Agricultural Trade Policy and Arrangements Chapter 19

Discussion Topics Trade and welfare Why restrict trade? Trade restrictions Agricultural trade policy making The importance of preferential trading agreements Forms of economic integration 2

Trade and Welfare Autarky/closed economy – A country is self-sufficient  No trade takes place between nations  Markets are in equilibrium Arbitrage – purchasing commodities in one market at a low price and rapidly selling them in another market at a higher price. Partial equilibrium and excess supply – goods will always move from where prices are low (excess supply) to where prices are high (excess demand). Page 370 3

Page 371 Equilibrium price in U.S. market: P US  Prices above P US, → excess supply  P E: producers would supply QS US3 while consumers would only want QD US4 4 $ Q P US PEPE Trade and Welfare Q US QS US3 QD US4 S US D US US Market Excess Supply (ES)

Page 371 Equilibrium price in U.S. market: P J  Prices below P J, → excess demand  P E: producers would only want supply QS J3 while consumers would want QD J4 5 $ Q PEPE PJPJ Trade and Welfare QJQJ QD J4 QS J3 SJSJ DJDJ Japan Market Same P E as in U.S. Same P E as in U.S. A B Excess Demand (ED)

Page Trade and Welfare United States Japan P US PJPJ SJSJ DJDJ S US D US ES ED ES 0 ED 0 P US → U.S. price where ES = 0  ES = S US – D US at price above P US P J → Japanese price where ED = 0 P E → World price after trade (ES = ED = Q E ) World Trade PEPE $ $ $ QJQJ QDQD QEQE QEQE QEQE

Page Trade and Welfare United States Japan P US PJPJ SJSJ DJDJ S US D US ES ED ES 0 ED 0 Let P J2 = P US2 What happens if the price in Japan decrease to P J2 ? What happens if the price in the U.S. increases to P US2 ? At P J2 = P US2 → ES > ED Thru trade, both country’s markets would be equilibrium where ED = ES at P E World Trade P US2 $ $ $ QJQJ QDQD P J2 Excess Supply Excess Demand

Page Trade and Welfare United States Japan P US PJPJ SJSJ DJDJ S US D US ES ED ES 0 ED 0 If Japan price ↓ from P J to P E  Japan consumer surplus ↑ by area (A+B)  Japan producer surplus ↓ by area A  If U.S. price ↑ from P US to P E  U.S. consumer surplus ↓ by area 1  U.S. producer surplus ↑ by area (1+2) World Trade PEPE $ $ $ PEPE A B 1 2 B 2

Page 373 Both countries register a net societal gain from trade  Who wins and who loses differ across country U.S.Japan Consumer Gain– Area 1+ Area (A+B) Producer Gain+ Area (1+2)– Area A Net Gain to Society+ Area 2+ Area B Trade and Welfare Gains From Trade 9

Why Restrict Trade? To protect a new or infant industry To counter unfair foreign competition To improve the balance of payments To protect national health, the environment or food safety Page

Trade Restrictions Tariff barriers Nontariff barriers (NTB)  Voluntary export restraints (VERs)  Tariff rate quotas (TRQ)  Import quotas Page

Domestic market equilibrium SdSd DdDd $/ton Q 50 4,000 Domestic demand Domestic supply Page ,000 1, At world price, ED = (80-20) = 60 Free trade supply (S FT ) World price World price ED Importing Country Tariff Impact

SdSd DdDd $/ton Q Page ,000 1,500 $t With tariff, ED = (60-40) = 20 World price plus tariff of $1,500 ED S FT S FT + Tariff

SdSd DdDd $/ton Q Page ,000 1,500 $t S FT World price plus tariff of $1, World price A B C D E F G H Importing Country Tariff Impact S FT +Tariff

Welfare Effects of a Tariff CS before tariff on the previous slide was equal to Area (A+B+C+D+E+F+G) After the tariff, the CS would fall to Area (E+F+G), or a loss of Area (A+B+C+D) PS ↑ from area H to Area (A+H) after tariff The tariff revenue received by the gov’t is Area C Dead-weight loss to society is Area (B+D) Page 377

Tariff Rate Quota (TRQ) TRQ: combines two trade policy tools  Quota component: Imports entering under quota portion of a TRQ are subject to a lower (sometimes zero) tariff  Imports above the quota’s threshold face a much higher (usually prohibitive) tariff Page 377

SdSd DdDd $/ton Q (tons) Page TRQ Impact on Small Nation Importer Autarkic price Autarkic price S FT S FT +Tariff 1 S FT +Tariff Without trade: domestic price of $300 With free trade, S d = 10, Q d = 50, Q I = 40 Assume TRQ is set at 5 tons With initial imports exceeding the imports both within and over quota rates apply TRQ causes price to ↑ from $100/ton to $200/ton Tariff 1 = $50 Tariff 2 = $50 Tariff 1 = $50 Tariff 2 = $50

Page TRQ Impact on Small Nation Importer TRQ causes price to ↑ from $100/ton to $200/ton  Domestic production ↑ to 20 tons  Domestic consumption ↓ to 40 tons  Imports ↓ to 20 tons SdSd DdDd $/ton Q (tons) S FT S FT +Tariff 1 S FT +Tariff Tariff 1 = $50 Tariff 2 = $50 Tariff 1 = $50 Tariff 2 = $50

Page TRQ Impact on Small Nation Importer Welfare effects of TRQ  ↑ in domestic prices and ↑ in production ↑ PS to E SdSd DdDd $/ton Q (tons) S FT S FT +Tariff 1 S FT +Tariff F E G 25 A D B C Tariff 1 = $50 Tariff 2 = $50 Tariff 1 = $50 Tariff 2 = $50

Page TRQ Impact on Small Nation Importer Government tariff revenue generated by TRQ = Area (A + B + C) SdSd DdDd $/ton Q (tons) S FT S FT +Tariff 1 S FT +Tariff A B C Tariff 1 = $50 Tariff 2 = $50 Tariff 1 = $50 Tariff 2 = $50 Government Tariff Revenue 20 tons imported after TRQ Area A = Gov’t tariff revenue under initial tariff = $50 x 5 tons Area (B + C) = Gov’t tariff revenue from TRQ = $100 x 15 tons Government Tariff Revenue 20 tons imported after TRQ Area A = Gov’t tariff revenue under initial tariff = $50 x 5 tons Area (B + C) = Gov’t tariff revenue from TRQ = $100 x 15 tons 150

Page TRQ Impact on Small Nation Importer Windfall profits generated by TRQ for domestic or foreign producers = Area D SdSd DdDd $/ton Q (tons) S FT S FT +Tariff 1 S FT +Tariff Tariff 1 = $50 Tariff 2 = $50 Tariff 1 = $50 Tariff 2 = $50 Windfall Profits For 1 st 5 tons imported, price = $150/ton ($100 price + $Tariff 1 )  Importer obtains foreign corn for $150 and sell domestically for $200 → Area D windfall profits  If exporters restrict corn shipments and raise price to $200/ton  Any portion of Area D captured by exporters represents a welfare loss to importing nation Windfall Profits For 1 st 5 tons imported, price = $150/ton ($100 price + $Tariff 1 )  Importer obtains foreign corn for $150 and sell domestically for $200 → Area D windfall profits  If exporters restrict corn shipments and raise price to $200/ton  Any portion of Area D captured by exporters represents a welfare loss to importing nation 150 D

Page Welfare Effects of aTRQ CS would ↓ by Area (E + F + D + A + C + B + G) PS would ↑ by Area (E + D) Tariff revenue obtained by gov’t is Area (A + B + C) Dead-weight loss to society is Area (F + G) SdSd DdDd $/ton Q (tons) S FT S FT +Tariff 1 S FT +Tariff F E G 25 A D B C Tariff 1 = $50 Tariff 2 = $50 Tariff 1 = $50 Tariff 2 = $50

Rationale for Export Policy Dispose of surplus production Limit price increases in domestic markets Grow processing industries and employment Limit capability of another nation Encourage policy reforms by denying trade Page 382

Examples of Economic Integration Free trade areas  1994 North American Free Trade Agreement (NAFTA)  Canada, Mexico and U.S.  Free trade agreements with S. Korea, Panama, and Columbia  Signed by Pres. Obama in October 2011 Unions: European Union and its common agricultural policy (CAP)  27 member countries  Transferred some of their sovereignty or lawmaking authority Page 388

Reasons for U.S. Preferential Trading Agreements… Economic or political reasons tied to U.S. strategic interest Timely reductions in barriers to trade Counter economic and political power of other trading agreements Reduce illegal immigration Foster political stability and economic prosperity Page 389

Impact of Trade Agreements Page 391 SMSM DMDM $ Q Lets look at trade between Mexico and the U.S. where Mexico is the small nation importer  Assume U.S. is the least cost supplier  Prior to free-trade agreement a tariff of t per unit of imports  Domestic (Mexican) production, Q S1, and demand, Q D1  Quantity imported is (Q D1 -Q S1 ) D M,S M are Mexico D & S M US+t = supply of U.S imports w/the tariff D M,S M are Mexico D & S M US+t = supply of U.S imports w/the tariff P M+t M US+t Q D1 Q S1 Quantity imported

Impact of Trade Agreements Page 391 SMSM DMDM $ Q Lets assume a free trade area is created  Removes tariff  ↑imports from the U.S. to M US and ↓ price to P M  Domestic (Mexican) production ↓  Domestic (Mexican) consumption ↑  Imports from the US ↑ to (Q D2 – Q S2 ) P M+t M US+t Q D1 Q S1 PMPM M US Q S2 Q D2 Increased imports Increased imports

Impact of Trade Agreements Page 392 SMSM DMDM $ Q Impacts of Free Trade Agreement of small nation tariff  Mexican CS ↑ by Area (A + B + C + D)  Mexican PS ↓ by Area A  Mexican gov’t loses tariff revenue by Area C  Total Mexican welfare gains is Area (B + D) P M+t M US+t PMPM M US Q S2 Q D2 A B C D

Impact of Trade Diversion Page 392 Trade Diversion  Assume one has a free-trade agreement  Lower-cost imports from a non-member nation  Replaced (diverted) by higher cost imports from a member nation Trade diversion ↓ global welfare  Shifts production from more efficient producers outside Agreement  To less efficient producers within the Agreement  Trade Diversion may result in Agreement members gaining or losing individually

Trade Diversion:  Assume one has a free-trade agreement  Lower-cost imports from a non-member nation  Replaced (diverted) by higher cost imports from a member nation Assume the following  Both the EU and the U.S. compete for the Mexican market  The EU is initially the largest supplier to the Mexican market, M EU > M US  There is an equal tariff, t, applied to the imports from both countries Impact of Trade Diversion Page 392

Trade Diversion: With an equal tariff, the EU is the sole exporter to Mexico because P EU+t < P US+t With no free trade area the price in Mexico is P EU+t Mexican consumption: Q D1, Mexican production, Q S1 Impact of Trade Diversion Page 392 SMSM DMDM $ Q P US+t P EU+t P US P EU M US M EU M US+t M EU+t Q S1 Q D1 Imports from the EU = Q D1 – Q S1 PMPM QMQM No trade equilibrium

Trade Diversion:  Free-Trade Agreement between Mexico and the U.S.  Remove tariff from U.S. but not EU imports  P US is now the price in Mexico  Mexican consumption ↑ to Q D2, Mexican production ↓ to Q S2  Imports from the EU ↓ to 0 and U.S. imports ↑ from 0 to Q D2 - Q S2  →EU imports replaced by imports from the U.S. Impact of Trade Diversion Page 392 SMSM DMDM $ Q P US+t P EU+t P US M US M US+t M EU+t Q S1 Q D1 Q S2 Q D2 Imports from the US = Q D2 – Q S2

Welfare Impacts of Trade Diversion:  Consumers gain at the expense of producers and gov’t Impact of Trade Diversion Page 393 SMSM DMDM $ Q P US+t P EU+t P US M US M US+t M EU+t Q S1 Q D1 Q S2 Q D2 Who ImpactedImpact Consumer gainsArea (A+B+C+D) Producer gains− Area A Government revenue− Area (C + E) Net gains to society= Area (B + D – E) Welfare Impacts of Price ↓ A B C D P EU M EU E

Summary Free trade affects exporting and importing nations differently Restrictions take the form of tariff and nontariff barriers. PTAs can take many forms, including free trade areas and economic unions PTAs should lead to trade creation and increased welfare of member nations. PTAs take on political importance.

$ PWPW PCPC China DCDC SCSC Q Cd Q Cs Q World Oil Trade: China and ROW P w is world oil price  China demands more than supplied domestically P w is world oil price  China demands more than supplied domestically The difference (Q Cd -Q Cs ) is the amount imported The difference (Q Cd -Q Cs ) is the amount imported

$ PWPW PCPC Venezuela DVDV SVSV Q Vd Q Vs Q World Oil Trade: China and ROW P w is world oil price  Venezuela produces more than domestic demand P w is world oil price  Venezuela produces more than domestic demand The difference (Q VS -Q VD ) is the amount exported The difference (Q VS -Q VD ) is the amount exported

World Oil Trade: China and ROW China and Venezuela are two economies that obviously benefit from oil trade. A graph of all importing nations would look similar to our one for China. A graph of all exporting nations would look similar to our one for Venezuela. By combining exporters and importers in systematic way, we can identify an equilibrium world price.

World Oil Trade: China and ROW Crude Oil Exporter Excess Supply P SeSe DeDe Oil Exporters Export (Trade) Potential ES P NT $ = Amounts Q Q

World Oil Trade: China and ROW Why is crude oil Excess Supply (ES) upward sloping?  At higher and higher prices, exporting nations not bound by OPEC production constraints start producing more oil  Exploration increases  Stocks (inventories) decline  Domestic consumption declines at higher prices

$ SmSm DmDm P NT Oil Importers ES ED Trade ES World Oil Trade: China and ROW = Amounts

World Oil Trade: China and ROW Why is crude oil Excess Demand (ED) downward sloping?  As prices rise, importers demand less (i.e., people start driving less, purchasing hybrids)  As prices rise, suppliers in importing region increase output. (i.e., U.S. oil production rises.)

P SmSm DmDm PwPw P SeSe DeDe Oil Importers Oil Exporters ES ED Trade QtQt World Oil Trade: China and ROW Q World price determined where ES = ED P

World Oil Trade: China and ROW Let's work through some examples using the above model of trade  The emerging tiger  Former Vice-President Gore: Tax what you burn, not what you earn policy.  How could a hurricane cause gasolines prices to rise while at the same time cause crude oil prices to fall at the same time?

Impact of China’s growing economy World Oil Trade: China and ROW P SCSC DCDC PwPw P SeSe DeDe China Oil Exporters ES ED Trade QTQT Q P ED * P*wP*w Q*TQ*T QtQt Q*tQ*t

Impact of Global Carbon Tax World Oil Trade: China and ROW P SCSC DCDC PwPw P SeSe DeDe China Oil Exporters ES ED Trade Q*TQ*T Q P ED * P*wP*w QTQT D*eD*e ES * D*CD*C Pre-Tax Equilibrium

World Oil Trade: China and ROW Downward pressure on world oil prices Reduce greenhouse gases Increase demand for non-carbon energy sources: Wind, geothermal, solar, etc. Carbon Tax on World Oil Markets

Katrina Impacts on World Oil Markets Shuts down oil supply into the US  a left shift of the import demand for oil by a major importer, the U.S.  →An excess supply available to ROW’s importers  Decreases world crude oil prices Shuts down gasoline refineries leaving U.S. consumers with less gas supply  → a left shift in the supply of gasoline to the U.S. retail market  Increased domestic retail gasoline price

Impact of Hurricane Katrina World Oil Trade: U.S. and ROW P SCSC DCDC PwPw P SeSe DeDe U.S. Oil Exporters ES ED Trade QTQT Q P ED * P*wP*w Q*TQ*T

Impact of Katrina on U.S. Retail Gasoline Market World Oil Trade: U.S. and ROW S D P S*S* P RG Q RG P * RG Q * RG Q The supply curve shifts up due to lack of ability to access enough crude oil feedstock to produce Q RG

P SmSm DmDm PwPw P SeSe DeDe Corn Importers U.S. ES ED Trade QTQT Impact of the Use of Corn as an Ethanol Feedstock Q P

P SmSm DmDm PwPw P SeSe DeDe Corn Importers U.S. ES ED Trade QTQT Impact of the Use of Corn as an Ethanol Feedstock Q P P*wP*w Q*TQ*T Q* T < Q T

Summary Trade occurs because traders anticipate gains from trading. Comparative advantage determines why nations trade. The basis for trade is differing opportunity costs among nations. Nations specialize in producing those goods in which they are most efficient and exchange these goods with other nations. 53