Essential Micro Tools © Baldwin & Wyplosz 2006. The Economics of European Integration, 2nd Edition

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, 2nd Edition

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. Horizontal sum. A firm’s supply curve is its marginal cost curve. © Baldwin & Wyplosz 2006. The Economics of European Integration, 2nd Edition

Welfare analysis: consumer surplus Since demand curve based on marginal utility, it can be used to show how 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, 2nd Edition

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, 2nd Edition

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*. S=MC © Baldwin & Wyplosz 2006. The Economics of European Integration, 2nd Edition

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, 2nd Edition

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, 2nd Edition

Import demand curve (MD) Home Supply price price 1 P* 2 P” P” 3 P’ P’ Home Demand Home import demand curve, MDH quantity imports Z’ Z” C” C’ M” M’ © Baldwin & Wyplosz 2006. The Economics of European Integration, 2nd Edition

Import supply curve (MS) quantity exports C” X’ X” price Foreign export Supply curve, XSF, or MSH. Foreign Supply Demand 1 3 Z’ Z” 2 © Baldwin & Wyplosz 2006. The Economics of European Integration, 2nd Edition

Welfare & Import demand curve price Home Supply NB: E=B+D P* P” P’ Z’ C’ quantity imports Z” C” Demand A B C D E import demand curve, MDH M’ M” 1 2 3 ToT effect © Baldwin & Wyplosz 2006. The Economics of European Integration, 2nd Edition

Welfare & Import supply curve quantity exports C” X’ X” price Foreign export Supply curve, XSF, or MSH. A B C D E F=C+E F Foreign Supply Demand 1 3 Z’ Z” 2 Trade price effect, i.e.ToT effect © Baldwin & Wyplosz 2006. The Economics of European Integration, 2nd Edition

The Workhorse: MD-MS Diagram Diagram very useful. easy identification of price and volume effects of a trade policy change. Welfare change likewise easy. euros imports MS MD Import supply curve demand curve Imports PFT © Baldwin & Wyplosz 2006. The Economics of European Integration, 2nd Edition

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. euros imports quantity MS MD Z C Domestic price, euros Import supply curve Domestic demand curve Imports demand curve Sdom Ddom PFT © Baldwin & Wyplosz 2006. The Economics of European Integration, 2nd Edition

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

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. Home imports MD Border price Foreign exports XS=MS MS w/FT MS with T Domestic price T Pa 2 Pa+T Ma Xa=Ma 1 © Baldwin & Wyplosz 2006. The Economics of European Integration, 2nd Edition

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 MS with T MS XS=MS P’ PFT PFT T P’-T MD Foreign exports Home imports M’ MFT X’=M’ XFT= MFT © Baldwin & Wyplosz 2006. The Economics of European Integration, 2nd Edition

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, 2nd Edition

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. ToT 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, 2nd Edition

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., ToT 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, 2nd Edition

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, 2nd Edition

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, 2nd Edition

Distributional consequences: Home Home consumers lose, area E+C2+A+C1; Home producers gain E, Home tariff revenue rises by A+B. net change = B-C2+-C1 (this equals B-C in left panel). euros imports quantity MS MD C Domestic price, euros Sdom Ddom PFT Z P’ P’-T C’ Z’ A B D E C2 C1 © Baldwin & Wyplosz 2006. The Economics of European Integration, 2nd Edition

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, 2nd Edition

A typology for trade barriers Net Home 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 MS P’ A C PFT D B P’-T MD M’ MFT Home imports © Baldwin & Wyplosz 2006. The Economics of European Integration, 2nd Edition

Common Agricultural Policy © Baldwin & Wyplosz 2006. The Economics of European Integration, 2nd Edition

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, 2nd Edition

Simple price support with tariff Home Demand Home Supply Home Demand Home Supply price price pss Price floor (Pw+T, or Pw’+T’) Price floor T’ T A B Pw’ C1 C2 Pw Pw Imports (with floor) Q Q Z Zf Cf C Z Zf Cf C Imports (without price floor) © Baldwin & Wyplosz 2006. The Economics of European Integration, 2nd Edition

Food tax interpretation Price floor supported by tariff is like all-in-one package made up of simpler policy measures. (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 C1 and C2). Home Demand Home Supply price Price floor A B C1 C2 Pw Q Z Zf Cf C © Baldwin & Wyplosz 2006. The Economics of European Integration, 2nd Edition

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 (millions) Number of farms as share of total Share of EU12 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% 7.0 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, 2nd Edition

Pw+T Atotal Asmall Abig Pw B price price price Family farm supply curve Commercial farm supply curve Total supply curve Pw+T Asmall Atotal Abig Pw B Q Q Zsmall Zbig Ztotal Q © Baldwin & Wyplosz 2006. The Economics of European Integration, 2nd Edition

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, 2nd Edition

S’ Pw Cf Zf price price S1 S2 S3 S4 Home Supply Demand p1ss p2ss Price floor p3ss S’ B A a b c Price floor d e C1 C2 p4ss Pw EU purchase Home Demand Q Q Cf Zf © Baldwin & Wyplosz 2006. The Economics of European Integration, 2nd Edition

Follow-on problems of oversupply EU switches from net food import to exporter in most products. © Baldwin & Wyplosz 2006. The Economics of European Integration, 2nd Edition

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, 2nd Edition

Follow-on problems: Budget Buy and storing or dumping food becomes increasingly expensive. © Baldwin & Wyplosz 2006. The Economics of European Integration, 2nd Edition

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, 2nd Edition

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, 2nd Edition

CAP Reforms Supply control attempts: 1992: MacSharry Reforms: 1980s, experimentation with ad hoc & complex set supply ‘controls’ to discourage production. Generally failed; technological progress & high guaranteed prices overwhelmed supply controls. 1992: MacSharry 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 MacSharry reforms in spirit. Still might not be enough to allow Doha Round to finish. © Baldwin & Wyplosz 2006. The Economics of European Integration, 2nd Edition

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, 2nd Edition

Farm incomes & CAP support inequity Reformed CAP (post MacSharry) 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/BookDetail.php?item_id=1285 © Baldwin & Wyplosz 2006. The Economics of European Integration, 2nd Edition

CAP support inequity Size Class Payment per farm % of EU15 farms in size class Number of farms in size class % of EU15 payments to size class Cumulative % of budget (from largest to smallest) Cumulative % of farms (from largest to smallest) 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 Average, All farms €5,015 © Baldwin & Wyplosz 2006. The Economics of European Integration, 2nd Edition

Future challenges Doha Round: Eastern Enlargement: 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, 2nd Edition

EU newcomers: Farm facts © Baldwin & Wyplosz 2006. The Economics of European Integration, 2nd Edition