1. Lecture 2. November 30th Macroeconomics, foreign trade and the European Union. Basics and Examples.

2. Macroeconomics, foreign trade and European Union. Basics. Tariffs. What they are, what they cause. free trade zones: a better world? A theoretical approach comparative static analysis of free trade dynamic effects of free trade Is EU a useful free trade zone? Lecture 2 Dipl.- Kfm. Thomas Stiegler, University of Göttingen. 2 Todays topics

3. Macroeconomics, foreign trade and European Union. Basics. International trade is always accompanied with tariffs Tariffs can have different itentions: willingness to protect home industries income for the state to control imports Tariffs lead to an economical suboptimal situation Dipl.- Kfm. Thomas Stiegler, University of Göttingen. 3 Tariffs – a fact in international trade Lecture 2

4. Macroeconomics, foreign trade and European Union. Basics. In the following argumentation we assume tariffs, that lead to a substitution of imports by domestic products. losses in production efficiency; suboptimal allocation of recourses losses in consumer welfare (as more expensive domestic goods have to be consumed) change in terms of trades towards the tariff implementing state Dipl.- Kfm. Thomas Stiegler, University of Göttingen. 4 What are the impacts of tariffs? Lecture 2

5. Macroeconomics, foreign trade and European Union. Basics. The negative effects described above will be persistent. However, one could make up situations in which tariffs are useful to a state in some extend. infant industry protection protection of strategical production (can be substituted by subsidies) optimal tariffs (more theoretical option, partners would act the same way with leaving no positive effect) Dipl.- Kfm. Thomas Stiegler, University of Göttingen. 5 Are there situations when tariffs are positive? Lecture 2

6. Macroeconomics, foreign trade and European Union. Basics. As we learnt in the last lecture, EU implemented a common market. That means, it is a free trade zone without any tariffs inside. So we should take a closer look to the effects of free trade in general we have to distinguish between two types of effects of free trade: 1. comparative statical effects (traditional welfare theory) 2. dynamical effects of integration In the following we will have a short look at these effects Dipl.- Kfm. Thomas Stiegler, University of Göttingen. 6 Effects of free trade Lecture 2

7. Macroeconomics, foreign trade and European Union. Basics. There are a number of assumptions in traditional free trade theory: competitive market ( no oligopolies or monopolies) homogenous goods no economies of scale no market access barriers no technological advance, no advance in products we clearly see, that these assumptions are not too realistic, but lets see what theory brings to us though… Dipl.- Kfm. Thomas Stiegler, University of Göttingen. 7 Comparative statical analysis - assumptions Lecture 2

8. Macroeconomics, foreign trade and European Union. Basics. Creating a free trade zone erases the discrimination against the partner states. However, the free trade zone itself now discriminates all other states. Again there are two main effects in foreign trade by a free trade zone: 1. trade creation (creating new trade - efficient) 2. trade diversion (changing existing trade relations - inefficient) lets have a look at a very simple example to explain: Dipl.- Kfm. Thomas Stiegler, University of Göttingen. 8 Comparative statical analysis – trade impact of free trade Lecture 2

9. Macroeconomics, foreign trade and European Union. Basics. Dipl.- Kfm. Thomas Stiegler, University of Göttingen. 9 Trade structure impact of free trade – example (1) Lecture 2

10. Macroeconomics, foreign trade and European Union. Basics. 3) – 5) trade creation. As the tariff was set that way, that it hindered any trade, the free trade area now allows trade again and brings the factor allocation to a more efficient level 2) – 4)trade diversion. The – in terms of factor allocation efficient – import from Japan is substituted by a less efficient import from France, as through the free trade area Japan is discriminated against France. However the situation is better than a non trade situation. Dipl.- Kfm. Thomas Stiegler, University of Göttingen. 10 Trade structure impact of free trade – example (2) Lecture 2

11. Macroeconomics, foreign trade and European Union. Basics. As we saw above there are positive and negative effects of free trade zones. In the following we will have a look at 3 scenarios: 1. Free trade area, in a situation with non prohibitive tariffs before 2. Free trade after prohibitive tariffs. Small partner country 3. Free trade after prohibitive tariffs. Big partner country Dipl.- Kfm. Thomas Stiegler, University of Göttingen. 11 Three scenarios of a free trade area Lecture 2

12. Macroeconomics, foreign trade and European Union. Basics. Dipl.- Kfm. Thomas Stiegler, University of Göttingen. 12 Trade structure impact of free trade – example (2) Scenario 1 Lecture 2

13. Macroeconomics, foreign trade and European Union. Basics. To describe the curves: To the left we see domestic demand and supply for good X at different price levels To the right we see the domestic excess demand for good X = demand for imports of X, as well as the supply curves of the countries A1 and A2, where A1 is a small country (import demand effects A1s prices) and A2 a big country, which can produce any demanded X for price G Dipl.- Kfm. Thomas Stiegler, University of Göttingen. 13 What do these curves show us? Lecture 2

14. Macroeconomics, foreign trade and European Union. Basics. The price of X is set by the world market = G. As domestic firms rarely can compete at that price import demand FE exists. The import can substitute inefficient local production and increase over all efficiency. Country A1 produces export goods of X the cheapest, but through demand, prices are rising. Import from A1 takes place until price in A1 reaches G: 0M1 The rest of the domestic import demand is bought from A2 at G: M0M3 Dipl.- Kfm. Thomas Stiegler, University of Göttingen. 14 Scenario 0 – what would happen without any tariffs? Lecture 2

15. Macroeconomics, foreign trade and European Union. Basics. Generally the situation is similar to above As the prices for consumers in the domestic market rose to pt now, the import demand decreases to AB Import structure is the same as above. First the cheaper A1 (0M0) then from A2 (M0M2 = less than before) The efficiency structure of import is not disturbed, however more of the less efficient domestic production is used and the overall consummation decreased. The received tariff payments are lower than this loss negative welfare effect Dipl.- Kfm. Thomas Stiegler, University of Göttingen. 15 Scenario 1 – non prohibitive tariff is implemented Lecture 2

16. Macroeconomics, foreign trade and European Union. Basics. What are now the effects of a free trade area with A1? A1 can export goods without tariff burden, so there is a price advantage of T towards A2 Although the local prices in A1 are higher between M0M1 the price for domestic consumers is lower. The less effective production from A1 is bought. Structure: 0M1 from A1, M1M2 from A2 (which is discriminated) Dipl.- Kfm. Thomas Stiegler, University of Göttingen. 16 Scenario 1 – tariff union with the small country Lecture 2

17. Macroeconomics, foreign trade and European Union. Basics. Lets evaluate the effects of the tariff and the tariff union. The curves help: By implementing a tariff the consumers wealth is decreasing by ABEF. However, the state gets income from the tariffs, which increases the income again: ABCD. We clearly see the income is smaller than the loss. The loss is ACF + BDE, so called dead weight loss The tariff union now does not increase the consummation, the price to pay abroad for imports increased, the terms of trade decreased, the income of the state decreased; c.p. the free trade zone with A1 has only negative effects Dipl.- Kfm. Thomas Stiegler, University of Göttingen. 17 Scenario 1 – tariff union and worse off… Lecture 2

18. Macroeconomics, foreign trade and European Union. Basics. Dipl.- Kfm. Thomas Stiegler, University of Göttingen. 18 Trade structure impact of free trade – example (2) Scenario 2 Lecture 2

19. Macroeconomics, foreign trade and European Union. Basics. In this scenario there is a quite high tariff set, a free trade agreement then is agreed with the smaller country. implementing a high tariff has the same consequences as in scenario 1. Income ABCD for the state, deadweight loss of ACF+BDE Import structure with tariffs: OM0 from A1 and M0M1 from A2 (efficient structure) Dipl.- Kfm. Thomas Stiegler, University of Göttingen. 19 Scenario 2 – some light, but still more shadow… (1) Lecture 2

20. Macroeconomics, foreign trade and European Union. Basics. Free trade area with A1. Again Imports from A2 are discriminated. through the tariff union A1 products get that cheap on the domestic market, that more can be consumed than before (0M2) (trade creation) No goods from A2 are imported anymore (trade diversion) The price paid for the import goods got higher No income from tariffs In total we see again a negative effect of free trade area as the trade diversion effect is bigger than the trade creation effect Dipl.- Kfm. Thomas Stiegler, University of Göttingen. 20 Scenario 2 – some light, but still more shadow… (2) Lecture 2

21. Macroeconomics, foreign trade and European Union. Basics. Dipl.- Kfm. Thomas Stiegler, University of Göttingen. 21 Trade structure impact of free trade – example (2) Scenario 3 Lecture 2

22. Macroeconomics, foreign trade and European Union. Basics. Again the same situation as in (1) and (2) occurs for the tariff situation Having a free trade zone with the big country now brings us almost to the price level for our imports we would have in world wide free trade. The trade creation is much bigger than trade diversion The allocation of recourses improved overall Dipl.- Kfm. Thomas Stiegler, University of Göttingen. 22 Scenario 3 – positive effects of free trade zone Lecture 2

23. Macroeconomics, foreign trade and European Union. Basics. It is more likely, that a free trade zone brings positive effects, if… the tariffs between the future partners are relatively high (big trade creating effect) the tariffs towards third parties are low (small diversion effects) the area of the tariff union is big (small diversion, big creating effect) the product structure of the partner countries is similar to each other but different from third parties (small diversion effect) Dipl.- Kfm. Thomas Stiegler, University of Göttingen. 23 When is free trade useful? (1) Lecture 2

24. Macroeconomics, foreign trade and European Union. Basics. It is more likely, that a free trade zone brings positive effects, if… transport costs between the member states are low (they are geographically close) the number of efficient suppliers in the union is bigger than outside However these positive effects are if they exist usually not really big, if we follow the classical theory. Therefore lets have a look at the dynamical effects of free trade in the following Dipl.- Kfm. Thomas Stiegler, University of Göttingen. 24 When is free trade useful? (2) Lecture 2

25. Macroeconomics, foreign trade and European Union. Basics. in contrast to the comparative static effects, the dynamical effects of a tariff union are not that easy to present analytically. However there is hardly any doubt that they exist. We will have a closer look at three of them: 1. economies of scale 2. competition effects 3. growth impulses through integration Dipl.- Kfm. Thomas Stiegler, University of Göttingen. 25 Dynamical effects of free trade Lecture 2

26. Macroeconomics, foreign trade and European Union. Basics. the most competitive firms of each sector get a bigger market to sell their goods on to some point it gets more and more efficient to produce more units of the same product: positive effects of mass production lowering share of fixed costs better efficiency of organizational structures Dipl.- Kfm. Thomas Stiegler, University of Göttingen. 26 Economies of scale Lecture 2

27. Macroeconomics, foreign trade and European Union. Basics. in some fields of national economies exist oligopolies and monopolies which set prices at a sub optimal level in order to maximize the national wealth Through a common market competitors from other countries occur forcing the monopolists now to act as a firm in competition. Prices decrease, wealth increases Danger of monopolies of the whole integration zone : necessary to observe. (EU has competition observing institutions) Dipl.- Kfm. Thomas Stiegler, University of Göttingen. 27 Competition effects Lecture 2

28. Macroeconomics, foreign trade and European Union. Basics. Companies get access to bigger markets and might see the possibility of expansion To use these new markets an impulse on technology development is set By entering markets with high technology spill over effects can occur These effects will be bigger, the bigger the common market and the number of industries is Dipl.- Kfm. Thomas Stiegler, University of Göttingen. 28 Growth impulses through integration Lecture 2

29. Macroeconomics, foreign trade and European Union. Basics. we saw from a theoretical view, that regional free trade integration is not necessarily useful but can be positive as we saw in the first lecture, EU is a huge market with many differently structured states. Thats a good basis. the big market allows to assume potential dynamic effects are big Dipl.- Kfm. Thomas Stiegler, University of Göttingen. 29 Conclusions (1) Lecture 2

30. Macroeconomics, foreign trade and European Union. Basics. through common currency transaction costs are quite low. To conclude we can say that European could be a good free trade zone, however to which extent positive effects occur is difficult to say. As conditions for positive effects under comparative static analysis exist, we can conclude, that in addition a even bigger effect as of dynamic effects should be existing. Dipl.- Kfm. Thomas Stiegler, University of Göttingen. 30 Conclusions (2) Lecture 2

31. Macroeconomics, foreign trade and European Union. Basics. What are the consequences of common market in Europe? Some evidence from European reality. Prime Ministers Putins proposal: of November 25 th : free trade from Lisbon to Vladivostok? The Euro. One market one currency? Chances and dangers. Dollar vs. Yuan currency as economical weapon? Dipl.- Kfm. Thomas Stiegler, University of Göttingen. 31 What will be next Lecture 2