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© R.Baldwin & C. Wyplosz Baldwin & Wyplosz The Economics of European Integration Chapter 4: Basic Economics of Preferential Liberalisation “A careful presentation.

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Presentation on theme: "© R.Baldwin & C. Wyplosz Baldwin & Wyplosz The Economics of European Integration Chapter 4: Basic Economics of Preferential Liberalisation “A careful presentation."— Presentation transcript:

1 © R.Baldwin & C. Wyplosz Baldwin & Wyplosz The Economics of European Integration Chapter 4: Basic Economics of Preferential Liberalisation “A careful presentation of the Open Economy Supply and Demand Diagram (Figures 4-1 to 4-3 Chapter 4)” 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 Teaching/Studying Presentation

2 © R.Baldwin & C. Wyplosz m’ The import supply curve shows the volume of imports that will be offered at any given price. For example: if the price is p’, then foreign firms would like to export m’ to Home. if the price is p”, then foreign nations would like to export m” The MS curve is upward sloped since higher prices make foreign firms want to sell more to Home. p’ p” m” Import supply curve MS The import demand curve shows the volume of imports that Home demands at any given price. For example: if the price is p’”, then Home would like to import m’”. if the price is p””, then Home would like to import m”” The MD curve is downward sloped since a higher price makes Home want to import less. m”’ p”” p’” m”” MD Import demand curve euros imports The MS-MD Diagram: The International Market MD Import demand curve Import supply curve MS Imports m FT p FT A The equilibrium price of imports and quantity of imports are indicated by the point “A”. The corresponding price (called the market clearing price) is p FT. The corresponding quantity of imports is m FT. The equilibrium price is p FT because at this price, the amount foreign firms wish to sell to Home is just equal to the amount that Home wants to buy. The import supply (MS) and import demand (MD) diagram has price (measured in euros) on the vertical axis And the quantity of imports on the horizontal axis

3 © R.Baldwin & C. Wyplosz The MS-MD Diagram: The International Market euros imports MD Import demand curve Import supply curve MS Imports m FT p FT

4 © R.Baldwin & C. Wyplosz Open Economy Supply & Demand Analysis: The Home Market euros quantity D dom S dom This is the supply curve of Home firms. It is upward sloped since firms wish to sell more when prices are high. This is the demand curve of Home consumers. It is downward sloped since consumers wish to buy more when prices are low. D dom S dom Imports p FT ZC At p FT, Home consumers buy a quantity of goods equal to C. When the price of imports is p FT as shown here, Home firms supply a quantity of goods equal to Z. The level of imports equals the difference between Home consumption and Home production. D dom S dom Imports Without trade barriers, the import price fixes the Home market price; because when the import price is p FT, the total supply curve in the Home market is the kinked line shown. The first Z units of supply are made by Home firms. The rest is imported. Demand and supply thus meet at point B. B ZC p FT The price p FT indicates the price at which foreign firms are willing to supply imports.

5 © R.Baldwin & C. Wyplosz Open Economy Supply & Demand Analysis: The Home Market euros quantity D dom S dom Imports ZC p FT

6 © R.Baldwin & C. Wyplosz Putting together the diagrams euros importsquantity p FT MS MD D dom S dom m FT ZC The reason is that the horizontal difference between D dom and S dom at any world price always equals the level of imports indicated by the MD curve (this is how the MD curve was constructed). m’ Here we put the two diagrams together. This is very useful when studying the effects of changing a trade barrier. We first see how the change alters the border and domestic prices in the left panel and then use the right panel to see the impact of the price changes on the Home market. There are a few features of this diagram that you should know. The level of imports can be seen directly in the left-hand panel, or indirectly in the right-hand panel as the horizontal difference between D dom and S dom. p’ For instance if the world price were p’, Home would wish to import m’. Click 5 times to see that the indicated import level is the same in both panels.

7 © R.Baldwin & C. Wyplosz importsquantity p FT MS MD D dom S dom m FT ZC Border price, euros Domestic price, euros Chapter 4:Figure 3

8 © R.Baldwin & C. Wyplosz 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 Positive Effects of an MFN Tariff in the MS-MD diagram” !!! This is not in the book, but it will help you understand the MS-MD diagram Teaching/Studying Presentation

9 © R.Baldwin & C. Wyplosz MD D dom MS importsquantity ZCm FT P FT Border price, euros Domestic price, euros S dom Positive Effects of an MFN Tariff 1.We now use the diagrams to study the positive effects (i.e. price and quantity effects) of a tariff 2.We start by supposing that initially no tariff is imposed. With no tariff, the equilibrium price is P FT and the equilibrium imports is m FT.

10 © R.Baldwin & C. Wyplosz MD D dom MS importsquantity ZCm FT P FT Border price, euros Domestic price, euros S dom Positive Effects of an MFN Tariff 1. Now we impose a tariff equal to “T” 2. Imposition of a tariff by Home drives a “wedge” between the price in the Home market and the price received by foreign firms exporting to Home. This is to say … T

11 © R.Baldwin & C. Wyplosz MD D dom MS importsquantity ZCm FT P FT Border price, euros Domestic price, euros S dom Positive Effects of an MFN Tariff 1. Due to the tariff wedge T, the Home price (also called the domestic price) is higher than the price foreign firms receive (also called the ‘border’ price); the difference is exactly T. T

12 © R.Baldwin & C. Wyplosz MD D dom MS importsquantity ZCm FT P FT Border price, euros Domestic price, euros S dom Positive Effects of an MFN Tariff P’ P’-T 2. To make this clear, we call the domestic price P’ and the border price P’-T.

13 © R.Baldwin & C. Wyplosz MD D dom MS importsquantity ZCm FT P FT Border price, euros Domestic price, euros S dom Positive Effects of an MFN Tariff P’ P’-T m’ 1. We know that P’ and P’-T are the equilibrium prices since the market for imports clears at these prices. More precisely, at P’ Home wishes to import m’ and at P’-T foreigners want to sell m’ to Home.

14 © R.Baldwin & C. Wyplosz Positive 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’ 1. Notice that the domestic price and border price move in opposite directions. That is to say The tariff raises the domestic price.. 2. but lowers the border price

15 © R.Baldwin & C. Wyplosz MD D dom MS importsquantity ZCm FT P FT Border price, euros Domestic price, euros S dom P’ P’-T m’ Positive Effects of an MFN Tariff Z’C’ 1. Now consider the impact of the domestic price rise on Home production and consumption. 2. The rise in the Home price from P FT to P’ causes Home firms to expand production to Z’ and Home consumers to reduce consumption to C’.

16 © R.Baldwin & C. Wyplosz Chapter 4 MD D dom MS importsquantity ZCm FT P FT Border price, euros Domestic price, euros S dom P’ P’-T m’ Z’C’ T

17 © R.Baldwin & C. Wyplosz 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

18 © R.Baldwin & C. Wyplosz 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

19 © R.Baldwin & C. Wyplosz 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.

20 © R.Baldwin & C. Wyplosz 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’.

21 © R.Baldwin & C. Wyplosz 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

22 © R.Baldwin & C. Wyplosz 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).

23 © R.Baldwin & C. Wyplosz 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

24 © R.Baldwin & C. Wyplosz 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

25 © R.Baldwin & C. Wyplosz 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

26 © R.Baldwin & C. Wyplosz 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.

27 © R.Baldwin & C. Wyplosz 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.

28 © R.Baldwin & C. Wyplosz 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.

29 © R.Baldwin & C. Wyplosz 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

30 © R.Baldwin & C. Wyplosz


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