Economics of Trade Liberalization and Integration

Jan Fidrmuc

Brunel University

Import demand curve (MD)price price

HomeSupply

P*

P”

P’

Z’ C’ quantity importsZ” C”

HomeDemand

Home importdemand curve,MDH

P”

P’

M’M”

1

2

3

Import supply curve (MS)

P*

P”

P’

C’ quantity exportsC” X’ X”

price price

Foreign exportsupply curve, XSF, or MSH.

ForeignSupply

ForeignDemand

1

3

Z’ Z”

2

MD-MS Diagram MD-MS diagram permits tracking domestic &

international consequences of trade policy changes.`

euros

imports quantity

MS

MD

Z C

Domestic price, euros

Import (foreignexport) supply curve

Domestic demand curve Domestic supply curve

Imports

Importdemand curve

Imports

Sdom

Ddom

PFT

Non-discriminatory (MFN) Tariff Consider tariff of T euros per unit MFN non-discriminatory tariffs

WTO rules: lowest tariff (most-favored nation) must apply equally to all trading partners

Exception: FTAs Tariff shifts MS curve up by T.

Exporters earn domestic price minus T They would need domestic price of P+T to

continue to offer the same exports.

MFN Tariff Analysis New equilibrium in

Home (MD=MS) is at P’ and M’.

Domestic price P’ now differs from border price (price exporters receive) P’-T.

Domestic price rises.

Border price falls. Imports fall.

Homeimports

MD

Border price

Foreignexports

XS=MSMS

MS with TDomestic price

TP’-T

X’=M’ MFTXFT= MFT

PFTPFT

M’

P’

Welfare effects 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., ToT 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).

MD

MS

MFT=XFT

PFT

M’=X’

P’A

C

BD

Homeimports

Domestic price

Home and Foreign in one diagram

P’-T

Distributional consequences

Home consumers lose area E+C2+A+C1

Home producers gain E Home tariff revenue: A+B. Net change = B-C2-C1 (this equals B-C in left panel).

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

With reciprocity, protectionism is not a zero-sum game

Distributional consequences

euros

imports quantity

MS

MD

C

Domestic price, euros

Sdom

Ddom

PFT PFT

Z

P’

P’-T

P’

P’-T

C’Z’

A C

B D B

EC2

AC1

Preferential Trade Liberalization Previous analysis used 2 countries only:

Home and Foreign European integration is discriminatory (or

preferential) and its analysis requires at least three countries: 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

Domestic price

Homeimports

MD

PFT

RoWExports

PartnerExports

XSPXSR MS

M=XP+XR

Partner HomeRoW

Border price Border price

21

XPXR

The PTA Diagram: MFN tariff

Domestic price

Homeimports

MD

PFT

RoWExports

PartnerExports

XSPXSR MS

MSMFN

P’

M’ M=XP+XR

Partner HomeRoW

Border price Border price

T

P’-T

21

X’R X’P

XPXR

Discriminatory unilateral liberalization 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. Shifts up MS to half way between MS (free trade)

and MS (MFN tariff) More complex, kinked MS curve with PTA.

If price falls below Pa, RoW will export zero.

Discriminatory, unilateral liberalization

Domestic price

Homeimports

MD

RoWExports

PartnerExports

XSPXSR MS

MSMFN

M’

Partner HomeRoWBorder price Border price

MSPTA

1

Pa

P’

T

T

P” P”

P’-TP”-T

XR” XR’ XP’ XP” M”

p*

Domestic price & border price changes Domestic price falls to P’ from P”. Partner-based firms see border price rise, P’-T to P”. RoW firms see border price fall from P’-T to P”-T.

Domestic price

Homeimports

MD

RoWExports

PartnerExports

XSPXSR

MS

MSMFN

M’

Border price Border price

MSPTA

P’

TP”

P’-T

P”-T

XR” XR’ XP’ XP” M”

P’-T

P”

Quantity changes: supply switching RoW exports fall and Partner exports rise: supply switching: trade diversion Domestic imports rise: trade creation. Partner exports rise more than RoW exports fall.

Domestic price

Homeimports

MD

RoWExports

PartnerExports

XSPXSR

MS

MSMFN

M’

Border price Border price

MSPTA

P’

TP”

P’-T

P”-T

XR” XR’ XP’ XP” M”

P’-T

P”

Impact of customs union formation

0%

20%

40%

60%

80%

100%

19

58

19

59

19

60

19

61

19

62

19

63

19

64

19

65

196

61

967

19

68

19

69

19

70

EEC-6 Other 6 Europe Rest of World

$0

$10

$20

$30

$40

$50

$60

$70

$80

$90

$100

195

8195

919

60

1961

1962

1963

196

4196

519

66

1967

1968

1969

1970

$ b

illio

n (

curr

ent

pri

ces)

EEC

Total imports

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, 1958-1991, EUROSTAT, 1992, Luxembourg.

Welfare effects Home’s net change = A+B-C ambiguous Partner’s net change = +D. RoW’s net change = -E.

Domestic price

Homeimports

MD

RoWExports

PartnerExports

XSPXSR

M’

Partner HomeRoWBorder price Border price

P’

P”

XR’ XP’ XP” M”

C

B

A

XR”XR”

P’-TP”-T

P’-TP”-T

P”

E

D

Analysis of a Customs Union European integration

involved a sequence of preferential liberalisations, all of them reciprocal: 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

Good 1

Good 3

Good 2

Good 2

Good 3

Good 1

HomeHome PartnerPartner

RoWRoW

Analysis of a Customs Union Home and Partner eliminate T on their mutual

trade Both impose T on trade with RoW

Home-Partner CU has Common External Tariff (CET) equal to T

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, Home plays the role of Partner

and Partner plays role of Home.

Welfare effects of a customs union In market for good 1: Home change = A+B-

C1-C2. In market for good 2:

Home change = +D1+D2.

NB: D1=C1. Net Home impact

=A+B-C2+D2 . Partner impact

identical. RoW loses in both

markets. RoW exports fall but

imports stay the same: trade deficit

euros

imports

MD

euros

Exports

XS

M’

A

D2

D1 C1

B

C2

XP”XP’ XR” XR’

P’-T

P”

P’

P”-T

EU Trade Policy

Geographical Structure of Trade

Differences among Member States

Composition of trade

Food & live animals

Other raw materials

Fuel products

Chemical products

Other manufactured

Machinery, transport equipment

Machinery, transport equipment 45% 34%

Other manufactured 26% 26%

Chemical products 16% 9%

Fuel products 3% 18%

Other raw materials 2% 5%

Food & live animals 5% 6%

Misc. 2% 3%

Exports, 2004 Imports, 2004

Manufactured Goods, 87%

Manufactured Goods, 69%

What with whom?

EU’s MFN tariff structure (the CET)

Institutions Trade policy is an exclusive prerogative of

the EU. Customs Union requires agreement.

Commission has responsibility for negotiating Trade Commissioner.

Council of Ministers sets “Directives for Negotiation,” accepts/rejects final deal.

Commission in charge of surveillance and enforcement of 3rd nation commitments. Trade disputes with US, China, etc.

EU External Trade Policy EU has special arrangements with 139 nations; often more

than one per partner. Each can be very complex.

Non-preferential trade

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