Master Économie et Affaires Internationales Paris Dauphine – October 2012 Dr. Ramón Mahía

1. International Trade with Partial Equilibrium Models and Optimization Strategies:A basic Approach Master Économie et Affaires Internationales Paris Dauphine –October 2012 Dr. Ramón Mahía Professor of Applied Economics Department www.uam.es/ramon.mahia

2. STRUCTURE OF DOCUMENT AND EXPOSITION International Trade with Partial Equilibrium Models and Optimization Strategies:A basic Approach Basic elements for understanding Partial Equilibrium Models Closed economy Do we need optimization? Open Economy Basic concepts Tradable / Non tradable Goods definition Optimization example: Impact of trade measures

3. STARTING POINT: CLOSED ECONOMY International Trade with Partial Equilibrium Models and Optimization Strategies:A basic Approach Equilibrium with linear demand & supply curves can be mathematically derived easily

4. STARTING POINT: CLOSED ECONOMY International Trade with Partial Equilibrium Models and Optimization Strategies:A basic Approach But it turns complex if only linearity is lost

5. OPEN ECONOMY: BASIC DEFINITIONS International Trade with Partial Equilibrium Models and Optimization Strategies:A basic Approach We will use Partial Equilibrium Model with three assumptions: Single product: with no substitutive items Small country: When our economy opens, the new international trade is NOT big enough to change international prices Perfect competition: Domestic prices automatically move to converge to international prices (financial parity prices)

6. FINANCIAL PARITY PRICES International Trade with Partial Equilibrium Models and Optimization Strategies:A basic Approach When an economy opens, an alternative market with a different price appears inducing a price competition with domestic market. The idea is to compare domestic prices (DP) with export (ExP) and import international prices (ImP). If: ImP > DP and ExP < DP: Non tradable good ImP < DP : Importable good ExP > DP : Exportable good

7. FINANCIAL PARITY PRICES International Trade with Partial Equilibrium Models and Optimization Strategies:A basic Approach For a meaningful comparison between international market price and the domestic price received by producers, we must adjust: 1.- Choose a domestic wholesale reference market, where imported goods are supposed to enter into competition with locally produced equivalent goods) (*). 2.- Put the price of the product in the international market at the same basis of the domestic prices using what it is usually called financial parity prices. (*) If we further want to obtain the import parity price at the factory-gate, we subtract the transport and marketing costs that producers have to pay to put their product in the market of reference

8. FINANCIAL PARITY PRICES: FExPP International Trade with Partial Equilibrium Models and Optimization Strategies:A basic Approach We calculate the financial export parity price by deducting from the border price (FOB) all transport and marketing costs from the factory to the port, any export taxes or subsidies, and all local port charges including taxes, storage, loading agents' fees, etc., so as to be left with the factory-gate price. FExPP= FOB Price – FOB Export costs FOB stands for FREE ON BOARD. It is the cost of an export good at the exit point in the exporting country loaded in the ship (or other means of transport) in which it will be carried to the importing country. It is equal to the CIF price at the port of destination minus the cost of international freight, insurance and the unloading onto the destination dock.

9. FINANCIAL PARITY PRICES: FExPP International Trade with Partial Equilibrium Models and Optimization Strategies:A basic Approach We calculate the financial import parity price adding to the border price (CIF in this case) all port charges after the import touches the dock, any domestic tariffs and other taxes or fees, duties, and the transport and marketing costs from the port to the market of reference. FImPP= CIF Price + “Inwards” costs CIF stands for COST, INSURANCE AND FREIGHT. It is the landed cost of an import good on the dock or other entry point in the receiving country. It includes the cost of international freight and insurance and usually also the cost of unloading onto the dock. It excludes any charge after the import touches the dock such as port charges, handling and storage and agents' fees. It also excludes any domestic tariffs and other taxes or fees, duties or subsidies.

10. OPEN ECONOMY: NON TRADABLE GOODS International Trade with Partial Equilibrium Models and Optimization Strategies:A basic Approach Non tradable good. (1) Exporting the good is not justified: the domestic price (Pd) is higher than the financial export parity price (Pep)

11. OPEN ECONOMY: NON TRADABLE GOODS International Trade with Partial Equilibrium Models and Optimization Strategies:A basic Approach Non tradable good. (2) Importing the good is not justified: Financial import parity price of the good (pip) is higher than the domestic price (Pd)

12. OPEN ECONOMY: NON TRADABLE GOODS International Trade with Partial Equilibrium Models and Optimization Strategies:A basic Approach Non tradable good: (1) the domestic price (Pd) is higher than the financial export parity price (Pep) and lower than financial import parity price (Pip)

13. OPEN ECONOMY: EXPORTABLE GOODS International Trade with Partial Equilibrium Models and Optimization Strategies:A basic Approach Exportable goods: The financial export parity price "pep" is higher than the domestic price in the absence of trade, and hence there is an incentive for the good to be exported

14. OPEN ECONOMY: EXPORTABLE GOODS International Trade with Partial Equilibrium Models and Optimization Strategies:A basic Approach Exportable goods: The financial export parity price “Pep" is higher than the domestic price

15. OPEN ECONOMY: EXPORTABLE GOODS International Trade with Partial Equilibrium Models and Optimization Strategies:A basic Approach Main effects before opening economy for an exportable good: Domestic demand price tends to rise up to Pep so domestic demand is lower at this new price and consumer surplus reduces Supply is higher at this prices ….going now both to domestic and export markets Producers gain more money and producers surplus grows

16. OPEN ECONOMY: IMPORTABLE GOODS International Trade with Partial Equilibrium Models and Optimization Strategies:A basic Approach Importable goods: The financial import parity price of the good IS LOWER than the domestic price, so there is an incentive to import the good

17. OPEN ECONOMY: IMPORTABLE GOODS International Trade with Partial Equilibrium Models and Optimization Strategies:A basic Approach Importable goods: The financial import parity price “Pip" is lower than the domestic price

18. OPEN ECONOMY: IMPORTABLE GOODS International Trade with Partial Equilibrium Models and Optimization Strategies:A basic Approach Main effects before opening economy for an importable good: Consumers have an incentive to import at this new price …..so domestic supply price tend to fall down to "Pip“ Demand is higher at this new and lower prices Coming from domestic producers but also from abroad Domestic supply is lower at this new price Producers lose some money ..but public revenues are collected from imports

19. OPEN ECONOMY: IMPACT OF TRADE MEASSURES International Trade with Partial Equilibrium Models and Optimization Strategies:A basic Approach Which is the effects of a tariff measure in an open economy for an importable good? We assume that the product is an importable good and we start from the previous situation of equilibrium with trade and no protection. The domestic price will be equal to the international price Pw. Then a tariff “t” is introduced as a percentage of the import value (ad-valorem tariff). The tariff will generate a series of reactions over time from producers, consumers and traders until a new equilibrium is reached in the domestic market. Comparing the initial and final situations the effects of the tariff are the next:

20. OPEN ECONOMY: IMPORTABLE GOODS International Trade with Partial Equilibrium Models and Optimization Strategies:A basic Approach Main effects of a tariff in an open economy: Domestic Prices Increases …...and therefore, consumers expenditures reduces ….. and consumption reduces in volume Higher prices encourages producers to increase their supply …… that replaces imported supply …… reducing dependency on imports …… and generating a rise in revenues of producers …... and goverment

21. OPEN ECONOMY: OPTIMIZATION SCHEME International Trade with Partial Equilibrium Models and Optimization Strategies:A basic Approach Now, I porpoise an optimization problem: Are we able to rise the tariff to restore the initial situation of a closed economy? Objective function: reduce to 0% dependency on imports Parameters to move: tariff level Restrictions: none (apart from logical mathematical restrictions such as non negativity )

22. OPEN ECONOMY: OPTIMIZATION SCHEME International Trade with Partial Equilibrium Models and Optimization Strategies:A basic Approach Further complexity: Non linearity for every relation in the scheme Non small country assumption Non perfect competition Importable and exportable good at the same time Different trade measures for import and export and even “non measurable measures” Matrixes: different countries, different CIF and Fob prices, different transport costs,…etc Market distortions: market power, dumping strategies, ….

23. REFERENCES International Trade with Partial Equilibrium Models and Optimization Strategies:A basic Approach (***) José María Caballero. Geraldo Calegar and Carlo Cappi. 2000. Instruments of Protection and their economic Impact. Multilateral trade negotiations on agriculture a resource manual. FAO de Janvry, A. & Sadoulet, E. 1995. Quantitative Development Policy Analysis. Baltimore and London, The John Hopkins University Press FAO. 1998. The Implications of Uruguay Round Agreement on agriculture for Developing countries - a Training Manual. Training Materials for Agricultural Planning, No. 41. Rome. Gittinger, P J. 1982. Economic Analysis of Agricultural Projects. Second Edition. Baltimore and London, John Hopkins University Press. Josling, T. E., Tangermann, S. & Warley, T. K. 1996. Agriculture in the GATT. London, Macmillan Press. Just, R., Hueth, D.L. & Schmitz, A. 1982. Applied Welfare Economics and Public Policy. Prentice-Hall, N.J. Tsakok, I. 1990. Agricultural Price Policy: a Practitioner's Guide to Partial Equilibrium Analysis. Ithaca, New York, Cornell University Press.