Journal of International Economics 6 (1976) 385-388. @INorth-Holland Publishing Company A NOTE ON THE ECONCMICS OF THE DUTY FREE ZONE Carlos Alfred0 RODRIGUEZ Cohmbia University, New York, NY 10027, U.S.A. Received November 1975, revised version received March.1976 This note extends some of the results of Hamada (1974) on the economic effects of a duty free zone. It is shown that, in the presence of factor mobility between the daty free zone and the rest of the economy, the tial equilibrium will yield the same trade pattern which would have prevaiIedunder free trade; moreover, all of the trade will be done by the duty free zone. This note attempts to expand on one of the results obtained by Hamada (1974) in a recent contribution to this Journal. There, Hamada proceeds in the context of the standard 2 x 2 x 2 Hecksher-Ohlin trade model for a slmall country (i.e. tied terms of trade) and, among other things, he concludes that after the establishment of a duty free zone (DFZ), assuming perfect factor mobility between the rest of the economy (DZ, for domestic zone) and the DFZ while allowing factors to consume only in the place they earn their incomes: ‘. . . factor movements would let the domestic as well as the duty free zone reach the selfsufficient equilibrium with no trade between them’ (p. 231). It is not clear from this quotation whether the implication is that both regions will eventually become self-sufficient vis-a-vis eaciz other and the rest of the world, in which case the implication would be that after the establishment of the DFZ the economy as a whole wou’? stop trading or that both zones would only be self-sufficient vis-a-vis each other; that is, they would not trade among themselves but could continue trading with the rest of the world independently. Whatever the intended meaning of Hamada’s conclusion it is clear that he does not analyze for this case the full effects of the establishment of the DFZ olrlthe patterns of production and trade in both regions, and to the extent that this note analyzes it, it can be considered as an extension to that section of his paper. The main conclusion which follows from this analysis is that, after the establishment of the DFZ, factor mcvements between the DZ and the DFZ wiil produce an equilibrium where the DZ will stop trading completely with both the DFZ and the rest of the world while the DFZ will do by itself exactly all the trading that the economy as a whole would have done if free trade were to prevail everywhere. Thus, the establishment of a DFZ proves to be a perfect substitute for free trade for the whole country prc3videdfactors are allowed to consume in the place where they earn their incomes. Under the standard assumptions of identical technology everywhere, incomplete specialization and no factor intensity reversals, there is a one-to-one relation between the relative price of goods and the relative factor rewards. If in the new equilibrium the DZ were to be trading with the ‘DFZ, to the extent that there is a tariff in the DZ it would be impossible for the internal relative prices to be the same. Thus relative factor rewards would have to be different, which is impossible given the perfect mobility of fac?ors between both regions. We conclude that the internal relative prices will have to be the same in both regions for equilibrium to prevail, which in turn implies that the DFZ and ihe DZ do not trade among themselves such that the tariff of the DZ is ineffective.’ Wo6ever, the DFZ is free to trade with the rest of the world, which implies that its internal relative price will equal the free trade terms of trade, p*. Thus, in the new equilibrium, the only consistent solution will be when the DZ does not trade at all and the free trade terms of trade prevail everywhere. In consequence, real factor rewards will be the same as under free trade and thus, for the economy as a whole, real income and the pattern of demand will be the same as under free trade. Furthermore, since the overall factor endowment of the economy is the same as under free trade, the same set of relative prices prevails and factor price equalization must also prevail; it follows that the structure of production will be the same as under free trade. Since both production and consumption for the economy as a whole are the same as under free trade, it follows that the economy will do exactly the same amount of trade and attain the same level of welfare as if free trade had prevailed everywhere. Fig. 1 is used to derive the effects of the creation of a DFZ on the structure of prsduction, consumption and trade in both regions. It is a,;:sumedfor simplicity that tastes are ‘identical and homothetic for all owners of factors of production. The line OC represents the ratio in which both goods are delmanded at the world terms of trade, p*. The lines LeLand KU are respectively the labor and capital constraints for the economy at the input-output coefficients determined by *he wage-rental ratio implied by I’$. The vertical axis measures the output oi’ the exportable good and the importable is measured along the horizontal axis, If prior to the introduction of a DFZ free trade were to preva& production will be at the intersecljoa of the LL ;nd KK schedules, at point Q, , while consumption will be at the intersection of the price line p*p* and the income expansion line OC, at point Cs. The lines L,L1 and K& represent the factor constraints for the DZ afkr .SLI and KK, units of labor and capiml (measured in terms of either good) have Scan moved into the DFZ. Mow production in !;heDZ is at point Q, and it exactly matches the desired consumption of both goods by the remaining factors of pn~duction at the world terms of trade. Thus, if exactly those amounts ‘The analysis Ime dosely follows tbt of Mu&U (1957). CA. Rodriguez, Economicsof the duty free zone 387 of labor and capital are removed from the DZ, there will be no need for international trade at all and the international terms of trade can prevail despite the existence of a tariff. Taking Q, as the origin, and QILz and QrK2 as the axes rt is easy to see that the factor constraints for production in the DFZ are giveu by the lines K&i and L,L$ with production occurring at Q, (recalling that Q, is now the origin). Fig. 1. It follows ‘that consumption will be at CO(the amounts consumed being measured against the new origin Q,) and that the segment Q& gives the z~unts traded, by the DFZ with the rest of the world, which, it is easy to see, are exactly the same as those that would have been traded by the econom:y as a whole if free trade were to prevail. To the extent that the DFZ did not have any factor endowments before it was created, it is interesting to find the maximum and minimum transfer OF factors from the DZ which are consistent with equilibrium. Clearly, the rnti- 388 , CA. Ro&@ez, Economics of the d&y free wne mum transfer of facbors into the DFZ amounts to aill the factors which were originally in the DZ, If&& is done, all production and consumption will be made in the DFZ, which would thus become the whole economy. The minimum transfer of factors into the DFZ consistent with equilibrium can be shown to be that necessary for product.ion in the DZ to take place at Q,. For that to be the case, KK, and LL3 units of capital a,nd labor have to be transferred into the DFZ and, taking Q, as the origin, the DFZ is p:roducing exactly at the comer of the specialization point in the exportable good with both factors still fully employed (such ,that p* and the associated wage-rental ratio still prevail). In this situation, trhe output of the exportable good in the DFZ is equal to the distance Q,Q,, and consumption, measured against the new origin Q2$ is at CO while the amounts traded are still described by the segment Q,,C,,. The reader can.verify that any transfer of factors into the DFZ in amounts less than AX3 and LL3, which would still allow for autarky in the DZ, would however be inconsistent with incomplete specialization in the DFZ, and thus factor price equalization between the DFZ and the DZ would not prevail. Whether the DFZ wiil become the whole economy, or- whether only the minimum amount of factors will be transferred into it, will depend crucially on the initial factor endowment of the DFZ and the extent to which there are transport costs for factors. If the initial endoqJvmentof the DFZ was nil (which might have been one of the reasons for the establishment of the DFZ) and there are transport costs for factors, the presumption is that the market will tend to minimize the ftransfer of factors into the DF:Z and thus the final situation will be closer to Q,. References Hamada, IL, 1974, An economic analysis of the duty free zone, Journal of International Economics 4,2:25-241. Mundell, RA., 1957, International trade and factor mobility, American Economic Review 47,321-335,
