Impact of Asean Australia and New Zealand free trade agreement on beef industry in Indonesia
IMPACT OF ASEAN AUSTRALIA AND NEW ZEALAND
FREE TRADE AGREEMENT ON BEEF INDUSTRY
IN INDONESIA
THATO TSEUOA
GRADUATE SCHOOL
BOGOR AGRICULTURAL UNIVERSITY
2011
DECLARATION
I, Thato Tseuoa, hereby declare that the thesis entitled:
IMPACT OF ASEAN AUSTRALIA AND NEW ZEALAND FREE TRADE
AGREEMENT ON BEEF INDUSTRY IN INDONESIA
submitted to fulfil a requirement for the award of Master of Science in
Agricultural Economics from Bogor Agricultural University is my own piece of
work produced through the guidance of my academic advisors and that to the best
of my knowledge it has not been submitted for the award of any degree in any
other academic institutions. This thesis does not contain any pieces of work of
other persons, except those that are duly acknowledged and referenced in the text.
Bogor, July 2010
THATO TSEUOA
NRP H353098231
ABSTRACT
THATO TSEUOA. Impact of ASEAN Australia and New Zealand Free Trade
Agreement on Beef Industry in Indonesia (YUSMAN SYAUKAT as Chairman
and DEDI BUDIMAN HAKIM as Member of Advisory Committee).
Participation of Indonesia in ASEAN, Australia and New Zealand Free
Trade Agreement (AANZFTA) may have negative effects on beef industry in
Indonesia. Every year more than 90 percent of beef imports come from Australia
and New Zealand. If beef import tariff is removed, Indonesia beef farmers may be
in danger. The objectives of this study are to: (1) evaluate the impact of tariff
removal on production, consumption, domestic price and import of beef, (2)
evaluate impact of free trade agreement on beef producer and consumer surpluses
and, (3) propose alternative policies that can be implemented to increase domestic
beef production and reduce beef imports. Yearly time series data from 1990 to
2008 was used and parameters were estimated by Two-Stage Least Squares
method. Removal of beef import tariffs for imports from Australia and New
Zealand under AANZFTA will reduce domestic beef production, increase beef
import and domestic beef supply, leading to reduction in domestic beef price
hence, increased beef demand. AANZFTA will increase consumers’ surplus and
reduce producers’ surplus. Reduction of beef imports in terms of imports from
Australia, New Zealand, rest of the world and imported feeder cattle by 90 percent
each, will result in highest producers’ surplus, however domestic beef production
does not increase significantly. Combination of interest rate reduction to four
percent, increasing imported breeding cattle by 60 percent, artificial insemination
technology by 64 percent and beef import tariffs for imports from Australia and
New Zealand by 40 percent each, is the best policy alternative to increase
domestic beef production and curb beef imports. This policy combination can be
implemented ahead of AANZFTA implementation. Nonetheless, Indonesia will
achieve only 52 percent of beef self sufficiency with this policy in 2014. To
minimize the effects of AANZFTA on beef industry, it is recommended that
policy combination of interest rate reduction, increasing artificial insemination
technology and number of imported breeding cattle be implemented.
Key words: beef industry, trade, AANZFTA
ABSTRAK
THATO TSEUOA. Dampak Perjanjian Perdagangan Bebas ASEAN, Australia
dan Selandia Baru Terhadap Industri Daging Sapi di Indonesia (YUSMAN
SYAUKAT sebagai Ketua dan DEDI BUDIMAN HAKIM, sebagai Anggota
Komisi Pembimbing).
Partisipasi
Indonesia
dalam
ASEAN,
Australia
and
New
Zealand Free Trade Agreement (AANZFTA) bisa memberikan efek negatif terhad
ap industri daging sapi di Indonesia. Setiap tahun lebih dari 90 persen impor
daging sapi berasal dari Australia dan Selandia Baru. Jika tarif impor daging
sapi
dihapus,
peternak
sapi
Indonesia
akan
menghadapi
kerugian.
Tujuan
penelitian
ini
adalah
untuk:
(1)
mengevaluasi
dampak
penghapusan
tarif
terhadap
produksi,
konsumsi,
harga
domestik
dan
impor
daging
sapi, (2) mengevaluasi dampak perjanjian perdagangan bebas pada
surplus produsen dan konsumen daging sapi dan, (3) mengusulkan alternatif
kebijakan yang dapat diterapkan untuk meningkatkan pasokan daging sapi dalam
negeri dan mengurangi impor daging sapi. Penelitian ini menggunakan data
tahunan time series tahun 1990-2008 dan pendugaan parameter dilakukan dengan
metode Two Stage Least Squares. Penghapusan tarif impor daging sapi untuk
impor dari Australia dan Selandia Baru dalam AANZFTA akan mengurangi
produksi daging sapi dalam negeri, meningkatkan impor daging sapi dan
penawaran daging sapi dalam negeri, menurunkan harga daging sapi dalam negeri
sehingga permintaan daging sapi meningkat. AANZFTA akan meningkatkan
surplus konsumen dan mengurangi surplus produsen. Pengurangan impor daging
sapi dari Australia, Selandia Baru, seluruh dunia dan sapi bakakan sebesar 90
persen masing-masing akan menghasilkan surplus produsen tertinggi, namun
produksi daging sapi dalam negeri tidak meningkat secara signifikan. Kombinasi
dari pengurangan suku bunga hingga empat persen, meningkatkan impor sapi bibit
dengan 60 persen, teknologi inseminasi buatan dengan 64 persen dan tarif impor
untuk impor daging sapi dari Australia dan Selandia Baru sebesar 40 persen,
merupakan alternatif kebijakan terbaik untuk meningkatkan produksi daging sapi
dalam negeri dan mengurangi impor daging sapi. Kombinasi kebijakan ini dapat
dilaksanakan menjelang pelaksanaan AANZFTA. Meskipun demikian, dengan
kebijakan ini pada tahun 2014 Indonesia hanya akan mencapai swasembada
daging sapi 52 persen. Untuk meminimalkan efek AANZFTA pada industri
daging sapi, dianjurkan berupa kebijakan kombinasi pengurangan suku bunga,
meningkatkan teknologi inseminasi buatan dan peningkatan jumlah impor sapi
bibit.
Kata kunci: industri daging sapi, perdagangan, AANZFTA
SUMMARY
THATO TSEUOA. Impact of ASEAN Australia and New Zealand Free Trade
Agreement on Beef Industry in Indonesia (YUSMAN SYAUKAT as Chairman
and DEDI BUDIMAN HAKIM as Member of Advisory Committee).
Persistent increase in income and population and change in food
consumption in Indonesia has led to considerable increase in food demand such as
vegetables, fruits, sugar, beef, dairy products, poultry and seafood. As the result,
there has been increasing imports of some of these products to meet their domestic
demand. In particular, roughly 30 percent of national beef demand is met by
imports of beef and beef cattle largely from Australia and New Zealand. For the
past years Government of Indonesia has implemented several policies to protect
domestic beef farmers so that domestic beef production can increase and reduce
dependence on imports. One of such policies is imposition of beef import tariff.
Nonetheless, with several free trade agreements that Indonesia has been
participating in, such as ASEAN, Australia and New Zealand Free Trade
Agreement (AANZFTA), those efforts will cease. Every year more than 90
percent of Indonesian beef imports come from Australia and New Zealand.
Involvement of Indonesia in AANZFTA may have negative effects on beef
industry when beef import tariffs are phased out in 2020. Hence, the objectives of
this study are (1) to evaluate the impact of tariff removal on production,
consumption, domestic price and import of beef, (2) to evaluate impact of free
trade agreement on beef producer and consumer surpluses and (3) to propose
alternative policies that can be implemented to increase domestic beef production.
In this study, yearly time series data from 1990 to 2008 was used and
analysed with econometric model. The model consists of eight structural
equations and four identity equations. Parameters were estimated with Two Stage
Least Squares method. Several policy alternatives were simulated which include
single policies and their combinations: (1) removal of beef import tariffs for beef
imports from Australia and New Zealand, (2) reducing interest rate, (3) increasing
number of imported breeding cattle, (4) increase artificial insemination
technology, (5) combination of reducing interest rate, increasing imported
breeding cattle and increasing artificial insemination technology, (6) increasing
import tariffs for beef imports from Australia and New Zealand, (7) combination
of reducing interest rate, increasing imported breeding cattle, increasing artificial
insemination technology and increasing import tariff, (8) combination of reducing
interest rate, increasing imported breeding cattle, increasing artificial insemination
technology and removal of beef import tariffs for imports from Australia and
New Zealand, (9) reduction of beef imports from Australia, New Zealand, rest of
the world and imported feeder cattle by 90 percent each, (10) combination of
reduction of beef imports from Australia, New Zealand, rest of the world and
imported feeder cattle by 90 percent each, reducing interest rate, increasing
number of imported breeding cattle and increasing artificial insemination
technology, and (11) combination of interest rate reduction, increasing import
beef tariffs for imports from Australia and New Zealand, artificial insemination
technology and number of imported breeding cattle.
Simulation results revealed that removal of beef import tariff will increase
beef import, increase domestic beef supply, leading to reduction in domestic beef
price hence, increased beef demand. However, domestic beef production does not
decrease drastically. The free trade agreement will increase consumers’ surplus
and reduce producers’ surplus. Reduction of beef imports from Australia, New
Zealand, rest of the world and imported feeder cattle by 90 percent each will result
in highest producers’ surplus, however domestic beef production does not increase
significantly. Domestic beef supply is drastically reduced, leading to high
domestic beef price hence, reduced beef demand. As the result, producers benefit
at the expense of consumers. The study found out that, in case Indonesia can be
allowed to increase beef import tariff, combination of interest rate reduction to
four percent, increasing imported breeding cattle by 60 percent, artificial
insemination technology by 64 percent and beef import tariffs for imports from
Australia and New Zealand by 40 percent each, can be the best policy alternative
to increase domestic beef production and curb beef imports from Australia and
New Zealand by almost 100 percent. This policy combination can be implemented
ahead of implementation of AANZFTA in Indonesia as it has been discovered that
it gives highest domestic beef production among the proposed policy alternatives.
Nonetheless, Indonesia will achieve only 52 percent beef self sufficiency with this
policy in 2014. There is a need to improve productivity so that domestic beef
production can be increased. To minimize the effects of AANZFTA on
Indonesian beef industry, it is recommended that policy combination of interest
rate reduction, increasing artificial insemination technology and number of
imported breeding cattle be implemented.
Copyright© 2011, Bogor Agricultural University All right reserved
1. No part or all of this thesis may be excerpted without inclusion or
mentioning the sources
a. Excerption only for research and education use, writing for
scientific papers, reporting, critical writing or reviewing of a
problem
b. Excerption does not inflict a financial loss in the proper interest of
Bogor Agricultural University
2. No part of or entire thesis may be translated and reproduced in any
form or by any means, without permission in writing from Bogor
Agricultural University
IMPACT OF ASEAN AUSTRALIA AND NEW ZEALAND
FREE TRADE AGREEMENT ON BEEF INDUSTRY
IN INDONESIA
THATO TSEUOA
A thesis
Submitted to the Graduate School in Partial Fulfillment of the Requirements for
Master of Science
Degree in
Agricultural Economics
GRADUATE SCHOOL
BOGOR AGRICULTURAL UNIVERSITY
2011
1. Thesis External Examiner
: Dr. Ir. Muhammad Firdaus, PS, M.Si
2. Study Program Representative : Dr. Ir. M. Parulian Hutagaol, MSc
Thesis Title
: Impact of ASEAN, Australia and New Zealand
Free Trade Agreement on Beef Industry in
Indonesia
Name
: Thato Tseuoa
Registration Number
: H353098231
Major
: Agricultural Economics
Approved
1. Advisory Committee
Dr. Ir. Yusman Syaukat, MEc.
Chairman
Dr. Ir. Dedi Budiman Hakim, MEc.
Member
Agreed
2. Coordinator of Major
Agricultural Economics
3. Dean of Graduate School
Prof. Dr. Ir. Bonar M. Sinaga, MA
Dr. Ir. Dahrul Syah, M.Sc.Agric
Examination Date: 2nd May 2011
Submission Date:
ACKNOWLEDGEMENTS
Firstly, I thank God Almighty for giving me the spirit and wisdom to
complete this study – there is none like You God. My profound gratitude goes to
my supervisors, Dr. Ir. Yusman Syaukat and Dr. Ir. Dedi Budiman Hakim, for
their excellent supervision, their practical inputs as well as their professional
guidance during completion of this study.
I am greatly indebted to major coordinator, Professor Bonar M. Sinaga,
who made constructive criticism and valuable suggestions during the writing of
this thesis. I am grateful to the staff members of Agricultural Economics
Postgraduate Program at Bogor Agricultural University for their kind assistance
and staff at Directorate General of Livestock Services for providing me with all
the necessary information concerning Indonesian beef industry.
My sincere thanks are extended to Developing Countries Partnership
Scholarship Program for financial support that made it possible for me to attain
Master of Science degree in Indonesia.
My deepest appreciation goes to my loving parents, sisters, brothers and
other family members for their love, care and encouragement through the graduate
school experience. I would like to thank all people, my friends, who have
contributed to this research with their experience and insights and other help.
Finally, this thesis is dedicated to my parents, ‘Matebello and Mosehle
Tseuoa, who inspired me to pursue a career in the field of agriculture.
Bogor, July 2011
Thato Tseuoa
AUTOBIOGRAPHY
Thato Tseuoa, the author of this thesis, was born on the 7th February 1983 in
Maseru District, Lesotho. She completed her primary education in 1995 and
joined St. James Anglican High School for secondary education from where she
did her Lesotho Junior Certificate in 1998. At the same school, she did her
Cambridge Overseas School Certificate in 2000. She joined National University
of Lesotho in 2001 and graduated with Bachelor of Science in Agriculture in 2006.
Between August 2006 and November 2007, she worked as science and
agriculture teacher at Phomolong LEC High School. In December 2007 she joined
Department of Agricultural Research, Agronomy Section, where she worked as
research officer until August 2008. In September 2008 she was awarded
scholarship to pursue Master’s Degree in Bogor Agricultural University by
Indonesian Government under the Developing Countries Partnership Scholarship
Program. She is to graduate with a Master of Science degree in Agricultural
Economics.
TABLE OF CONTENTS
Page
I.
II.
LIST OF TABLES ....................................................................................
vi
LIST OF FIGURES ..................................................................................
vii
LIST OF APPENDICES ...........................................................................
viii
INTRODUCTION ....................................................................................
1
1.1. Background ......................................................................................
1
1.2. Problem Statement ...........................................................................
4
1.3. Objectives .........................................................................................
6
1.4. Research Scope and Limitations ......................................................
7
LITERATURE REVIEW..........................................................................
9
2.1. Economics of Free Trade .................................................................
9
2.1.1. Theory of Absolute Advantage ............................................
9
2.1.2. Theory of Comparative Advantage ......................................
10
2.1.2.1. Ricardo’s theory .....................................................
10
2.1.2.2. Heckscher – Ohlin Theory ......................................
11
2.2. Regional Integration Agreements ....................................................
13
2.3. Economic Benefits and Costs of Regional Economic Agreements .
15
2.3.1. Competition and Scale Effects .............................................
15
2.3.2. Trade and Location Effects ..................................................
17
2.4. Theory of Regional Free Trade Areas ..............................................
19
2.4.1. ASEAN Australia New Zealand Free Trade Area ...............
19
2.5. Beef Cattle Population .....................................................................
21
2.6. Beef Production................................................................................
22
2.6.1. Indonesia Beef Production ...................................................
22
2.6.2. World Beef Production and Indonesian Position .................
24
2.7. Beef Consumption............................................................................
26
2.8. Beef Trade ........................................................................................
29
i
III.
IV.
2.8.1. Beef Trade in Indonesia .......................................................
29
2.8.2. World Beef Trade .................................................................
32
2.9. Beef Marketing.................................................................................
34
2.10. Government Policies and Regulations in Beef Industry ..................
36
2.10.1. Inter – Regional Trade Restriction Policy............................
36
2.10.2. Marketing Quota ..................................................................
37
2.10.3. Marketing Tax and Restriction Policy .................................
37
2.10.4. Subsidized Credit Policy ......................................................
38
2.10.5. Tariff Policy .........................................................................
39
2.10.6. Health – Based Import Restriction Policy............................
41
2.11. Review of Previous Studies .............................................................
41
THEORETICAL FRAMEWORK ............................................................
47
3.1. Theoretical Framework ....................................................................
47
3.1.1. Beef Production and Supply Function .................................
47
3.1.2. Beef Demand Function ........................................................
50
3.2. Elasticity...........................................................................................
52
3.3. Impact of Free Trade Area ...............................................................
54
3.4. Conceptual Framework ....................................................................
57
3.5. Hypothesis ........................................................................................
59
RESEARCH METHOD ............................................................................
61
4.1. Model Specification .........................................................................
61
4.1.1. Domestic Beef Supply..........................................................
62
4.1.2. Domestic Beef Production ...................................................
62
4.1.3. Beef Import ..........................................................................
64
4.1.4. National Beef Demand .........................................................
65
4.1.5. World Beef Demand ............................................................
66
4.1.6. Real Domestic Beef Price ....................................................
66
4.1.7. Real Import Beef Price .........................................................
67
4.1.8. Real World Beef Price .........................................................
67
ii
V.
VI.
4.1.9. Imported Feeder Cattle.........................................................
67
4.2. Model Identification and Estimation................................................
68
4.3. Model Validation .............................................................................
70
4.4. Elasticity...........................................................................................
71
4.5. Model Simulation .............................................................................
71
4.6. Producer and Consumer Surplus Analysis .......................................
72
4.7. Data Type and Sources.....................................................................
74
RESULTS OF ESTIMATED ECONOMETRIC MODEL ......................
75
5.1. Model Statistics ................................................................................
75
5.2. Model Results ..................................................................................
76
5.2.1. Domestic Beef Production ...................................................
76
5.2.2. Beef Imports from Australia ................................................
77
5.2.3. Beef Imports from New Zealand..........................................
78
5.2.4. National Beef Demand .........................................................
80
5.2.5. Real Domestic Beef Price ....................................................
80
5.2.6. Real Import Beef Price .........................................................
81
5.2.7. Real World Beef Price .........................................................
82
5.2.8. Feeder Cattle Import ............................................................
83
5.3. Interpretation of Estimated Parameters ............................................
84
POLICY EVALUATION .........................................................................
91
6.1. Model Validation .............................................................................
91
6.2. Impact of Different Policy Alternatives on Beef Industry ...............
92
6.2.1. Impact of Removal of Beef Import Tariffs for Imports
from Australia and New Zealand .........................................
96
6.2.2. Impact of Interest Rate Reduction to Five Percent ..............
99
6.2.3. Impact of Increasing Imported Breeding Cattle by 30
Percent .................................................................................. 101
6.2.4. Impact of Increasing Artificial Insemination
Technology in Previous Year by 40 Percent ........................ 102
iii
6.2.5. Impact of Reducing Interest Rate to Five Percent,
Increasing Imported Breeding Cattle by 30 Percent
and increasing Artificial Insemination Technology
in the Previous Year by 40 Percent ...................................... 103
6.2.6. Impact of Increasing Import Tariffs for Imports from
Australia and New Zealand by 20 Percent Each .................. 104
6.2.7. Impact of Increasing Import Tariffs for Imports from
Australia and New Zealand by 20 Percent Each, Interest
Rate Reduction to Five Percent, Increasing Volume of
Imported Breeding Cattle by 30 Percent and Increasing
Artificial Insemination Technology in Previous Year by
40 Percent ............................................................................. 106
6.2.8. Impact of Removal of Import Tariffs for Imports from
Australia and New Zealand, Interest Rate Reduction
to Five Percent, Increasing Volume of Imported
Breeding Cattle by 30 Percent and Increasing
Artificial Insemination Technology in Previous Year
by 40 Percent ........................................................................ 107
6.2.9. Impact of Reducing Beef Imports from Australia, New
Zealand, Rest of the World and Imported Feeder Cattle
by 90 Percent Each ............................................................... 108
6.2.10. Impact of Combination of Interest Rate Reduction to
Five Percent, Increasing Imported Breeding Cattle
by 30 Percent, Increasing Artificial Insemination
Technology in Previous Year by 40 Percent and
Reducing Beef Imports from Australia, New Zealand,
Rest of the World and Imported Feeder Cattle by 90
Percent Each ......................................................................... 110
6.2.11. Impact of Combination of Reducing Real Interest Rate
to Four Percent, Increasing Beef Import Tariffs for
Imports from Australia and New Zealand by 40 Percent
Each, Increasing Imported Breeding Cattle by 60
Percent and Increasing Artificial Insemination
Technology by 64 Percent.................................................... 111
6.3. Projection of Production and Consumption of Beef ........................ 112
6.4. Summary of Policy Simulation Alternatives ................................... 113
VII.
CONCLUSION AND POLICY IMPLICATIONS................................... 115
7.1. Conclusion ....................................................................................... 115
iv
7.2. Policy Implications .......................................................................... 116
REFERENCES.......................................................................................... 119
APEPENDICES ........................................................................................ 125
v
LIST OF TABLES
Number
1.
Page
Ten Major Beef Producing Countries in the World and Indonesia
Position in 2000 and 2008 ............................................................................
25
2.
Meat Consumption per Capita in Indonesia from 1981 to 2008 ..................
26
3.
Beef Consumption in Indonesia from 1999 to 2008 ....................................
27
4.
Indonesia’s Beef Products Imports from 1990 to 2008 ...............................
30
5.
Beef Exports by Major World Exporters of Beef in 2000 and 2008 ...........
33
6.
Comparison of Beef Imports from Largest World Beef Importers with
Indonesia in 2000 and 2008 .........................................................................
34
Results of Parameter Estimation and Statistical Tests for Domestic
Beef Production............................................................................................
77
Results of Parameter Estimation and Statistical Tests for Beef Imports
from Australia ..............................................................................................
78
Results of Parameter Estimation and Statistical Tests for Beef Imports
from New Zealand........................................................................................
79
Results of Parameter Estimation and Statistical Tests for National Beef
Demand ........................................................................................................
80
Results of Parameter Estimation and Statistical Tests for Real domestic
Beef Price .....................................................................................................
81
Results of Parameter Estimation and Statistical Tests for Real Import
Beef Price .....................................................................................................
82
Results of Parameter Estimation and Statistical Tests for Real World
Beef Price .....................................................................................................
83
Results of Parameter Estimation and Statistical Tests for Feeder Cattle
Import ...........................................................................................................
83
15.
Model Validation Results.............................................................................
91
16.
Percentage Change of Alternative Policy Simulations ................................
97
17.
Impact of alternative Policies on Beef Industry in Indonesia ......................
98
18.
Impact of Alternative Policies on Beef Producer Surplus and Consumer
Surplus in Indonesia .....................................................................................
98
7.
8.
9.
10.
11.
12.
13.
14.
19.
Projection of Production and Consumption of Beef from 2009 to 2014
in Indonesia .................................................................................................. 112
vi
LIST OF FIGURES
Number
Page
1.
Beef Production In Indonesia from 1984 to 2008 .....................................
24
2.
Comparison of Countries with Largest Beef Supply per Capita in the
World with Indonesia ...............................................................................
28
3.
Volume of Beef Export and Import in Indonesia from 1990 to 2008 .......
31
4.
Indonesian Beef Imports According to Source of Origin from 1990
to 2008.......................................................................................................
32
Beef Trade Creation as a Result of Participation of Indonesia in
AANZFTA ................................................................................................
55
Beef Trade Diversion as a Result of Participation of Indonesia in
AANZFTA ................................................................................................
57
Economic Model of Beef Industry in Indonesia .......................................
63
5.
6.
7.
vii
LIST OF APPENDICES
Number
Page
1.
Data ...........................................................................................................
127
2.
Parameter Estimation Program and Results ..............................................
131
3.
Model Validation Program and Results ....................................................
141
viii
1
I. INTRODUCTION
1.1.
Background
Economic growth and industrialization in Indonesia have led to increase in
competition for domestic resources. As a result, this has led to reduction in the
contribution of agriculture to gross domestic product (GDP). Agriculture’s share
to GDP has declined from around 49 percent in 1970 (Bond et al., 2007) to just
around 13.8 percent in 2007 while livestock subsector contributed 1.7 percent
(Central Bureau of Statistics (CBS), 2010). Persistent increases in income per
capita and population in Indonesia has resulted in considerable increase for food
demand such as vegetables, fruits, sugar, beef, dairy products, poultry and
seafood. Imports have become an increasingly important source of vegetables,
sugar, beef and dairy products (Bond et al., 2007) as demand for these products
increases.
Beef industry in Indonesia makes an important contribution to the country.
Besides providing meat protein to consumers, it is also source of employment and
income for millions of rural families and investment opportunities for private
companies, both of which are important for Indonesia’s regional development.
Through its demand for inputs and the sale of cattle along the beef value chain, it
also provides a stimulus to many other sectors of economic activity (Hadi et al.,
2002).
Demand for beef in Indonesia persistently increases, whereas beef
production tends to fluctuate, consequently leading to increased beef imports.
Approximately 30 percent of national beef demand in Indonesia is met by imports
of beef, beef offal and feeder cattle (Directorate General of Livestock Services
2
(DGLS), 2010). Beef consumption per capita per year in Indonesia is 1.11kg
(Ministry of Agriculture, 2008). In 2008 alone, Indonesia slaughtered 392511
heads of beef cattle and imported 510 100 heads of feeder cattle, 45708.5 tons of
beef and 5776 tons of beef offal (DGLS, 2009). Most beef imports come from
Australia and New Zealand. Population growth rate of beef cattle is low, that is,
0.93 percent per year from 1990 to 2008. This population growth rate is not able
to meet continuing beef demand. This causes low contribution of beef cattle to
national meat production (Mersyah, 2005 and Santi, 2008), leading to wide
imbalance between demand and supply. There are number of factors which have
contributed to low productivity. Foremost among these is low genetic potential.
This together with low cattle reproductive efficiency with long calving interval
(18-24 months), high number of service per conception (2-3), limited sources of
feeds especially during dry season, low quality feeds, presence of reproductive
disorders, high rate of calf mortality and slaughter of productive cows, reduces
number of calves born each year hence slow growth in beef cattle population
(Suryana, 2009, Sullivan and Diwyanto, 2007, and Umiyasih and Anggraeny,
2007).
In order to meet this persistent increase in beef demand, Government of
Indonesia imports beef and feeder cattle to be fattened (Priyanti et al., 1998). This
policy is carried out even though it drains country’s foreign exchange. Another
motive there is increased beef imports is because domestic beef production is
unable to meet consumers’ demand in the country in terms of quality (Priyanti et
al., 1998 and Yusdja et al., 2003). Moreover, import beef price is relatively lower
than domestic beef price. Beef imports have impact on reducing beef
competitiveness from domestic farmers. To overcome this, Government of
Indonesia has made systematic efforts by pursuing policies that develop beef
3
production and protect to beef farmers. The instruments used for development and
protection include both tariff and nontariff barriers, mainly import regulations,
and have resulted in domestic beef prices being well above prevailing
international prices. One of the efforts to suppress beef import rate is the
imposition of import tariff. Currently import tariff for beef products is five
percent.
Besides being a member of World Trade Organization (WTO), in the
recent years, Indonesia has pursued regional trade agreement as a strategy to
gradually reduce protection and increase access to the markets of trading partners.
Indonesia is currently a member of ASEAN Free Trade Area (FTA), ChinaASEAN FTA, Korea-ASEAN FTA and ASEAN-Australia-New Zealand FTA and
several others under negotiations. Agreements between countries which reduce
trade barriers faced by agricultural products assist agricultural exporters in those
countries. The lower tariff and nontariff barriers that certain agricultural exports
from member countries face put products from these countries at an advantage
compared to products from countries without such agreements. The magnitude of
expected benefits from such agreement depends on how comprehensive
elimination of trade barriers is by those involved (Bond et al., 2007).
The recently signed FTA by Indonesia is ASEAN, Australia and New
Zealand Free Trade Agreement (AANZFTA). AANZFTA was signed in February
2009 and came into force in January 2010 in some members while in Indonesia,
Laos and Cambodia is still not yet effective. Indonesia’s interest in this free trade
agreement is its textile products exports to Australia and New Zealand markets
whereas Australia and New Zealand, due to their competitive advantage, are
concerned with their livestock products exports, which include milk and beef, to
4
Indonesia. With respect to agriculture, products that are dominantly exported to
Australia and New Zealand markets by Indonesia are coffee, cacao, rubber and
palm oil. Nevertheless, Indonesia competes with Malaysia and Thailand in both
markets for the same products (Hutabarat et al., 2009). Among the FTAs
Indonesia is involved in, AANZFTA is the first anticipated to have significant
impact on the Indonesian beef industry as majority of beef imports come from
Australia and New Zealand. In this forum, according to schedule of tariff
commitments of Indonesia, the tariff rates for beef will be completely phased out
by 2020.
Like many agricultural products, besides forces of demand and supply in
domestic market, beef prices are also influenced by changes in the international
environment among others presence of economy liberalization and trade, as a
result they are closely related with changes in the policies of each country.
Therefore, policy that is comprehensive and consistent is needed in trade system
of beef in Indonesia. Regional trade agreements such as AANZFTA have to be
observed whether or not they will benefit beef industry of Indonesia.
1.2.
Problem Statement
General Agreements on Trade and Tariff and WTO have significantly
contributed to trade liberalization. However, delays in multinational negotiations
under the Doha Development Round have coerced world trade participants to
pursue Regional Trade Agreements (RTAs) as a trade policy instrument and as a
complementary to Most Favored Nation (MFN) principle (Crawford and
Fiorentino, 2005). The Free Trade Agreement (FTA) which has been negotiated
by ASEAN countries, Australia and New Zealand is complex one covering trades
5
of goods, services, investment, intellectual property, electronic commerce,
movement of business persons and competition policy and economic cooperation.
According to Stephenson and Erwidodo (1995) in Sayekti (2009),
consequences of ratification of these agreements are that, countries that have
strong export position will gain greater benefits because they have high
comparative and competitive advantages so they have greater ability to exist and
even penetrate international market. Whereas countries with low comparative and
competitive advantages will be unable to develop their exports and commodities
from competing countries will fill the domestic market. Beef is one of the
commodities with low comparative and competitive advantage in Indonesia.
Although in the long run, participation of Indonesia in AANZFTA may
have positive impact, for instance, through technological transfer that can improve
Indonesian cattle productivity; nonetheless, in the short run this may bring
negative effects on the Indonesian beef industry. AANZFTA eliminates tariffs
among member countries using different tariff levels ratified by members.
Currently, Indonesia imposes import tariff, presently at five percent, as an
instrument to protect its domestic beef farmers from competing with exporting
countries such as Australia and New Zealand. Opponents of free trade argue that
free beef trade with Australia and New Zealand is going to exacerbate the current
condition by increasing domestic beef supply in the Indonesia market as, already,
more than 90 percent of beef imports come from these countries, therefore
causing downward pressure on domestic beef price received by farmers hence
driving them out of beef industry. Statistical data indicate that export shares of
Australia and New Zealand to total beef imports in Indonesia have increased from
27.5 and 34.3 percent in 1990 to 57.2 and 41.4 percent in 2008, respectively. At
the same time, Indonesia is not only aiming to be self sufficient in beef by 2014
6
but also to have sustainable beef self sufficiency afterwards. Therefore it is
important to find out which policies can be implemented to help achieve beef self
sufficiency by 2014 and pursue the sustainable one afterwards.
Possible effects of AANZFTA on domestic beef industry in Indonesia
have not yet been explored. Previous studies focused on the impact of trade
liberalisation (in compliance with WTO regulations) on beef import as a whole. In
this study, beef imports are divided into imports from Australia and New Zealand
as the major beef exporters to Indonesia. This study is useful for beef producers
and government legislators to evaluate the future of beef industry under
AANZFTA. It is important to evaluate the impact that AANZFTA will have on
beef industry in Indonesia. Therefore, this study wishes to answer the following
questions:
1. What will be the impact of tariff removal on production, consumption,
domestic price and imports of beef?
2. What will be the impact of AANZFTA on beef producers’ and consumers’
surpluses?
3. What policy alternatives could be implemented to increase domestic beef
production in Indonesia?
1.3.
Objectives
Based on background and problem statement above, the general research
objective is to evaluate the impact of ASEAN, Australia and New Zealand free
trade agreement on the performance of beef industry in Indonesia. Specific
objectives are:
1. To evaluate the impact of tariff removal on production, consumption,
domestic price and import of beef.
7
2. To evaluate impact of free trade agreement on beef producer and consumer
surpluses.
3. To propose alternative policies that can be implemented to increase domestic
beef production.
1.4.
Research Scope and Limitations
This research focuses on the analysis of impact of free trade agreement on
the performance of beef industry in Indonesia based on the analysis of demand
and supply of beef. Yearly data from 1990 to 2008 was used. Domestic beef
supply consists of domestic beef production from domestically reared cattle,
imports of beef, and supply from imported live feeder cattle while national beef
demand was made equivalent to domestic beef supply. With the existence of
supply from imports, generally domestic beef market is also influenced by
international beef market.
This study has limitations which includes the following:
1. The study does not separate consumers into rural and urban communities
when looking at the behaviour of beef demand. Differences in education and
welfare level among rural and urban communities determine food
consumption pattern including beef consumption. These differences cannot be
looked at in this research because of unavailability of data of beef demand by
rural and urban communities separately. Furthermore, beef demand is not
differentiated into demand by households, hotels, supermarkets and
restaurants due data unavailability.
2. Domestic beef production is not separated into supply from feedlots and
smallholders due to lack of data. Data used is the one provided on the
livestock statistics books.
8
3. Beef exports are minimal therefore they are ignored.
4. Import tariff rate for boneless beef is used because its quantity imported is
larger than other types of beef.
5. Beef import price is the average import beef price from Australia and New
Zealand.
6. World beef price is taken as United States’ import beef price because United
States is the largest beef importer in the world.
7. Domestic beef production includes supply from imported feeder cattle. In this
study, it is assumed that the slaughter weight of imported feeder cow is 224kg,
therefore this number is multiplied by number of feeder cattle imported each
year, and the result is subtracted from domestic beef production reported in
statistical books to get supply from domestically produced cattle.
9
II.
2.1.
LITERATURE REVIEW
Economics of Free Trade
There has been gradual evolution of economic theories on international
trade over the past centuries. Adam Smith (1723-90), David Ricardo (1772-1823),
Eli Heckscher (1879-1962) and Bertil Ohlin (1899-1979) have been regarded as
the most influential economists and scholars of international trade (Morgan and
Katsikeas, 1997 in Ruming, 2007). Countries engage in international trade for two
basic reasons, each of which contributes to their gains from trade. Firstly,
countries trade because they are different from each other. Nations can benefit
from their differences by reaching an arrangement in which each does the things it
does relatively well. Secondly, countries are involved in trade to achieve
economies of scale in production. That is, if each country produces only a limited
range of goods, it can produce each of these goods at a large scale and hence more
efficiently than if it tried to produce everything (Krugman and Obstfeld, 2003).
Economics of free trade can be explained based on two theories: theory of
absolute advantage and theory of comparative advantage.
2.1.1. Theory of Absolute Advantage
The benefits of free trade were first observed and documented by Adam
Smith in his book, The Wealth of Nations, in 1776. Smith explained free trade
between nations based on the concept of absolute advantage in production of each
country. His theory of absolute advantage was based on free market economy. In
this book, he stressed the benefits of specialization and the workings of market
mechanism (pricing system). Smith argued that with free trade, each nation should
10
specialize in the production of those commodities in which it had an absolute
advantage (or could produce more efficiently than other nations) and imports
those commodities in which it had an absolute disadvantage (or could produce
less efficiently) (Salvatore, 1995). For example, nation A has absolute advantage
over nation B in production of commodity Y, while nation B has absolute
advantage over nation A in producing X. Each country could benefit by each
specialising in the production of the commodity it has absolute advantage and
exchange part of its output with other country for the commodity it has absolute
disadvantage. The international specialization of factors of production would
result in an increase in world output using the same amount of resources, thereby
increasing overall wealth (Condon, 2002 and Salvatore, 1995). However, absolute
advantage cannot explain the trade pattern where one of the countries has absolute
advantage in both commodities.
2.1.2. Theory of Comparative Advantage
2.1.2.1. Ricardo’s Theory
In reality it is difficult for a country to maintain absolute advantage in a
product. Furthermore, theoretically, international competition can ruin a country
that has absolute disadvantage in any product (Condon, 2002). David Ricardo
filled these gaps through his theory of comparative advantage in 1817. It became
the most basic concept of international trade theory. He argued that even if one
country has absolute disadvantage in production of both commodities, there is still
a basis for mutually beneficial trade (Condon, 2002 and Salvatore, 1995). Ricardo
described free trade in terms of single factor of production with constant
productivity of labour in two goods, but with relative productivity between the
11
goods different across two countries. In this model, labour is the only factor of
production and countries differ only in the productivity of labour in different
industries. In the Ricardian model, countries will export goods that their labour
produces relatively efficiently and import goods that their labour produces
relatively inefficiently. In other words, a country's production pattern is
determined by comparative advantage. A country has comparative advantage in
producing a good if the opportunity cost of producing that good in terms of others
is lower in that country than it is in other countries (Krugman and Obstfeld, 2003).
Ricardian theory was criticised in that it assumes that capital and labour
are immobile and that it therefore no longer applies in a world where capital
moves freely and production can be moved to countries with lower labour costs
(Condon, 2002). Another concern was that comparative advantage only works in
perfect competition. Free trade advocates argue that modernization has decreased
transportation and logistics costs through interventions such as aeroplane and
internet unavailability in Ricardo’s time make his theory increasingly sound with
time. Moreover, despite increased capital movement, wide differences in
capacities of production still exists, in fact, free trade creates wider gap of
production in many areas despite the larger increases it makes in absolute wealth.
Advocates of free trade claim that perfect competition is the result of universal
free trade, not its precondition (Ruming, 2007).
2.1.2.2. Heckscher –Ohlin Theory
Ricardian model have been developed further by other neoclassical and
modern economists and they have carried out empirical studies to verify its
validity. The theory of comparative advantage, sometimes also referred to as
12
factor endowments/proportions theory (Krugman and Obstfeld, 2003), has been
elaborated and refined many times. Ricardo's theory of comparative advantage
had been further developed by Heckscher and Ohlin in 1920s into international
trade theory called factor proportion theory. The theory is also called HeckscherOhlin theory. The theory assumes consumer tastes and preferences are similar
across nations. Moreover, the theory assumes constant returns to scale in
production, incomplete specialisation in production, perfectly competitive
product and factor markets, perfect factor mobility within nations but no factor
mobility between nations, no transportation costs or other trade barriers, full
employment of resources within nations and balanced international trade
(Gunawardana and Khorchurklang, 2007). The theory stresses that countries
should produce and export goods that require resources that are abundant and
import goods that require resources in short supply. This theory differs from the
theories of comparative advantage and absolute advantage since those theories
focus on the productivity of the production process for a particular good. On the
contrary, the Heckscher-Ohlin theory states that a country should specialize in
production and export using factors that are most abundant, and thus the
cheapest 1.
Heckscher-Ohlin theory was examined empirically by Wassily Leontief
(1956) using United States input-output table for 1947. As United States was a
capital abundant nation, he hypothesized that United States exported capital
intensive commodities and imported labour intensive commodities. Although
capital intensive, Leontief found out that United States exported labour-intensive
1
http://en.wikipedia.org/wiki/International_trade Accessed on 27/04/2010
13
commodities and imported capital-intensive commodities, which contradict
Heckscher-Ohlin theor
FREE TRADE AGREEMENT ON BEEF INDUSTRY
IN INDONESIA
THATO TSEUOA
GRADUATE SCHOOL
BOGOR AGRICULTURAL UNIVERSITY
2011
DECLARATION
I, Thato Tseuoa, hereby declare that the thesis entitled:
IMPACT OF ASEAN AUSTRALIA AND NEW ZEALAND FREE TRADE
AGREEMENT ON BEEF INDUSTRY IN INDONESIA
submitted to fulfil a requirement for the award of Master of Science in
Agricultural Economics from Bogor Agricultural University is my own piece of
work produced through the guidance of my academic advisors and that to the best
of my knowledge it has not been submitted for the award of any degree in any
other academic institutions. This thesis does not contain any pieces of work of
other persons, except those that are duly acknowledged and referenced in the text.
Bogor, July 2010
THATO TSEUOA
NRP H353098231
ABSTRACT
THATO TSEUOA. Impact of ASEAN Australia and New Zealand Free Trade
Agreement on Beef Industry in Indonesia (YUSMAN SYAUKAT as Chairman
and DEDI BUDIMAN HAKIM as Member of Advisory Committee).
Participation of Indonesia in ASEAN, Australia and New Zealand Free
Trade Agreement (AANZFTA) may have negative effects on beef industry in
Indonesia. Every year more than 90 percent of beef imports come from Australia
and New Zealand. If beef import tariff is removed, Indonesia beef farmers may be
in danger. The objectives of this study are to: (1) evaluate the impact of tariff
removal on production, consumption, domestic price and import of beef, (2)
evaluate impact of free trade agreement on beef producer and consumer surpluses
and, (3) propose alternative policies that can be implemented to increase domestic
beef production and reduce beef imports. Yearly time series data from 1990 to
2008 was used and parameters were estimated by Two-Stage Least Squares
method. Removal of beef import tariffs for imports from Australia and New
Zealand under AANZFTA will reduce domestic beef production, increase beef
import and domestic beef supply, leading to reduction in domestic beef price
hence, increased beef demand. AANZFTA will increase consumers’ surplus and
reduce producers’ surplus. Reduction of beef imports in terms of imports from
Australia, New Zealand, rest of the world and imported feeder cattle by 90 percent
each, will result in highest producers’ surplus, however domestic beef production
does not increase significantly. Combination of interest rate reduction to four
percent, increasing imported breeding cattle by 60 percent, artificial insemination
technology by 64 percent and beef import tariffs for imports from Australia and
New Zealand by 40 percent each, is the best policy alternative to increase
domestic beef production and curb beef imports. This policy combination can be
implemented ahead of AANZFTA implementation. Nonetheless, Indonesia will
achieve only 52 percent of beef self sufficiency with this policy in 2014. To
minimize the effects of AANZFTA on beef industry, it is recommended that
policy combination of interest rate reduction, increasing artificial insemination
technology and number of imported breeding cattle be implemented.
Key words: beef industry, trade, AANZFTA
ABSTRAK
THATO TSEUOA. Dampak Perjanjian Perdagangan Bebas ASEAN, Australia
dan Selandia Baru Terhadap Industri Daging Sapi di Indonesia (YUSMAN
SYAUKAT sebagai Ketua dan DEDI BUDIMAN HAKIM, sebagai Anggota
Komisi Pembimbing).
Partisipasi
Indonesia
dalam
ASEAN,
Australia
and
New
Zealand Free Trade Agreement (AANZFTA) bisa memberikan efek negatif terhad
ap industri daging sapi di Indonesia. Setiap tahun lebih dari 90 persen impor
daging sapi berasal dari Australia dan Selandia Baru. Jika tarif impor daging
sapi
dihapus,
peternak
sapi
Indonesia
akan
menghadapi
kerugian.
Tujuan
penelitian
ini
adalah
untuk:
(1)
mengevaluasi
dampak
penghapusan
tarif
terhadap
produksi,
konsumsi,
harga
domestik
dan
impor
daging
sapi, (2) mengevaluasi dampak perjanjian perdagangan bebas pada
surplus produsen dan konsumen daging sapi dan, (3) mengusulkan alternatif
kebijakan yang dapat diterapkan untuk meningkatkan pasokan daging sapi dalam
negeri dan mengurangi impor daging sapi. Penelitian ini menggunakan data
tahunan time series tahun 1990-2008 dan pendugaan parameter dilakukan dengan
metode Two Stage Least Squares. Penghapusan tarif impor daging sapi untuk
impor dari Australia dan Selandia Baru dalam AANZFTA akan mengurangi
produksi daging sapi dalam negeri, meningkatkan impor daging sapi dan
penawaran daging sapi dalam negeri, menurunkan harga daging sapi dalam negeri
sehingga permintaan daging sapi meningkat. AANZFTA akan meningkatkan
surplus konsumen dan mengurangi surplus produsen. Pengurangan impor daging
sapi dari Australia, Selandia Baru, seluruh dunia dan sapi bakakan sebesar 90
persen masing-masing akan menghasilkan surplus produsen tertinggi, namun
produksi daging sapi dalam negeri tidak meningkat secara signifikan. Kombinasi
dari pengurangan suku bunga hingga empat persen, meningkatkan impor sapi bibit
dengan 60 persen, teknologi inseminasi buatan dengan 64 persen dan tarif impor
untuk impor daging sapi dari Australia dan Selandia Baru sebesar 40 persen,
merupakan alternatif kebijakan terbaik untuk meningkatkan produksi daging sapi
dalam negeri dan mengurangi impor daging sapi. Kombinasi kebijakan ini dapat
dilaksanakan menjelang pelaksanaan AANZFTA. Meskipun demikian, dengan
kebijakan ini pada tahun 2014 Indonesia hanya akan mencapai swasembada
daging sapi 52 persen. Untuk meminimalkan efek AANZFTA pada industri
daging sapi, dianjurkan berupa kebijakan kombinasi pengurangan suku bunga,
meningkatkan teknologi inseminasi buatan dan peningkatan jumlah impor sapi
bibit.
Kata kunci: industri daging sapi, perdagangan, AANZFTA
SUMMARY
THATO TSEUOA. Impact of ASEAN Australia and New Zealand Free Trade
Agreement on Beef Industry in Indonesia (YUSMAN SYAUKAT as Chairman
and DEDI BUDIMAN HAKIM as Member of Advisory Committee).
Persistent increase in income and population and change in food
consumption in Indonesia has led to considerable increase in food demand such as
vegetables, fruits, sugar, beef, dairy products, poultry and seafood. As the result,
there has been increasing imports of some of these products to meet their domestic
demand. In particular, roughly 30 percent of national beef demand is met by
imports of beef and beef cattle largely from Australia and New Zealand. For the
past years Government of Indonesia has implemented several policies to protect
domestic beef farmers so that domestic beef production can increase and reduce
dependence on imports. One of such policies is imposition of beef import tariff.
Nonetheless, with several free trade agreements that Indonesia has been
participating in, such as ASEAN, Australia and New Zealand Free Trade
Agreement (AANZFTA), those efforts will cease. Every year more than 90
percent of Indonesian beef imports come from Australia and New Zealand.
Involvement of Indonesia in AANZFTA may have negative effects on beef
industry when beef import tariffs are phased out in 2020. Hence, the objectives of
this study are (1) to evaluate the impact of tariff removal on production,
consumption, domestic price and import of beef, (2) to evaluate impact of free
trade agreement on beef producer and consumer surpluses and (3) to propose
alternative policies that can be implemented to increase domestic beef production.
In this study, yearly time series data from 1990 to 2008 was used and
analysed with econometric model. The model consists of eight structural
equations and four identity equations. Parameters were estimated with Two Stage
Least Squares method. Several policy alternatives were simulated which include
single policies and their combinations: (1) removal of beef import tariffs for beef
imports from Australia and New Zealand, (2) reducing interest rate, (3) increasing
number of imported breeding cattle, (4) increase artificial insemination
technology, (5) combination of reducing interest rate, increasing imported
breeding cattle and increasing artificial insemination technology, (6) increasing
import tariffs for beef imports from Australia and New Zealand, (7) combination
of reducing interest rate, increasing imported breeding cattle, increasing artificial
insemination technology and increasing import tariff, (8) combination of reducing
interest rate, increasing imported breeding cattle, increasing artificial insemination
technology and removal of beef import tariffs for imports from Australia and
New Zealand, (9) reduction of beef imports from Australia, New Zealand, rest of
the world and imported feeder cattle by 90 percent each, (10) combination of
reduction of beef imports from Australia, New Zealand, rest of the world and
imported feeder cattle by 90 percent each, reducing interest rate, increasing
number of imported breeding cattle and increasing artificial insemination
technology, and (11) combination of interest rate reduction, increasing import
beef tariffs for imports from Australia and New Zealand, artificial insemination
technology and number of imported breeding cattle.
Simulation results revealed that removal of beef import tariff will increase
beef import, increase domestic beef supply, leading to reduction in domestic beef
price hence, increased beef demand. However, domestic beef production does not
decrease drastically. The free trade agreement will increase consumers’ surplus
and reduce producers’ surplus. Reduction of beef imports from Australia, New
Zealand, rest of the world and imported feeder cattle by 90 percent each will result
in highest producers’ surplus, however domestic beef production does not increase
significantly. Domestic beef supply is drastically reduced, leading to high
domestic beef price hence, reduced beef demand. As the result, producers benefit
at the expense of consumers. The study found out that, in case Indonesia can be
allowed to increase beef import tariff, combination of interest rate reduction to
four percent, increasing imported breeding cattle by 60 percent, artificial
insemination technology by 64 percent and beef import tariffs for imports from
Australia and New Zealand by 40 percent each, can be the best policy alternative
to increase domestic beef production and curb beef imports from Australia and
New Zealand by almost 100 percent. This policy combination can be implemented
ahead of implementation of AANZFTA in Indonesia as it has been discovered that
it gives highest domestic beef production among the proposed policy alternatives.
Nonetheless, Indonesia will achieve only 52 percent beef self sufficiency with this
policy in 2014. There is a need to improve productivity so that domestic beef
production can be increased. To minimize the effects of AANZFTA on
Indonesian beef industry, it is recommended that policy combination of interest
rate reduction, increasing artificial insemination technology and number of
imported breeding cattle be implemented.
Copyright© 2011, Bogor Agricultural University All right reserved
1. No part or all of this thesis may be excerpted without inclusion or
mentioning the sources
a. Excerption only for research and education use, writing for
scientific papers, reporting, critical writing or reviewing of a
problem
b. Excerption does not inflict a financial loss in the proper interest of
Bogor Agricultural University
2. No part of or entire thesis may be translated and reproduced in any
form or by any means, without permission in writing from Bogor
Agricultural University
IMPACT OF ASEAN AUSTRALIA AND NEW ZEALAND
FREE TRADE AGREEMENT ON BEEF INDUSTRY
IN INDONESIA
THATO TSEUOA
A thesis
Submitted to the Graduate School in Partial Fulfillment of the Requirements for
Master of Science
Degree in
Agricultural Economics
GRADUATE SCHOOL
BOGOR AGRICULTURAL UNIVERSITY
2011
1. Thesis External Examiner
: Dr. Ir. Muhammad Firdaus, PS, M.Si
2. Study Program Representative : Dr. Ir. M. Parulian Hutagaol, MSc
Thesis Title
: Impact of ASEAN, Australia and New Zealand
Free Trade Agreement on Beef Industry in
Indonesia
Name
: Thato Tseuoa
Registration Number
: H353098231
Major
: Agricultural Economics
Approved
1. Advisory Committee
Dr. Ir. Yusman Syaukat, MEc.
Chairman
Dr. Ir. Dedi Budiman Hakim, MEc.
Member
Agreed
2. Coordinator of Major
Agricultural Economics
3. Dean of Graduate School
Prof. Dr. Ir. Bonar M. Sinaga, MA
Dr. Ir. Dahrul Syah, M.Sc.Agric
Examination Date: 2nd May 2011
Submission Date:
ACKNOWLEDGEMENTS
Firstly, I thank God Almighty for giving me the spirit and wisdom to
complete this study – there is none like You God. My profound gratitude goes to
my supervisors, Dr. Ir. Yusman Syaukat and Dr. Ir. Dedi Budiman Hakim, for
their excellent supervision, their practical inputs as well as their professional
guidance during completion of this study.
I am greatly indebted to major coordinator, Professor Bonar M. Sinaga,
who made constructive criticism and valuable suggestions during the writing of
this thesis. I am grateful to the staff members of Agricultural Economics
Postgraduate Program at Bogor Agricultural University for their kind assistance
and staff at Directorate General of Livestock Services for providing me with all
the necessary information concerning Indonesian beef industry.
My sincere thanks are extended to Developing Countries Partnership
Scholarship Program for financial support that made it possible for me to attain
Master of Science degree in Indonesia.
My deepest appreciation goes to my loving parents, sisters, brothers and
other family members for their love, care and encouragement through the graduate
school experience. I would like to thank all people, my friends, who have
contributed to this research with their experience and insights and other help.
Finally, this thesis is dedicated to my parents, ‘Matebello and Mosehle
Tseuoa, who inspired me to pursue a career in the field of agriculture.
Bogor, July 2011
Thato Tseuoa
AUTOBIOGRAPHY
Thato Tseuoa, the author of this thesis, was born on the 7th February 1983 in
Maseru District, Lesotho. She completed her primary education in 1995 and
joined St. James Anglican High School for secondary education from where she
did her Lesotho Junior Certificate in 1998. At the same school, she did her
Cambridge Overseas School Certificate in 2000. She joined National University
of Lesotho in 2001 and graduated with Bachelor of Science in Agriculture in 2006.
Between August 2006 and November 2007, she worked as science and
agriculture teacher at Phomolong LEC High School. In December 2007 she joined
Department of Agricultural Research, Agronomy Section, where she worked as
research officer until August 2008. In September 2008 she was awarded
scholarship to pursue Master’s Degree in Bogor Agricultural University by
Indonesian Government under the Developing Countries Partnership Scholarship
Program. She is to graduate with a Master of Science degree in Agricultural
Economics.
TABLE OF CONTENTS
Page
I.
II.
LIST OF TABLES ....................................................................................
vi
LIST OF FIGURES ..................................................................................
vii
LIST OF APPENDICES ...........................................................................
viii
INTRODUCTION ....................................................................................
1
1.1. Background ......................................................................................
1
1.2. Problem Statement ...........................................................................
4
1.3. Objectives .........................................................................................
6
1.4. Research Scope and Limitations ......................................................
7
LITERATURE REVIEW..........................................................................
9
2.1. Economics of Free Trade .................................................................
9
2.1.1. Theory of Absolute Advantage ............................................
9
2.1.2. Theory of Comparative Advantage ......................................
10
2.1.2.1. Ricardo’s theory .....................................................
10
2.1.2.2. Heckscher – Ohlin Theory ......................................
11
2.2. Regional Integration Agreements ....................................................
13
2.3. Economic Benefits and Costs of Regional Economic Agreements .
15
2.3.1. Competition and Scale Effects .............................................
15
2.3.2. Trade and Location Effects ..................................................
17
2.4. Theory of Regional Free Trade Areas ..............................................
19
2.4.1. ASEAN Australia New Zealand Free Trade Area ...............
19
2.5. Beef Cattle Population .....................................................................
21
2.6. Beef Production................................................................................
22
2.6.1. Indonesia Beef Production ...................................................
22
2.6.2. World Beef Production and Indonesian Position .................
24
2.7. Beef Consumption............................................................................
26
2.8. Beef Trade ........................................................................................
29
i
III.
IV.
2.8.1. Beef Trade in Indonesia .......................................................
29
2.8.2. World Beef Trade .................................................................
32
2.9. Beef Marketing.................................................................................
34
2.10. Government Policies and Regulations in Beef Industry ..................
36
2.10.1. Inter – Regional Trade Restriction Policy............................
36
2.10.2. Marketing Quota ..................................................................
37
2.10.3. Marketing Tax and Restriction Policy .................................
37
2.10.4. Subsidized Credit Policy ......................................................
38
2.10.5. Tariff Policy .........................................................................
39
2.10.6. Health – Based Import Restriction Policy............................
41
2.11. Review of Previous Studies .............................................................
41
THEORETICAL FRAMEWORK ............................................................
47
3.1. Theoretical Framework ....................................................................
47
3.1.1. Beef Production and Supply Function .................................
47
3.1.2. Beef Demand Function ........................................................
50
3.2. Elasticity...........................................................................................
52
3.3. Impact of Free Trade Area ...............................................................
54
3.4. Conceptual Framework ....................................................................
57
3.5. Hypothesis ........................................................................................
59
RESEARCH METHOD ............................................................................
61
4.1. Model Specification .........................................................................
61
4.1.1. Domestic Beef Supply..........................................................
62
4.1.2. Domestic Beef Production ...................................................
62
4.1.3. Beef Import ..........................................................................
64
4.1.4. National Beef Demand .........................................................
65
4.1.5. World Beef Demand ............................................................
66
4.1.6. Real Domestic Beef Price ....................................................
66
4.1.7. Real Import Beef Price .........................................................
67
4.1.8. Real World Beef Price .........................................................
67
ii
V.
VI.
4.1.9. Imported Feeder Cattle.........................................................
67
4.2. Model Identification and Estimation................................................
68
4.3. Model Validation .............................................................................
70
4.4. Elasticity...........................................................................................
71
4.5. Model Simulation .............................................................................
71
4.6. Producer and Consumer Surplus Analysis .......................................
72
4.7. Data Type and Sources.....................................................................
74
RESULTS OF ESTIMATED ECONOMETRIC MODEL ......................
75
5.1. Model Statistics ................................................................................
75
5.2. Model Results ..................................................................................
76
5.2.1. Domestic Beef Production ...................................................
76
5.2.2. Beef Imports from Australia ................................................
77
5.2.3. Beef Imports from New Zealand..........................................
78
5.2.4. National Beef Demand .........................................................
80
5.2.5. Real Domestic Beef Price ....................................................
80
5.2.6. Real Import Beef Price .........................................................
81
5.2.7. Real World Beef Price .........................................................
82
5.2.8. Feeder Cattle Import ............................................................
83
5.3. Interpretation of Estimated Parameters ............................................
84
POLICY EVALUATION .........................................................................
91
6.1. Model Validation .............................................................................
91
6.2. Impact of Different Policy Alternatives on Beef Industry ...............
92
6.2.1. Impact of Removal of Beef Import Tariffs for Imports
from Australia and New Zealand .........................................
96
6.2.2. Impact of Interest Rate Reduction to Five Percent ..............
99
6.2.3. Impact of Increasing Imported Breeding Cattle by 30
Percent .................................................................................. 101
6.2.4. Impact of Increasing Artificial Insemination
Technology in Previous Year by 40 Percent ........................ 102
iii
6.2.5. Impact of Reducing Interest Rate to Five Percent,
Increasing Imported Breeding Cattle by 30 Percent
and increasing Artificial Insemination Technology
in the Previous Year by 40 Percent ...................................... 103
6.2.6. Impact of Increasing Import Tariffs for Imports from
Australia and New Zealand by 20 Percent Each .................. 104
6.2.7. Impact of Increasing Import Tariffs for Imports from
Australia and New Zealand by 20 Percent Each, Interest
Rate Reduction to Five Percent, Increasing Volume of
Imported Breeding Cattle by 30 Percent and Increasing
Artificial Insemination Technology in Previous Year by
40 Percent ............................................................................. 106
6.2.8. Impact of Removal of Import Tariffs for Imports from
Australia and New Zealand, Interest Rate Reduction
to Five Percent, Increasing Volume of Imported
Breeding Cattle by 30 Percent and Increasing
Artificial Insemination Technology in Previous Year
by 40 Percent ........................................................................ 107
6.2.9. Impact of Reducing Beef Imports from Australia, New
Zealand, Rest of the World and Imported Feeder Cattle
by 90 Percent Each ............................................................... 108
6.2.10. Impact of Combination of Interest Rate Reduction to
Five Percent, Increasing Imported Breeding Cattle
by 30 Percent, Increasing Artificial Insemination
Technology in Previous Year by 40 Percent and
Reducing Beef Imports from Australia, New Zealand,
Rest of the World and Imported Feeder Cattle by 90
Percent Each ......................................................................... 110
6.2.11. Impact of Combination of Reducing Real Interest Rate
to Four Percent, Increasing Beef Import Tariffs for
Imports from Australia and New Zealand by 40 Percent
Each, Increasing Imported Breeding Cattle by 60
Percent and Increasing Artificial Insemination
Technology by 64 Percent.................................................... 111
6.3. Projection of Production and Consumption of Beef ........................ 112
6.4. Summary of Policy Simulation Alternatives ................................... 113
VII.
CONCLUSION AND POLICY IMPLICATIONS................................... 115
7.1. Conclusion ....................................................................................... 115
iv
7.2. Policy Implications .......................................................................... 116
REFERENCES.......................................................................................... 119
APEPENDICES ........................................................................................ 125
v
LIST OF TABLES
Number
1.
Page
Ten Major Beef Producing Countries in the World and Indonesia
Position in 2000 and 2008 ............................................................................
25
2.
Meat Consumption per Capita in Indonesia from 1981 to 2008 ..................
26
3.
Beef Consumption in Indonesia from 1999 to 2008 ....................................
27
4.
Indonesia’s Beef Products Imports from 1990 to 2008 ...............................
30
5.
Beef Exports by Major World Exporters of Beef in 2000 and 2008 ...........
33
6.
Comparison of Beef Imports from Largest World Beef Importers with
Indonesia in 2000 and 2008 .........................................................................
34
Results of Parameter Estimation and Statistical Tests for Domestic
Beef Production............................................................................................
77
Results of Parameter Estimation and Statistical Tests for Beef Imports
from Australia ..............................................................................................
78
Results of Parameter Estimation and Statistical Tests for Beef Imports
from New Zealand........................................................................................
79
Results of Parameter Estimation and Statistical Tests for National Beef
Demand ........................................................................................................
80
Results of Parameter Estimation and Statistical Tests for Real domestic
Beef Price .....................................................................................................
81
Results of Parameter Estimation and Statistical Tests for Real Import
Beef Price .....................................................................................................
82
Results of Parameter Estimation and Statistical Tests for Real World
Beef Price .....................................................................................................
83
Results of Parameter Estimation and Statistical Tests for Feeder Cattle
Import ...........................................................................................................
83
15.
Model Validation Results.............................................................................
91
16.
Percentage Change of Alternative Policy Simulations ................................
97
17.
Impact of alternative Policies on Beef Industry in Indonesia ......................
98
18.
Impact of Alternative Policies on Beef Producer Surplus and Consumer
Surplus in Indonesia .....................................................................................
98
7.
8.
9.
10.
11.
12.
13.
14.
19.
Projection of Production and Consumption of Beef from 2009 to 2014
in Indonesia .................................................................................................. 112
vi
LIST OF FIGURES
Number
Page
1.
Beef Production In Indonesia from 1984 to 2008 .....................................
24
2.
Comparison of Countries with Largest Beef Supply per Capita in the
World with Indonesia ...............................................................................
28
3.
Volume of Beef Export and Import in Indonesia from 1990 to 2008 .......
31
4.
Indonesian Beef Imports According to Source of Origin from 1990
to 2008.......................................................................................................
32
Beef Trade Creation as a Result of Participation of Indonesia in
AANZFTA ................................................................................................
55
Beef Trade Diversion as a Result of Participation of Indonesia in
AANZFTA ................................................................................................
57
Economic Model of Beef Industry in Indonesia .......................................
63
5.
6.
7.
vii
LIST OF APPENDICES
Number
Page
1.
Data ...........................................................................................................
127
2.
Parameter Estimation Program and Results ..............................................
131
3.
Model Validation Program and Results ....................................................
141
viii
1
I. INTRODUCTION
1.1.
Background
Economic growth and industrialization in Indonesia have led to increase in
competition for domestic resources. As a result, this has led to reduction in the
contribution of agriculture to gross domestic product (GDP). Agriculture’s share
to GDP has declined from around 49 percent in 1970 (Bond et al., 2007) to just
around 13.8 percent in 2007 while livestock subsector contributed 1.7 percent
(Central Bureau of Statistics (CBS), 2010). Persistent increases in income per
capita and population in Indonesia has resulted in considerable increase for food
demand such as vegetables, fruits, sugar, beef, dairy products, poultry and
seafood. Imports have become an increasingly important source of vegetables,
sugar, beef and dairy products (Bond et al., 2007) as demand for these products
increases.
Beef industry in Indonesia makes an important contribution to the country.
Besides providing meat protein to consumers, it is also source of employment and
income for millions of rural families and investment opportunities for private
companies, both of which are important for Indonesia’s regional development.
Through its demand for inputs and the sale of cattle along the beef value chain, it
also provides a stimulus to many other sectors of economic activity (Hadi et al.,
2002).
Demand for beef in Indonesia persistently increases, whereas beef
production tends to fluctuate, consequently leading to increased beef imports.
Approximately 30 percent of national beef demand in Indonesia is met by imports
of beef, beef offal and feeder cattle (Directorate General of Livestock Services
2
(DGLS), 2010). Beef consumption per capita per year in Indonesia is 1.11kg
(Ministry of Agriculture, 2008). In 2008 alone, Indonesia slaughtered 392511
heads of beef cattle and imported 510 100 heads of feeder cattle, 45708.5 tons of
beef and 5776 tons of beef offal (DGLS, 2009). Most beef imports come from
Australia and New Zealand. Population growth rate of beef cattle is low, that is,
0.93 percent per year from 1990 to 2008. This population growth rate is not able
to meet continuing beef demand. This causes low contribution of beef cattle to
national meat production (Mersyah, 2005 and Santi, 2008), leading to wide
imbalance between demand and supply. There are number of factors which have
contributed to low productivity. Foremost among these is low genetic potential.
This together with low cattle reproductive efficiency with long calving interval
(18-24 months), high number of service per conception (2-3), limited sources of
feeds especially during dry season, low quality feeds, presence of reproductive
disorders, high rate of calf mortality and slaughter of productive cows, reduces
number of calves born each year hence slow growth in beef cattle population
(Suryana, 2009, Sullivan and Diwyanto, 2007, and Umiyasih and Anggraeny,
2007).
In order to meet this persistent increase in beef demand, Government of
Indonesia imports beef and feeder cattle to be fattened (Priyanti et al., 1998). This
policy is carried out even though it drains country’s foreign exchange. Another
motive there is increased beef imports is because domestic beef production is
unable to meet consumers’ demand in the country in terms of quality (Priyanti et
al., 1998 and Yusdja et al., 2003). Moreover, import beef price is relatively lower
than domestic beef price. Beef imports have impact on reducing beef
competitiveness from domestic farmers. To overcome this, Government of
Indonesia has made systematic efforts by pursuing policies that develop beef
3
production and protect to beef farmers. The instruments used for development and
protection include both tariff and nontariff barriers, mainly import regulations,
and have resulted in domestic beef prices being well above prevailing
international prices. One of the efforts to suppress beef import rate is the
imposition of import tariff. Currently import tariff for beef products is five
percent.
Besides being a member of World Trade Organization (WTO), in the
recent years, Indonesia has pursued regional trade agreement as a strategy to
gradually reduce protection and increase access to the markets of trading partners.
Indonesia is currently a member of ASEAN Free Trade Area (FTA), ChinaASEAN FTA, Korea-ASEAN FTA and ASEAN-Australia-New Zealand FTA and
several others under negotiations. Agreements between countries which reduce
trade barriers faced by agricultural products assist agricultural exporters in those
countries. The lower tariff and nontariff barriers that certain agricultural exports
from member countries face put products from these countries at an advantage
compared to products from countries without such agreements. The magnitude of
expected benefits from such agreement depends on how comprehensive
elimination of trade barriers is by those involved (Bond et al., 2007).
The recently signed FTA by Indonesia is ASEAN, Australia and New
Zealand Free Trade Agreement (AANZFTA). AANZFTA was signed in February
2009 and came into force in January 2010 in some members while in Indonesia,
Laos and Cambodia is still not yet effective. Indonesia’s interest in this free trade
agreement is its textile products exports to Australia and New Zealand markets
whereas Australia and New Zealand, due to their competitive advantage, are
concerned with their livestock products exports, which include milk and beef, to
4
Indonesia. With respect to agriculture, products that are dominantly exported to
Australia and New Zealand markets by Indonesia are coffee, cacao, rubber and
palm oil. Nevertheless, Indonesia competes with Malaysia and Thailand in both
markets for the same products (Hutabarat et al., 2009). Among the FTAs
Indonesia is involved in, AANZFTA is the first anticipated to have significant
impact on the Indonesian beef industry as majority of beef imports come from
Australia and New Zealand. In this forum, according to schedule of tariff
commitments of Indonesia, the tariff rates for beef will be completely phased out
by 2020.
Like many agricultural products, besides forces of demand and supply in
domestic market, beef prices are also influenced by changes in the international
environment among others presence of economy liberalization and trade, as a
result they are closely related with changes in the policies of each country.
Therefore, policy that is comprehensive and consistent is needed in trade system
of beef in Indonesia. Regional trade agreements such as AANZFTA have to be
observed whether or not they will benefit beef industry of Indonesia.
1.2.
Problem Statement
General Agreements on Trade and Tariff and WTO have significantly
contributed to trade liberalization. However, delays in multinational negotiations
under the Doha Development Round have coerced world trade participants to
pursue Regional Trade Agreements (RTAs) as a trade policy instrument and as a
complementary to Most Favored Nation (MFN) principle (Crawford and
Fiorentino, 2005). The Free Trade Agreement (FTA) which has been negotiated
by ASEAN countries, Australia and New Zealand is complex one covering trades
5
of goods, services, investment, intellectual property, electronic commerce,
movement of business persons and competition policy and economic cooperation.
According to Stephenson and Erwidodo (1995) in Sayekti (2009),
consequences of ratification of these agreements are that, countries that have
strong export position will gain greater benefits because they have high
comparative and competitive advantages so they have greater ability to exist and
even penetrate international market. Whereas countries with low comparative and
competitive advantages will be unable to develop their exports and commodities
from competing countries will fill the domestic market. Beef is one of the
commodities with low comparative and competitive advantage in Indonesia.
Although in the long run, participation of Indonesia in AANZFTA may
have positive impact, for instance, through technological transfer that can improve
Indonesian cattle productivity; nonetheless, in the short run this may bring
negative effects on the Indonesian beef industry. AANZFTA eliminates tariffs
among member countries using different tariff levels ratified by members.
Currently, Indonesia imposes import tariff, presently at five percent, as an
instrument to protect its domestic beef farmers from competing with exporting
countries such as Australia and New Zealand. Opponents of free trade argue that
free beef trade with Australia and New Zealand is going to exacerbate the current
condition by increasing domestic beef supply in the Indonesia market as, already,
more than 90 percent of beef imports come from these countries, therefore
causing downward pressure on domestic beef price received by farmers hence
driving them out of beef industry. Statistical data indicate that export shares of
Australia and New Zealand to total beef imports in Indonesia have increased from
27.5 and 34.3 percent in 1990 to 57.2 and 41.4 percent in 2008, respectively. At
the same time, Indonesia is not only aiming to be self sufficient in beef by 2014
6
but also to have sustainable beef self sufficiency afterwards. Therefore it is
important to find out which policies can be implemented to help achieve beef self
sufficiency by 2014 and pursue the sustainable one afterwards.
Possible effects of AANZFTA on domestic beef industry in Indonesia
have not yet been explored. Previous studies focused on the impact of trade
liberalisation (in compliance with WTO regulations) on beef import as a whole. In
this study, beef imports are divided into imports from Australia and New Zealand
as the major beef exporters to Indonesia. This study is useful for beef producers
and government legislators to evaluate the future of beef industry under
AANZFTA. It is important to evaluate the impact that AANZFTA will have on
beef industry in Indonesia. Therefore, this study wishes to answer the following
questions:
1. What will be the impact of tariff removal on production, consumption,
domestic price and imports of beef?
2. What will be the impact of AANZFTA on beef producers’ and consumers’
surpluses?
3. What policy alternatives could be implemented to increase domestic beef
production in Indonesia?
1.3.
Objectives
Based on background and problem statement above, the general research
objective is to evaluate the impact of ASEAN, Australia and New Zealand free
trade agreement on the performance of beef industry in Indonesia. Specific
objectives are:
1. To evaluate the impact of tariff removal on production, consumption,
domestic price and import of beef.
7
2. To evaluate impact of free trade agreement on beef producer and consumer
surpluses.
3. To propose alternative policies that can be implemented to increase domestic
beef production.
1.4.
Research Scope and Limitations
This research focuses on the analysis of impact of free trade agreement on
the performance of beef industry in Indonesia based on the analysis of demand
and supply of beef. Yearly data from 1990 to 2008 was used. Domestic beef
supply consists of domestic beef production from domestically reared cattle,
imports of beef, and supply from imported live feeder cattle while national beef
demand was made equivalent to domestic beef supply. With the existence of
supply from imports, generally domestic beef market is also influenced by
international beef market.
This study has limitations which includes the following:
1. The study does not separate consumers into rural and urban communities
when looking at the behaviour of beef demand. Differences in education and
welfare level among rural and urban communities determine food
consumption pattern including beef consumption. These differences cannot be
looked at in this research because of unavailability of data of beef demand by
rural and urban communities separately. Furthermore, beef demand is not
differentiated into demand by households, hotels, supermarkets and
restaurants due data unavailability.
2. Domestic beef production is not separated into supply from feedlots and
smallholders due to lack of data. Data used is the one provided on the
livestock statistics books.
8
3. Beef exports are minimal therefore they are ignored.
4. Import tariff rate for boneless beef is used because its quantity imported is
larger than other types of beef.
5. Beef import price is the average import beef price from Australia and New
Zealand.
6. World beef price is taken as United States’ import beef price because United
States is the largest beef importer in the world.
7. Domestic beef production includes supply from imported feeder cattle. In this
study, it is assumed that the slaughter weight of imported feeder cow is 224kg,
therefore this number is multiplied by number of feeder cattle imported each
year, and the result is subtracted from domestic beef production reported in
statistical books to get supply from domestically produced cattle.
9
II.
2.1.
LITERATURE REVIEW
Economics of Free Trade
There has been gradual evolution of economic theories on international
trade over the past centuries. Adam Smith (1723-90), David Ricardo (1772-1823),
Eli Heckscher (1879-1962) and Bertil Ohlin (1899-1979) have been regarded as
the most influential economists and scholars of international trade (Morgan and
Katsikeas, 1997 in Ruming, 2007). Countries engage in international trade for two
basic reasons, each of which contributes to their gains from trade. Firstly,
countries trade because they are different from each other. Nations can benefit
from their differences by reaching an arrangement in which each does the things it
does relatively well. Secondly, countries are involved in trade to achieve
economies of scale in production. That is, if each country produces only a limited
range of goods, it can produce each of these goods at a large scale and hence more
efficiently than if it tried to produce everything (Krugman and Obstfeld, 2003).
Economics of free trade can be explained based on two theories: theory of
absolute advantage and theory of comparative advantage.
2.1.1. Theory of Absolute Advantage
The benefits of free trade were first observed and documented by Adam
Smith in his book, The Wealth of Nations, in 1776. Smith explained free trade
between nations based on the concept of absolute advantage in production of each
country. His theory of absolute advantage was based on free market economy. In
this book, he stressed the benefits of specialization and the workings of market
mechanism (pricing system). Smith argued that with free trade, each nation should
10
specialize in the production of those commodities in which it had an absolute
advantage (or could produce more efficiently than other nations) and imports
those commodities in which it had an absolute disadvantage (or could produce
less efficiently) (Salvatore, 1995). For example, nation A has absolute advantage
over nation B in production of commodity Y, while nation B has absolute
advantage over nation A in producing X. Each country could benefit by each
specialising in the production of the commodity it has absolute advantage and
exchange part of its output with other country for the commodity it has absolute
disadvantage. The international specialization of factors of production would
result in an increase in world output using the same amount of resources, thereby
increasing overall wealth (Condon, 2002 and Salvatore, 1995). However, absolute
advantage cannot explain the trade pattern where one of the countries has absolute
advantage in both commodities.
2.1.2. Theory of Comparative Advantage
2.1.2.1. Ricardo’s Theory
In reality it is difficult for a country to maintain absolute advantage in a
product. Furthermore, theoretically, international competition can ruin a country
that has absolute disadvantage in any product (Condon, 2002). David Ricardo
filled these gaps through his theory of comparative advantage in 1817. It became
the most basic concept of international trade theory. He argued that even if one
country has absolute disadvantage in production of both commodities, there is still
a basis for mutually beneficial trade (Condon, 2002 and Salvatore, 1995). Ricardo
described free trade in terms of single factor of production with constant
productivity of labour in two goods, but with relative productivity between the
11
goods different across two countries. In this model, labour is the only factor of
production and countries differ only in the productivity of labour in different
industries. In the Ricardian model, countries will export goods that their labour
produces relatively efficiently and import goods that their labour produces
relatively inefficiently. In other words, a country's production pattern is
determined by comparative advantage. A country has comparative advantage in
producing a good if the opportunity cost of producing that good in terms of others
is lower in that country than it is in other countries (Krugman and Obstfeld, 2003).
Ricardian theory was criticised in that it assumes that capital and labour
are immobile and that it therefore no longer applies in a world where capital
moves freely and production can be moved to countries with lower labour costs
(Condon, 2002). Another concern was that comparative advantage only works in
perfect competition. Free trade advocates argue that modernization has decreased
transportation and logistics costs through interventions such as aeroplane and
internet unavailability in Ricardo’s time make his theory increasingly sound with
time. Moreover, despite increased capital movement, wide differences in
capacities of production still exists, in fact, free trade creates wider gap of
production in many areas despite the larger increases it makes in absolute wealth.
Advocates of free trade claim that perfect competition is the result of universal
free trade, not its precondition (Ruming, 2007).
2.1.2.2. Heckscher –Ohlin Theory
Ricardian model have been developed further by other neoclassical and
modern economists and they have carried out empirical studies to verify its
validity. The theory of comparative advantage, sometimes also referred to as
12
factor endowments/proportions theory (Krugman and Obstfeld, 2003), has been
elaborated and refined many times. Ricardo's theory of comparative advantage
had been further developed by Heckscher and Ohlin in 1920s into international
trade theory called factor proportion theory. The theory is also called HeckscherOhlin theory. The theory assumes consumer tastes and preferences are similar
across nations. Moreover, the theory assumes constant returns to scale in
production, incomplete specialisation in production, perfectly competitive
product and factor markets, perfect factor mobility within nations but no factor
mobility between nations, no transportation costs or other trade barriers, full
employment of resources within nations and balanced international trade
(Gunawardana and Khorchurklang, 2007). The theory stresses that countries
should produce and export goods that require resources that are abundant and
import goods that require resources in short supply. This theory differs from the
theories of comparative advantage and absolute advantage since those theories
focus on the productivity of the production process for a particular good. On the
contrary, the Heckscher-Ohlin theory states that a country should specialize in
production and export using factors that are most abundant, and thus the
cheapest 1.
Heckscher-Ohlin theory was examined empirically by Wassily Leontief
(1956) using United States input-output table for 1947. As United States was a
capital abundant nation, he hypothesized that United States exported capital
intensive commodities and imported labour intensive commodities. Although
capital intensive, Leontief found out that United States exported labour-intensive
1
http://en.wikipedia.org/wiki/International_trade Accessed on 27/04/2010
13
commodities and imported capital-intensive commodities, which contradict
Heckscher-Ohlin theor