Economics of Trade Liberalization and Integration

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Economics of Trade Liberalization and Integration

• Jan Fidrmuc
• Brunel University

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Import demand curve (MD)
Home Supply
price
price
1
P
2
P
P
3
P
P
Home import demand curve, MDH
Home Demand
quantity
imports
Z
C
Z
C
M
M
3
Import supply curve (MS)
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MD-MS Diagram

• MD-MS diagram permits tracking domestic
  international consequences of trade policy
  changes.

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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 PT to continue
  to offer the same exports.

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MFN Tariff Analysis

• New equilibrium in Home (MDMS) 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
XSMS
P
PFT
PFT
T
P-T
MD
Foreign exports
Home imports
M
MFT
XM
XFT MFT
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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 AB.
• Net effect on Home -CB.
• World welfare change is -D-C.
• If Home gains (-CBgt0) it is because it exploits
  foreigners by making them pay part of the
  tariff (i.e. area B).

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Distributional consequences

• Home consumers lose area EC2AC1
• Home producers gain E
• Home tariff revenue AB.
• 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

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Distributional consequences
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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.

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The PTA Diagram Free trade
Partner
Home
RoW
Border price
Border price
Domestic price
MS
XSP
XSR
1
2
PFT
MD
XP
RoW Exports
Partner Exports
Home imports
XR
MXPXR
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The PTA Diagram MFN tariff
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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.

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Discriminatory, unilateral liberalization
Border price
Border price
Domestic price
MSMFN
Partner
RoW
Home
MSPTA
XSP
MS
XSR
P
P
P
T
P-T
P-T
Pa
1
T
MD
p
RoW Exports
Partner Exports
Home imports
M
XP
XP
M
XR
XR
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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.

Domestic price
Border price
Border price
MSMFN
XSP
XSR
MSPTA
MS
P
P
P
T
P-T
P-T
P-T
MD
Home imports
M
XR
XR
XP
XP
M
Partner Exports
RoW Exports
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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.

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Impact of customs union formation
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Welfare effects

• Homes net change AB-C ? ambiguous
• Partners net change D.
• RoWs net change -E.

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Analysis of a Customs Union

• European integration involved a sequence of
  preferential liberalisations, all of them
  reciprocal
• Both Home Partner drop T on each others
  exports.
• Need to address the 3-nation trade pattern.
• Example each country produces 3 goods, exports 2
  and imports 1

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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.

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Welfare effects of a customs union

• In market for good 1
• Home change AB-C1-C2.
• In market for good 2
• Home change D1D2.
• NB D1C1.
• Net Home impact AB-C2D2 .
• Partner impact identical.
• RoW loses in both markets.
• RoW exports fall but imports stay the same trade
  deficit

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EU Trade Policy
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Geographical Structure of Trade
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Differences among Member States
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Composition of trade
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What with whom?
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EUs MFN tariff structure (the CET)
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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.

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EU External Trade Policy

• EU has special arrangements with 139 nations
  often more than one per partner. Each can be very
  complex.

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Non-preferential trade

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