Trade and offer curves in the EU ref: offer curves v4

Introduction Previously, we saw there are other reasons for forming a CU, beyond static effects (TC/TD) – Dynamic effects – Public goods argument Cooper & Massell (1965) Terms of Trade (ToT) effect – focus on this

ToT important for a large CU Improvement in ToT increases welfare ToT - secondary objective Any ToT gain transferred from rest of world - not wealth creating effect

A countrys offer curve (OC) shows the quantity that the country is willing to offer (export) in exchange for a given quantity of imports Derived from PPCs & trade triangles – see below

Derived from PPCs & trade triangles

General equilibrium analysis. Consider: – better than partial equilibrium analysis? – small country – large country – offer curves & CUs

Tariffs & offer curves: small country Exports of cloth (C) Imports of food (F)

Tariffs & offer curves: small country Exports of cloth (C) Imports of food (F) O M OM = terms of trade (TOT). Unaffected by small country imposing tariffs

OH = free trade OC Exports of cloth (C) Imports of food (F) O M H

Trade at point Q. OA are imports against exports. Exports of cloth (C) Imports of food (F) O M H Q A

OH* = tariff ridden OC which raises price of imports. Thus, demand shifts away from imports from OA to OB Exports of cloth (C) Imports of food (F) O M H Q A H*

OH* = tariff ridden OC which raises price of imports. Thus, demand shifts away from imports from OA to OB Exports of cloth (C) Imports of food (F) O M H Q A H* Q* B Q shifts to Q*, represents smaller size of trade- contraction of trade

OH* = tariff ridden OC which raises price of imports. Thus, demand shifts away from imports from OA to OB Exports of cloth (C) Imports of food (F) O M H Q A H* Q* B Q shifts to Q*, represents smaller size of trade- contraction of trade cd

Exports of cloth (C) Imports of food (F) O M H Q A H* Q* B Size of tariff

Large country Assume 2 countries – OCH (large home country) & OCF (small foreign country) Large country imposing tariff can move TOT in its favour TOT determined by intersection of 2 OCs Free trade equilibrium at point Q OQ represents relative prices of exports & imports

Large country: tariff Exports of cloth (C) Imports of food (F) O OC H

Large country: tariff Exports of cloth (C) Imports of food (F) O OC H OC F Q

Large country: tariff Exports of cloth (C) Imports of food (F) O OC H OC F Q Line OQ= terms of trade

OCH t = tariff ridden offer curve. Large country improves TOT (line OQt steeper than OQ) Exports of cloth (C) Imports of food (F) O OC H OC F Q OCH t Qt

Size of tariff: determination of optimal tariff If very high tariff; possible trade drastically reduced. Thus, country can not improve its welfare Introduce trade indifference curves (TIC)

Country is not better off after tariff, domestic consumption still at Qt is still on TIC Exports (C) Imports (F) O OC H OC F Q OCH t Qt

Country is not better off after tariff, domestic consumptionat Qt is; still on TIC Exports (C) Imports (F) O OC H OC F Q OCH t QtTIC

Optimal tariff lies between Q & Qt, represented by OCH t1. Intersects OCF at Qt2 & TIC2 is tangent to foreign country offer curve (OCF) at point Qt2 Exports (C) Imports (F) O OC H OC F Q OCH t QtTIC This optimal tariff improves welfare and TOT OCH t1 Qt2

Optimal tariff lies between Q & Qt, represented by OCH t1. Intersects OCF at Qt2 & TIC2 is tangent to foreign country offer curve (OCF) at point Qt2 Exports (C) Imports (F) O OC H OC F Q OCH t Qt TIC This optimal tariff improves welfare and TOT OCH t2 TIC1 Qt2

Optimal tariff formula T =__1____ e-1 – (2) lower vol imports (loss) Where; e = RoW PED for imports 2 forces at work – (1) TOT (benefit) Optimum tariff where gain from (1) > loss from (2) by greatest margin; (where TIC1 tangent to OCF) SEE HANDOUT in lecture for more information

Conclusion Large countries (or the EU) can move the ToT in its favour This shouldnt be the sole reason for forming a CU