Does a free-trade agreement affect prices you pay?

New Zealand's free-trade agreement with India has been in force for a little over a week - but will consumers notice any change in the prices they pay?

Economists say the answer isn't clear cut.

Infometrics chief forecaster Gareth Kiernan said the effect would depend a lot on whether India was a large importing country or not, for any particular product.

When it was, its trade policies would have an effect on the world price.

"Reducing the amount of international product that its consumers are willing to buy, as domestic products are effectively relatively cheaper. This lower demand for international product effectively reduces the world price … and given New Zealand's situation where consumers effectively pay the world price for products that we export, prices end up being lower here as well, as do production levels because there's not as much profit or incentive to squeeze out the last marginal unit of production at a higher cost. So reversing that situation out, by removing a tariff, will lead to greater demand globally and a higher global price.

"However, if India is not a large importing country, then any change to its trade policies will have little or no effect on the world price. For example, if India removed an import tariff on beef, but there were still no beef imports because everyone in the country was Hindu and didn't eat beef, then the world price would remain unchanged - even though the price of available beef for Indian consumers had fallen. Thus there would be no effect on prices for NZ consumers (and no effect on exporters' revenue or volumes either)."

He said the question then became whether Indian demand for New Zealand products was expected to increase materially due to a reduction in tariffs, and whether the demand was significant enough that it would affect global activity.

"In reality, there will be a continuum between India having a large effect on the world price and having none at all.

"Having had a quick skim through NZ's key export categories to India, wool and apples look like the shift in Indian demand could be significant enough on a global scale to have some effect on the price, although wool prices are so poor that it might not make much difference, whereas Indian demand for lamb and wine is so low from a global perspective that it seems unlikely to affect prices."

Murat Ungor, an economist at Otago University, said free-trade agreements could create lower prices for local consumers by letting cheaper goods in to be stocked on shop shelves.

But that was not always what happened.

"Trade creation occurs when cheaper imports from a partner replace higher-cost domestic production, so prices fall, consumers gain, and resources shift towards what the country does best," he said.

"Trade diversion occurs when imports switch from a cheaper outside supplier to a partner who is now cheaper only because of the tariff preference. Prices may still fall, but by less than under a non-discriminatory tariff cut, and the country loses tariff revenue and ends up buying from a higher-cost source. The gain shrinks and can turn negative."

He said which outcome dominated in any particular scenario would depend on a range of factors.

"Creation is more likely when the partner is a low-cost producer and the two economies make overlapping products at different costs, because there is domestic production to displace. Strict rules of origin can push firms to source inputs from partners even when outsiders are cheaper, adding to diversion. And the more of world supply the bloc covers, the less room there is for diversion."

Ungor said another important consideration was how much was actually passed on to shoppers.

"Even when a tariff cut lowers import costs, market structure determines how much of that reaches consumers. Where retail or distribution is concentrated, pass-through can be well below 100 percent. The overall effect on prices can therefore be modest, gradual and a one-off shift in the price level, not a change in ongoing inflation."

Kiernan said a big part of the rationale for the free-trade agreement with India was to allow some diversification away from the Chinese market.

He said that had served New Zealand well over the past 17 years but came with geopolitical risks, as well as the issue of being overly reliant on a single market.

"Risks that we saw demonstrated a few years ago when the Chinese government effectively turned off the tap on several Australian export categories, such as wine. Additionally, there's a widespread expectation that Chinese economic growth will be slower going forward than it has been over the 1990-2020 period, meaning that there are fewer gains to be made for exporters in that market.

"In contrast, Indian's outlook for economic growth and population growth remains relatively strong - and that's before one considers the rapid growth in the size of the country's middle class that has yet to occur, much like we've seen in China over the last 30-odd years. So the growth potential for exporters is considerable given the confluence of those factors, and the FTA's removal of impediments to realising that growth is key."

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