DATA RESPONSE

Course: AS - Year: 2018 - Serie: October/November - Version: 2

(a)

(i) In 2010, the EU’s balance of trade in goods with China was equal to -170.4 billions of euros.
In 2015, it was equal to -180 billions of euros. In both years, the EU experienced a trade in
goods deficit with China. Besides, the EU‘s trade in goods deficit has increased between 2010
and 2015.

(ii) Over the period 2010-2015, the EU’s trade balance in goods with China is in deficit whereas
the EU’s trade balance in services with China is in surplus.

Besides, the EU’s balance of trade deficit in goods with China is much more important than
the EU’s balance of trade surplus in services with China. Indeed, between 2010 and 2015, the
former ranged from 131.9 to 180 billions of euros while the latter ranged from 2.3 to 10.3
billions of euros.

Finally, the EU’s balance of trade in goods with China has worsened whereas the EU’s
balance of trade in services with China has improved. Indeed, between 2010 and 2015, the
former moved from -170.4 to -180 billions of euros while the latter moved from 2.3 to 10.3
billions of euros.

(b) Subsidies to Chinese steel producers reduce their costs of production and allow them to
supply their output at a very low price. As a result, Chinese steel producers will gain market
shares at the expense of US steel producers. That is why subsidies will give Chinese steel
producers an advantage in world markets. This advantage can be regarded as unfair because
the price of Chinese steel does not reflect its true factor cost of production. That is, subsidies
could make Chinese steel internationally competitive even if its production was relatively less
efficient than in the US. However, the US government could respond by subsidising the
American steel industry so it is difficult to determine whether subsidies to Chinese steel
makers actually give them an unfair advantage in world markets, or whether they simply make
the US a sore loser.
(c) Figure 1 below shows the impact of an import tariff on the Indian market for steel.

Figure 1: Import tariff & Indian steel market

SD is the domestic supply and DD is the domestic demand. With no tariff, the foreign supply SF
is perfectly-elastic at P1, the world price of steel. In that case, the equilibrium price is P1 and
the equilibrium quantity is Q1. At that price, domestic firms produce D1 units while M1 = Q1 –
D1 units are imported. After the tariff T is introduced, the foreign supply SF + T is perfectly
price-elastic at P2. In that case, the equilibrium price is P2 and the equilibrium quantity is Q2.
At that price, domestic firms produce D2 units while M2 = Q2 – D2 units are imported.

Overall, we can conclude that the introduction of an import tariff leads to (i) an increase in
price (from P1 to P2), (ii) a decrease in the overall quantity traded (from Q1 to Q2), (iii) an
increase in domestic production (from D1 to D2), and (iv) a decrease in imports (from M1 to
M2).

(d) (i) Chinese steel producers will most likely lose from the introduction of tariffs on Chinese
steel. Indeed, the tariffs will make Chinese steel less internationally competitive so Chinese
steel producers will lose market shares abroad. They might respond by laying off employees
so those working in China’s steel mills will also be the collateral victims. The increase in
unemployment may be accompanied with an increase in welfare benefits so the Chinese
government can also be adversely affected by the introduction of tariffs on Chinese steel.
(ii) European firms importing steel from China will most likely lose from the introduction of
tariffs on Chinese steel. Indeed, tariffs will raise the price of Chinese steel, so European firms
will experience an increase in the production costs, either because they keep purchasing steel
from China at a higher price, or because they source it from formerly less competitive suppliers.
Since steel is widely used material, an increase in its price can be expected to lead to cost-
push inflation. An increase in the price level will harm consumers on fixed incomes, it will
create uncertainty and discourage long-term investments, and will generate additional menu,
unit-of-account and shoe-leather costs.

(e) A country has a Comparative Advantage (CA) in the production of a good or service if it
can produce it at a lower opportunity cost than all of its trading partners. If Country A has a
CA in the production of Good X and if Country B has a CA in the production of Good Y, then
specialisation and trade can lead to mutual gains from trade. Namely, Country A should
specialise in the production of Good X and Country B should specialise in the production of
Good Y.

The increase in exports of EU services to China, most likely tourism, may indicate that
the EU has a CA in the production of services. Therefore, the EU may have chosen to
specialise in the production of services in order to export them to China as well as to other
trading partners, and eventually to benefit from international trade. Yet, these gains from trade
will only exist if the EU can effectively import goods such as steel and for which it has a
comparative disadvantage. It follows that protectionism can undermine the benefits brought
about by specialisation and international trade because it artificially narrows the gap between
the domestic cost of production and the import price. From that perspective, the increase in
exports of EU services to China could justify free trade in the market for steel.

However, even if China can supply steel at a lower price than all of its trading partners,
this does not necessarily imply that it has a CA in steel production. This is because Chinese
steel is heavily subsidized so there is a substantial gap between the market price and the
factor cost of steel. Therefore, it is difficult to asses whether the exports of EU services to
China can be regarded as an application of the principle of CA.

Finally, there are reasons for which free-trade in the market for steel may harm the EU
economy. First, steel production can be regarded as a strategic industry. Therefore, the EU
may have a strong interest in avoiding over-dependence on imported steel. To that end, the
EU could implement import tariffs and quotas in order to encourage domestic steel production.
This is all the more relevant if EU steel production is an infant industry that is not yet mature
enough to withstand international competition. Besides, the consequences of free-trade on
employment in the EU should be considered. If specialisation in services results in a net loss
in jobs, then the gains from trade should be balanced against the costs of higher
unemployment.

Overall, the increase in exports of EU services to China would justify free trade in the
market for steel (i) if China actually has a CA in steel production in spite of the subsidies which
are given, (ii) if free-trade in the market for steel has no or minimal adverse effects on
employment in the EU, and (iii) if free-trade the market for steel does not significantly
undermine the EU economic sovereignty.