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Essential Micro Tools © Baldwin & Wyplosz 2006. The Economics of European Integration, 2 Essential Micro Tools © Baldwin & Wyplosz 2006. The Economics of European Integration, 2 nd Edition 1

Preliminaries I • Demand curve shows how much consumers would buy of a particular Preliminaries I • Demand curve shows how much consumers would buy of a particular good at any particular price. • It is based on optimisation exercise: – Would one more be worth price? • Market demand is aggregated over all consumers’ demand curves. – Horizontal sum. © Baldwin & Wyplosz 2006. The Economics of European Integration, 2 nd Edition 2

Preliminaries I • Supply curve shows how much firms would offer to the market Preliminaries I • Supply curve shows how much firms would offer to the market at a given price. • Based on optimisation: – Would selling one more unit at price increase profit? • Market supply is aggregated over all firms. A firm’s supply curve is its marginal cost curve. – Horizontal sum. © Baldwin & Wyplosz 2006. The Economics of European Integration, 2 nd Edition 3

Welfare analysis: consumer surplus • Since demand curve based on marginal utility, it can Welfare analysis: consumer surplus • Since demand curve based on marginal utility, it can be used to show consumers’ well-being (welfare) is affected by changes in the price. • Gap between marginal utility of a unit and price paid shows ‘surplus’ from being able to buy c* at p*. = MU © Baldwin & Wyplosz 2006. The Economics of European Integration, 2 nd Edition 4

Welfare analysis: consumer surplus • If the price falls: – Consumers obviously better off. Welfare analysis: consumer surplus • If the price falls: – Consumers obviously better off. – Consumer surplus change quantifies this intuition. • Consumer surplus rise, 2 parts: – Pay less for units consumed at old price; measure of this = area A. • A = Price drop times old consumption. – Gain surplus on the new units consumed (those from c* to c’); measure of this = area B. • B = sum of all new gaps between marginal utility and price © Baldwin & Wyplosz 2006. The Economics of European Integration, 2 nd Edition 5

Welfare analysis: producer surplus • Since supply curve based on marginal cost, it can Welfare analysis: producer surplus • Since supply curve based on marginal cost, it can be used to show producers’ wellbeing (welfare) is affected by changes in the price. • Gap between marginal cost of a unit and price received shows ‘surplus’ from being able to sell q* at p*. S=MC © Baldwin & Wyplosz 2006. The Economics of European Integration, 2 nd Edition 6

Welfare analysis: producer surplus • If the price rises: – producers obviously better off. Welfare analysis: producer surplus • If the price rises: – producers obviously better off. – Producer surplus change quantifies this intuition. • producer surplus rise, 2 parts: – Get more for units sold at old price; measure of this = area A. • A = Price rise times old production. – Gain surplus on the new units sold (those from q* to q’). – measure of this = area B. • B= sum of all new gaps between marginal cost and price. © Baldwin & Wyplosz 2006. The Economics of European Integration, 2 nd Edition 7

Preliminaries II • Introduction to Open Economy Supply & Demand Analysis. • Start with Preliminaries II • Introduction to Open Economy Supply & Demand Analysis. • Start with Import Demand Curve. – This tells us how much a nation would import for any given domestic price. – Presumes imports and domestic production are perfect substitutes. – Imports equal gap between domestic consumption and domestic production. © Baldwin & Wyplosz 2006. The Economics of European Integration, 2 nd Edition 8

Import demand curve (MD) Home Supply price 1 P* 2 P” 3 P’ C” Import demand curve (MD) Home Supply price 1 P* 2 P” 3 P’ C” C’ quantity P’ Home import demand curve, MDH Home Demand Z’ Z” P” M” M’ imports © Baldwin & Wyplosz 2006. The Economics of European Integration, 2 nd Edition 9

Import supply curve (MS) price Foreign Supply P” P’ 2 P* 1 Foreign 3 Import supply curve (MS) price Foreign Supply P” P’ 2 P* 1 Foreign 3 export Supply curve, XSF, or MSH. Foreign Demand C” C’ Z’ Z” quantity X’ X” exports © Baldwin & Wyplosz 2006. The Economics of European Integration, 2 nd Edition 10

Welfare & Import demand curve Home Supply price To. T effect price NB: E=B+D Welfare & Import demand curve Home Supply price To. T effect price NB: E=B+D 1 P* 2 P” P” P’ A B C D C 3 E Home import demand curve, MDH Home Demand Z’ Z” C” C’ quantity P’ M” M’ imports © Baldwin & Wyplosz 2006. The Economics of European Integration, 2 nd Edition 11

Welfare & Import supply curve price Trade price effect, i. e. To. T effect Welfare & Import supply curve price Trade price effect, i. e. To. T effect Foreign Supply P” P’ A C B D F=C+E E D F 2 P* 1 Foreign 3 export Supply curve, XSF, or MSH. Foreign Demand C” C’ Z’ Z” quantity X’ X” exports © Baldwin & Wyplosz 2006. The Economics of European Integration, 2 nd Edition 12

The Workhorse: MD-MS Diagram • Diagram very useful. – easy identification of price and The Workhorse: MD-MS Diagram • Diagram very useful. – easy identification of price and volume effects of a trade policy change. euros Import demand curve supply curve • Welfare change likewise easy. MS PFT MD Imports imports © Baldwin & Wyplosz 2006. The Economics of European Integration, 2 nd Edition 13

MD-MS + open econ. supply & demand • MD-MS diagram can be usefully teamed MD-MS + open econ. supply & demand • MD-MS diagram can be usefully teamed with open economy supply and demand diagram. • Permits tracking domestic & international consequences of a trade policy change. Domestic demand curve Domestic price, euros Sdom Import supply curve MS Import demand curve Imports Domestic supply curve PFT MD Ddom Imports imports Z C quantity © Baldwin & Wyplosz 2006. The Economics of European Integration, 2 nd Edition 14

MFN Tariff Analysis • 1 st step: determine how tariff changes prices and quantities. MFN Tariff Analysis • 1 st step: determine how tariff changes prices and quantities. – suppose tariff imposed equals T euros per unit. – Small country ‘fiction’. • Tariff shifts MS curve up by T. – Exporters would need a domestic price that is T higher to offer the same exports. • Because they earn the domestic price minus T. © Baldwin & Wyplosz 2006. The Economics of European Integration, 2 nd Edition 15

MFN Tariff Analysis • For example, how high would domestic price have to be MFN Tariff Analysis • For example, how high would domestic price have to be in Home for Foreigners to offer to export Ma to Home? – Answer is Pa+T, so Foreigners would see a price of Pa. Domestic price Border price MS with T MS w/FT XS=MS Pa+T 2 T Pa MD 1 Xa=Ma Foreign exports Ma Home imports © Baldwin & Wyplosz 2006. The Economics of European Integration, 2 nd Edition 16

MFN Tariff Analysis • New equilibrium in Home (MD=MS with T) is with P’ MFN Tariff Analysis • New equilibrium in Home (MD=MS with T) is with P’ and M’. • Domestic price now differs from border price (price exporters receive). • P’ vs P’-T. Border price Domestic price XS=MS PFT P’-T MS with T MS P’ PFT T MD Foreign exports X’=M’ XFT= MFT M’ MFT Home imports © Baldwin & Wyplosz 2006. The Economics of European Integration, 2 nd Edition 17

Positive effects • • Domestic price rises. Border price falls. Imports fall. Can’t see Positive effects • • Domestic price rises. Border price falls. Imports fall. Can’t see in diagram: – – Domestic consumption falls. domestic production rises. Foreign consumption rises. Foreign production falls. • Could get this in diagram by adding open economy S & D diagram to right. © Baldwin & Wyplosz 2006. The Economics of European Integration, 2 nd Edition 18

Welfare effects: Home • Drop in imports creates loss equal area C. (Trade volume Welfare effects: Home • Drop in imports creates loss equal area C. (Trade volume effect). • Drop in border price creates gain equal to area B. (Border price effect, i. e. To. T effect). • Net effect on Home = -C+B. • ALTERNATIVELY: – Private surplus change (sum of change in producer and consumer surplus) equal to minus A+C. – Increase in tariff revenue equal to +A+B. • Same net effect, B-C (but less intuition). © Baldwin & Wyplosz 2006. The Economics of European Integration, 2 nd Edition 19

Welfare effects: Foreign • Drop in exports creates loss equal area D – (Trade Welfare effects: Foreign • Drop in exports creates loss equal area D – (Trade volume effect). • Drop in border price creates loss equal to area B. – (Border price effect, a. k. a. , To. T effect). • Net effect on Foreign = -D-B. • ALTERNATIVELY: – Private surplus change (sum of change in producer and consumer surplus) equal to minus -D-B. – Same net effect, B-C (but less intuition). © Baldwin & Wyplosz 2006. The Economics of European Integration, 2 nd Edition 20

Welfare effects: useful compression • In cases of more complex policy changes useful to Welfare effects: useful compression • In cases of more complex policy changes useful to do Home and Foreign welfare changes in one diagram. • MS-MD diagram allows this: – Home net welfare change is –C+B. – Foreign net welfare change is –D-B. – World welfare change is –D-C. • NB: if Home gains (-C+B>0) it is because it exploits foreigners by ‘making’ them to pay part of the tariff (i. e. area B). • Notice similarity with standard tax analysis. © Baldwin & Wyplosz 2006. The Economics of European Integration, 2 nd Edition 21

Distributional consequences: Home • Trade protection imposed mainly due to politically considerations raised by Distributional consequences: Home • Trade protection imposed mainly due to politically considerations raised by distributional consequences. • Thus important for some purposes to see domestic consequences of trade policy change. • For this, add the open economy supply & demand diagram to the right of the MD-MS diagram. – MD-MS diagram tells us the price and quantity effects of trade policy change. – Open-economy S&D tells us the domestic distributional consequences. © Baldwin & Wyplosz 2006. The Economics of European Integration, 2 nd Edition 22

Distributional consequences: Home • Home consumers lose, area E+C 2+A+C 1; Home producers gain Distributional consequences: Home • Home consumers lose, area E+C 2+A+C 1; Home producers gain E, Home tariff revenue rises by A+B. – net change = B-C 2+-C 1 (this equals B-C in left panel). Domestic price, euros Sdom P’ A PFT P’-T B C MS P’ E C 2 D A C 1 PFT P’-T B MD imports Ddom Z Z’ C’ C quantity © Baldwin & Wyplosz 2006. The Economics of European Integration, 2 nd Edition 23

A typology for trade barriers • Many ways to categorise trade barriers. • A A typology for trade barriers • Many ways to categorise trade barriers. • A useful 3 -way categorisation. • Focuses on ‘rents’ i. e. who earns the gap between domestic and border price? – DCR (domestically captured rents) e. g. tariff, import licence. – FCR (foreign captured rents), price undertakings, export taxes. – Frictional (no rents since barriers involve real costs of importing/exporting), e. g. . Swedish wipers on headlights, paper recycling for carton boxes. © Baldwin & Wyplosz 2006. The Economics of European Integration, 2 nd Edition 24

A typology for trade barriers • Net Home welfare changes for: – DCR = A typology for trade barriers • Net Home welfare changes for: – DCR = B-C – FCR = -A-C – Frictional = -A-C • Net Foreign welfare changes for: euros P’ PFT MS A C B D P’-T MD – DCR = -B-D – FCR = +A-D – Frictional = -B-D • Note: foreign may gain from FCR. M’ MFT Home imports © Baldwin & Wyplosz 2006. The Economics of European Integration, 2 nd Edition 25

Common Agricultural Policy © Baldwin & Wyplosz 2006. The Economics of European Integration, 2 Common Agricultural Policy © Baldwin & Wyplosz 2006. The Economics of European Integration, 2 nd Edition 26

CAP • Massively complex, massively expensive policy. • Hard to understand without seeing how CAP • Massively complex, massively expensive policy. • Hard to understand without seeing how it developed. • CAP started as simple price support policy in 1962. • EU was net importer of most food, so could support price via tariff. – Technically known as a ‘variable levy. ’ © Baldwin & Wyplosz 2006. The Economics of European Integration, 2 nd Edition 27

Simple price support with tariff price Home Demand Home Supply Home Demand price Home Simple price support with tariff price Home Demand Home Supply Home Demand price Home Supply pss T’ Price floor (Pw+T, or Pw’+T’) T Pw’ Pw Price floor A B C 1 Pw C 2 Imports (with floor) Z Zf Cf C Q Imports (without price floor) © Baldwin & Wyplosz 2006. The Economics of European Integration, 2 nd Edition 28

Food tax interpretation • Price floor supported by tariff is like all-in-one package made Food tax interpretation • Price floor supported by tariff is like all-in-one package made up of simpler policy measures. Home Demand price Home Supply – (i) free trade in the presence of – (ii) a consumption tax equal to T and – (iii) a production subsidy equal to T. • Price, quantity, revenue and welfare effects are identical. • This is insightful: – makes plain that consumers are the ones who pay for a price floor enforced with a variable levy. – Part of what they pay goes to domestic farmers (area A), – part of it goes to the EU budget (area B), – part of it wasted (areas C 1 and C 2). Price floor A B C 1 Pw Z Zf C 2 Cf C © Baldwin & Wyplosz 2006. The Economics of European Integration, 2 nd Edition Q 29

Farm size distribution in 1987 • Very skewed ownership: – Biggest 7% of farmers Farm size distribution in 1987 • Very skewed ownership: – Biggest 7% of farmers owned ½ of the land. – Smallest 50% of farmers owned only 7% of the land. Farm size class (hectares) Number of farms Share of EU 12 (millions) as share of total farm land in size class Average farm size (hectares) 1 to 5 3. 411 49. 2% 7. 1% 2. 4 5 to 10 1. 163 16. 8% 7. 1% 7. 0 10 to 20 0. 936 13. 5% 11. 5% 14. 1 20 to 50 0. 946 13. 7% 25. 7% 31. 2 over 50 0. 473 6. 8% 48. 6% 117. 6 total 6. 929 100% 115 (mill. ha) 16. 5 © Baldwin & Wyplosz 2006. The Economics of European Integration, 2 nd Edition 30

price Family farm supply curve price Commercial farm supply curve Total supply curve Pw+T price Family farm supply curve price Commercial farm supply curve Total supply curve Pw+T Asmall Atotal Abig Pw B Zsmall Q Zbig Q Ztotal Q © Baldwin & Wyplosz 2006. The Economics of European Integration, 2 nd Edition 31

CAP problems • #1 Problem: The supply problem. • ‘Green’ revolution technology boom, supply CAP problems • #1 Problem: The supply problem. • ‘Green’ revolution technology boom, supply ↑ – High guaranteed prices encourage investment & adoption. – Output rises much faster than consumption. © Baldwin & Wyplosz 2006. The Economics of European Integration, 2 nd Edition 32

price S 1 S 2 S 3 Home Demand S 4 Home Supply p price S 1 S 2 S 3 Home Demand S 4 Home Supply p 1 ss p 2 ss Price floor p 3 ss p 4 ss a b c d e Price floor S’ A B C 1 C 2 Pw EU purchase Home Demand Q Cf Zf © Baldwin & Wyplosz 2006. The Economics of European Integration, 2 nd Edition Q 33

Follow-on problems of oversupply • EU switches from net food import to exporter in Follow-on problems of oversupply • EU switches from net food import to exporter in most products. © Baldwin & Wyplosz 2006. The Economics of European Integration, 2 nd Edition 34

Follow-on problems: World market impact • Import protection insufficient for price support. • CAP Follow-on problems: World market impact • Import protection insufficient for price support. • CAP becomes major food buyer. – Some of this is dumped on world market. • CAP protection and dumping depresses prices on world markets. – Harms non-EU food exporters. © Baldwin & Wyplosz 2006. The Economics of European Integration, 2 nd Edition 35

Follow-on problems: Budget • Buy and storing or dumping food becomes increasingly expensive. © Follow-on problems: Budget • Buy and storing or dumping food becomes increasingly expensive. © Baldwin & Wyplosz 2006. The Economics of European Integration, 2 nd Edition 36

Other CAP problems • #2 Problem: The farm income problem. – General problem, inelastic Other CAP problems • #2 Problem: The farm income problem. – General problem, inelastic demand means farm sector’s total income falls with prices, so either average farmer income must fall, or then number of farmers must fall. • In EU: Average farm incomes fail to keep up despite huge protection and budget costs. – Most of money goes to big farms that don’t need it: • CAP makes some farmers/landowners rich. • Keeps average (i. e. small) farmer on edge of bankruptcy. – Farmers continue to exit farming (about 2% per year for last 4 decades). © Baldwin & Wyplosz 2006. The Economics of European Integration, 2 nd Edition 37

Other CAP problems • Factory Farming: – Pollution, – Animal welfare, – Nostalgia. • Other CAP problems • Factory Farming: – Pollution, – Animal welfare, – Nostalgia. • Bad for ‘image’ and thus public support for CAP. © Baldwin & Wyplosz 2006. The Economics of European Integration, 2 nd Edition 38

CAP Reforms • Supply control attempts: – 1980 s, experimentation with ad hoc & CAP Reforms • Supply control attempts: – 1980 s, experimentation with ad hoc & complex set supply ‘controls’ to discourage production. – Generally failed; technological progress & high guaranteed prices overwhelmed supply controls. • 1992: Mac. Sharry Reforms: – Basic idea: CUT PRICES supports to near world-price level & COMPENSATE farmers with direct payments. – Was essential to complete the Uruguay Round. – Worked well. • June 2003 Reforms; essential to Doha Round. – Implementation 2004 -2007. – Similar to Mac. Sharry reforms in spirit. – Still might not be enough to allow Doha Round to finish. © Baldwin & Wyplosz 2006. The Economics of European Integration, 2 nd Edition 39

Evaluation of the today’s CAP • Supply problems & food “mountains. ” – Left Evaluation of the today’s CAP • Supply problems & food “mountains. ” – Left figure: massive shift to direct payments. – Price cut reduced EU buying of food: right figure shows important drop in EU storage of food. – EU dumping of food on world market also dropped. © Baldwin & Wyplosz 2006. The Economics of European Integration, 2 nd Edition 40

Farm incomes & CAP support inequity • Reformed CAP (post Mac. Sharry) support still Farm incomes & CAP support inequity • Reformed CAP (post Mac. Sharry) support still goes mostly to big, rich farmers. – payments intended to compensate, so inequity continued. • Half the payments to 5% of farms (the largest). • Half the farms (smallest) get only 4% of payments. • Recent studies show that only about half of these payments go to farmers. – Rest to non-farming landowners and suppliers of agricultural inputs (seed, fertilisers, agri-chemicals, etc. ) – See: “Who Finances the Queen’s CAP payments? ” http: //shop. ceps. be/Book. Detail. php? item_id=1285 © Baldwin & Wyplosz 2006. The Economics of European Integration, 2 nd Edition 41

CAP support inequity Payment per farm % of EU 1 5 farm s in CAP support inequity Payment per farm % of EU 1 5 farm s in size class Number of farms in size class % of EU 1 5 paym ents to size class 0 to 1. 25 € 405 53. 76% 2, 397, 630 4. 3% 100. 0% 99. 97% 1. 25 to 2 € 1, 593 8. 54% 380, 800 2. 7% 95. 7% 46. 21% 2 to 5 € 3, 296 16. 30% 726, 730 10. 7% 93. 0% 37. 67% 5 to 10 € 7, 128 9. 17% 409, 080 13. 0% 82. 2% 21. 37% 10 to 20 € 13, 989 6. 81% 303, 500 19. 0% 69. 2% 12. 20% 20 to 50 € 30, 098 4. 13% 184, 100 24. 8% 50. 2% 5. 39% 50 to 100 € 67, 095 0. 94% 41, 700 12. 5% 25. 4% 1. 27% 100 to 200 € 133, 689 0. 24% 10, 720 6. 4% 12. 9% 0. 33% 200 to 300 € 241, 157 0. 05% 2, 130 2. 3% 6. 5% 0. 09% 300 to 500 € 376, 534 0. 03% 1, 270 2. 1% 4. 2% 0. 04% over 500 € 768, 333 0. 01% 610 2. 1% 0. 01% Size Class Average, All farms Cumulative % of budget (from largest to smalles t) Cumulative % of farms (from largest to smalles t) € 5, 015 © Baldwin & Wyplosz 2006. The Economics of European Integration, 2 nd Edition 42

Future challenges • Doha Round: – Completing these WTO talks may require deeper reform Future challenges • Doha Round: – Completing these WTO talks may require deeper reform of CAP. • Eastern Enlargement: – Number of farms will rise. – Farmland rise from 130 million hectares to 170 million. © Baldwin & Wyplosz 2006. The Economics of European Integration, 2 nd Edition 43

EU newcomers: Farm facts © Baldwin & Wyplosz 2006. The Economics of European Integration, EU newcomers: Farm facts © Baldwin & Wyplosz 2006. The Economics of European Integration, 2 nd Edition 44