Economics of integration Lecture 2 Trade integration Dariusz

Economics of integration Lecture 2: Trade integration Dariusz K. Rosati 1

International trade in goods and services • Trade is considered to be a source of economic benefits: – Absolute advantages; – Comparative advantages; – Economies of scale and scope; – Technology transfer; – Consumer satisfaction (utiliy); • But trade barriers are common and protectionism has always been popular; • Trade in goods and services: similarities, differences; Dariusz K. Rosati 2

Motives for barriers in trade in goods • Imports: – – – – Strategic independence (e. g. protection of own agriculture); Infant industries; Defence against dumping and other prohibited trade practices; Protection of employment; Diversification of economic structure for more independence; Balance of payments reasons; Fiscal reasons; • Exports: – Protection of natural resources & cultural heritage; – Security reasons (arms, weapons); – Fiscal reasons; • Protectionism: policy of protecting national markets with barriers to trade; • Why protectionism is popular? Because it allows for protection of specific interest groups while costs of protectionism are incurred by all: individual benefits vs social costs; Dariusz K. Rosati 3

Categories of barriers to trade • Tariffs: import duties, export duties, levies, taxes; – Tariff categories: ad-valorem, specific, mixed; • Non-tariff barriers: – quantitative restrictions (QRs - quotas), – tariff quotas, – administrative restrictions (documents, norms and standards, health & sanitary requirements, other legal requirements); – VERs; – Public procurement regulations; • Currency restrictions; Dariusz K. Rosati 4

Why protectionism is bad policy? • Suboptimal allocation of production factors (a country tries to produce many goods and services that could be imported cheaper); • Wrong specialization and lower (or no) gains from trade; • Supplying the national market only implies small scale production which means higher costs, less innovation, lower quality; • Terms-of-trade losses; • The results: slower economic growth, lower incomes, stagnation; • Autarky: isolation from outside world - an extreme form of protectionism; Dariusz K. Rosati 5

The impact of an import tariff on production, consumption and welfare Price D SK PA Pt A PW 0 B K M C H L N R Dariusz K. Rosati F J G SW Quantity 6

Impact of a tariff on production, prices nd consumpion • • • Free trade: production = 0 C, consumption = 0 G, price = P(w), imports = CG; Import tariff t raises domestic price to P(t): production increases to 0 H, consumption falls to 0 J, imports falls to HJ; Full autarky (pkt A): production = consumption = 0 R, price P(A); Dariusz K. Rosati 7

Impact of a tariff on welfare • • • Producer surplus: area [PW, Pt, K, B]; Consumer loss: area [PW, Pt, L, F]; Government gain (tariff revenue, administrative costs assumed zero): area [K, L, M, N] Net effect: producer surplus + government gain – consumer loss = net loss (the total area of triangles BKM i LFN); The net efect of a tariff is always a net loss of welfare for the economy (except when a country enjoys a monopsonic position in the market); Dariusz K. Rosati 8

Customs union: static effects CU = no tariffs (and NTB) on internal trade plus a common external tariff; Three quantitative effects (Viner, 1950): • • – – – trade creation effect: when demand in one member country will shift from more expensive domestic products to cheaper products imported from another member country; trade diversion effect: when cheaper imports from a third country will be made more expensive because of a common tariff and will be replaced by more expensive imports from a member country; trade expansion effect: when a lower market price in a member country will stimulate domestic demand which will be satisfied by additional imports; Dariusz K. Rosati 9

Static effects of a customs union: graphical illustration Price D SK Pt B PC PW E J Y 0 N R C F L T G M X K SW U V Z Quantity Dariusz K. Rosati H 10

Static effects of joining CU from protectionism • If the starting point is a country with protectionism (domestic price= Pt, production= 0 T, imports from the rest of world (ROW) = TU at price PW, and consumption= 0 U), the effects of accession to CU with the price level = PC and external tariff (PC-PW) are as follows: – – domestic price falls to PC, production falls to 0 R, imports rise to RV at prices PC, and consumption rises to 0 V; • Static trade effects are as follows: – Trade creation effect: section RT; – Trade diversion effect: section TU; – Trade expansion effect: section UV. • Net impact on welfare: total area of trianges EBF i GCH, minus area of rectangle FGML; • Net effect on welfare may be positive or negative, depending on the ratio of PC and PW: the closer PC is to PW, and the lower PC is compared to Pt, the better; Dariusz K. Rosati 11

CU: net welfare effect With high CU tariff t(1), the net welfare effect is negative because the sum of triangles A and B is smaller than the area (C+D). With low CU tariff t(2) the sum of extended triangles is bigger than the area D. B A PC = PW+t(1) C PC = PW+t(2) D PW Dariusz K. Rosati 12

Static effects of joining CU from free trade • If the starting point is a country with free trade (domestic price= PW, production= 0 N, imports from the rest of world (ROW) = NZ at price PW, consumption= 0 Z), the impact of accession to CU with the price level = PC and external tariff (PC-PW) is as follows: – – domestic price increases to PC, production increases to 0 R, imports fall to RV at prices PC, and consumption falls to 0 V; PC, PV • Static trade effects are the following: – Trade creation effect (negative): section -NR; – Trade diversion effect: section RV; – Trade expansion effect (negative): section-VZ. • Net effect on welfare: the sum of areas PC, Pw, E, J and YEHX, minus area PC, PW, H, K; • Net effect on welfare is always negative: consumer loss is always greater than the sum of producer surplus and government revenues; Dariusz K. Rosati 13

Dynamic effects of CU Effects of market enlargement on competition: • • • More competition (because more firms on the market); More competition leads to lower production costs and … quality improvement and… wider selection and wider choice; Lower costs increase available resources, and these allow for higher efficiency and faster technical progress; Economies of scale; Higher investments; Faster economic growth; Graphically: the long-term supply curve shifts downwards and becomes flatter; Dariusz K. Rosati 14

Dynamic effects of CU: Graphical illustration Price D SK Pt PC 2 PC 1 PW 0 B C SC Y F J E L N R T G M H U W V Dariusz K. Rosati K Z SW Quantity 15

Dynamic effects of CU: an interpretation • After accession o CU prices fell from Pt to PC 1; domestic producers have either to cut production from 0 T do 0 R – producer loss – or find ways to cut costs; • Some producers will leave the market, but many will not accept losses and will lower production costs, taking advantage of market enlargement and increased competition; • In result the supply curve will gradually shift to Sc; • Producers in CU will thus gradually increase production from 0 R back to 0 T, at a tariff (PC 1 – Pw); • (If the common tariff increased to (PC 2 – Pw), CU producers would satisfy all union demand at level 0 W (pkt Y), and imports would cease); • Total cost reduction on „initial” producion level 0 T equals the area Pt, B, F, PC 1 at price PC 1. This is a net gain. Dariusz K. Rosati 16

Dynamic effects of CU: economies of scale Price Country A Country B P(A) S(A) P(B) P(W) D(A) E D(B) C Quantity Customs union P(CU) P(W) D(CU)=D(A)+D(B) H Dariusz K. Rosati FG S(B) Quantity Assume supply curves are downward sloping (decreasing costs and economies of scale). If A and B are separate markets, they either open to import from world markets (levels C and G) at world marekt price P(W), or they produce themselves in autarky (levels E and F). If they form a CU, country B can satisfy the combined demand of A and B equal D(CU) at level H higher than E+F, at price P(CU) which is higher than world market price P(W), but lower than domestic prices P(A) and P(B). 17

Economies of scale: an interpretation • Assume a producer who uses a technology which allows him to increase production from the existing capacities, but demand at the national market is limited and exports face high tariffs abroad; • Under these constraints the producer will have to reduce output and his unit costs will be high; • A CU allows this producer to expand production to supply other markets beyond the national market, and he will be able to reduce unit costs; • The effect is a lower price and higher output; • Similarly, a producer may contemplate to use a technology which requires large-scale production but allows for lower unit costs, but limited domestic market does not allow for the use of this technology; in that case, joining a CU will allow this producer to use the large-scale technology; Dariusz K. Rosati 18

Trade in services • Services are specific: – most services are consumed at the moment of production, – services cannot be stored, – services are labor-intensive so that prices are determined by wage levels, – technological progress in services is slow; • Four types of cross-border trade in services: a) b) c) d) Cross-border supply; Consumption abroad; Production abroad; Commercial presence; • Types a) and d) are not problematic; but types b) and c) involve direct competition between national and foreign service providers, including different national regulatory frameworks Dariusz K. Rosati 19

Motives for barriers in trade in services • Consumer protection (direct control over service poviders, e. g. health care, financial, transport); • Strategic importance (e. g. air transport, telecommunication, natural monopolies); • Safeguarding national cultural values (TV); • Employment protection; Dariusz K. Rosati 20

Effect of heterogeneity of regulation of service markets on cost of providing services: the cost curve of providing sevices on heterogeneous markets CC(B) lies higher than the cost curve for a homogeneous (integrated) market CC(A) Cost CC(B) CC(A) 0 Market A Market B Market C Dariusz K. Rosati Market D 21