Economics of Trade Liberalization and Integration Jan Fidrmuc Brunel University

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’

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

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

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.

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

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).

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

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

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.

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

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

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.

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”

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

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”

Impact of customs union formation

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

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

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.

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

EU Trade Policy

Geographical Structure of Trade

Differences among Member States

Composition of trade

What with whom?

EU’s MFN tariff structure (the CET)

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.

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

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