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Simulation with Optimization strategies: International Trade with Partial Equilibrium Models (A basic Approach). Master Économie et Affaires Internationales September – October 2014 Dr. Ramón Mahía Professor of Applied Economics Department www.uam.es/ramon.mahia. AIM OF THE EXPOSITION.
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Simulation with Optimization strategies: International Trade with Partial Equilibrium Models (A basic Approach)
Master Économie et Affaires Internationales
September –October 2014
Dr. Ramón Mahía
Professor of Applied Economics Department
Review (Im sure you already know) the basic elements of a simple Partial Equilibrium Model for an open economy
Introduce the idea of using simple optimization strategies for simulation exercises.
Understand the logic of a simulation exercise running a simple example using Excel Solver (Linnear Programing)
Basic elements for understanding Partial Equilibrium Models
Do we need optimization?
Tradable / Non tradable Goods definition
Optimization example: Impact of trade measures
Equilibrium with linear demand & supply curves can be mathematically derived easily
But it turns complex if only linearity is lost
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)
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).
ImP > DP and ExP < DP: Non tradable good
ImP < DP : Importable good
ExP > DP : Exportable good
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
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.
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.
Non tradable good. (1) Exporting the good is not justified: the domestic price (Pd) is higher than the financial export parity price (Pep)
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)
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)
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
Exportable goods: The financial export parity price “Pep" is higher than the domestic price
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
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
Importable goods: The financial import parity price “Pip" is lower than the domestic price
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
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:
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
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 )
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, ….
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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.
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