JEM081
ADVANCED ECONOMICS OF EUROPEAN INTEGRATION:
Microeconomic Aspects
Lecture 4
Topic 5, Economics of Customs Union
GENERAL EQUILIBRIUM
APPROACH
Dr. Wadim Strielkowski
IES FSV CUNI
4 November 2013
1
Contents
• general equilibrium approach to market equilibrium
• waiving perfect price elasticity assumption
• economic behavior of individual countries has an
influence (more or less) on other countries
• single commodity markets, more small countries
• instead of single commodity market we assume
also multi-commodity markets
• closed equilibrium, free trade, tariff protection and
welfare on multi-commodity markets
Readings:
•
•
•
Baldwin, R, Wyplosz, C.: The Economics of European
Integration. McGraw-Hill Higher Education, 2003. Ch.5
Frank, R.: Microeconomics and Behaviour. McGraw-Hill, 2002.
Turnovec, F.: Political Economy of European Integration.
Karolinum, Charles University Press, Prague, 2003, chapter 3,
pp. 41-51
2
General equilibrium: key issues
1. general equilibrium
2. Pareto principal
3. efficiency and equity
3
Partial equilibrium analysis
• an examination of equilibrium and
changes in equilibrium in one market in
isolation
• problem: by holding prices and quantities
of other goods fixed, we ignore possibility
that events in this market affect other
markets' equilibrium prices and quantities
• doing so is OK for small markets (hoola
hoops)
4
General-equilibrium analysis
• study of how equilibrium is determined in
all markets simultaneously an event in one
market may have a spillover effect on
other markets may be linked
– through demand
– through supply
• because output in one market is an input
in another
5
Partial vs. General Equilibrium
• study equilibrium in several—but not all—
markets simultaneously
• shock in one market has spillover effect in
another market
• general-equilibrium analysis takes account of
spillover, unlike partial-equilibrium analysis
• partial-equilibrium and general-equilibrium
analyses give different answers if spillover
effects are large
6
Feedback between competitive
markets
• corn and soybean markets are linked
• consumers substitute between corn and
soybeans
• producers substitute between corn and
soybeans
7
Sequence of events
• shock in corn market affects soy market
• resulting shift in the soy market affects
corn market
• diminishing reverberations occur until
markets settle at new equilibria
• whether nearly instantaneously or not
depends on reaction speeds of consumers
and producers
8
Suppose
• foreign demand for American corn
decreases
• export of corn falls by 10% at the current
price
• total American demand for corn shifts left
9
10
Partial equilibrium bias in corn
market is small
Drop in price
Drop in quantity
partial equilibrium
10.8%
2.5%
general equilibrium
11.4%
2.1%
11
General vs. Partial Equilibrium
• In the early 1970s, OPEC dramatically reduced
its output of oil.
• Use general equilibrium analysis to determine
the effect of the shock on the markets for
gasoline and automobiles.
• In this example, the initial response in the
gasoline market was larger than the final
response. Can you think of an example of
related markets where the initial response would
be smaller? What must be true about the two
goods being analyzed?
12
Welfare
society decides whether a particular
equilibrium (or change in equilibrium) is
desirable by answering 2 questions:
• Is the equilibrium efficient?
• Is the equilibrium equitable?
13
Efficiency
• production efficiency: cannot produce
more output at current cost given current
knowledge
• consumption efficiency: goods cannot be
reallocated across people so that at least
someone is better off and no one is
harmed
14
Pareto principle
allows us to rank different allocations of
goods and services where no
interpersonal comparisons need to be
made
15
Pareto efficient
any allocation where we cannot make one
person better off without harming another
person is Pareto efficient
16
First theorem of welfare
economics
any competitive equilibrium is Pareto
efficient
Second theorem of welfare
economics
any Pareto-efficient equilibrium can be
obtained by competition, given an
appropriate endowment
17
General Equilibrium
• Magnitude of spillover effects
• General vs. partial equilibrium models
18
Pareto-Efficient Equilibrium
• Can make one better off iff no other party is
harmed
• Competitive exchange: All traders are price
takers
• Ratio of relative prices equals marginal rates of
substitution for each person
• Competitive equilibrium is Pareto-efficient
• First and second Theorems of Welfare
Economics
19
• Edgeworth Box Diagram Analysis
• Efficiency vs. Equity Tradeoffs:
– Need welfare function
20
The Edgeworth Box Analysis
• Francis Edgeworth developed this method
of analysis in the last portion of the 19th
century.
• Provides a powerful way of graphically
studying exchange and the role of
markets.
• Understanding the Edgeworth Box is
critical to understanding exchange and
markets.
21
The Edgeworth Box
III2 II2
x2
I2
Jane
y2
B
E”
E’
A
Price or budget
line
E
C
y1
Bill x1
I1 II1
III1
22
NOW RETURN TO
EXPANDING VINER’S MODEL
p
consumers'
surplus in CU
p
consumers'
surplus in TP
Sd(q)
Sh(q)
EH
pH
Et
p +t
W
p =p
CU P
p
(a)
(b) (c)
(d)
no tariff
revenues in CU
ECU
(e)
W
St(q)
p +t
W
p
P
p
W
Scu(q)
Sw(q)
Et
dt
dCU
q
tariff revenues
in TP
St(q)
(a)
Sw(q)
producers'
surplus in TP
producers'
surplus in CU
sCU st qH
EH
p
H
s
t
q
H
Dd(q)
d
t
q
23
Two oversimplifications of
traditional Viner’s model
• Perfect elasticity of partner's country supply is a
rather strong assumption, that is, perhaps, valid for
economic relations between San Marino and Italy,
but hardly for non-trivial economies.
• Single commodity market assumption is also
rather misleading. Changes in supply, demand and
price on one partial market influence also other
partial markets, so multi-commodity analysis can
lead to more realistic results
24
Model of a customs union of two
small countries on one-commodity
market
• assume as before two countries H and P, and the
world market W
• In this case let both countries H and P are small
economies, they still face a perfectly elastic world
supply curve, but after formation of eventual
customs union of H and P the customs union
supply curve will be the sum of the two domestic
supply curves, the customs union demand curve
will be the sum of the two domestic demand curves
and the customs union equilibrium price will be
different from closed equilibrium prices in the both
member countries
25
Two small countries supply and
demand, closed equilibrium
• let
SH(p) be a supply function in H
DH(p) be a demand function in H
SP(p) be a supply function in P
DP(p) be a demand function in P
• Closed equilibrium (qH,pH) in H
pH: SH(p)=DH(p), qH= SH(pH)=DH(pH)
Closed equilibrium (qP,pP) in P
pP: SP(p)=DP(p), qP=SP(pP)=DP(pP)
26
Two small countries supply and
demand, closed equilibrium
COUNTRY H
COUNTRY P
EcH
pH
EcP
pP
pw
qH
qP
27
Two small countries:
Illustrative example – part 1
Consider supply and demand function on a partial market
S H (p) = 50p - 50
D H (p) = 370 - 20p
in country H and
S p(p) = 300p - 800
D P(p) = 1000 - 100p
in country P. In no trade regime the equilibrium prices and
equilibrium quantities will be
p H = 6, q H = 250
in country H and
p P = 4.5, q P = 550
in country P
28
Two small countries:
Illustrative example – part 1
Let world price be pw = 4 and by a general tariff protection
agreement the maximal tariff is 25% of world price, in our
case t = 1
Assume that both countries adopted this level of tariff
protection, then tariff protected price in H and P be
pt = pW + t = 5.
Country H will import from the world market because tariff
protected price is lower than internal no trade equilibrium
price
country P will neither import nor export (why?).
29
Two small countries:
Illustrative example – part 1
Tariff protection regime equilibrium:
in country H
effective equilibrium price pHTP = 5
domestic supply sdH = 200
domestic demand ddH = 270
import from the world market ddH - sdH = 70
tariff revenue t(ddH – sdH) = 70
in country P
effective equilibrium price pPTP = 4,5
domestic supply sdP = 550
domestic demand ddP = 550
30
Two small countries supply and
demand, closed equilibrium
COUNTRY H
COUNTRY P
EcH
pH
pt
EtH
EcP
pP
pw
stH qH dtH
qP
31
Customs unions of H and P, joint
supply and demand
• Considering customs union of H and P, there will
be a free trade among H and P leading to joint
equilibrium, and common external tariff for trade
protection with respect of the rest of the world
• Supply in customs union: “sum” of two supply
functions, demand in customs union: “sum” of two
demand functions
• What means “sum” in our case?
32
Sum of supply and demand
functions in H and P
Price of zero supply in H
0
pSH
: S H ( p)  0
Price of zero demand in H
0
pDH
: DH ( p)  0
Price of zero supply in P
0
pSP
: S P ( p)  0
Price of zero demand in P
0
pDP
: DP ( p)  0
33
Two small countries:
Illustrative example – part 2
Price of zero supply in H from equation
0
1
50p - 50 = 0  pSH
Price of zero demand in H from equation
37
0

370 - 20p = 0  pDH
2
Price of zero supply in P from equation
8
0

300p - 800 = 0  pSP
3
Price of zero demand in P from equation
0
 10
1000 - 100p = 0  pDP
34
Sum of supply and demand
functions in H and P
Country H
Customs union of
H and P
Country P
SH
DP
DCU
DH
SCU
SP
pH
p +t
W
p
CU
pP
p
W
CU
H
s
q
H
CU
H
d
d
CU
q
P
P
CU
P
s
q
CU
35
Sum of supply functions
Sum of supply functions in H and P
0
0
 0
if 0  p  min{ pSH
, pSP
}

0
0
S
(
p
)
if
p

p

p

H
SH
SP
SCU ( p )  
0
0
S
(
p
)
if
p

p

p
P
SP
SH

0
0
 S H ( p)  S P ( p)
if p  max{ pSH
, pSP
}
36
Two small countries:
Illustrative example – part 3
Sum of supply functions in H and P


0
for p  1

8

S H ( p )  50 p  50 for 1  p 
S CU (p) = 
3

8

S
(
p
)

S
(
p
)

350
p

850
for
p

P
 H
3
since in our case
0
0
0
min{ pSH
, pSP
}  1  pSH
and
8
0
0
1  pSH
 pSP

3
37
Sum of supply and demand
functions in H and P
Sum of demand functions in H and P
0
0
0
if p  max{ pDH
, pDP
}

0
0
if pDP
 p  pDH
 DH ( p )
DCU ( p )  
0
0
D
(
p
)
if
p

p

p
P
DH
DP

0
0
 DH ( p )  DP ( p )
if p  min{ pDH
, pDP
}
38
Two small countries:
Illustrative example – part 4
Sum of demand functions in H and P
37

0
for
p


2

37

 p  10
D CU (p) =  DH ( p )  370  20 p for
2

 DH ( p )  DP ( p )  1370  120 p for p  10

since in our case
0
0
max{ pDH
, pDP
}
37
0
 pDH
2
and
37
0
0
 pDH
 pDP
 10
2
39
Two small countries:
Illustrative example – part 5
Eventual customs union equilibrium price pCU (in the case of no trade
with the rest of the world) will be located somewhere between pP and pH,
hence
4.5  p CU  6
To calculate it we can use the last segment of the joint supply function (for
p > 8/3) and the last segment of the joint demand function (for p < 10):
350p - 850 = 1370 - 120p
From this equation
p CU =
222
= 4.724
47
(rounded).
40
Customs union price and tariff
protected price
Only knowing pCU and comparing it to world price and tariff
protected price we can decide whether the customs union of H
and P has some justification or not. The necessary condition for
welfare increasing customs union of H and P in this case is
p CU < pW + t
Let in our case pW = 4 and t = 1, then pW + t = 5 and eventual
customs union price pCU = 4,724 is less than tariff protected
price.
41
Welfare in customs union of two
small countries
country H
country P
EH
pH
p +t
W
p
CU
p
P
p
(a )
(b )
(c )
W
s1H sH2 qH d2H dH1
(d )
EP
d1P qP s1P
42
Welfare in customs union of two
small countries
• country H imports from the country P for the price
pCU and the welfare effects for country H are given
by known formula reg(a)+reg(b)-reg(c), i.e. gain in
consumers' surplus minus loss of government
tariff revenues
• country P is an exclusive exporter into country H
and its welfare effect is given by the area (d),
increase in producers' surplus minus decrease of
consumers' surplus, which is, under given
assumptions, always positive.
43
Two small countries
• Then the total welfare
effect of customs union
for the both countries
is reg(a)+reg(b)reg(c)+reg(d)
• Taking into account a
bit more realistic case
of an influence of
customs union on
market equilibrium in
both considered
countries, the total
balance of welfare
changes increases
country H
country P
EH
pH
p +t
W
p
CU
p
P
p
(a) (b)
(c)
W
s1H sH2 qH d2H dH1
(d)
EP
d1P qP s1P
44
Multi-commodity markets
• until now we used a very simplified partial
equilibrium approach to customs union and
measuring welfare effects
• Instead of single commodity market we
assume multi-commodity markets
• closed equilibrium, free trade, tariff
protection and customs union on multicommodity markets
• Welfare analysis on multi-commodity
markets
45
Multi-commodity markets
• we assumed an isolated market for a one
commodity where the demand and supply for a
given commodity depend only on the price of that
commodity
• in real world it is usually not the case: the supply
of one commodity depends not only on its price,
but also on the prices of other commodities (for
example supply of cars depends on the price of
cars but also on the price of electricity used in their
production), and the demand for one commodity
depends not only on its price, but also on the
prices of other commodities (for example demand
for cars depends on the price of the car but also on
the price of gas etc.)
46
Multi-commodity markets
• Then the welfare gains or losses on the
market of one commodity are compensated
by welfare losses or gains on the other
commodities markets
• To reflect these effects in full complexity we
have to consider multi-commodity markets
and consider a general equilibrium
framework.
47
Model of multi-commodity
market
Let us consider two-commodity market with commodities k
= 1, 2. Assume that commodity 1 is tradable (meaning that it
is subject to international exchange), and commodity 2 is
non- tradable (being produced and consumed on particular
market, no import or export).
Let
S k ( p1 , p2 )
be the supply function for the k-th commodity as a function
of prices p1, p2 of both commodities traded on the market,
and
Dk ( p1 , p2 )
be the demand function for the k-th commodity as a
function of prices p1, p2 of both commodities traded on the
market.
48
Supply and demand functions
on multi-commodity markets
We assume that
S k
>0
 pk
(it means that, ceteris paribus, the k-th supply function is an
increasing function of the price of the k-th commodity, i.e.
the higher price pk, the higher supply of the k-th
commodity), and
 Dk
<0
 pk
(it means that, ceteris paribus, the k-th demand function is a
decreasing function of the price of the k-th commodity, i.e.
the price pk, the less demand for the k-th commodity).
49
Complements and substitutes
If k  r, then
a) demand for k can be a decreasing function of pr (the higher price of
commodity r, ceteris paribus, the lower demand for k), formally written
 Dk
<0
 pr
(in this case we say that commodities k and r are complements in
consumption);
b) or demand for k can be an increasing function of pr (the higher
price of commodity r, ceteris paribus, the higher demand for commodity
k), formally written
 Dk
>0
 pr
(in this case we say that commodities k and r are substitutes in
consumption);
50
Complements and substitutes
Similarly, for supply we can have
S k
0
 pr
(supply of k is a non-increasing function of the price pr, ceteris
paribus), or
S k
0
 pr
(supply of k is a non-decreasing function of the price pr, ceteris
paribus).
51
Closed equilibrium
The closed equilibrium on multi-commodity market is
given as a solution of the following system of
equations:
S1 ( p1 , p2 )  D1 ( p1 , p2 )
S2 ( p1 , p2 )  D2 ( p1 , p2 )
The solution of this system
p c  ( p1c , p2c )
gives the equilibrium prices and equilibrium quantities
q c  (q1c , q2c )
Where
q1c  S1 ( p1c , p2c )  D1 ( p1c , p2c )
q2c  S2 ( p1c , p2c )  D2 ( p1c , p2c )
52
Closed equilibrium
To illustrate two-commodity market analysis we shall
consider a world of two commodities with linear supply
and demand functions
S 1( p 1, p 2 ) = a 10 + a 11 p 1 + a 12 p 2
S 2( p 1, p 2 ) = a 20 + a 21 p 1 + a 22 p 2
D 1( p 1, p 2 ) = b10 + b11 p 1 + b12 p 2
D 2( p 1, p 2 ) = b 20 + b 21 p 1 + b 22 p 2
where
a10 , a11, a12 , a 20 , a 21, a 22
b10 , b11, b12 , b 20 , b 21, b 22
are constants and p1, p2 are prices.
53
How to calculate closed
equilibrium
We assume that
( a 11 - b11 )( a 22 - b 22 ) - ( a 21 - b 21 )( a 12 - b12 )  0
Closed equilibrium is defined by the system of nonhomogeneous linear equations
a 10 + a 11 p 1 + a 12 p 2 = b10 + b11 p 1 + b12 p 2
a 20 + a 21 p 1 + a 22 p 2 = b 20 + b 21 p 21 + b 22 p 2
of the two variables p1 and p2. After transferring terms
with variables on the left-hand side and absolute terms
on the right hand side we obtain
( a 11 - b11 ) p 1 + ( a 12 - b12 ) p 2 = ( b10 - a 10 )
( a 21 - b 21 ) p 1 + ( a 22 - b 22 ) p 2 = ( b 20 - a 20 )
54
How to calculate closed
equilibrium:
illustrative example
For a particular market with supply and
demand functions
S 1( p 1, p 2 ) = - 8 + 10 p 1 - 2 p 2
S 2( p 1, p 2 ) = - 3 - p 1 + 8 p 2
D 1( p 1, p 2 ) = 20 - 2 p 1 + 2 p 2
D 2( p 1, p 2 ) = 6 + 2 p 1 - p 2
we have
a 10 = - 8, a 11 = 10, a 12 = - 2 , a 20 = - 3, a 21 = - 1, a 22 = 8
b10 = 20, b11 = - 2, b12 = 2, b 20 = 6, b 21 = 2, b 22 = - 1
In our case
( a11 - b11 )( a 22 - b 22 ) - ( a 21 - b 21 )( a12 - b12 ) = 96  0
55
How to calculate closed
equilibrium:
illustrative example
We obtain the following system of equations: :
12 p1 - 4 p2  28
3 p1  9 p 2  9
Then we can use the Cramer’s rule to calculate
equilibrium prices
( b10 - a 10 )( a 22 - b 22 ) - ( b 20 - a 20 )( a 12 - b12 ) 288

3
( a 11 - b11 )( a 22 - b 22 ) - ( a 21 - b 21 )( a 12 - b12 ) 96
( a - b )( b 20 - a 20 ) - ( a 21 - b 21 )( b10 - a 10 ) 192
c

2
p 2 = 1 11
( a 11 - b11 )( a 22 - b 22 ) - ( a 21 - b 21 )( a 12 - b12 ) 96
c
1
p =
The equilibrium quantities are
q1 = a10 + a11 p1  a12 p 2 = b10  b11 p1 + b12 p 2  18
c
c
c
c
c
and
q 2 = a20  a21 p1  a22 p 2 = b20 + b21 p1  b22 p 2  10
c
c
c
c
c
56
How to calculate welfare
welfare effects in multi-commodity analysis?
for each k = 1, 2 we shall consider supply and
demand function as a function of one variable
pk while other price is fixed on equilibrium
level.
for supply and demand on the first market
c
c
S 1( p1, p2 ), D1 ( p1 , p2 )
and for supply and demand on the second
market
S2 (p1c , p2 ) = D2(p1c,p2 )
57
How to calculate welfare
Then we can proceed in the same way as
in the case of partial market and identify
consumers' surplus and producers'
surplus on the first and second market
with respect to closed equilibrium prices
pc and total welfare as the sum of both of
them. Let W1 be the welfare on the first
market and W2 be the welfare on the
second market, then the total welfare for
multi-commodity market with respect to
equilibrium pc will be the sum of welfare
effects on both markets
W ( p c )  W1 ( p c )  W2 ( p c )
58
How to calculate welfare:
illustrative example
two commodity market from previous example
with closed equilibrium
c
c
p = (3, 2), q (18, 10)
by substituting equilibrium prices we obtain
supply and demand functions of one variable
c
S 1( p1, p 2 ) = - 8 + 10 p1 - 2* 2 = - 12 + 10 p1
c
S 2( p1 , p 2 ) = - 3 - 1* 3 + 8 p 2 = - 6 + 8 p 2
c
D1( p1, p 2 ) = 20 - 2 p1 + 2* 2 = 24 - 2 p1
c
D 2( p1 , p 2 ) = 6 + 2* 3 - p 2 = 12 - p 2
59
How to calculate welfare:
illustrative example
Then we have to consider two partial markets:
a) for k = 1
point A (the price of zero supply) we get from the
equation
c
S 1( p1, p 2 ) = 0
which gives
12
-12 + 10 p1 = 0, p1 = = 1.2
10
60
How to calculate welfare:
illustrative example
point B (the price of zero demand) we get from the
equation
c
D1( p1, p 2 ) = 0
which gives
24 - 2 p 1 = 0, p 1 =
24
= 12
2
61
How to calculate welfare:
illustrative example
B
p1
12
Consumers' surplus on
the first market
c
pc1
A
E1
3
1.2
0
Producers' surplus on the
first market
18
qc1
q1
62
How to calculate welfare:
illustrative example
Consumers' surplus (area p1cE1cB):
1
(12 - 3)* 18 = 81
2
Producers’ surplus (area p1cE1cA):
1
( 3 - 1.2 )* 18 = 16.2
2
Total welfare for k = 1:
c
c
W 1( p1 , p 2 ) = 16.2 + 81 = 97.2
63
How to calculate welfare:
illustrative example
b) for k = 2
point A (the price of zero supply) we get from the
equation
c
S 2( p1 , p 2 ) = 0
which gives
6
-6 + 8 p 2 = 0, p 2 = = 0.75
8
point B (the price of zero demand) we get from the
equation
c
D 2( p1 , p 2 ) = 0
which gives
12 - p 2 = 0, p 2 =
12
= 12
1
64
How to calculate welfare:
illustrative example
p
B
2
12
Consumers' surplus on the
second market
Producers' surplus on the
second market
c
E2
pc
2 2
A
0.75
0
10
c
q2
q
2
65
How to calculate welfare:
illustrative example
Consumers' surplus (area p2cE2cB)
1
(12 - 2)* 10 = 50
2
Total welfare for k = 2:
c
c
W 2( p1 , p 2 ) = 6.25 + 50 = 56.25
Total welfare for the two commodity market with respect to the
closed equilibrium
W( p1c , p c2 ) = W 1( p1c , p c2 ) + W 2( p1c , p c2 ) = 97.2 + 56.25 = 153.45
66
Free trade
In our model we assume that good 1 is tradable and good 2 non
tradable.
Let us assume a free trade regime on the market of good 1 with
perfectly elastic world supply and demand and "price taking" position
of the country.
Let p1c, p2c be closed equilibrium prices on both markets, p1W be a world
price on the market of the good 1. If p1c > p1W, then country will import
commodity 1, if p1c < p1W, then country will export commodity 1.
What will be the effect of import or export of tradable commodity 1 on
the market of non-tradable commodity 2?
67
Free trade: has import or export on
the first market an influence on the
second market?
In our case domestic supply and demand on the market for the good 2 is
given by
S2 ( p1W , p2 )
D2 ( p1W , p2 )
where p2 is the price on the market of the good 2. If the world price is
fixed, then the supply and demand of commodity 2 is a function of p2
Free trade equilibrium price on the second market has to guarantee
equality of supply and demand of non-tradable commodity.
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Free trade equilibrium
To find free trade equilibrium on the second market we have to find
solution of equation
S2 ( p1W , p2 )  D2 ( p1W , p2 )
Let p2* is solution of it. Only then we can find free trade equilibrium on
the first market: domestic supply of the first (tradable) commodity and
level of import or export:
Domestic supply
S1 ( p1W , p2* )
and import
D1 ( p1W , p2* )  S1 ( p1W , p2* ) if p1W  p1c
or export
S1 ( p1W , p2* )  D1 ( p1W , p2* )
p1W  p1c
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Welfare effect of free trade
To analyze welfare effect of free trade with commodity 1 we have to
analyze consumers’ surplus and producers’ surplus on the first and
second market in equilibrium, using supply and demand functions on
the first market
S1 ( p1 , p2* )
D1 ( p1 , p2* )
as functions on one variable p1 with fixed equilibrium price p2* on the
second market, and supply and demand functions on the second market
S2 ( p1W , p2 )
D2 ( p1W , p2 )
as functions of one variable p2 with fixed equilibrium price p1W on the
first market
70
Tariff protection
small country
two commodities
general tariff protection regime with the world price w1W and tariff t
supply functions
S 1( p1, p 2 ), S 2( p1, p 2 )
demand functions
D1( p1, p 2 ), D 2( p1, p 2 )
of the small country with commodities 1 (tradable) and 2 (non-tradable),
where p1 and p2 are the prices of commodities 1 and 2.
Let p1C and p2C be closed equilibrium prices in the country
considered and
p1W  t  p1c
71
Tariff protection equilibrium
As in the case of free trade we have to consider impact of tariff
protection import of the first commodity on the market of second
commodity. To find tariff protection equilibrium on the second market
we have to solve equation
S2 ( p1W  t , p2 )  D2 ( p1W  t , p2 )
Let p2t is solution of this equation, then we have to find tariff
equilibrium on the first market with tradable commodity: domestic
supply, demand and level of import
Domestic supply
S1 ( p1W  t , p2t )
demand
D1 ( p1W  t , p2t )
and import
D1 ( p1W  t , p2t )  S1 ( p1W  t , p2t )
By the known technique we can evaluate welfare on both markets in
tariff equilibrium
72
Customs union
Two countries and world market, more than one commodity
Case of one small country H and one big country P, considering export
supply and import demand of the big country P completely price elastic
with respect to the trade with the small country H.
Supply functions in H
H
H
S 1 ( p1, p 2 ), S 2 ( p1, p 2 )
demand functions in H
H
H
D1 ( p1, p 2 ), D 2 ( p1, p 2 )
of the small country H for the commodities 1 and 2
Closed equilibrium prices in H
H
H
H
p = (p1 , p 2 )
73
Customs union
As before, we shall denote by p1W the world
price of the tradable commodity, by t nondiscriminative tariff for tradable commodity,
and by p1P the price of tradable commodity in
potential partner country P.
Assuming
p1P  p1W  t  p1H
it may have sense for country H to consider
formation of customs union with country P.
To find equilibrium in customs union of big P
and small H, we have to start with analysis of
second (non-tradable) market:
S2H ( p1P , p2 )  D1 ( p1P , p2 )
Let p2* be solution of this equation.
74
Equilibrium in customs union
Equilibrium prices:
( p1P , p2* )
Then we have to evaluate domestic supply
and demand in country H on both markets
and level of import of tradable commodity
from customs union partner P:
75
Equilibrium in customs union
Equilibrium prices:
( p1P , p2* )
Then we have to evaluate domestic supply and
demand in country H on both markets:
Domestic supply on market 1 (tradable)
S1H ( p1P , p2* )
Domestic demand on market 1 (tradable):
D1H ( p1P , p2* )
and level of import of tradable commodity
from customs union partner P:
D1H ( p1P , p2* )  S1H ( p1P , p2* )
76
Welfare effect of customs union
Domestic supply on market 2 (non-tradable)
S2H ( p1P , p2* )
Domestic demand on market 2 (non-tradable):
D2H ( p1P , p2* )
By the known technique we have to evaluate
welfare on both markets in customs union and
general tariff protection. Economic justification
of customs union of a small country H with a big
country P: Welfare effect of customs union in H
has to be greater than welfare effect in general
tariff protection.
77
Questions?
78