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CHAPTER4 Assessing the Implications for Lebanon of Free Trade with the European Union Will Martin A key component of the proposed EMA between Lebanon and the EU is liberalization of their bilateraltrade. This liberalizationparallels the proposals for liberalization between the EU and other Mediterranean countries (Hoekman and Djankov 1996b). Completion of all of these agreements would lead to a "hub and spoke" system of FTAs between the EU and its Mediterranean partners, a pattern that is likely to both reduce the gains relative to a free trade area involving all of the Mediterranean countries and to give a larger share of these diminished gains to the EU hub (Wonnacott 1996). The proposed agreement provides for-and the EU explicitly encourages-the negotiation of complementary FTAs around the Mediterraneanrim, a process that could lead to the construction of a free trade area extending from the Baltics to the Mediterranean rim. While unilateral trade liberalization by a small country is unambiguously beneficial in the long run, it is not necessarily the case that discriminatory liberalization of the type proposed will be beneficial for either or both of the partners. Whether such liberalization will be beneficial to a small country like Lebanon depends heavily upon a number of factors such as the protection rates applied by Lebanon and its trading partners, the pattern of trade, and the structure of production and consumption. This chapter will examine the factors that influence whether Lebanon will gain from the proposed preferential trade liberalization, make a preliminary assessment of the potential gains or losses, and consider some policy alter-natives in the implementation of such an agreement. This task is complicated by the special features of Lebanon's reconstruction economy, particularly the massive imbalance between imports and exports currently being financed by financial flows from abroad. Since this imbalance may have I04 CatchingUp with the Competition affected the pattern of trade, we examine evidence on trade patterns and balances from the pre-civil war period to provide a crosscheck on the reliability of the most recent data. The chapter begins with a review of the economic issues involved in assessing a preferential agreement and an examination of the direction and composition of Lebanon's trade flows. This is followed by an a description of the pattern of protection applied by Lebanon, and an assessment of the incentives it creates for distorting industrial output, and the implications of these distortions for adjustment costs following liberalization. The final part of the chapter considers the consequences of different forms of trade liberalization for the Lebanese economy using a simple, illustrative general equilibrium model of the Lebanese economy. The details of the model that is used are reported in the appendix to this chapter. The approach used is quite general and can be used for any small developing economy for which there are only limited data available. Economic Impacts of FTAs This section outlines the framework used to evaluate the proposed FTA between Lebanon and the EU. To do this, the effects of changes in the rates of protection that Lebanon levies on its imports must first be considered. Then, we consider the implications of changes in the protection imposed by Lebanon's trading partners. We follow Armington in assuming that Lebanese consumers distinguish between imported and domestic goods and between imports by country of origin (Armington 1969). For simplicity, and because of Lebanon's small size in world markets, it is assumed to be a price taker in the markets for its imports and exports. This specification considerably simplifies the analysis of the trade diversion and trade creation that are central to the evaluation of discriminatory trade liberalization. A very simple diagrammatic approach is used in this section; however, this approach can be shown to provide a second order approximation to a rigorous estimate derived from the balance of trade function approach (Martin 1996). The market for goods imported by Lebanon from the EU is illustrated in figure 4.1. In this market, the elimination of tariff barriers creates additional trade and contributes positively to welfare. In the diagram, the elimination of the tariff reduces the price within Lebanon of goods from the EU from Pd to Pw- This reduces tariff revenues by pdabpw- However, the gains to consumers are greater than this loss because they are able to increase the quantity of European goods that they purchase. Following the decline in the domestic price, consumers move down the (compensated) demand curve for European goods, DEU, from initial quantity Qo...

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