Theory of Economic Integration Regional Trade Agreements and The Traditional Welfare Analysis. Presentation of MSMD diagram Dr Katarzyna Śledziewska Katarzyna Śledziewska
Outline Introduction to MSMS curve Essential microeconomic tools The essential economics of FTA The Traditional Welfare Analysis Trade Creation and Trade Diversion Dr Katarzyna Śledziewska
Demand curve mu p* mu Marginal utility curve is the demand curve for one consumer c c* c quantity
Demand curve Demand curve shows how much consumers would buy of a particular good at any particular. It is based on optimisation exercise: Would one more be worth? Market demand is aggregated over all consumers demand curves Horizontal sum mu p* mu Marginal utility curve is the demand curve for one consumer c c* c quantity
Welfare analysis: consumer surplus T rian gle is su m of all gap s betw een m argin al u tility an d p rice paid (su m m ed o ver to tal consu m p tio n) p* D em and curve c* quantity
Welfare analysis: consumer surplus Since demand curve based on marginal utility, it can be used to show how consumers well-being (welfare) is affected by changes in the. Gap between marginal utility of a unit and paid shows surplus from being able to buy c* at p* p* Triangle is sum of all gaps between m arginal utility and paid (sum m ed over total consum ption) D em and curve c* quantity
Welfare analysis: consumer surplus p* p A B Demand curve c* c quantity
Welfare analysis: consumer surplus If the falls: Consumers obviously better off. Consumer surplus change quantifies this intuition. consumer surplus rise, 2 parts: Pay less for units consumed at old ; measure of this = area A. p* p A B = Price drop times old consumption Gain surplus on the new units consumed (those from c* to c ) measure of this = area B = sum of all new gaps between marginal utility and Demand curve c* c quantity
Supply curve m c p ric e M a rg in a l c o st p * m c q q * q q u a n tity
Supply curve Supply curve shows how much firms would offer to the market at a given Based on optimisation: Would selling one more unit at increase profit? Market supply is aggregated over all firms Horizontal sum mc p* mc Marginal cost q q* q quantity
Welfare analysis: producer surplus Triangle is sum of all gaps between received and m arginal cost (sum m ed over total production) S=MC p* q* quantity
Welfare analysis: producer surplus Since supply curve based on marginal cost, it can be used to show how producers well-being (welfare) is affected by changes in the. p* Triangle is sum of all gaps between received and m arginal cost (sum m ed over total production) S=MC Gap between marginal cost of a unit and received shows surplus from being able to sell q* at p* q* quantity
Welfare analysis: producer surplus p p* A B Supply curve q* q quantity
Welfare analysis: producer surplus If the rises: producers obviously better off Producer surplus change quantifies this intuition p p* A B Supply curve producer surplus rise, 2 parts: Get more for units sold at old ; measure of this = area A = Price rise times old production Gain surplus on the new units sold (those from q* to q ) measure of this = area B = sum of all new gaps between marginal cost and q* q quantity
Open Economy Introduction to Open Economy Supply & Demand Analysis Start with Import Demand Curve This tells us how much a nation would import for any given domestic Presumes imports and domestic production are perfect substitutes Imports equal gap between domestic consumption and domestic production
Import demand curve (MD) Home Supply 1 P* 2 P P 3 P P Home Demand Home import demand curve, MD H Z Z C C quantity M M imports
Import supply curve (MS) P P P* Foreign Supply 1 2 3 Foreign export Supply curve, XS F, or MS H. Foreign Demand C X X C quantity exports Z Z
Welfare & Import demand curve Home Supply ToT effect 1 NB: E=B+D P* 2 P P A B C D C E Home Demand 3 P P Home import demand curve, =MU an e MD H Z Z C C quantity M M imports
Welfare & Import supply curve P P P* Foreign Supply A C E B D D 1 Trade effect == ToT effect F=C+E F 2 3 Foreign export Supply curve, XS F, or MS H. Foreign Demand C X X C quantity exports Z Z
Trade volume effect & border effect Domestic P P C E MD M M Home imports
Trade volume effect & border effect Domestic Decomposing Home loss from rise, P to P. Area C: Home pays more for units imported at the old. P Area C is the size of this loss. Home loses from importing less at P area E measures loss P C E MD marginal value of first lost unit is the height of the MD curve at M, but Home paid P for it before, so net loss is gap, P to MD. adding up all the gaps gives area E M M Home imports
Trade volume effect & border effect Systematic net welfare analysis using the and quantity effects: border effect (area C), and the import volume effect (area E). Very useful in more complex diagrams Domestic P P C Border effect Trade volume effect E MD M M Home imports
Trade volume effect & border effect Can do same for Foreign gain rise, P to P. Foreign gains from getting a higher for the goods it sold before at P (border effect), area D And gains from selling more (trade volume effect), area F P P D B order effect Trade volum e effect F X S F, M S H. X X exp orts
The Workhorse: MD-MS Diagram Diagram very useful easy identification of and volume effects of a trade policy change Welfare change likewise easy euros Import demand curve Import supply curve P FT MS MD Imports imports
MD-MS + open econ. supply & demand MD-MS diagram can be usefully teamed with open economy supply and demand diagram Permits tracking domestic & international consequences of a trade policy change
MD-MS + open econ. supply & demand euros Import supply curve Domestic, euros Domestic demand curve S dom Domestic supply curve MS P FT Import demand curve MD Imports D dom Imports imports Z C quantity
MFN Tariff Analysis 1 st step: determine how tariff changes s and quantities. suppose tariff imposed equals T euros per unit. Small country fiction Tariff shifts MS curve up by T. Exporters would need a domestic that is T higher to offer the same exports. Because they earn the domestic minus T
MFN Tariff Analysis For example, how high would domestic have to be in Home for Foreigners to offer to export M a to Home? Answer is P a +T, so Foreigners would see a of P a
MFN Tariff Analysis Border XS=MS Domestic MS with T MS w/ft P a T P a +T 2 1 MD X a =M a Foreign exports M a Home imports
MFN Tariff Analysis New equilibrium in Home (MD=MS with T) is with P and M Domestic now differs from border ( exporters receive) P vs P -T
MFN Tariff Analysis Border Domestic MS with T P FT P -T XS=MS T P MS P FT MD X =M X FT = M FT Foreign exports M M FT Home imports
Positive effects Domestic rises Border falls Border Domestic MS with T Imports fall Can t see in diagram XS=MS P MS Domestic consumption falls P FT T P FT domestic production rises P -T Foreign consumption rises Foreign production falls MD Could get this in diagram by adding open economy S & D diagram to right X =M X FT = M FT Foreign exports M M FT Home imports
Welfare effects: Home Domestic Home T.vol. P P FT P -T A B C MD M =X M FT =X FT Home imports
Welfare effects: Home Drop in imports creates loss equal area C (Trade volume effect) Drop in border creates gain equal to area B (Border effect) Net effect on Home = -C+B ALTERNATIVELY: Private surplus change (sum of change in producer and consumer surplus) equal to minus A+C. Increase in tariff revenue equal to +A+B. Same net effect, B-C (but less intuition). Domestic P P FT P -T A B T. Home C T.vol. MD M =X M FT =X FT Home imports
Welfare effects: Foreign Border Foreign XS=MS P FT P -T B D X X FT Foreign exports
Welfare effects: Foreign Drop in exports creates loss equal area D (Trade volume effect) Border Foreign Drop in border creates loss equal to area B (Border effect, a.k.a., ToT effect) XS=MS Net effect on Foreign = -D-B ALTERNATIVELY: Private surplus change (sum of change in producer and consumer surplus) equal to minus -D-B P FT P -T B D Same net effect, B-C (but less intuition) X X FT Foreign exports
Welfare effects: useful compression Domestic P P FT P -T A B Home and Foreign in one diagram C MS MD D Home imports Dr Katarzyna Śledziewska M =X M FT =X FT
Welfare effects: useful compression In cases of more complex policy changes useful to do Home and Foreign welfare changes in one diagram MS-MD diagram allows this Home net welfare change is C+B Foreign net welfare change is D-B World welfare change is D-C Domestic P P FT P -T A B Home and Foreign in one diagram C MS MD D NB: if Home gains (-C+B>0) it is because it exploits foreigners by making them to pay part of the tariff (i.e. area B). Notice similarity with standard tax analysis. Home imports M =X M FT =X FT
Distributional consequences: Home Trade protection imposed mainly due to politically considerations raised by distributional consequences. Thus important for some purposes to see domestic consequences of trade policy change. For this, add the open economy supply & demand diagram to the right of the MD- MS diagram. MD-MS diagram tells us the and quantity effects of trade policy change. Open-economy S&D tells us the domestic distributional consequences.
Distributional consequences: Home Home consumers lose, area E+C 2 +A+C 1 ; Home producers gain E, Home tariff revenue rises by A+B net change = B-C 2 +-C 1 (this equals B-C in left panel) euros Domestic, euros S dom P P FT P -T A C MS B D B E C 2 A C 1 P P FT P -T MD D dom imports Z Z C C quantity