Journal of International Economics 6 (1976) 385-388. @I North-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
prevaiIed under 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 self-
sufficient 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
olrl the 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 estab-
lishment of the DFZ, factor mcvements between the DZ and the DFZ wiil pro-
duce 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 prc3vided factors are allowed to
consume in the place where they earn their incomes.
Under the standard assumptions of identical technology everywhere, incom-
plete 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,;:sumed for 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 LeL and 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’$. The vertical axis measures the output oi’ the
exportable good and the importable is measured along the horizontal axis, If
prior to the introduction of a DFZ free trade were to preva& production will be
at the intersecljoa of the LL ;nd KK schedules, at point Q, , while consumption
will be at the intersection of the price line p*p* and the income expansion line
OC, at point Cs. The lines L,L1 and K& represent the factor constraints for
the DZ afkr .SLI and KK, units of labor and capiml (measured in terms of either
good) have Scan moved into the DFZ. Mow production in !;he DZ is at point Q,
and it exactly matches the desired consumption of both goods by the remaining
factors of pn~duction at the world terms of trade. Thus, if exactly those amounts
‘The analysis Ime dosely follows tbt of Mu&U (1957).
CA. Rodriguez, Economics of the duty free zone 387
of labor and capital are removed from the DZ, there will be no need for inter-
national trade at all and the international terms of trade can prevail despite the
existence of a tariff.
Taking Q, as the origin, and QILz and QrK2 as the axes rt is easy to see that
the factor constraints for production in the DFZ are giveu by the lines K&i
and L,L$ 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 endoqJvment of 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,
1
/
4
100%
