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International Trade with Partial Equilibrium Models and Optimization Strategies: A basic Approach. Master Économie et Affaires Internationales Paris Dauphine -October 2006 Dr. Ramón Mahía Professor of Applied Economics Department www.uam.es/ramon.mahia. STRUCTURE OF DOCUMENT AND EXPOSITION.

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International Trade with Partial Equilibrium Models and Optimization Strategies:A basic Approach

Master Économie et Affaires Internationales

Paris Dauphine -October 2006

Dr. Ramón Mahía

Professor of Applied Economics Department

www.uam.es/ramon.mahia

international trade with partial equilibrium models and optimization strategies a basic approach

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?

A break for introducing Excel Solver

Open Economy

Basic concepts

Tradable / Non tradable Goods definition

Impact of trade measures: example of tariffs

A real example: Banana Market

international trade with partial equilibrium models and optimization strategies a basic approach1

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

international trade with partial equilibrium models and optimization strategies a basic approach2

STARTING POINT: CLOSED ECONOMY

International Trade with Partial Equilibrium Models and Optimization Strategies:A basic Approach

But it runs out to be very complex if linearity is lost

international trade with partial equilibrium models and optimization strategies a basic approach3

EXCEL SOLVER COMPLEMENT

International Trade with Partial Equilibrium Models and Optimization Strategies:A basic Approach

The optimization problem should be written in an Excel worksheet as it could be solved “by hand”

The basic elements of an optimization problem are:

Optimization function to maximize, minimize or achieve an exact value

Parameters to move to achieve optimization function objective

Restrictions to be taken into account

Options for changing optimization algorithm definition

international trade with partial equilibrium models and optimization strategies a basic approach4

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 an economy opens, new international trade is small enough to not change international prices

Perfect competition: Domestic prices automatically move to converge to international prices = financial parity prices

international trade with partial equilibrium models and optimization strategies a basic approach5

OPEN ECONOMY: BASIC DEFINITIONS

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.

For a meaningful comparison between international market price and the domestic price received by farmers, we must adjust the price of the product in the international market. International prices thus adjusted are called financial parity prices.

international trade with partial equilibrium models and optimization strategies a basic approach6

OPEN ECONOMY: BASIC DEFINITIONS

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 in this case) all transport and marketing costs from the farm 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 farm-gate price.

international trade with partial equilibrium models and optimization strategies a basic approach7

OPEN ECONOMY: BASIC DEFINITIONS

International Trade with Partial Equilibrium Models and Optimization Strategies:A basic Approach

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 and insurance and the unloading onto the destination dock.

international trade with partial equilibrium models and optimization strategies a basic approach8

OPEN ECONOMY: BASIC DEFINITIONS

International Trade with Partial Equilibrium Models and Optimization Strategies:A basic Approach

We calculate the financial import parity price by first choosing a domestic wholesale reference market, for instance the wholesale market of the capital city, where imported goods are supposed to enter into competition with locally produced equivalent goods.

We then add 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 or subsidies, and the transport and marketing costs from the port to the market of reference. If we further want to obtain the import parity price at the farm-gate, we subtract the transport and marketing costs that farmers have to pay to put their produce in the market of reference

international trade with partial equilibrium models and optimization strategies a basic approach9

OPEN ECONOMY: BASIC DEFINITIONS

International Trade with Partial Equilibrium Models and Optimization Strategies:A basic Approach

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.

international trade with partial equilibrium models and optimization strategies a basic approach10

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), so that exporting the good is not justified

international trade with partial equilibrium models and optimization strategies a basic approach11

OPEN ECONOMY: NON TRADABLE GOODS

International Trade with Partial Equilibrium Models and Optimization Strategies:A basic Approach

Non tradable good: (2) in addition the financial import parity price of the good (pip) is higher than the domestic price (Pd), and hence importing the good is not justified

international trade with partial equilibrium models and optimization strategies a basic approach12

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 export parity price (Pip)

international trade with partial equilibrium models and optimization strategies a basic approach13

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

international trade with partial equilibrium models and optimization strategies a basic approach14

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

international trade with partial equilibrium models and optimization strategies a basic approach15

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 to domestic and export markets

Producers gain more money and producers surplus grows

international trade with partial equilibrium models and optimization strategies a basic approach16

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

international trade with partial equilibrium models and optimization strategies a basic approach17

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

international trade with partial equilibrium models and optimization strategies a basic approach18

OPEN ECONOMY: IMPORTABLE GOODS

International Trade with Partial Equilibrium Models and Optimization Strategies:A basic Approach

Main effects before opening economy for an exportable 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

international trade with partial equilibrium models and optimization strategies a basic approach19

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 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 as follows

international trade with partial equilibrium models and optimization strategies a basic approach20

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 production

…… that replaces imported supply

…… reducing dependency on imports

…… and generating a rise in revenues of producers

…... and goverment

international trade with partial equilibrium models and optimization strategies a basic approach21

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

international trade with partial equilibrium models and optimization strategies a basic approach22

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, ….

international trade with partial equilibrium models and optimization strategies a basic approach23

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.