Regional and European Economic Integration - Spring 2010
Review Session 2 - Essential
Economics of Preferential
Liberalisation
Lorenzo Rotunno
24/03/2010
Review Session 2 - Essential Economics of Preferential Liberalisation
2
1 Types of Trade Barriers
Three types of trade barriers according to their effects on rents:
Domestically Captured Rents (DCR): go to a domestic group (private or public);
Foreign Captured Rents (FCR): go to a foreigner group (private or public);
"Frictional" barriers: no rents.
Rents arise whenever a trade policy drives a wedge between the domestic and the
border price (also called "price decoupling"). They signal the presence of market distortions: someone is obtaining something without paying the corresponding costs.
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1.1 The Classic DCR barrier: Tariffs
Figure 1
Open-Economy Market
Domestic
Price
MS’
C
XS ≡ MS
p’
A
pFT
B
p’
-T
D
M’ MFT = XFT
MD
Imports
The Home Government captures the trade rents (A+B). The Home net welfare effects
of the tariff are ambiguous: B (terms of trade effect) - C (trade volume effect).
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1.2 Possible DCR barriers: Quota and Tariff Quota
Home imposes a quantitative restriction (M 0) to the imports from Foreign. The price
and quantity effects are analogous to those of the tariff T (referred to as the "tariff equivalent" of the quota M 0). Quotas are administered through import or export licences. If
domestic agents (e.g., rms) are holders of import licences, they can buy at the (lower)
border price p0 T and resell at the (higher) domestic price p0. In this case, the quota
is a DCR barrier.
Domestically administered quotas have the same effects of tariffs, yet they are forbidden by the WTO...why?
They tend to favour corruption and smuggling (but not clear if more than tariffs);
Dynamic ef ciency losses: the quota removes linkages between more ef cient
international rms and less ef cient domestic rms.
The tariff quota (or tariff-rate quota) has been used as a transition policy instrument
from quotas to tariffs (e.g., cotton in the U.S.). It is currently the main (only?...
http://ec.europa.eu/taxation_customs/customs/customs_duties/tariff_aspects/quotas/
index_en.htm) quantitative restriction in the EU. Imports enter duty free the market up
to a certain ceiling (quota), after which they face a (often prohibitive) tariff.
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1.3 FCR Barriers: Export Licences and Price Undertakings
If the quota is administered by Foreigners through export licenses, the trade rents (A+B)
go to Foreign.
A more interesting FCR barrier is the price undertaking: Home (e.g., the EU) asks
Foreign to sell its goods in the Home market at a price no lower than a certain level
(e.g. p0). The rationale for this instrument is political economy: Home wants to protect
in uential domestic industry from international competition without hurting Foreign.
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Figure 2
Export Supply
(Foreign)
Border
Price
Import Demand
(Home)
Open-Economy Market
Domestic
Price
MS’
MS
C
Domestic
Price
XS ≡ MS
C=C1+C2
D= D1+D2
p’
p’
A
p’
A
A
pFT
pFT
B
pFT
B
p’
-T
B
p’
-T
p’
-T
D
X’
XFT
Exports
M’
MFT = XFT
MD
Imports
M’
MFT
Imports
Home is unambiguously worse off from a FCR barrier (net welfare loss= -A-C). Foreign
obtains the trade rents and can thus bene t from the FCR barrier (net welfare impact=
A-D; since B cancels out: it a loss for exporting rms that face a lower border price, but
is a gain for export license holders).
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1.4 Frictional Barriers (TBTs)
They are product standards and domestic regulations that increase to cost of exporting,
providing a cost advantage to domestic rms. No rents are created.
The key difference with other trade barriers is that the domestic price equals the border
price, since the regulation or standard is applied to all rms, both domestic and foreign.
Home loses -A-C, as in the FCR barrier case. Foreign does not receive any rents, so it
is worse off with frictional barriers (-B-D).
While these barriers are always detrimental to Home from an economic perspective,
they might have an important role in ensuring "public goods" such as health or the
environment.
The EU has partly eliminated (at least theoretically) TBTs through the principle of mutual recognition.
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2 Preferential Trade Liberalisation
The analysis of Preferential Trade Arrangements (PTAs) or Discriminatory Trade Liberalisation requires at least three countries:
Home, which decides unilaterally to remove tariffs to imports from
Partner;
while the Rest of the World (RoW) is the discriminated country, which has to pay the
tariff T to export goods to Home.
The three countries are assumed to be identical. In particular, Home is a net importer
of the good while Partner and RoW are net exporters.
Our benchmark case is a MFN tariff levied by Home towards both Partner and RoW.
What happens if Home removes T only towards imports from Partner?
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2.1 Price and Quantity Effects
Figure 3
Export Supply
(RoW)
Border
Price
XSR
Export Supply
(Partner)
Border
Price
XSP
Open-Economy Market
(Home)
Domestic
Price
MSMFN’
MSPTA
MS
p’
p’
’
p’
p’
’
p’
-T
p’
-T
p’
’
-T
p’
-T
MD
X’
’
R X’
R
Exports
X’
P
X’
’
P
Exports
X’
’
R
M’ M’
’
Imports
2.1.1 Quantity Effects
Under a MFN tariff, RoW and Partner export the same quantity (XR0 = XP0 ). The
M SM F N curve is thus the horizontal sum of the two exporters' supply curves (XSR +
XSP ).
Following the PTA, Partner does not pay T and thus expands its exports from XP0 to XP00 .
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RoW is now discriminated and its exports fall from XR0 to XR00 . The resulting M SP T A has
two segments. In the rst one, RoW does not export since the border price (i.e., the
domestic price at Home minus the tariff) is lower than its autarky price, while Partner
can export since now its border price equals the domestic price at home p00. When the
domestic price is suf ciently high, both RoW and Partners export and the MS curve
has the usual slope (i.e., half of the slope of XSR and XSP ).
The fact that Partners exports increase while RoW exports decrease creates supply
switching (or trade diversion). However, Home imports increase with respect to the
MFN equilibrium (trade creation): consumers can now purchase imports from Partner
at a lower price p00. This implies that the rise in exports of Partner is bigger than the fall
in exports from RoW.
2.1.2 Price Effects
The domestic price lowers following the PTA from p0 to p00, since part of imports does
not pay tariffs. The discrimination creates two border prices: the one of Partner equals
the domestic price at Home, while the border price for RoW is now the new domestic
price minus the tariff (p00 T ). Note that the border price has decreased for RoW: rms
have to be more competitive to ll the "arti cial" gap created by the PTA.
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2.2 Welfare Effects
Look at trade price (terms of trade - ToT) and trade volume effects.
2.2.1 On Partner and RoW
Figure 4
Export Supply
(RoW)
Border
Price
XSR
Export Supply
(Partner)
Border
Price
XSP
D2
E1
p’
’
D1
p’
-T
p’
’
-T
p’
-T
E2
X’
’
R X’
R
Exports
X’
P
X’
’
P
Exports
Partner gains from PTA: it expands export volumes (trade volume effect= +D1) and it
receives an higher price (ToT effect= +D2). RoW loses from a PTA: its export volume
shrinks (trade volume effect= -E2) and its export price goes down (ToT effect= -E1).
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2.2.2 On Home
Figure 5
Import Demand
(Home)
Domestic
Price
Home Market
Domestic
Price
A=A2+A3
A1
A1
B2
D
A2
A3
p’
p’’
p’
p’’
C
C
B2
p’-T
p’’-T
p’-T
p’’-T
Demand
Supply
B1
X’’R
MD
M’M’’
Imports
B1
Z’
C’
Quantity
Looking at the Import Demand curve:
Gains on the imports coming from RoW (area B1) since the border price for RoW
has decreased (from p0 T to p00 T , positive ToT effect).
Regional and European Economic Integration - Spring 2010
Review Session 2 - Essential Economics of Preferential Liberalisation
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Losses on the imports coming from Partner (area C) since in this case the border
price has increased (from p0 T to p00, negative ToT effect).
Gains on the new imports (from M 0 to M 00, positive trade volume effect) thanks to the
drop in the domestic price.
Looking at the Home market (redistributive effects):
As domestic price falls, consumers gain the area D+A2+A1+A3;
The area D is transferred from producers, who will oppose the PTA;
Under the MFN equilibrium, tariff revenues equal A1+C+B2. With the PTA, the government receives tariffs only from RoW exporters (the area B1+B2), but loses tariffs
from Partner (-A1-C).
Both procedure lead to a net welfare change that is ambiguous and equal to the area
B1-C+A.
3 Customs Union
A Customs Union (CU) is a reciprocal PTA (e.g., Home and Partner liberalise reciprocally their markets) where the parties agree on a Common External Tariff (CET).
Regional and European Economic Integration - Spring 2010
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A simpli ed trade structure: 3 countries (identical), 3 goods, each country exporting
2 goods and importing one (Home imports good 1 and Partner good 2). Partner and
Home do not alter their tariff vis-à-vis RoW.
The price and quantity effects are symmetric at Home and Partner. Repeat the same
reasoning (see Figure 3) for the unilateral discriminatory liberalization of Home (market
of good 1) and apply it to Partner (market of the good 2).
Home exports more of the good 2 to Partner, while RoW exports less because of the
lower border price (supply switching). Rather, Home faces now a higher border price
that is equal to the domestic price of good 2 in Partner. As shown in Figure 3 for good
1 at Home, Partner imports more of the good 2 following the CU (trade creation).
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Review Session 2 - Essential Economics of Preferential Liberalisation
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3.1 Welfare Effects of CU
Welfare effects will be identical in Home and Partner. Focus on Home.
Figure 6
Export Supply –Good 1
(Partner)
Border
Price
Import Demand –Good 1
(Home)
Domestic
Price
MS
A
C2
D2
p’
p’
’
p’
’
D1
C1
p’
-T
p’
-T
p’
’
-T
MD
B1
X’
P
X’
’
P
Exports
Regional and European Economic Integration - Spring 2010
X’
’
R X’
P
M’M’
’
Imports
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In the import market (good 1), the net welfare effect at Home is B1–C+A (see Figure
4).
Partner gains D1+D2 because it sees an higher border price. The positive ToT effect for Partner (D1) equals part of the negative ToT effects suffered by Home (C1).
This last area is given by the value of previous imports from Partner that are now
purchased by Home at an higher border price (from p0 T to p00).
However, reciprocal liberalisation between Home and Partner implies that in the market of good 2 Home is gaining D1, and this cancels out the loss of C1 in the market
of good 1. Moreover, Home gains D2 in the market of good 2.
Summing up, the net welfare change for Home (and for Foreign by symmetry) due to
the formation of a CU (from a MFN equilibrium) is: A+B+D2-C2.
The net effect is still ambiguous, but more likely to be positive than the welfare effect of
a PTA.
RoW loses more under a CU, since now it is discriminated in two markets (each country
imports a different good). Moreover, it may end up losing even more in the long run
because of the negative difference between its exports, which fall, and its imports,
which do not change.
Regional and European Economic Integration - Spring 2010
Review Session 2 - Essential Economics of Preferential Liberalisation
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3.2 CU with Frictional Barriers
Starting point: a frictional barrier imposed by each country with tariff equivalent T .
Price and quantity effects of a CU between Home and Partner:
The cost of imports (Home's border price in the market of good 1) decreases, since
the cost of importing and the domestic price do not differ with a frictional barrier.
Partner (or Home in the market of good 2) receives an higher border price and thus
increases exports of good 1 to Home
RoW sees a lower border price and its exports decreases.
The Welfare effects for Home (symmetric for Foreign) are (go back to Figure 5):
Since the domestic price falls, the private surplus change is positive in the market of
good 1 (A2+A1+A3)
This gain is no longer offset by loss of tariff revenues, since these do no exist with
frictional barriers.
Moreover, Home gains D1+D2 (see Figure 6) in its export market (good 2).
A trade liberalisation of frictional barriers is always welfare enhancing, even if discriminatory (RoW loses).
Regional and European Economic Integration - Spring 2010