1. 1 Università di Pisa Academic Year 2011/2012 The Economics of the European Union Lecture 3 Theory of Trade and EU Instructor: Prof. Pompeo Della Posta pompeodellaposta@yahoo.it These slides are derived either directly or indirectly (with some integrations and modifications) from: The European Union, Susan Senior Nello: “Economics, Policies and History”, McGraw Hill, 2004 and Richard Baldwin and Charles Wyplosz: “The Economics of European Integration”, 2nd Edition, MacGraw Hill, 2006 (in particular from the files downladable at Richard Baldwin’s Web site: http://hei.unige.ch/~baldwin/PapersBooks/BW/BW.html)

2. 2 The basic ideal argument in favour of integration: the search for ‘Peace and Prosperity’ Peace: avoid wars like the two world ones that last century took place in Europe; Prosperity: economic integration (freedom of movement of goods, services, labour and capital) is believed to allow a more efficient allocation of resources, and to increase the overall prosperity

3. 3 The main economic arguments in favour of free trade  The benefits of inter-industry trade: –Adam Smith’s theory of absolute advantage –David Ricardo’s theory of comparative advantage –The Hecksher-Ohlin theorem The benefits of intra-industry trade –Static economies of scale –Dynamic economies of scale

4. 4 Adam Smith’s theory of absolute advantage It is based on his idea of the division of labor. As people specialize in a particular job or activity, similarly countries should specialize in producing the goods in which they are more efficient. He proves that, contrary to the ‘Mercantilist’ view, international trade is NOT a zero sum game, i.e. in the simple two-country model that he considers, both the importing and the exporting countries benefit from trade.

5. 5 David Ricardo’s theory of comparative advantage This theory goes beyond the idea of absolute advantage introduced by Adam Smith at the end of the XVIII Century; it says that even if a country is more efficient (i.e. more productive) than a second one in two different sectors, it would still have convenience to concentrate its productive efforts on just one good, the one on which it is comparatively more efficient. (see the example in Table 4.1 of the book)

6. 6 The Hecksher-Ohlin theorem It reformulates the conclusions reached by Ricardo by abandoning the labor-value theory and by embracing the ‘marginalist’ approach, i.e. the modern microeconomic approach still followed and taught all over the world.

7. 7 It explains the comparative advantage of a country by looking at its factor endowments and by considering the factor intensity of the goods to be produced. Its conclusions are intuitive: a country specializes in the production and the export of the goods that make an intensive use of the factor which is relatively more abundant and (generally) less expensive in that country. (See the graphical representation in Figure 4.1 in the book).

8. 8 The benefits of intra-industry trade The arguments presented above refer to inter- industry trade, namely the one relative to exchange of different kinds of products: North- South or Developed-Developing countries type of trade. A large part of the current world trade, however, refers to intra-industry trade, i.e. trade relative to the exchange of different varieties of the same kind of product (cars, washing machines etc.).

9. 9 This is precisely the trade that is taking place within Europe, or between Europe and the US. This kind of trade is less problematic than the inter-industry one, since it does not imply the (almost complete) abandonment of productive sectors and this helps explaining the success of the process of the European integration. It can be shown (Krugman and many others have worked on this issue during the Eighties) that intra-industry trade is beneficial too, since it allows reducing the production cost (and therefore the price at which products can be sold) and increasing the varieties available for consumers.

10. 10 Static economies of scale The first argument in favour of intra- industry trade is that it allows to benefit of increasing returns to scale: a larger market allows selling a higher number of products, thereby reducing their unit costs (the high fixed costs – a characteristic of many of today’s production processes - are spread over a larger number of products). See figure 4.2.

11. 11 Dynamics economies of scale The fact of specializing in a given productive activity allows ignating a cumulative learning process that releases its positive effects over time. See figure 4.3.

12. 12 Protectionist measures Despite the benefits of free inter-industry and intra-industry trade described above, many protectionst measures prevent free trade. The most important of them is the application of import tariffs. Other non-tariff barriers are: quotas on imports, voluntary export restraints (VERs), cartels, anti-dumping subsidies, export subsidies, differences in technical standards and discrimination in public procurement.

13. 13 Import tariffs They are considered the ‘lesser evil’ compared with other trade barriers, because they are more transparent. They can be: –Ad valorem (a given percentage applied to the total value) –Specific (a fixed amount) –Compound (a mix of the two above)

14. 14 In order to analyze the effects of the introduction of an import tariff, we need to use some diagrams. The slides and (nicely drawn) diagrams that follow are borrowed (and sometimes modified or adapted to our needs) from the web site of Richard Baldwin, the author, together with Charles Wyplosz, of: “The Economics of European Integration”, 2nd Edition, MacGraw Hill, 2006. The modified slides have been distributed to the students upon their request and of course can only be devoted to an internal use.

15. 15 Demand curve 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

16. 16 Supply Curve 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

17. 17 Welfare analysis: consumer surplus Since the demand curve is 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*

18. 18 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 = Price drop times old consumption –Gain surplus on the new units consumed (those from c* to c’) –measure of this = area B = sum of all new gaps between marginal utility and price

19. 19 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*

20. 20 Welfare analysis: producer surplus If the price rises: –producers obviously better off –Producer surplus change quantifies this intuition producer surplus rise, 2 parts: –Get a higher price for the q* units previously sold; measure of this = area A = Price rise times old production –Gain surplus on the new units sold (those from q* to q’) –measure of this = area B = sum of all new gaps between marginal cost and price

21. 21 We are now ready to analyze: The economic effects of introducing a tariff in a ‘small country’ The (ad valorem) tariff induces a correspondingly higher price so that (see figure 4.4): –consumers will loose a large ‘surplus’ (a+b+c+d); –Producers will gain some surplus (a); –The State will gain some revenues (c); –As a result the economy will have a net loss represented by the triangles b and d.

22. 22 The effects of the imposition of a tariff in a ‘small’ country price P” P’ Home Supply Z’C’ quantity Z”C” Home Demand

23. 23 Welfare & Import demand curve price Home Supply P” P’ Z’C’ quantity Z”C” Home Demand ABCD

24. 24 The Home effect of introducing a tariff in a ‘large nation’ Fig 4.9

25. 25 The home, foreign and global economic effects of introducing a tariff in a ‘large country’: we will see that while for the home country it is not certain whether the application of an import tariff implies a net benefit or loss, the foreign exporting country against which the import tariff is applied obtains a loss with certainty and the global economic effect is also a loss.

26. 26 Let us consider first two new curves, that are derived respectively from the domestic open economy demand and supply and the foreign open economy demand and supply

27. 27 The Import Demand Curve – 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

28. 28 Import demand curve (MD) price Home Supply P* P” P’ Z’C’ quantityimports Z”C” Home Demand Home import demand curve, MD H P” P’ M’M” 1 2 3

29. 29 Similarly for the foreign demand and supply from which we obtain the domestic import supply curve (or foreign export supply curve):

30. 30 Import supply curve (MS) P* P” P’ C’ quantity exports C” X’ X” price Foreign export Supply curve, XS F, or MS H. Foreign Supply Foreign Demand 1 3 Z’Z” 2

31. 31 The Workhorse: MD-MS Diagram Very useful diagram –easy identification of price and volume effects of a trade policy change Welfare change likewise easy to identify euros imports MS MD Import supply curve Import demand curve Imports P FT

32. 32 MD-MS + Domestic Supply and 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 importsquantity MS MD Z C Domestic price, euros Import supply curve Domestic demand curve Domestic supply curve Imports Import demand curve Imports S dom D dom P FT

33. 33 Trade volume effect & border price effect First of all: notice that in this diagram you have the HOME IMPORTS and NOT the DOMESTIC demand that we have seen in slides 5-7-8. Decomposing Home loss from price rise, P’ to P”. –Area C: Home pays more for units imported at the old price. Area C is the size of this loss. –Home loses from importing less at P” area E measures loss Home imports MD MM’ P” CE Domestic price P’

34. 34 Trade volume effect & 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 Home imports MD MM’ P” CE Domestic price Border price effect Trade volume effect P’

35. 35 Trade volume effect & border price effect Can do same for Foreign price fall, P’’ to P’ (again, be careful, this is the home import supply or foreign export supply and NOT the domestic supply that we had in slides 6-9- 10). –Foreign loss from getting a lower price for the goods it sold before at P” (border price effect), area D –And loss from selling less (trade volume effect), area F.

36. 36 Most Favored Nation (MFN) Tariff Analysis 1 st step: determine how tariff changes prices and quantities. –suppose tariff imposed equals T euros per unit 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

37. 37 MFN Tariff Analysis For example, how high would domestic price have to be in Home for Foreigners to offer to export M a to Home? –Answer is P a +T, so Foreigners would see a price of P a Home imports MD Border price Foreign exports XS=MS MS MS with T Domestic price T PaPa 2 P a +T MaMa X a =M a 1

38. 38 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 Home imports MD Border price Foreign exports XS=MS MS MS with T Domestic price T P’-T X’=M’ M FT X FT = M FT P FT M’ P’

39. 39 Welfare effects: Home –Private surplus change (sum of change in producer and consumer surplus) equal to -(A+C) –Increase in tariff revenue equal to +A+B –Net effect, B-C

40. 40 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) Net effect on Foreign = -D-B ALTERNATIVELY: –Private surplus change (sum of change in producer and consumer surplus) equal to -D-B

41. 41 The overall welfare effect It is possible to evaluate the overall effect by considering 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)

42. 42 The analysis of this part can also be done in a very clear and intuitive way by following the interactive explanation reported below, provided by Baldwin and Wyplosz and downloadable at Richard Baldwin’s web site (at the Ecole des Hautes Etudes, in Geneva, Switzerland).

43. 43 The analysis that follows allows to identify more clearly the gains and losses of the home country. We will also see again, in a slightly different way, the net loss of the foreign country and the overall – global – loss resulting from the imposition of a tariff.

44. 44 Baldwin & Wyplosz The Economics of European Integration Chapter 4: Basic Economics of Preferential Liberalisation 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 “A careful presentation of the Welfare Effects of an MFN Tariff in the MS-MD diagram” NB: This analysis does not exactly follow the book, but it explains the results in diagram 4-5 Teaching/Studying Presentation

45. 45 Normative Effects of an MFN Tariff 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... NB: Mouse click or use arrow keys to advance

46. 46 MD D dom MS importsquantity ZCm FT P FT Border price, euros Domestic price, euros S dom P’ P’-T m’ Z’C’ P’ E F A G 1. The grey area is the loss of consumer surplus due to the tariff-induced price rise from P FT to P’. Normative Effects of an MFN Tariff 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.

47. 47 MD D dom MS importsquantity ZCm FT P FT Border price, euros Domestic price, euros S dom P’ P’-T m’ Z’C’ P’ Normative Effects of an MFN Tariff 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. 5. The grey area, E, is the gain in producer surplus due to the tariff-induced price rise from P FT to P’.

48. 48 MD D dom MS importsquantity ZCm FT P FT Border price, euros Domestic price, euros S dom P’ P’-T m’ Z’C’ P’ Normative Effects of an MFN Tariff 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 (P FT to P’). 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. P’-T 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 (P FT to P’-T). A B

49. 49 E F A G 2. Consumers lose E+F+A+G, but... MD D dom MS importsquantity ZCm FT P FT Border price, euros Domestic price, euros S dom P’ P’-T m’ Z’C’ P’ P’-T Normative Effects of an MFN Tariff 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. 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. 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).

50. 50 MD D dom MS importsquantity ZCm FT P FT Border price, euros Domestic price, euros S dom P’ P’-T m’ Z’C’ P’ P’-T B B Normative Effects of an MFN Tariff 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 … 5. (ii) … the loss D (green triangle) due to the reduction in foreign sales to Home. 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. AA D C

51. 51 Normative Effects of an MFN Tariff MD D dom MS importsquantity ZCm FT P FT Border price, euros Domestic price, euros S dom P’ P’-T m’ Z’C’ P’ P’-T B B 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). FG D

52. 52 MD D dom MS importsquantity ZCm FT P FT Border price, euros Domestic price, euros S dom P’ P’-T m’ Z’C’ P’ E G D C F 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 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). GF

53. 53 MD D dom MS importsquantity ZCm FT P FT Border price, euros Domestic price, euros S dom P’ P’-T m’ Z’C’ P’ E G D C F Normative Effects of an MFN Tariff GF 3. Now we move G over to C. Click 5 times to do this.

54. 54 Normative Effects of an MFN Tariff MD D dom MS importsquantity ZCm FT P FT Border price, euros Domestic price, euros S dom P’ P’-T m’ Z’C’ P’ E G D C F 4. Now we move F over to C. Click 5 times to do this.

55. 55 Normative Effects of an MFN Tariff MD D dom MS importsquantity ZCm FT P FT Border price, euros Domestic price, euros S dom P’ P’-T m’ Z’C’ P’ E G D C F 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. 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.

56. 56 MD D dom MS importsquantity ZC m FT P FT Border price, euros Domestic price, euros S dom P’ P’-T m’ Z’C’ P’ E FG D A A C E