1. Economics of Trade Liberalization and Integration
Jan Fidrmuc
Brunel University

2. 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’

3. 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

4. MD-MS Diagram
MD-MS diagram permits tracking domestic & international consequences of trade policy changes.`
euros
imports
quantity MS MD Z C
Domestic
price, euros
Import (foreign
export) supply
curve
Domestic demand curve
supply curve
Imports
Import
demand curve
Sdom
Ddom
PFT

5. Non-discriminatory (MFN) Tariff
Consider tariff of T euros per unit
MFN non-discriminatory tariffs
WTO rules: lowest tariff (most-favored nation) must apply equally to all trading partners
Exception: FTAs
Tariff shifts MS curve up by T.
Exporters earn domestic price minus T
They would need domestic price of P+T to continue to offer the same exports.

6. MFN Tariff Analysis MS with T MS XS=MS P’ PFT PFT P’-T MD
New equilibrium in Home (MD=MS) is at P’ and M’.
Domestic price P’ now differs from border price (price exporters receive) P’-T.
Domestic price rises.
Border price falls.
Imports fall.
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

7. Welfare effects
Foreign loss due to drop in exports equal to area D (trade volume effect).
Foreign loss due to drop in border price equal to area B (border price effect, a.k.a., ToT effect).
Net effect on Foreign = -D-B.
Home loss equal to area -A-C (trade volume drops and price rises).
Home gain due to drop in border price and tariff revenue equal to area A+B.
Net effect on Home = -C+B.
World welfare change is -D-C.
If Home gains (-C+B>0) it is because it exploits foreigners by ‘making’ them pay part of the tariff (i.e. area B).

8. Distributional consequences
Home consumers lose area E+C2+A+C1
Home producers gain E
Home tariff revenue: A+B.
Net change = B-C2-C1 (this equals B-C in left panel).
Net effect can be positive or negative.
Tariffs imposed because they benefit domestic producers who are often organized and politically influential
This comes at a cost to domestic consumers and to foreigners
If Foreign retaliates and also imposes a tariff, everyone loses
With reciprocity, protectionism is not a zero-sum game

9. Distributional consequences
euros
imports
quantity MS MD C
Domestic
price, euros
Sdom
Ddom
PFT Z P’
P’-T C’ Z’ A B D E C2 C1

10. Preferential Trade Liberalization
Previous analysis used 2 countries only: Home and Foreign
European integration is discriminatory (or preferential) and its analysis requires at least three countries:
At least two integrating nations.
At least one excluded nation.
MD-MS diagram must to allow for two sources of imports.

11. The PTA Diagram: Free trade
RoW
Partner
Home
Border price
Border price
Domestic price
XSP MS
XSR 1 2
PFT MD XR
RoW
Exports XP
Partner
Exports
Home
imports
M=XP+XR

12. The PTA Diagram: MFN tariff
Domestic price
Home
imports MD
PFT
RoW
Exports
Partner
XSP
XSR MS
MSMFN P’ M’
M=XP+XR
Border price T
P’-T 2 1
X’R
X’P XP XR

13. Discriminatory unilateral liberalization
Assume Home removes T on imports only from Partner.
This liberalization shifts up MS (as with MFN tariff) but not as far since it applies only to one half of imports.
Shifts up MS to half way between MS (free trade) and MS (MFN tariff)
More complex, kinked MS curve with PTA.
If price falls below Pa, RoW will export zero.

14. Discriminatory, unilateral liberalization
Border price
Border price
Domestic price
RoW
Partner
Home
MSMFN
MSPTA
XSR
XSP MS P’ P” P” T
P’-T
P”-T Pa T 1 p* MD
RoW
Exports
Partner
Exports
Home
imports
XR”
XR’
XP’
XP” M’ M”

15. Domestic price & border price changes
Domestic price falls to P’ from P”.
Partner-based firms see border price rise, P’-T to P”.
RoW firms see border price fall from P’-T to P”-T.
Border price
Border price
Domestic price
MSMFN
XSR
XSP
MSPTA MS P’ P” P” T
P’-T
P’-T
P”-T MD
XR”
XR’
RoW
Exports
XP’
XP”
Partner
Exports M’ M”
Home
imports

16. Quantity changes: supply switching
RoW exports fall and Partner exports rise: supply switching: trade diversion
Domestic imports rise: trade creation.
Partner exports rise more than RoW exports fall.
Domestic price
Home
imports MD
RoW
Exports
Partner
XSP
XSR MS
MSMFN M’
Border price
MSPTA P’ T P”
P’-T
P”-T
XR”
XR’
XP’
XP” M”

17. Impact of customs union formation

18. Welfare effects XSR A XSP D C B MD
Home’s net change = A+B-C  ambiguous
Partner’s net change = +D.
RoW’s net change = -E.
Domestic price
Home
imports MD
RoW
Exports
Partner
XSP
XSR M’
Border price P’ P”
XR’
XP’
XP” M” C B A
XR”
P’-T
P”-T E D

19. Analysis of a Customs Union
European integration involved a sequence of preferential liberalisations, all of them reciprocal:
Both Home & Partner drop T on each other’s exports.
Need to address the 3-nation trade pattern.
Example: each country produces 3 goods, exports 2 and imports 1

20. Analysis of a Customs Union
Home and Partner eliminate T on their mutual trade
Both impose T on trade with RoW
Home-Partner CU has Common External Tariff (CET) equal to T
Analysis is simply a matter of recombining results from the unilateral preferential case.
In market for good 1, analysis is identical.
In market for good 2, Home plays the role of Partner and Partner plays role of Home.

21. Welfare effects of a customs union
In market for good 1:
Home change = A+B-C1-C2.
In market for good 2:
Home change = +D1+D2.
NB: D1=C1.
Net Home impact =A+B-C2+D2 .
Partner impact identical.
RoW loses in both markets.
RoW exports fall but imports stay the same: trade deficit
euros
imports MD
Exports XS M’ A D 2 1 C B C2
XP”
XP’
XR”
XR’
P’-T P” P’
P”-T

22. EU Trade Policy

23. Geographical Structure of Trade

24. Differences among Member States

25. Composition of trade

26. What with whom?

27. EU’s MFN tariff structure (the CET)

28. Institutions Trade policy is an exclusive prerogative of the EU.
Customs Union requires agreement.
Commission has responsibility for negotiating
Trade Commissioner.
Council of Ministers sets “Directives for Negotiation,” accepts/rejects final deal.
Commission in charge of surveillance and enforcement of 3rd nation commitments.
Trade disputes with US, China, etc.

29. EU External Trade Policy
EU has special arrangements with 139 nations; often more than one per partner. Each can be very complex.

30. Non-preferential trade
Only about 1/3 EU imports are not granted some sort of preferential treatment
Only 9 nations (US, Japan, etc.).