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’
Home
import
demand
curve,
MDH
Home
Demand
Z’ Z”
C”
C’
quantity
P’
M”
M’
imports
Import
supply
curve
(MS)
price
price
Foreign
Supply
3
P”
P’
Foreign
export
supply
curve, XSF,
or MSH.
2
P*
1
Foreign
Demand
C” C’
Z’ Z”
quantity
X’
X”
exports
MD-MS Diagram

MD-MS diagram permits tracking domestic &
international consequences of trade policy changes.`
Domestic demand curve
Domestic
price, euros
euros
Domestic
supply curve
Sdom
Import (foreign
export) supply
curve
MS
PFT
Import
demand curve
Imports
MD
Ddom
Imports
imports
Z
C
quantity
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





New equilibrium in
Home (MD=MS) is Border price
at P’ and M’.
Domestic price P’
now differs from
border price (price
exporters receive) PFT
P’-T.
P’-T
Domestic price
rises.
Border price falls.
Imports fall.
Domestic price
XS=MS
MS with T
MS
P’
PFT
T
MD
Foreign
exports
X’=M’
XFT= MFT
M’
MFT
Home
impor
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).
Home and
Foreign in one
diagram
Domestic
price
MS
C
P’
PFT
A
D
B
P’-T
MD
Home
imports
M’=X’ MFT=XFT
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
Domestic
price, euros
euros
Sdom
P’
P’
A
PFT
P’-T
B
C
MS
E
C2
D
A
C1
PFT
P’-T
B
MD
imports
Ddom
Z Z’
C’
C
quantity
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
Border price
Border price
1
Domestic price
XSP
XSR
Home
2
MS
PFT
MD
XR
RoW
Exports
XP
Partner
Exports
M=XP+XR
Home
imports
The PTA Diagram: MFN tariff
RoW
Partner
Border price
Home
Border price
Domestic price
MSMFN
MS
XSP
XSR
1
P’
T
2
PFT
P’-T
MD
X’R
XR
RoW
Exports
X’
XP
P
Partner
Exports
M’
M=XP+XR
Home
imports
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
Partner
RoW
MSMFN
Home
MSPTA
XSR
XSP
MS
P’
P”
P”
T
P’-T
P”-T
Pa
T
1
p*
MD
XR” XR’
RoW
Exports
XP’ XP”
Partner
Exports
M’
M”
Home
imports
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
XSR
Domestic price
XSP
T
MSPTA
MS
P’
P”
P’-T
P”-T
MSMFN
P”
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.
Border price
Border price
XSR
Domestic price
XSP
T
MSPTA
MS
P’
P”
P’-T
P”-T
MSMFN
P”
P’-T
MD
XR” XR’
RoW
Exports
XP’ XP”
Partner
Exports
M’ M”
Home
imports
Impact of customs union formation
EEC-6
Other 6 Europe
Rest of World
$100
100%
$ billion (current prices)
$90
80%
60%
40%
$80
EEC
$70
T otal imp orts
$60
$50
$40
$30
$20
20%
$10
0%
$0
1970
1969
1968
1967
1966
1965
1964
1963
1962
1961
1960
1959
1958
1970
1969
1968
1967
1966
1965
1964
1963
1962
1961
1960
1959
1958
Note: Left panel shows share of EEC6’s import from the three regions. Other Euro-6 are the 6 countries that
joined the EU by the mid 1980s, UK, Ireland, Denmark, Spain, Portugal and Greece.
Source: Table 5, External Trade and Balance of Payments, Statistical Yearbook, Recapitulation, 1958-1991,
EUROSTAT, 1992, Luxembourg.
Welfare effects



Home’s net change = A+B-C  ambiguous
Partner’s net change = +D.
RoW’s net change = -E.
Border price
RoW
Border price
Domestic price
Partner
XSR
Home
A
XSP
P’
P”
P”
P’-T
P”-T
D
P’-T
P”-T
E
C
B
XR” XR’
RoW
Exports
XP’ XP”
Partner
Exports
MD
XR” M’ M”
Home
imports
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 3nation trade pattern.
Example: each country
produces 3 goods,
exports 2 and imports 1
Good 1
Good 2
Home
Good 1
Good 2
Good 3
Good 3
RoW
Partner
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+Beuros
C1-C2.
In market for good 2:
 Home change =
+D1+D2.
D2
 NB: D1=C1.
Net Home impact
P”
=A+B-C2+D2 .
D1
P’-T
Partner impact
identical.
RoW loses in both
markets.
RoW exports fall but
imports stay the same:
trade deficit
XP’
euros
A
XS
P’
C2
P”-T
XP”
Exports
C1
MD
B
XR” XR’ M’
imports
EU Trade Policy
Geographical Structure of Trade
Differences among Member States
Composition of trade
Machinery, transport
equipment
Other manufactured
Manufactured
Goods, 69%
Manufactured
Goods, 87%
Chemical products
Fuel products
Other raw materials
Food & live animals
Exports, 2004
Imports, 2004
Machinery, transport equipment
45%
34%
Other manufactured
26%
26%
Chemical products
16%
9%
Fuel products
3%
18%
Other raw materials
2%
5%
Food & live animals
5%
6%
Misc.
2%
3%
What with whom?
EU’s MFN tariff structure (the CET)
Institutions

Trade policy is an exclusive prerogative of
the EU.


Commission has responsibility for negotiating



Customs Union requires agreement.
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.).