 3304.99.10 CRP Beauty creams 18% 36%
60 3304.99.90 CRP Other beauty preparations 18% 36%
61 3305.10.00 CRP Shampoos 18% 36%
62 3305.90.00 CRP Other preparations 18% 36%
63 3306.10.00 CRP Dentifrices 18% 36%
64 3306.90.00 CRP Other preparations 18% 36%
65 3307.10.00 CRP Pre-shave, shaving 18% 36%
66 3307.20.90 CRP Other personal deodorants 18% 36%
67 3307.90.00 CRP Other depilatories 18% 36%
68 3401.19.00 CRP Other soap 18% 36%
69 3402.90.39 CRP Other surface-active prep. 18% 36%
70 3923.30.00 CRP Carboys, bottles 18% 36%
71 8212.10.20 FMP Non-electric razors 18% 36%
72 8212.20.10 FMP Safety razor blades 18% 36%
73 8703.21.00 MVH Motor cars 35% 50%
74 8703.23.10 MVH Motor cars 35% 50%
75 8703.24.10 MVH Motor cars 35% 50%
76 8703.24.90 MVH Motor cars 35% 50%
77 8703.33.10 MVH Motor cars 35% 50%
78 8711.50.00 OTN Motorcycles 20% 40%
79 8903.92.00 OTN Motorboats 20% 40%
135
Nr. HS8 Code GTAP HS8 Code Description Current Retaliatory
80 8903.99.00 OTN Other vessels 20% 40%
81 8471.90.12 ELE Bar-code readers 12% 22%
82 8517.12.31 ELE Portable telephones 16% 32%
83 8518.10.90 ELE Other microphones 20% 40%
84 8518.21.00 ELE Single loudspeakers 20% 40%
85 8518.22.00 ELE Multiple loudspers 20% 40%
86 8518.30.00 ELE Headphones and earphones 20% 40%
87 8518.50.00 ELE Electric sound ampliers 20% 40%
88 8521.90.90 ELE Other video recording 20% 40%
89 8525.80.19 ELE Other television cameras 20% 40%
90 8525.80.29 ELE Other digital cameras 20% 40%
91 8527.21.90 ELE Other radio-broadcast receiver 20% 40%
92 8528.49.29 ELE Other colour monitors 20% 40%
93 8418.40.00 OME Freezers, upright 20% 40%
94 8433.11.00 OME Mowers for lawns 18% 36%
95 8506.80.90 OME Other primary cells, batteries 16% 32%
96 8516.60.00 OME Other ovens 20% 40%
97 9004.10.00 OME Sunglasses 20% 40%
98 9008.30.00 OME Other image projectors 18% 36%
99 9018.32.19 OME Other tubular needles 16% 32%
100 9018.39.10 OME Other needles 16% 32%
101 9403.70.00 OMF Furniture of plastic 18% 36%
102 9603.21.00 OMF Tooth brushes 18% 36%
136
Appendix C: Monopolistic Competition Extension in GTAP
Private Consumption
qpdv
ir
= qpd
ir
+n
ir
+
i
(ppd
ir
ppdv
ir
)
qpmv
ir
= qpm
ir
+n
ir
+
i
(ppm
ir
ppmv
ir
)
ppdv
ir
= ppd
ir
[1/(
i
1)] n
ir
ppmv
ir
= ppm
ir
[1/(
i
1)] n
ir
Government consumption
qgdv
ir
= qgd
ir
+n
ir
+
i
(pgd
ir
pgdv
ir
)
qgmv
ir
= qgm
ir
+n
ir
+
i
(pgm
ir
pgmv
ir
)
pgdv
ir
= pgd
ir
[1/(
i
1)] n
ir
pgmv
ir
= pgm
ir
[1/(
i
1)] n
ir
Production
qfdv
ijr
= qfd
ijr
+n
ir

i
(pfdv
ijr
pfd
ijr
)
qfmv
ijr
= qfm
ijr
+n
ir

i
(pfmv
ijr
pfm
ijr
)
pfdv
ijr
= pfd
ijr
[1/(
i
1)] n
ir
pfmv
ijr
= pfm
ijr
[1/(
i
1)] n
ir
qvaf
ir
= n
ir
+ao
ir
qva
ir
= V AV
ir
/V A
ir
qvav
ir
+V AF
ir
/V A
ir
qvaf
ir
qvav
ir
= qo
ir
ps
ir
= avc
ir
+mkupslack
ir
qo
ir
= qof
ir
+n
ir
V C
ir
avc
ir
=

i
V FA
ijr
pf
ijr
+V AV
ir
pva
ir
V OA
ir
scatc
ir
=

i
V FA
ijr
pf
ijr
+V A
ir
pva
ir
VITA
137
VITA
Csilla Lakatos was born on January 2, 1982 in Cehu Silvaniei, Romania. She
holds a BA in Economics from West University of Timisoara (Romania) and an
MSc in Business Economics and Management in from the Mediterranean Agronomic
Institute of Chania (Greece). During her MSc studies, Csilla worked as a junior
researcher for the European Commissions 6th Framework Programme TradeAG:
Agricultural Trade Agreements consortium. She began PhD studies in Agricultural
Economics at Purdue University in the fall of 2006 and nished in the spring of
2011. During her PhD studies, she worked a Research Assistant at the Centre for
Global Trade Analysis where she will continue working as a Post Doctoral Research
Associate.