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# Section 3

3.2 Supply and demand in the small open
economy
3 4 Interventions in importables
3.4
3.5 Interventions in exportables

3.1
If relative p
prices differ and there are no
profitable.
Example:
price off x
price of y

country A
\$
\$2
\$6

country B
240
480

## How to profit from this? (assume no

transaction costs)

1. buy 2 units of x in A
2. sell 2 units of x in B
and
buy 1 unit of y in B
3. sell 1 unit of y in A

(cost = \$4)
(receipts= 480)
(cost= 480)
(receipts = \$6)

## Net benefits = benefits - costs = \$6 - \$4 = \$2

Why is this?
good y is 3 more expensive
g
p
than x in A
good y is 2 more expensive than x in B
Country A has a comparative advantage in
good x, i.e. good x is relatively cheaper pretrade.

1. We trade because it is profitable to do so.
- in the interests of private individuals
- trade is also socially profitable in that it
allows consumption possibilities to lie
outside the PPF
Country A

y
possible
consumption
point

Consumption
Possibility
Frontier (CPF)
assuming can
px/py=1/2

PPF

1
3
1
production
point

2
x

## 2. Everyone potentially benefits from trade but

not everyone actually benefits from trade.
- e.g. there is less demand for labour with
skills specific to import-competing
industries
3. Relative prices matter.
- have made no references to exchange
rates or even the necessity of having
convertible currencies
4 Th
4.
The greater
t th
the diff
difference in
i relative
l ti
prices,
i
the greater the net benefits of trade.
- although sometimes hear the argument
that cant trade fairly with countries
that
are unequal to us

## 5. Dont need to know which country is most

efficient
or
has lowest costs
or
is most technologically advanced etc etc.
-

## a country could have an absolute

there is still a basis for trade

## 6. What ensures that trade is balanced?

Importance of the exchange rate:
Suppose that \$1= 240.
Then in previous example, the \$ prices of
goods x and y from country B would be \$1
and \$2 respectively.
Thus at this exchange rate both goods
would be cheaper in country B. So country
A would want to import both x and y.

## What ensures that trade is balanced? (cont)

If the exchange rate is floating, then the
quantity demanded of would exceed the
quantity supplied and the \$ price of a
would increase.
increase This would make the prices
of goods from country B more expensive in
country A.
Fixed exchange rates
As is discussed in ECC1100 macroeconomics, if the
FX rate
t is
i fi
fixed
d th
then there
th
would
ld be
b a loss
l
off FX
reserves that would lead to a decrease in the
amount of money in country A. This would be
expected to depress prices and economic activity in
A thereby reducing demand for imports and making
exports from A more attractive in overseas markets.

3.2
Supply and demand
in the small open
p
economy
y
3.2.1
3.2.2
3.2.3
3.2.4

3.2.1

International prices
Supply & demand for importables
Supply & demand for exportables

International prices

## The small economy

cant affect prices in foreign currency in
international markets (pi*))
must pay transportation costs to/from
markets (zi)
can import any amount at the c.i.f. price (picif)
picif = pi* e + zi
where e is the p
price of foreign
g currency
y (i.e.
(
the exchange rate)
can export any amount at the f.o.b. price
(pifob)
pifob = pi* e - zi

## In the absence of trade, the domestic price

of good i would be either
(1) greater than the c.i.f. price; or
(2) less than the f.o.b. price ; or
(3) between the ff.o.b.
o b and c
c.i.f.
i f prices
And goods can be classified into three groups:
S

price

price

price
S

S
pcif
pfob

pcif

pcif

pfob

pfob
D

(1)
importables

3.2.2

price
p

D
quantity

quantity

(2)
exportables

quantity

(3)

importables
domestic
supply

S MC
S=MC

supply from
r.o.w.

pcif=p* e + z

quantity
qs domestic

qs imports

## total quantity demanded

Exercises
Show that for domestic producers of
importables:
changes in domestic demand are not
important for determining output and
prices
increases in costs cannot be passed on
the exchange rate is important for
dete mining output
determining
o tp t and prices
p ices
(assume the good remains an importable
with these changes)

3.2.3

exportables
price
demand
from r.o.w.

domestic
demand

S=MC
pfob=p* e - z

D
quantity
qd domestic

qd exports

## total quantity supplied

Exercises
Show that for domestic producers of
exportables:
changes in domestic demand are not
important for determining output and
prices
increases in costs cannot be passed on
the exchange rate is important for
dete mining output
determining
o tp t and prices
p ices
(assume the good remains an exportable
with these changes)

3.2.4

non
price
S

pcif=p* e + z
p0
pfob=p* e - z

D
q0

quantity

## This is the case studied in Section 2.

domestic demand changes are important
f determining
for
d t
i i
output
t t and
d prices
i
increases in costs are partly offset by
rising prices.

3.3
3 3 1 Importables
3.3.1
3.3.2 Exportables

3.3.1

Importables

Domestic S & D
price

S & D of imports
price

S
1
p0
pcif

p0

pcif

D
q1s

q0

q1d

quantity

Simports
Dimports

imports

## Effects of opening to trade:

price decreases from p0 to pcif
quantity supplied decreases from q0 to q1s
quantity demanded increases from q0 to q1d
imports
i
t off q1d - q1s units
it
foreign exchange outlays = pcif (q1d - q1s )
loss in real income of factors specific to
production of importables
change in welfare
CS
= + (2) + (4)
PS
= - (2)
Welfare = CS + PS
= +(2)+(4)-(2)
= +(4)

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3.3.2

Exportables

Domestic S & D
price

price

p0

Sexports

5
pfob

S & D of exports

pfob

p0

Dexports

7
D
q1d q0 q1s

quantity

Dimports
0

(q1s - q1d)

quantity
exports

## Effects of opening to trade:

price increases from p0 to pfob
quantity supplied increases from q0 to q1s
quantity demanded decreases from q0 to q1d
exports
t off q1s - q1d units
it
foreign exchange earnings = pfob (q1s - q1d)
gain in real income of factors specific to
production of exportables
change in welfare
CS
= - (6)
PS
= + (6) + (8)
Welfare = CS + PS
= -(6)+(6)+(8)
= +(8)

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3.3.3

## Opening an economy up to trade results in

increases in:
prices of exportables relative to
importables
production of exportables relative to
importables
consumption of importables relative to
exportables
welfare in both importables and
exportables so that
Welfare = +(4)+(8)
which are the gains from trade

## Other effects of opening up trade

The real income of factors used specifically or
intensively in the production of exportables
increases.
And the real income of factors used specifically
or intensively in the production of importables
decreases.

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3.4
Interventions in
importables
p
3.4.1
3.4.2
3.4.3
3.4.4

Consumption tax
Production subsidy
Import tariffs
Import quotas

Blank slide

13

3.4.1

Consumption tax
price
S

pb = ps + t
ps = pcif

2 3 4

pcif
6

q0

q1

D
q0

quantity

## Effects of consumption tax:

price to buyers increases by t \$ from pcif to pb
quantity demanded decreases from q0d to q1d
price to sellers unchanged at ps = pcif
quantity supplied unchanged at q0s
imports decrease by q0d - q1d units
foreign exchange savings = pcif (q0d - q1d) = 6
increase in tax revenues = t q1d
changes in welfare
CS
= - (1) - (2) - (3) - (4)
PS
= 0
Rev
= + (1) + (2) + (3)
Welfare = CS + PS + Rev = - (4)

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3.4.2

Production subsidy
price
S

ps = pb + s
pb = pcif

pcif

5
q0

q1

D
s

q0

quantity

## Effects of production subsidy:

price to buyers unchanged at pcif
quantity demanded unchanged at q0d
price to sellers increases by s \$ to ps = pcif +s
quantity
tit supplied
li d iincreases ffrom q0s to
t q1s
imports decrease by q1s - q0s units
foreign exchange savings = pcif (q1s - q0s) = 5
subsidy payments = s q1s
changes in welfare
CS
= 0
PS
= + (1)
Rev
= - (1) - (2)
Welfare = CS + PS + Rev = - (2)

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Alternative approaches
to welfare analysis of a subsidy
Net benefit (NB) measures:
NB = Value of additional output
- additional factor cost - subsidy
= [(1)+(2)+(5)] -[(2)+(5)]
[(2)+(5)] -[(1)+(2)]
[(1)+(2)] = -(2)
(2)
NB

## = Rise in factor income - subsidy

= [(1)] - [(1)+(2)] = -(2)

NB

## = FX saved - additional resources used

= [5] - [(2)+(5)] = -(2)

## Domestic Resource Cost (DRC) measure:

DRC = (Resources used / FX saved or earned)
= ((2)+(5))/(5) > 1
(i.e. subsidy results in using more than \$1 worth of
resources to save \$1 in FX, so 'not worth it')

Blank slide

16

3.4.3

Import tariffs

Tax on imports
price
S

pb = ps = pcif +
pcif

3 4

5
q0

pcif
6

q1

q1

D
q0

quantity

Effects of tariff:
prices:
increases in ps and pb
by \$ per unit
production:
increases to q1s
consumption: decreases to q1d
imports:
decrease to q1d - q1s
revenue:
increases by (q1d - q1s)
welfare:
decreases by areas (2) + (4)
= cost of protection
Other effects of tariffs
Although not shown
exports decrease because exporters face cost
increases and lose resources
employment increases in the tariff-protected
industry but decreases elsewhere

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Note on tariffs:
1. The effects of a tariff are identical to the
effects of a production subsidy combined
with a consumption tax.
2. The cost of protection would be larger
if protected firms were foreign owned.
In this case, part of the increase in
producer surplus would accrue to
overseas residents and thus would not
increase domestic welfare.
welfare

Blank slide

18

3.4.4

Import quotas

## Restriction on quantity of imports

Domestic S&D

S&D of imports

price

price
S
Simports with quota

p1
pcif

2 3 4

pcif
D
quantity

Simports
Dimports

quantity
imports

## Effects of import quota:

domestic price increases from pcif to p1
imports decrease to the amount of the
quota
quantity supplied domestically increases and
quantity demanded decreases
quota rents go to holders of import licences
assuming no rent-seeking, the changes in
welfare are:
CS
= - (1) - (2) - (3) - (4)
PS
= + (1)
Rents = + (3)
Welfare = CS + PS + Rents
= -(2)-(4)
= cost of protection

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## if there is rent-seeking, the cost of

resources used in obtaining the licences
would need to be added to the cost of
protection
if the
th import
i
t licences
li
are given
i
to
t foreign
f
i
residents (as is the case with Voluntary
Export Restraints), then there would be
larger costs of protection for domestic
residents

## Note on import quotas:

Although quotas have similar effects to
tariffs, they differ in a number of important
regards.
1. Any change in domestic demand or supply
results in a change in the domestic price
(and a change in the value of the import
licences). Thus industries with import
2. The protective effect of quotas is much
more hidden than with tariffs.
3. Quota holders get the rents.

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3.5
Interventions in
exportables
3.5.1
3.5.2

Production subsidy
Export subsidy

Blank slide

21

3.5.1

Production subsidy

price
S

ps = pfob+ s
pb = pfob

D
q0d

q0s

q1s

quantity

## Effects of production subsidy:

price to buyers unchanged at pfob
quantity demanded unchanged at q0d
price to sellers increases to pfob + s
quantity supplied
l d increases ffrom q0s to q1s
exports increase by (q1s - q0s )
subsidy payments = s q1s
changes in welfare
CS
= 0
PS
= + (1) + (2) + (3)
Rev
= - (1) - (2) - (3) - (4)
Welfare = CS + PS + Rev = - (4)

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3.5.2

Export subsidy

price
ps = pb = pfob +
pfob

S
2
1a 1b

D
q1d q0d

q0s

q1s

quantity

## Effects of export subsidy:

ps and pb increase by \$ per unit
quantity demanded decreases from q0d to q1d
quantity supplied increases from q0s to q1s
exports increase to (q1s - q1d)
subsidy payments = exports = (q1s-q1d)
changes in welfare
CS
= - (1a) - (1b)
PS
= + (1a) + (1b) + (2) + (3)
Rev
= - (1b) - (2) - (3) - (4)
Welfare = CS + PS + Rev
= - (1b) - (4)

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## Note on export subsidies:

1. The effects of export subsidies are
identical to the effects of a production
subsidy combined with a consumption
tax.
2. Thus export subsidies have the same
effects on exportables as do import
tariffs on importables, although export
subsidies are costs to government
g
budgets whereas tariffs generate
revenue.

## 3. Export subsidies are less costly to

government budgets than production
subsidies for exportables, but they are
more costly in economic welfare.
4. Export subsidies are prohibited under