Trade liberalization gains under different trade theories: A case study for Ukraine

Given Ukraine's difficult political and economic situation, the EU focuses its efforts on providing financial and economic support as well as accelerating the establishment of the Association Agreement (AA) incorporating the Deep and Comprehensive Free Trade Area (DCFTA). To analyze a DCFTA between Ukraine and the EU we develop a GTAP 8.1 based multi-regional CGE model with three different setups. In addition to the standard model specification of trade based on the Armington assumption of regionally differentiated goods, we implement monopolistic competition and competitive selection of heterogeneous firms suggested by Krugman [1980] and Melitz [2003]. This allows us to capture trade growth in new varieties and changes in aggregate productivity due to within industry reallocation of resources. The core results indicate substantial benefit for Ukraine whereas the gains for the EU are quite small. A comparison of welfare results for Ukraine across the different structural assumptions shows that the impact is much higher under the Armington assumption than under either the Krugman or Melitz trade formulations. Deep integration with the EU intensifies import competition in the increasing returns sectors, while inducing a movement of resources in to Ukraine's traditional export sectors which are produced under constant returns. The indication is that traditional CGE models may overstate the gains from the DCFTA between Ukraine and EU. Consistent with Balistreri et al. (2010) and Arkolakas et al. (2012) the gains from trade can be lower under an assumption of monopolistic competition if trade reduces the set of goods produced. This is our finding for Ukraine. We caution, however, that our model does not include capital flows so EU firms supply Ukraine's markets on a cross-border bases. Allowing for capital flows might change the story if EU firms were to engage in FDI, which would increase the number of EU varieties while increasing the demand for workers in Ukraine.