Baldwin & Wyplosz The Economics of European Integration Teaching/Studying Presentation Baldwin & Wyplosz The Economics of European Integration Chapter 5: The Essential Economics of Preferential Liberalization A careful presentation of the Open Economy Supply and Demand Diagram To view this, start the slide show (‘view show’ command under the Slide Show pull-down menu) and use either the arrow keys or click the mouse to proceed

The MS-MD Diagram: The International Market The import supply (MS) and import demand (MD) diagram has price (measured in euros) on the vertical axis And the quantity of imports on the horizontal axis euros imports The import demand curve shows the volume of imports that Home demands at any given price. For example: if the price is p’”, then Home would like to import m’”. if the price is p””, then Home would like to import m”” The MD curve is downward sloped since a higher price makes Home want to import less. m”’ p”” p’” m”” MD Import demand curve MD Import demand curve Import supply curve MS Imports mFT pFT A The equilibrium price of imports and quantity of imports are indicated by the point “A”. The corresponding price (called the market clearing price) is pFT. The corresponding quantity of imports is mFT. The equilibrium price is pFT because at this price, the amount foreign firms wish to sell to Home is just equal to the amount that Home wants to buy. m’ The import supply curve shows the volume of imports that will be offered at any given price. For example: if the price is p’, then foreign firms would like to export m’ to Home. if the price is p”, then foreign nations would like to export m” The MS curve is upward sloped since higher prices make foreign firms want to sell more to Home. p’ p” m” Import supply curve MS

The MS-MD Diagram: The International Market euros imports MD Import demand curve Import supply curve MS Imports mFT pFT

Open Economy Supply & Demand Analysis: The Home Market pFT The price pFT indicates the price at which foreign firms are willing to supply imports. euros quantity Ddom Sdom Imports pFT Z C At pFT, Home consumers buy a quantity of goods equal to C. When the price of imports is pFT as shown here, Home firms supply a quantity of goods equal to Z. The level of imports equals the difference between Home consumption and Home production. Ddom Sdom Imports Without trade barriers, the import price fixes the Home market price; because when the import price is pFT, the total supply curve in the Home market is the kinked line shown. The first Z units of supply are made by Home firms. The rest is imported. Demand and supply thus meet at point B. B Z C pFT Ddom Sdom This is the supply curve of Home firms. It is upward sloped since firms wish to sell more when prices are high. This is the demand curve of Home consumers. It is downward sloped since consumers wish to buy more when prices are low.

Open Economy Supply & Demand Analysis: The Home Market euros quantity Ddom Sdom pFT Imports Z C

Putting together the diagrams The level of imports can be seen directly in the left-hand panel, or indirectly in the right-hand panel as the horizontal difference between Ddom and Sdom. p’ For instance if the world price were p’, Home would wish to import m’. Click 5 times to see that the indicated import level is the same in both panels. Here we put the two diagrams together. This is very useful when studying the effects of changing a trade barrier. We first see how the change alters the border and domestic prices in the left panel and then use the right panel to see the impact of the price changes on the Home market. The reason is that the horizontal difference between Ddom and Sdom at any world price always equals the level of imports indicated by the MD curve (this is how the MD curve was constructed). euros imports quantity pFT MS MD Ddom Sdom mFT Z C There are a few features of this diagram that you should know. m’ m’ m’ m’ m’

Ddom Sdom MS pFT pFT MD mFT mFT Z C Border price, euros Domestic price, euros Ddom Sdom MS pFT pFT MD mFT imports quantity mFT Z C

Baldwin & Wyplosz The Economics of European Integration Teaching/Studying Presentation Baldwin & Wyplosz The Economics of European Integration Chapter 5: The Essential Economics of Preferential Liberalization A careful presentation of the positive effects of an MFN Tariff in the MS-MD diagram *This is not in the book, but it will help you understand the MS-MD diagram* To view this, start the slide show (‘view show’ command under the Slide Show pull-down menu) and use either the arrow keys or click the mouse to proceed

Positive Effects of an MFN Tariff MD Ddom MS imports quantity Z C mFT PFT Border price, euros Domestic price, Sdom 1.We now use the diagrams to study the positive effects (i.e. price and quantity effects) of a tariff With no tariff, the equilibrium price is PFT and the equilibrium imports is mFT. 2.We start by supposing that initially no tariff is imposed.

Positive Effects of an MFN Tariff MD Ddom MS imports quantity Z C mFT PFT Border price, euros Domestic price, Sdom 1. Now we impose a tariff equal to “T” 2. Imposition of a tariff by Home drives a “wedge” between the price in the Home market and the price received by foreign firms exporting to Home. This is to say … T

Positive Effects of an MFN Tariff MD Ddom MS imports quantity Z C mFT PFT Border price, euros Domestic price, Sdom 1. Due to the tariff wedge T, the Home price (also called the domestic price) is higher than the price foreign firms receive (also called the ‘border’ price); the difference is exactly T. T

Positive Effects of an MFN Tariff MD Ddom MS imports quantity Z C mFT PFT Border price, euros Domestic price, Sdom 2. To make this clear, we call the domestic price P’ and the border price P’-T. P’ P’-T

Positive Effects of an MFN Tariff MD Ddom MS imports quantity Z C mFT PFT Border price, euros Domestic price, Sdom 1. We know that P’ and P’-T are the equilibrium prices since the market for imports clears at these prices. More precisely, at P’ Home wishes to import m’ and at P’-T foreigners want to sell m’ to Home. m’ P’ P’-T m’

Positive Effects of an MFN Tariff MD Ddom MS imports quantity Z C mFT PFT Border price, euros Domestic price, Sdom P’ P’-T m’ 1. The tariff raises the domestic price .. 2. but lowers the border price 1. Notice that the domestic price and border price move in opposite directions. That is to say ...

Positive Effects of an MFN Tariff 1. Now consider the impact of the domestic price rise on Home production and consumption. MD Ddom MS imports quantity Z C mFT PFT Border price, euros Domestic price, Sdom P’ P’-T m’ 2. The rise in the Home price from PFT to P’ causes Home firms to expand production to Z’ and Home consumers to reduce consumption to C’. Z’ C’

Sdom P’ T MS PFT P’-T MD Ddom m’ mFT Z Z’ C’ C Border price, euros Domestic price, euros Sdom P’ T MS PFT P’-T MD Ddom m’ imports quantity mFT Z Z’ C’ C

Baldwin & Wyplosz The Economics of European Integration Teaching/Studying Presentation Baldwin & Wyplosz The Economics of European Integration Chapter 5: The Essential Economics of Preferential Liberalization A careful presentation of the welfare effects of an MFN Tariff in the MS-MD diagram To view this, start the slide show (‘view show’ command under the Slide Show pull-down menu) and use either the arrow keys or click the mouse to proceed

Normative Effects of an MFN Tariff NB: Mouse click or use arrow keys to advance 1. Next we consider the “welfare” or “normative” effects of T, i.e., we see who gains and who loses from T. 2. We start with the effects on Home. 3. Intuitively, it is easy to believe that the domestic price increase (i) hurts consumers, (ii) helps producers, and (iii) raises government revenue. 4. More specifically ...

Normative Effects of an MFN Tariff G 1. The grey area is the loss of consumer surplus due to the tariff-induced price rise from PFT to P’. MD Ddom MS imports quantity Z C mFT PFT Border price, euros Domestic price, Sdom P’ P’-T m’ Z’ C’ 2. Consumers lose for 2 reasons. 3. (i) They pay a higher price for the goods they continue to buy (this loss equals the blue rectangle defined by the price hike times consumption C’). 4. (ii) Consumers also lose because they consume less. This part of the loss corresponds to the green triangle.

Normative Effects of an MFN Tariff 5. The grey area, E, is the gain in producer surplus due to the tariff-induced price rise from PFT to P’. MD Ddom MS imports quantity Z C mFT PFT Border price, euros Domestic price, Sdom P’ P’-T m’ Z’ C’ 6. Home producers gain for 2 reasons. (i) they get a higher price for the quantity of goods they used to sell (this gain equals the blue rectangle defined by the price hike times Z). 7. (ii) they also gain because they sell more. This part of the gain corresponds to the green triangle.

Normative Effects of an MFN Tariff 8. The grey area is the increase in government revenue, i.e. the tariff revenue. It equals the level of imports C’-Z’ times the tariff T. MD Ddom MS imports quantity Z C mFT PFT Border price, euros Domestic price, Sdom P’ P’-T m’ Z’ C’ 9. The tariff revenue can be viewed as being paid partly by Home consumers and partly by foreigners. 10. (i) The part paid by Home consumers is shown by the blue rectangle. The area equals the level of imports consumed times the domestic price rise (PFT to P’). A B 11. (ii) The part paid by foreigners is the green rectangle. It equals imports (i.e. the level of exports) times the decrease in the border price (PFT to P’-T). P’-T

Normative Effects of an MFN Tariff MD Ddom MS imports quantity Z C mFT PFT Border price, euros Domestic price, Sdom P’ P’-T m’ Z’ C’ 1. Next we look at the net gain or loss to home, i.e. we want to know if the losers lose more than the winners win. E F A G 2. Consumers lose E+F+A+G, but ... 8. Note that if B-F-G is positive, it is due to exploitation of foreigners. That is, the amount of tariff revenue paid by foreigners (B) exceeds the domestic distortion loss (F+G). 3. … part of this is offset by the producers’ gain of E, and ... E 4. … more is offset by the part of the government’s gain of corresponding to A. A 5. To this, we add the other part of the government’s gain, namely B. The net Home welfare effect is thus +B-F-G. This may be positive or negative. B 7. We call the area “B” the ‘terms of trade’ gain, or “border price” effect. We call the triangles F and G, the ‘domestic distortion’ loss, or the “trade volume” effect (since they are related to the change in import volume.

Normative Effects of an MFN Tariff MD Ddom MS imports quantity Z C mFT PFT Border price, euros Domestic price, Sdom P’ P’-T m’ Z’ C’ B 1. Now we look at the welfare effect on the foreign nation. 2. The foreign nation definitely loses from the Home nation’s imposition of a tariff since it receives a lower price and exports less. 3. The loss consists of 2 parts. 4. (i) The loss B due to the lower border price and … A A C Note that the area B in the left panel and in the right panel are the same since both are exports times the fall in the border price. The area A is the same in both panels for a similar reason. D 5. (ii) … the loss D (green triangle) due to the reduction in foreign sales to Home.

Normative Effects of an MFN Tariff Border price, euros 1. Here we see the net global welfare effect. Home’s change is +E-F-G and Foreign’s change is -E-D. Adding these leaves a loss of the three triangles -(D+F+G). Domestic price, euros Sdom P’ P’ MS F G PFT B D B P’-T P’-T MD Ddom m’ imports quantity mFT Z Z’ C’ C

Normative Effects of an MFN Tariff 1. The book claims that the net global welfare effect also equals C+D in the left-panel. Here we shall show that this is true, i.e. C=F+G MD Ddom MS imports quantity Z C mFT PFT Border price, euros Domestic price, Sdom P’ P’-T m’ Z’ C’ E G D F 2. The first thing to note is that the sum of the bases of the triangles F and G equals the base of the triangle C (since both measure the change in imports). G F

Normative Effects of an MFN Tariff MD Ddom MS imports quantity Z C mFT PFT Border price, euros Domestic price, Sdom P’ P’-T m’ Z’ C’ E G D F 3. Now we move G over to C. Click 5 times to do this. G F

Normative Effects of an MFN Tariff MD Ddom MS imports quantity Z C mFT PFT Border price, euros Domestic price, Sdom P’ P’-T m’ Z’ C’ E G D F 4. Now we move F over to C. Click 5 times to do this.

Normative Effects of an MFN Tariff MD Ddom MS imports quantity Z C mFT PFT Border price, euros Domestic price, Sdom P’ P’-T m’ Z’ C’ E G D F 6. So this is what we wanted to show. The net global welfare change from Home’s MFN tariff is the sum of the triangles C+D. 5. Finally, we have to change the shape of F to fit into C. Remember that the area of a triangle depends only on its height and base. Changing the shape holding these constant does not change the area. Click 2 times to change the shape.

Sdom P’ P’ MS PFT P’-T MD Ddom m’ mFT Z Z’ C’ C Border price, euros Domestic price, euros Sdom P’ P’ A MS E C A F G PFT E D P’-T MD Ddom m’ mFT imports quantity Z Z’ C’ C

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