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

2. 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.
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3. 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 The Economics of European Integration, 2nd Edition

4. 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 The Economics of European Integration, 2nd Edition

5. 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 The Economics of European Integration, 2nd Edition

6. 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 The Economics of European Integration, 2nd Edition

7. 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 The Economics of European Integration, 2nd Edition

8. 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 The Economics of European Integration, 2nd Edition

9. 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 The Economics of European Integration, 2nd Edition

10. 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
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11. 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
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12. 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 The Economics of European Integration, 2nd Edition

13. 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 The Economics of European Integration, 2nd Edition

14. 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 The Economics of European Integration, 2nd Edition

15. 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 The Economics of European Integration, 2nd Edition

16. 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 The Economics of European Integration, 2nd Edition

17. 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 The Economics of European Integration, 2nd Edition

18. 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 The Economics of European Integration, 2nd Edition

19. 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 The Economics of European Integration, 2nd Edition

20. 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 The Economics of European Integration, 2nd Edition

21. 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 The Economics of European Integration, 2nd Edition

22. 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 The Economics of European Integration, 2nd Edition

23. 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 The Economics of European Integration, 2nd Edition

24. 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 The Economics of European Integration, 2nd Edition

25. 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 The Economics of European Integration, 2nd Edition

26. Common Agricultural Policy
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27. 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 The Economics of European Integration, 2nd Edition

28. 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 The Economics of European Integration, 2nd Edition

29. 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 The Economics of European Integration, 2nd Edition

30. 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 The Economics of European Integration, 2nd Edition

31. 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 The Economics of European Integration, 2nd Edition

32. 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 The Economics of European Integration, 2nd Edition

33. 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 The Economics of European Integration, 2nd Edition

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

35. 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.
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36. Follow-on problems: Budget
Buy and storing or dumping food becomes increasingly expensive.
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37. 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 The Economics of European Integration, 2nd Edition

38. Other CAP problems Factory Farming:
Pollution,
Animal welfare,
Nostalgia.
Bad for ‘image’ and thus public support for CAP.
© Baldwin & Wyplosz The Economics of European Integration, 2nd Edition

39. 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
Similar to MacSharry reforms in spirit.
Still might not be enough to allow Doha Round to finish.
© Baldwin & Wyplosz The Economics of European Integration, 2nd Edition

40. 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 The Economics of European Integration, 2nd Edition

41. 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?”
© Baldwin & Wyplosz The Economics of European Integration, 2nd Edition

42. 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 The Economics of European Integration, 2nd Edition

43. 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 The Economics of European Integration, 2nd Edition

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