Economics of Trade Liberalization and Integration Jan Fidrmuc

Economics of Trade Liberalization and Integration Jan Fidrmuc Brunel University

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

Import supply curveprice (MS) price Foreign Supply 3 P” P’ Foreign export supply curve, XSF, or MSH. 2 P* 1 Foreign Demand C” C’ Z’ Z” quantity X’ X” exports

MD-MS Diagram n MD-MS diagram permits tracking domestic & international consequences of trade policy changes. ` Domestic demand curve Domestic price, euros Sdom Import (foreign export) supply curve MS Import demand curve Imports Domestic supply curve PFT MD Ddom Imports imports Z C quantity

Non-discriminatory (MFN) Tariff n n Consider tariff of T euros per unit MFN non-discriminatory tariffs q q n WTO rules: lowest tariff (most-favored nation) must apply equally to all trading partners Exception: FTAs Tariff shifts MS curve up by T. q q Exporters earn domestic price minus T They would need domestic price of P+T to continue to offer the same exports.

MFN Tariff Analysis n n n New equilibrium in Home (MD=MS) is Border price at P’ and M’. Domestic price P’ now differs from border price (price exporters receive) PFT P’-T Domestic price rises. Border price falls. Imports fall. Domestic price XS=MS MS with T MS P’ PFT T MD Foreign exports X’=M’ XFT= MFT M’ MFT Home impor

Welfare effects n n n n Foreign loss due to drop in exports equal to area D (trade volume effect). Foreign loss due to drop in border price equal to area B (border price effect, a. k. a. , To. T effect). Net effect on Foreign = -D-B. Home loss equal to area -A-C (trade volume drops and price rises). Home gain due to drop in border price and tariff revenue equal to area A+B. Net effect on Home = -C+B. World welfare change is -D-C. If Home gains (-C+B>0) it is because it exploits foreigners by ‘making’ them pay part of the tariff (i. e. area B).

Distributional consequences n n n n Home consumers lose area E+C 2+A+C 1 Home producers gain E Home tariff revenue: A+B. Net change = B-C 2 -C 1 (this equals B-C in left panel). q Net effect can be positive or negative. Tariffs imposed because they benefit domestic producers who are often organized and politically influential This comes at a cost to domestic consumers and to foreigners If Foreign retaliates and also imposes a tariff, everyone loses q With reciprocity, protectionism is not a zero-sum game

Distributional consequences 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

Preferential Trade Liberalization n n Previous analysis used 2 countries only: Home and Foreign European integration is discriminatory (or preferential) and its analysis requires at least three countries: q q n At least two integrating nations. At least one excluded nation. MD-MS diagram must to allow for two sources of imports.

The PTA Diagram: Free trade Ro. W Partner Border price 1 Domestic price XSP XSR Home 2 MS PFT MD XR Ro. W Exports XP Partner Exports M=XP+XR Home imports

The PTA Diagram: MFN tariff Ro. W Partner Border price Home Border price Domestic price MSMFN MS XSP XSR 1 P’ T 2 PFT P’-T MD X’R XR Ro. W Exports X’P XP Partner Exports M’ M=XP+XR Home imports

Discriminatory unilateral liberalization n n Assume Home removes T on imports only from Partner. This liberalization shifts up MS (as with MFN tariff) but not as far since it applies only to one half of imports. q n Shifts up MS to half way between MS (free trade) and MS (MFN tariff) More complex, kinked MS curve with PTA. q If price falls below Pa, Ro. W will export zero.

Discriminatory, unilateral liberalization Border price Domestic price Partner Ro. W MSMFN Home MSPTA XSR XSP MS P’ P” P” T P’-T P”-T Pa T 1 MD p* XR” XR’ Ro. W Exports XP’ XP” Partner Exports M’ M” Home imports

Domestic price & border price changes n n n Domestic price falls to P’ from P”. Partner-based firms see border price rise, P’-T to P”. Ro. W firms see border price fall from P’-T to P”-T. Border price XSR Domestic price XSP T MSPTA MS P’ P” P’-T P”-T MSMFN P” P’-T MD XR” XR’ Ro. W Exports XP’ XP” Partner Exports M’ M” Home imports

Quantity changes: supply switching n n n Ro. W exports fall and Partner exports rise: supply switching: trade diversion Domestic imports rise: trade creation. Partner exports rise more than Ro. W exports fall. Border price XSR Domestic price XSP T MSPTA MS P’ P” P’-T P”-T MSMFN P” P’-T MD XR” XR’ Ro. W Exports XP’ XP” Partner Exports M’ M” Home imports

Impact of customs union formation

Welfare effects n n n Home’s net change = A+B-C ambiguous Partner’s net change = +D. Ro. W’s net change = -E. Border price Ro. W Border price Partner XSR P”-T Home A XSP P” P’-T Domestic price P’ P” D P’-T P”-T E C B XR” XR’ Ro. W Exports XP’ XP” Partner Exports MD XR” M’ M” Home imports

Analysis of a Customs Union n European integration involved a sequence of preferential liberalisations, all of them reciprocal: q n n Both Home & Partner drop T on each other’s exports. Need to address the 3 nation trade pattern. Example: each country produces 3 goods, exports 2 and imports 1

Analysis of a Customs Union n n Home and Partner eliminate T on their mutual trade Both impose T on trade with Ro. W q n Home-Partner CU has Common External Tariff (CET) equal to T Analysis is simply a matter of recombining results from the unilateral preferential case. q q In market for good 1, analysis is identical. In market for good 2, Home plays the role of Partner and Partner plays role of Home.

Welfare effects of a customs union n n n In market for good 1: q Home change = A+Beuros C 1 -C 2. In market for good 2: q Home change = +D 1+D 2. D 2 q NB: D 1=C 1. Net Home impact =A+B P” -C 2+D 2. D 1 P’-T Partner impact identical. Ro. W loses in both markets. Ro. W exports fall but imports stay the same: trade deficit XP ’ euros A XS P’ C 2 P”-T XP ” Exports C 1 MD B XR” XR’ M’ imports

EU Trade Policy

Geographical Structure of Trade

Differences among Member States

Composition of trade

What with whom?

EU’s MFN tariff structure (the CET)

Institutions n Trade policy is an exclusive prerogative of the EU. q n Commission has responsibility for negotiating q n n Customs Union requires agreement. Trade Commissioner. Council of Ministers sets “Directives for Negotiation, ” accepts/rejects final deal. Commission in charge of surveillance and enforcement of 3 rd nation commitments. q Trade disputes with US, China, etc.

EU External Trade Policy n EU has special arrangements with 139 nations; often more than one per partner. Each can be very complex.

Non-preferential trade n Only about 1/3 EU imports are not granted some sort of preferential treatment q Only 9 nations (US, Japan, etc. ).