Partial Equillibrium Of Trade Policies

University of Dhaka Department of Finance

International Trade and Finance (F208) “The Partial Equilibrium of Trade Policy”

Course Teacher: Md. Rabiul Islam

The Partial Equilibrium Analysis - an Overview Partial equilibrium analysis means that the effects of policy actions are examined only in the markets which are directly affected. Supply and demand curves are used to depict the price effects of policies. Producer and consumer surplus is used to measure the welfare effects on participants in the market. A partial equilibrium analysis either ignores effects in other industries in the economy or assumes that the sector in question is very small and therefore has little, if any, impact on other sectors of the economy. In other words, the prices of all substitutes and complements, as well as income levels of consumers are constant. Here the dynamic process is that prices adjust until supply equals demand. It is a powerfully simple technique that allows one to study equilibrium, efficiency and comparative static's. In economics, analysis that treats one particular sector of the economy

as operating in isolation from the other sectors of the economy.

The Goals of Partial Equilibrium Model Introduce a two-country partial equilibrium model of international trade. Use the partial equilibrium model to illustrate how consumers and producers are affected by international trade. Use the partial equilibrium model to analyze the effects of exchange rate changes, changes in demand, and transportation costs. Introduce international marketing and show how it complements comparative advantage by helping to determine the value of products that are traded internationally.

The Partial equilibrium ModelAssumptions: There are only two countries and one country affects markets in other countries. Partial equilibrium models assume “all other things remain equal” in other markets, obviously an unrealistic assumption. But, a two-country partial equilibrium model can isolate how, all other things equal, a change in a market in one country affects the market for the same product in another country. Specifically, the two-country partial equilibrium model lets us estimate the changes in consumer and producer surplus in two countries.

"Large" vs. "Small" Country Assumption Two cases are considered regarding the size of the policysetting country in international markets. If the country is "large" in international markets, then the countries imports or exports are a significant share in the world market for the product. Whenever a country is large in an international market, domestic trade policies can affect the world price of the good. This occurs if the domestic trade policy affects supply or demand on the world market sufficiently to change the world price of the product.

If the country is "small" in international markets then the policy-setting country has a very small share of world market for the product - so small, that domestic policies are unable to affect the world price of the good.

The Partial Equilibrium Model of TradeFree trade between two large countries.

P

P DB

S

B

DA

S

A

PA PB

O

QB

O Figure-1 showing Autarkic equilibrium in country-A and country-B.

QA

The Partial Equilibrium Model of TradeFree trade between two large countries (contd)

Due to exchange rate differential between the countries A and B, there may be trade between them. The price level PB of country-B is less than PA of country-A. So B will export goods to A.

Measuring the Welfare Gains from Exchange: Producer Surplus and Consumer Surplus Producer surplus: Producer Surplus is used to measure the welfare of a group of firms who sell a particular product at a particular price. Producer surplus is defined as the difference between what producers actually receive when selling a product and the amount they would be willing to accept for a unit of the good. Consumer surplus: Consumer Surplus is used to measure the welfare of a group of consumers who purchase a particular product at a particular price. Consumer surplus is defined as the difference between what consumers are willing to pay for a unit of the good and the amount consumers actually do pay for the product.

Market for T-Shirt Equilibrium price = $6 Equilibrium quantity = 50 S

P $9 E $6 D $1 O

50

T-Shirts

Producer Surplus Equilibrium price = $6 Equilibrium quantity = 50 Producer surplus = $125 ($5x50 = $250/2 = $125)

P $9

S E

$6

Producers Surplus

D $1 O

50

T-Shirts

Consumer Surplus Equilibrium price = $6 Equilibrium quantity = 50 Producer surplus = $125 ($5x50/2 = $250/2 = $125) Consumer surplus = $75 (3x50/2 = $150/2 = $75)

P $9

S consumer Surplus

C

$6

E

Producers Surplus

D $1 O

50

T-Shirts

Excess supply and excess demand Excess supply At a given price, the excess of the quantity supplied over the quantity demanded is called the excess supply.

Excess supply = QS (P) - QD (P)

Excess demand At a given price, the excess of the quantity demanded over the quantity supplied is called the excess demand.

Excess Demand = QD (P) - QS (P)

Excess Supply If the price is set too high, excess supply will be created within the economy and there will allocative inefficiency. S

PP

S

P1

D

O

Q1

Q2

Q

Graphical analysis of excess supply Price

(Here quantity supplied is greater than quantity demanded)

QS (P) > QD (P)

3.5 3 2.5 2 1.5 1 0.5 0

Supply = Demand

Price Falls

D0 S0

0

2000

4000

6000

8000

10000 12000

Quantity

Excess Demand Excess Demand is created when price is set below the equilibrium price. Because the price is so low, too many consumers want the good while producers are not making of it.

P

S

P1 D D O

Q1

Q2

Q

Price

Graphical analysis of excess demand Supply = Demand

3.5 3 2.5 2 1.5 1 0.5 0

Price Rises

D0 S0

0

2000

4000

6000

8000

QD (P) > QS (P) (Here quantity demanded is greater than supply )

10000 12000

Quantity

Other Distortions to Free Trade Import Tariff: An import tariff is a tax collected on imported goods. Generally , a tariff is a tax or fee collected by a government. Import tariffs raise prices of the imported commodities.

Graphical presentation of effects of Import Tariff Effect of tariff on imports. S

Dh

Price

Pwt2

h

Price increases

Pwt

J

K

Pw

L

Tariff

M

ESw (Excess

supply at Pw)

o

so

s1

d1

do

Quantity

(Figure showing how a small country is affected by imposing tariff).

Import Quotas Import Quotas: Import quotas are limitations on the quantity of goods that can be imported into the country during a specified period of time. An import quota is typically set below the free trade level of imports. In this case it is called a binding quota. If a quota is set at or above the free trade level of imports then it is referred to as a non-binding quota. The quota can harm the nation more than a tariff by giving monopoly power to foreign exporters.

Graphical presentation of effects of Import Quotas The effect of quota is to raise the domestic price since it restricts the supply to the domestic market, and in many ways the welfare effects of a quota are same as a tariff.

price

Sh

Dh

Ph

J

K

Pw

O

Quota

So

S1

L

Sh+Q

N M

d1

ESw

do

Figure showing the effects of import quotas.

Quantity

Other Distortions to Free Trade Import Subsidies: An import subsidy is a form of financial

assistance paid to domestic producers or distributors or to a particular economic sector of a country.

Import subsidies consist of subsidies on goods and services that become payable to resident producers or distributors when the goods cross the frontier of the economic territory or when the services are delivered to resident institutional units. Most subsidies are made by the government to producers or distributors in an industry to prevent the decline of that industry (e.g., as a result of continuous unprofitable operations) or an increase in the prices of its products. Subsidies can be regarded as a form of protectionism or trade barrier by making domestic goods and services artificially competitive against imports.

Effect of Import Subsidies An importing country decides to increase imports by allowing subsidies, so that, the price paid by consumers can be brought down the world market price. Sh Price Dh

Pw

J

H

K

L

M

N

ESw

Pw(1-s) O

so

s1

do

d1

Quantity

Other Distortions to Free Trade Export Subsidies: Export subsidies are payments made by the government to encourage the export of specified products. As with taxes, subsidies can be levied on a specific or ad valorem basis. The most common product groups where export subsidies are applied are agricultural and dairy products. Export subsidy refers to a payment of cash or a form of financial assistance paid to private sector business to encourage exports. Subsidies can be regarded as a form of protectionism or trade barriers by making domestic goods and services artificially competitive against imports.

Other Distortions to Free Trade Voluntary Export Restraints: A voluntary export restraint is a restriction set by a government on the quantity of goods that can be exported out of a country during a specified period of time. Typically VERs arise when the import-competing industries seek protection from a surge of imports from particular exporting countries. VERs are then offered by the exporter to appease the importing country and to avoid the effects of possible trade restraints on the part of the importer. Thus VERs are rarely completely voluntary. Voluntary export restraints are Non-tariff barriers to trade, equivalent to quotas. Exporting countries are coerced by the importing country into allocating a limited quota of exports. VERs are not legislated and can be imposed with or without formal international negotiations. ----------End-----------