Countries around the world currently are actively engaged in negotiating bilateral and regional free-trade agreements (FTA). FTAs normally contain provisions that require a phased reduction or elimination of tariffs by each side and either elimination or expansion of import quotas. FTAs also address a range of other trade-related issues, such as investment flows, access for service providers, and protection of intellectual property rights. The United States already has FTAs with fourteen countries: Canada and Mexico (NAFTA), Israel, Jordan, Morocco, Singapore, Chile, Bahrain, and certain Central American nations (CAFTA). FTAs with Columbia, Panama, and South Korea have been negotiated but await congressional approval, and several more are in the process of being negotiated.
What effect does an FTA have on a global supply chain? For the sake of brevity, consider a reduction in tariffs under an FTA between the United States and another country such as Thailand. The United States and Thailand have had intermittent talks on establishing a U.S.-Thailand FTA. The United States has an average tariff rate of 2.7% while Thailand’s is 10%. Eliminating import duties in the United States on products from Thailand implies that the assembled price of the product imported into the U.S. market avoids an increase in cost that would have been collected by U.S. Customs at the port of entry. Depending on the number of competing products in the domestic market, such tariff costs usually are passed on to the consumer or absorbed by the producer. Eliminating the tariff, therefore, either reduces costs to the U.S. consumer or increases profitability of the import supply chain. It also decreases U.S. government revenues and increases the incentive to produce in Thailand. This may divert production from the U.S. market, even though certain parts of the supply chain still located in the United States may become more profitable and employ more workers (e.g., research and development, branding, advertising, and management).
Eliminating import duties in Thailand have a comparable effect on U.S. exports there. The cost of U.S. products in Thailand would be reduced for the Thai consumer, and U.S. exports would be expected to increase. The impact of the mutual tariff reductions on the U.S. balance of trade with Thailand depends on how responsive imports in each country are to tariff reductions (demand elasticities) and the size of the trade flows before the FTA is implemented.
In addition to the bilateral trade effects, FTAs also may affect trade with other countries through the diversion of product flows. The increased trade or production within the FTA countries may either be a net addition to economic activity in the countries involved (because of the larger bilateral market) or a diversion of economic activity away from other countries and into the countries in question. In most cases, countries that negotiate FTAs with the United States also participate in other bilateral and regional FTAs. For example, Thailand also has an FTA-type agreement with China. The combination of the two FTAs would provide a two-fold incentive for the U.S. producer. If the U.S. company has assembly operations in Thailand but obtains parts or components from the United States or from China (with whom it also as an FTA), the U.S. company may ship more parts and components directly from the United States and China to Thailand and bring more finished product to the American and other markets. If the U.S. company provides raw materials for parts or components shipped to Thailand from either the United States or China, U.S. exports would tend to rise but to do so less than if the final product were manufactured directly in the United States and then shipped to Thailand. Either way, the