Theorie und Politik der Europäischen Integration Theory and Politics of European Integration

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1 Theorie und Politik der Europäischen Integration Theory and Politics of European Integration Lecture 3 The Economics of Trade and Preferential Trade Liberalisation Dr. Ehsan Vallizadeh

2 Theory and Politics of European Integration Lecture 3 Trade & Tariffs Last Lecture (cont.) EU Institutions Facts: income heterogeneity and trade links EU law: Rome Treaty and other Treaties The Big-5 Institutions: European Council Council of Ministers European Commission EU Parliament EU Court of Justice Budget structure of expenditure funding and net contributions by members

3 Theory and Politics of European Integration Lecture 3 Trade & Tariffs Last Lecture Decisionmaking Efficient Allocation of Tasks Subsidarity Theory of Fiscal Federalism Three Pillar structure of EU Voting rules Treaty of Nice Constitutional Treaty Efficiency of Decisionsmarking: Ability to Act Passage Probability and Blocking Coalitions Power Distribution Power to break: the Normalized Banzhaf Index (NBI) Fairness of Decisionmaking: The Square Root Rule

4 Theory and Politics of European Integration Lecture 3 Trade & Tariffs Today's Lecture - Overview Microeconomics of Trade and Tariffs Preliminaries: Marginal Supply and Demand Analysis Consumer and Producer Surplus, Welfare Analysis Import Demand and Supply Curve Trade Volume and Border Price Effects Workhorse model: MS- Diagram MFN Tariff Analysis Preferential Trade Liberalisation Preferential Trade Area Diagram Discriminatory trade liberalisation Welfare analysis of Custom Unions Frictional trade barriers

5 Theory and Politics of European Integration Lecture 3 Trade & Tariffs Today's Reading Microeconomics of Trade and Tariffs Baldwin & Wyplosz (2009/12) The Economics of European Integration, McGraw-Hill, Ch 4. Preferential Trade Liberalisation Baldwin & Wyplosz (2009/12) The Economics of European Integration, McGraw-Hill, Ch 5.

6 Part I Microeconomics of Trade and Tariffs

7 Theory and Politics of European Integration Lecture 3 Trade & Tariffs Preliminaries I price Demand curve shows how much consumers would buy of a particular good at any particular price. It is based on optimization exercise: Would one more be worth price? Market demand is aggregated over all consumers demand curves. Horizontal sum Assumption of representative agent mu p* mu c c* c Marginal utility curve is the demand curve for one consumer quantity

8 Theory and Politics of European Integration Lecture 3 Trade & Tariffs Preliminaries I Supply curve shows how much firms would offer to the market at a given price. Based on optimisation: price mc Marginal cost Would selling one more unit at price increase profit? p* Market supply is aggregated over all firms. mc Horizontal sum. Assumptions: no increasing returns to scale perfect competition q q* q quantity

9 Theory and Politics of European Integration Lecture 3 Trade & Tariffs Welfare Analysis: Consumer Surplus price 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. p* p A B A = Price drop times old consumption. Gain surplus on the new units consumed (those from c* to c ); measure of this = area B. Demand curve B = sum of all new gaps between marginal utility and price c* c quantity

10 Theory and Politics of European Integration Lecture 3 Trade & Tariffs Welfare Analysis: Producer Surplus Since supply curve based on marginal cost, it can be used to show how producers well-being (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*. p* price Triangle is sum of all gaps between price received and marginal cost (summed over total production) q* quantity

11 Theory and Politics of European Integration Lecture 3 Trade & Tariffs Welfare Analysis: Producer Surplus (cont.) price If the price rises: producers obviously better off. Producer surplus change quantifies this intuition. producer surplus rise, 2 parts: p p* A B Supply curve 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. q* q quantity

12 Theory and Politics of European Integration Lecture 3 Trade & Tariffs 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 and domestic production are perfect substitutes. Imports equal gap between domestic consumption and domestic production.

13 Theory and Politics of European Integration Lecture 3 Trade & Tariffs price Supply price Import Demand Curve P* 1 2 P Demand 3 P import demand curve, H Z Z C C quantity M M

14 Theory and Politics of European Integration Lecture 3 Trade & Tariffs Import Supply Curve (MS) price P P* Foreign Supply Foreign Demand price Foreign export Supply curve XS F or Import Supply Curve MS H. C X X C quantity exports Z Z

15 Theory and Politics of European Integration Lecture 3 Trade & Tariffs Welfare and Import Demand Curve price P* P Supply Z Z C C price A B C D C E Demand 1 Trade price effect 2 NB: E=B+D P import demand curve, H quantity M M 3

16 Theory and Politics of European Integration Lecture 3 Trade & Tariffs Welfare and Import Demand Curve price P* P Supply Z Z C C price A B C D C E Welfare Analysis of a price shift from p to p : Consumers: - (A+B+C+D) Producers: +A Total: -(B+C+D) Demand 1 2 NB: E=B+D P import demand Curve, H quantity M Trade price effect M 3

17 Theory and Politics of European Integration Lecture 3 Trade & Tariffs Welfare and Import Demand Curve price P* Supply Right hand panel: -C (border price effect) - E (trade volume effect) Logic: 1. curve is difference between domestic demand and supply curve P 2. Domestic demand curve is marginal utility and domestic supply curve 3. Diffence between curves is net gain of consuming one more unit and producing one Z Z C C price A B C D C E unit less. Demand 1 2 Trade volume effect NB: E=B+D P import demand Curve, H quantity M Border price effect M 3

18 Theory and Politics of European Integration Lecture 3 Trade & Tariffs Welfare and Import Supply Curve price P P* Foreign Supply price A B C E D D 1 Trade price effect, i.e.tot effect F F=C+E 2 3 Trade volume effect Foreign export supply curve, XS F, or MS H. Foreign Demand C X X C quantity exports Z Z

19 Theory and Politics of European Integration Lecture 3 Trade & Tariffs Trade Volume and Border Price Effect Decomposing loss from price rise, P to. Area C: pays more for units imported at the old price. Area C is the size of this loss. loses from importing less at. area E measures loss. marginal value of first lost unit is the height of the curve at M, but paid P for it before, so net loss is gap, P to. adding up all the gaps gives area E. Domestic price P C E M M

20 Theory and Politics of European Integration Lecture 3 Trade & Tariffs Trade Volume and Border Price Effect Systematic net welfare analysis using the price and quantity effects: border price effect (area C), and the import volume effect (area E). Very useful in more complex diagrams. Domesti c price P C Border price effect Trade volume effect E M M

21 Theory and Politics of European Integration Lecture 3 Trade & Tariffs Trade Volume and Border Price Effect Can do same for Foreign gain rise, P to. Foreign gains from getting a higher price for the goods it sold before at P (border price effect), area D. And gains from selling more (trade volume effect), area F. price P D Border price effect Trade volume effect F XS F, MS H. X X exports

22 Theory and Politics of European Integration Lecture 3 Trade & Tariffs The Workhorse: MS- Diagram Diagram very useful. easy identification of price and volume effects of a trade policy change. Welfare change likewise easy. P FT euros Import demand curve Import supply curve MS Imports

23 Theory and Politics of European Integration Lecture 3 Trade & Tariffs -MS + open economy supply & demand -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 supply curve euros Import supply curve Domestic price, euros S dom MS P FT Import demand curve Imports D dom Imports Z C quantity

24 Theory and Politics of European Integration Lecture 3 Trade & Tariffs MFN Tariff Analysis 1st 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.

25 Theory and Politics of European Integration Lecture 3 Trade & Tariffs MFN Tariff Analysis For example, how high would domestic price have to be in for Foreigners to offer to export M a to? Border price XS=MS Domestic price MS with T MS w/o T Answer is P a before tariff Answer is P a +T, so Foreigners would see a price of P a after tariff P a T P a +T 2 1 X a =M a Foreign exports M a

26 Theory and Politics of European Integration Lecture 3 Trade & Tariffs MFN Tariff Analysis New equilibrium in (=MS with T) is with P and M. Domestic price now differs from border price (price exporters receive). P vs P -T. Border price P FT P -T XS=MS T Domestic price P MS with T MS P FT X =M X FT = M FT Foreign exports M M FT

27 Theory and Politics of European Integration Lecture 3 Trade & Tariffs Price and Quantity Effects of a MFN tariff 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. Border price P FT P -T X =M XS=MS X FT = M FT T Foreign exports Domestic price P M MS with T M FT MS P FT

28 Theory and Politics of European Integration Lecture 3 Trade & Tariffs Welfare Effects: Drop in creates loss equal area C. (Trade volume effect). Drop in border price creates gain equal to area B. (Border price effect, i.e. ToT effect). Net effect on = B-C. 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). Domestic price P P FT P -T A B C M =X M FT =X FT

29 Theory and Politics of European Integration Lecture 3 Trade & Tariffs Welfare Effects: Foreign Drop in exports creates loss equal area D Border price Foreign (Trade volume effect). Drop in border price creates loss equal to area B. XS=MS (Border price effect, or: ToT effect). Net effect on Foreign = -(D+B). ALTERNATIVELY: P FT P -T B D Private surplus change (sum of change in producer and consumer surplus) equal to (D+B). Same net effect (but less intuition). X X FT Foreign exports

30 Theory and Politics of European Integration Lecture 3 Trade & Tariffs Welfare Effects: Useful Compression In cases of more complex policy changes useful to do and Foreign welfare changes in one diagram. Domestic price and Foreign in one diagram C MS MS- diagram allows this: net welfare change is C+B. Foreign net welfare change is (B+D). World welfare change is D-C. P P FT P -T A B D NB: if 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. M =X M FT =X FT

31 Theory and Politics of European Integration Lecture 3 Trade & Tariffs Welfare Effects: Distributional Effects consumers lose, area E+C 2 +A+C 1 ; producers gain E, tariff revenue rises by A+B. net change = B-C 2 -C 1 (this equals B-C in left panel). euros Domestic price, euros S dom P P FT P -T MS A C E C 2 A C1 B D B P P -T P FT D dom Z Z C C quantity

32 A Typology of Trade Barriers Domestically caputured rents (DCR) Tariffs Quotas + licences to domestic holders quota drives wedge between foreign and domestic price licence holder exploits price wedge Foreign captured rents (FCR) Price undertaking (generates rents to foreign firms) quotas and distribution of licences to foreign holders Frictional barriers technical standards, health and safety regulation e.g. Cassis Dijon ( Kir ) case

33 Theory and Politics of European Integration Lecture 3 Trade & Tariffs Welfare effects of different types of trade barriers Net welfare changes for: DCR = B-C FCR = -A-C Frictional = -A-C Net Foreign welfare changes for: DCR = -B-D FCR = +A-D Frictional = -B-D Note: foreign may gain from FCR. euros P P FT P -T A B C D MS M M FT

34 Memorize The Microeconomics of Trade and Tariffs Basic Tools Demand and Supply Import Demand Curve Export Supply Curve Welfare Analysis The Gains from Trade Welfare Analysis of MFN Tariffs Typology of welfare barriers: DCR, FCR, frictional barriers

35 Part II Preferential Trade Liberalisation

36 Today's Reading Preferential Trade Liberalisation Baldwin & Wyplosz (2009/12) The Economics of European Integration, McGraw-Hill, Ch 5.

37 The PTA Diagram Studying European integrations e.g. EEC s customs union which were discriminatory, i.e. preferential requires: at least three countries at least two integrating nations at least one excluded nation. Ability to track domestic and international consequences of liberalisation Must -MS diagram to allow for two sources of. Assumptions: No increasing returns to scale Perfect competition But: No small country assumption which allows tracking effects on third countries

38 The PTA Diagram: Free Trade Equilibrium Border price RoW XS R Border price Partner XS P Domestic price MS 1 2 P FT X R RoW X P Partner M=X P +X R

39 The PTA Diagram: MFN Tariff Equilibrium RoW Partner Border price Border price Domestic price MS MFN XS R XS P MS P -T 1 2 T P FT P X R RoW X R X P X P Partner M M=X P +X R

40 Discriminatory, Unilateral Liberalization To build up to analysis of real-world policy changes (e.g. customs union): Consider removes T on only from Partner 1 st step is to construct the new MS curve The liberalisation shifts up MS (as with MFN liberalisation) but not as far since only on half of Shifts up MS to half way between MS (free trade) and MS (MFN T), but More complex, kinked MS curve with PTA

41 Uniform MFN Tariff Border price RoW Border price Partner Domestic price MS MFN XS R XS P MS P -T T P P P a p* T X R X R RoW Partner X P X P M FREE M

42 Discriminatory, Unilateral Liberalization Border price RoW Border price Partner Domestic price MS MFN MS PTA XS R XS P MS P P -T P -T T P a p* T 1 RoW Partner X R X R X P X M M

43 Domestic Price and Border Price Changes Border price XS R Border price XS P Domestic price MS MFN MS PTA P -T P -T T P -T P MS X R X R X P X M M RoW Partner

44 Domestic Price and Border Price Changes Border price XS R Border price XS P Domestic price MS MFN MS PTA P -T P -T T P -T P MS domestic price falls to P from P X R X R X P X M M RoW Partner

45 Domestic Price and Border Price Changes Border price XS R Border price XS P Domestic price MS MFN MS PTA P -T P -T T P -T P MS domestic price falls to P from Partner-based firms see border price rise, from P -T to X R X R X P X M M RoW Partner

46 Domestic Price and Border Price Changes P -T P -T Border price RoW firms see border price fall XS from R P -T to -T. T Border price XS P P -T Domestic price P MS MFN MS PTA MS domestic price falls to P from Partner-based firms see border price rise, P -T to X R X R X P X M M RoW Partner

47 Quantity Changes: Supply Switching Border price XS R Border price XS P Domestic price MS MFN MS PTA P -T P -T T P -T P MS X R X R X P X M M RoW Partner

48 Theory and Politics of European Integration Lecture 3 Preferential Trade Liberalisatio Quantity Changes: Supply Switching Border price XS R Border price XS P Domestic price MS MFN MS PTA RoW exports fall P -T P -T T P -T P MS X R X R X P X M M RoW Partner

49 Quantity Changes: Supply Switching Border price XS R Border price XS P Domestic price MS MFN MS PTA RoW exports fall P -T P -T T P -T P MS Partner exports rise more than RoW exports fall, X R X R X P X M M RoW Partner

50 Quantity Changes: Supply Switching Border price XS R Border price XS P Domestic price MS MFN MS PTA RoW exports fall P -T P -T T P -T P MS Partner exports rise more than RoW exports fall, so domestic rise X R X R X P X M M RoW Partner

51 Theory and Politics of European Integration Lecture 3 Preferential Trade Liberalisation Impact of Customs Union formation 100% EEC-6 Other 6 Europe Rest of World $100 $90 80% 60% 40% 20% $ billion (current prices) $80 $70 $60 $50 $40 $30 $20 $10 EEC Total imp orts 0% $0 Note: Left panel shows share of EEC6 s import from the three regions. Other Euro-6 are the 6 countries that joined the EU by the mid 1980s, UK, Ireland, Denmark, Spain, Portugal and Greece. Source: Table 5, External Trade and Balance of Payments, Statistical Yearbook, Recapitulation, , EUROSTAT, 1992, Luxembourg.

52 Welfare Effects Border price RoW XS R Border price Partner XS P Domestic price A P -T P -T E D P P -T P -T C B X R X R X P X X R M M RoW Partner

53 Welfare Effects Border price RoW P -T P -T E XS R Border price Partner XS P D Domestic price P P -T P -T C A s net change = A+B-C B X R X R X P X X R M M RoW Partner

54 Welfare Effects Border price RoW P -T P -T E XS R Border price Partner D XS P Domestic price P P -T P -T C A s net change = A+B-C Partner s net change = +D B X R X R X P X X R M M RoW Partner

55 Welfare Effects Border price RoW P -T P -T E XS R Border price Partner XS P D Domestic price P P -T P -T C A s net change = A+B-C RoW s net change = -E Partner s net change = +D B X R X R X P X X R M M RoW Partner

56 Analysis of a Customs Union FTA vs Customs Unions Given symmetry 3-nation set up, FTA between and Partner is automatically a customs union -Partner CU has Common External Tariff (CET) equal to T in the real world, things are more complicated Analysis is simply a matter of recombining results from the unilateral preferential case In market for good 1, analysis is identical In market for good 2, plays the role of Partner In market for good 2, Partner plays role of

57 Symmetric three good case Good 1 Good 2 Good 1 Good 3 Good 2 RoW Partner Good 3

58 Welfare Effects of a Customs Union euros euros P -T D 2 XS P D 1 C 2 C 1 -T B A X P X P X R X P M

59 Welfare Effects of a Customs Union euros P -T D 2 euros XS P D 1 C 2 C 1 -T B A In market for good 1 change = A+B-C1-C2 X P X P X R X P M

60 Welfare Effects of a Customs Union euros P -T D 2 XS euros P D 1 C 2 C 1 -T B Q: Why splitting C into C1 and C2? A: C1 is exactly amount imported before from partner. Higher price can be understood as transfer to partner, but remains in PTA. Note: Same transfer is payed by partner to home M X P through X P higher border X R Xprice P for good 2. A In market for good 1 change = A+B-C1-C2

61 Welfare Effects of a Customs Union euros P -T D 2 euros XS P D 1 C 2 C 1 -T B A In market for good 1 change = A+B-C1-C2 In market for good 2 change = +D1+D2 X P X P X R X P M

62 Welfare Effects of a Customs Union euros P -T D 2 XS euros P D 1 C 2 C 1 -T B Net impact =A+B-C2 A In market for good 1 change = A+B-C1-C2 In market for good 2 change = +D1+D2 X P X P X R X P M

63 Welfare Effects of a Customs Union NB: D1=C1 euros P -T D 2 XS euros P D 1 C 2 C 1 -T B Net impact =A+B-C2 A In market for good 1 change = A+B-C1-C2 In market for good 2 change = +D1+D2 X P X P X R X P M

64 Welfare Effects of a Customs Union NB: D1=C1 euros P -T D 2 Partner impact identical XS euros P D 1 C 2 C 1 -T B Net impact =A+B-C2 A In market for good 1 change = A+B-C1-C2 In market for good 2 change = +D1+D2 X P X P X R X P M

65 Welfare Effects of a Customs Union NB: D1=C1 euros P -T D 2 Partner impact identical XS euros D 1 C 2 C 1 RoW loses (as before) Net impact =A+B-C2 X P X P Note: C2 is direct costs of M supply switching X R X P not compensated by exports to partner P -T B A In market for good 1 change = A+B-C1-C2 In market for good 2 change = +D1+D2

66 Frictional Barrier Preferential Trade Liberalisation In market for good 1 change = A+F In market for good 2 change = +D Net impact =A+F+D unambiguous positive Partner gains same RoW loses T = tariff equivalent of frictional barrier P -T euros euros XS P F D -T X P X P X R X P M A

67 Customs Union vs. FTA FTA like CU but no Common External Tariff Opens door to tariff cheats, goods from RoW destined for market enter via Partner if Partner has lower external tariff, called trade deflection Solution is rules of origin meant to establish where a good was made. Problems: Difficult and expensive to administer, especially as world get more integrated Rules often become vehicle for disguised protection Despite the origin-problem in FTAs, almost all preferential trade arrangements in world are FTAs. CU s require some political integration Must agree on common external tariff and how to change it, including anti-dumping duties, etc.

68 WTO Rules A basic principle of the WTO/GATT is non-discrimination in application of tariffs FTAs and CUs violate this principle Article 24 permits FTAs and CUs subject to conditions: Substantially all trade must be covered Cannot pick and choose products Intra-bloc tariffs must go to zero within reasonable period If CU, the CET must not on average be higher than the external tariffs of the CU members were before In EEC s CU this meant France and Italy lowered their tariffs, Benelux nations raised theirs (German tariffs were about at the average anyway)

69 NEXT LECTURE November 30, 2017 Benefitting from a larger Market: Market Size and Scale Effects EU Trade and Competition Policies Reading: Baldwin & Wyplosz (2015) The Economics of European Integration, McGraw-Hill, Chs. 6, 14, 15.