macroeconomics, foreign trade and the european union. basics and examples

Lecture 2. November 30th

Macroeconomics, foreign trade and the European Union. Basics

and Examples.

http://www.uni-goettingen.de/de/1.html

http://www.uni-goettingen.de/de/die-universitaet/50217.html

Macroeconomics, foreign trade and European Union. Basics.

• Tariffs. What they are, what they cause.• free trade zones: a better world? A theoretical approach• comparative static analysis of free trade• dynamic effects of free trade• Is EU a useful free trade zone?

Lecture 2Dipl.- Kfm. Thomas Stiegler, University of Göttingen.2

Today‘s topics



• International trade is always accompanied with tariffs• Tariffs can have different itentions:

• willingness to protect home industries• income for the state• to control imports

• Tariffs lead to an economical suboptimal situation

Dipl.- Kfm. Thomas Stiegler, University of Göttingen.3

Tariffs – a fact in international trade

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In the following argumentation we assume tariffs, that lead to a substitution of imports by domestic products.

• losses in production efficiency; suboptimal allocation of recourses• losses in consumer welfare (as more expensive domestic goods have to be consumed)• change in terms of trades towards the tariff implementing state


What are the impacts of tariffs?

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The negative effects described above will be persistent. However, one could make up situations in which tariffs are useful to a state in some extend.

• infant industry protection• protection of strategical production (can be substituted by subsidies)• optimal tariffs (more theoretical option, partners would act the same way with leaving no positive effect)


Are there situations when tariffs are positive?

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As we learnt in the last lecture, EU implemented a common market. That means, it is a free trade zone without any tariffs inside. So we should take a closer look to the effects of free trade in general we have to distinguish between two types of effects of free trade:1. comparative statical effects (traditional welfare theory)2. dynamical effects of integration

In the following we will have a short look at these effects


Effects of free trade

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There are a number of assumptions in traditional free trade theory:• competitive market ( no oligopolies or monopolies)• homogenous goods• no economies of scale• no market access barriers• no technological advance , no advance in products we clearly see, that these assumptions are not too realistic, but let’s see what theory brings to us though…


Comparative statical analysis - assumptions

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Creating a free trade zone erases the discrimination against the partner states. However, the free trade zone itself now discriminates all other states. Again there are two main effects in foreign trade by a free trade zone:1. trade creation (creating new trade - efficient)2. trade diversion (changing existing trade relations - inefficient)

let’s have a look at a very simple example to explain:


Comparative statical analysis – trade impact of free trade

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Trade structure impact of free trade – example (1)

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3) – 5) trade creation. As the tariff was set that way, that it hindered any trade, the free trade area now allows trade again and brings the factor allocation to a more efficient level

2) – 4) trade diversion. The – in terms of factor allocation efficient – import from Japan is substituted by a less efficient import from France, as through the free trade area Japan is discriminated against France. However the situation is better than a non trade situation.


Trade structure impact of free trade – example (2)

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As we saw above there are positive and negative effects of free trade zones. In the following we will have a look at 3 scenarios:

1. Free trade area, in a situation with non prohibitive tariffs before

2. Free trade after prohibitive tariffs. Small partner country3. Free trade after prohibitive tariffs. Big partner country


Three scenarios of a free trade area

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Trade structure impact of free trade – example (2) Scenario 1

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To describe the curves:• To the left we see domestic demand and supply for

good X at different price levels• To the right we see the domestic excess demand for

good X = demand for imports of X, as well as the supply curves of the countries A1 and A2, where A1 is a small country (import demand effects A1s prices) and A2 a big country, which can produce any demanded X for price G


What do these curves show us?

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• The price of X is set by the world market = G. As domestic firms rarely can compete at that price import demand FE exists. The import can substitute inefficient local production and increase over all efficiency.

• Country A1 produces export goods of X the cheapest, but through demand, prices are rising. Import from A1 takes place until price in A1 reaches G: 0M1

• The rest of the domestic import demand is bought from A2 at G: M0M3


Scenario 0 – what would happen without any tariffs?

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• Generally the situation is similar to above• As the prices for consumers in the domestic market rose to

pt now, the import demand decreases to AB• Import structure is the same as above. First the cheaper A1

(0M0) then from A2 (M0M2 = less than before)The efficiency structure of import is not disturbed, however more of the less efficient domestic production is used and the overall consummation decreased. The received tariff payments are lower than this loss negative welfare effect


Scenario 1 – non prohibitive tariff is implemented

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What are now the effects of a free trade area with A1?

• A1 can export goods without tariff burden, so there is a price advantage of T towards A2

• Although the local prices in A1 are higher between M0M1 the price for domestic consumers is lower. The less effective production from A1 is bought.

• Structure: 0M1 from A1, M1M2 from A2 (which is discriminated)


Scenario 1 – tariff union with the small country

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Let’s evaluate the effects of the tariff and the tariff union. The curves help:

• By implementing a tariff the consumers’ wealth is decreasing by ABEF. However, the state gets income from the tariffs, which increases the income again: ABCD. We clearly see the income is smaller than the loss. The loss is ACF + BDE, so called dead weight loss

• The tariff union now does not increase the consummation, the price to pay abroad for imports increased, the terms of trade decreased, the income of the state decreased; c.p. the free trade zone with A1 has only negative effects


Scenario 1 – tariff union and worse off…

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In this scenario there is a quite high tariff set, a free trade agreement then is agreed with the smaller country.• implementing a high tariff has the same consequences as in scenario 1. Income ABCD for the state, deadweight loss of ACF+BDE• Import structure with tariffs: OM0 from A1 and M0M1 from A2 (efficient structure)


Scenario 2 – some light, but still more shadow… (1)

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Free trade area with A1. Again Imports from A2 are discriminated.• through the tariff union A1 products get that cheap on the domestic market, that more can be consumed than before (0M2) (trade creation)• No goods from A2 are imported anymore (trade diversion)• The price paid for the import goods got higher• No income from tariffsIn total we see again a negative effect of free trade area as the trade diversion effect is bigger than the trade creation effect


Scenario 2 – some light, but still more shadow… (2)

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• Again the same situation as in (1) and (2) occurs for the tariff situation• Having a free trade zone with the big country now brings us almost to the price level for our imports we would have in world wide free trade. The trade creation is much bigger than trade diversion• The allocation of recourses improved overall


Scenario 3 – positive effects of free trade zone

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It is more likely, that a free trade zone brings positive effects, if…• the tariffs between the future partners are relatively high

(big trade creating effect)• the tariffs towards third parties are low (small diversion

effects)• the area of the tariff union is big (small diversion, big

creating effect)• the product structure of the partner countries is similar to each other but different from third parties (small diversion effect)


When is free trade useful? (1)

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It is more likely, that a free trade zone brings positive effects, if…• transport costs between the member states are low (they are geographically close)• the number of efficient suppliers in the union is bigger than outsideHowever these positive effects are if they exist usually not really big, if we follow the classical theory. Therefore let’s have a look at the dynamical effects of free trade in the following


When is free trade useful? (2)

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in contrast to the comparative static effects, the dynamical effects of a tariff union are not that easy to present analytically. However there is hardly any doubt that they exist. We will have a closer look at three of them:1. economies of scale2. competition effects3. growth impulses through integration


Dynamical effects of free trade

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• the most competitive firms of each sector get a bigger market to sell their goods on• to some point it gets more and more efficient to produce more units of the same product:

• positive effects of mass production• lowering share of fixed costs• better efficiency of organizational structures


Economies of scale

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• in some fields of national economies exist oligopolies and monopolies which set prices at a sub optimal level in order to maximize the national wealth• Through a common market competitors from other countries occur forcing the monopolists now to act as a firm in competition. Prices decrease, wealth increases• Danger of monopolies of the whole integration zone :

necessary to observe. (EU has competition observing institutions)


Competition effects

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• Companies get access to bigger markets and might see the possibility of expansion• To use these new markets an impulse on technology development is set• By entering markets with high technology spill over effects can occurThese effects will be bigger, the bigger the common market and the number of industries is


Growth impulses through integration

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• we saw from a theoretical view, that regional free trade integration is not necessarily useful but can be positive• as we saw in the first lecture, EU is a huge market with many differently structured states. That’s a good basis.• the big market allows to assume potential dynamic effects are big


Conclusions (1)

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• through common currency transaction costs are quite low.

To conclude we can say that European could be a good free trade zone, however to which extent positive effects occur is difficult to say. As conditions for positive effects under comparative static analysis exist, we can conclude, that in addition a even bigger effect as of dynamic effects should be existing.


Conclusions (2)

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• What are the consequences of common market in Europe? Some evidence from European reality.• Prime Minister’s Putin’s proposal: of November 25th: free trade from Lisbon to Vladivostok?• The Euro. One market one currency? Chances and dangers.• Dollar vs. Yuan currency as economical weapon?


What will be next

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macroeconomics, foreign trade and the european union. basics and examples

Documents

foreign trade

european union

tariffs tariffs

free trade zones

traditional free trade

useful free trade zone

effects of free tradelecture

university of gttingen