Essential Micro Tools Baldwin Wyplosz 2006

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 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 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 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. – 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 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. – 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 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” 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 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 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 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 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 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. – 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 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’ 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 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 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 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 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. • 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 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 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 = 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 nd Edition 26

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 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 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 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 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 ↑ – 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 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 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 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. © Baldwin & Wyplosz 2006. The Economics of European Integration, 2 nd Edition 36

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. • 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 & 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 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 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 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 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