Master Économie et Affaires InternationalesMaster Économie et Affaires InternationalesSeptember –October 2014

Dr. Ramón MahíaProfessor of Applied Economics Department

www.uam.es/ramon.mahia

Simulation with Optimization strategies: International Trade with

Partial Equilibrium Models (A basic Approach)

International Trade with Partial

Equilibrium Models and Optimization

Strategies:A basic Approach

AIM OF THE EXPOSITION

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)

International Trade with Partial

Equilibrium Models and Optimization

Strategies:A basic Approach

STRUCTURE OF DOCUMENT AND EXPOSITION

Basic elements for understanding Partial Equilibrium Models

Closed economyDo we need optimization?

Open EconomyBasic concepts

Tradable / Non tradable Goods definition

Optimization example: Impact of trade

measures

International Trade with Partial

Equilibrium Models and Optimization

Strategies:A basic Approach

STARTING POINT: CLOSED ECONOMY

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Equilibrium with linear demand & supply curves can be mathematically derived easily

International Trade with Partial Equilibrium

Models and Optimization Strategies:

A basic ApproachSTARTING POINT: CLOSED ECONOMY

But it turns complex if only linearity is lost

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International Trade with Partial Equilibrium

Models and Optimization Strategies:

A basic ApproachOPEN ECONOMY: BASIC DEFINITIONS

We will use Partial Equilibrium Model with three assumptions:

Single product: with no substitutive itemsSmall country: When our economy opens, the new international trade is NOT big enough to change international pricesPerfect competition: Domestic prices automatically move to converge to international prices (financial parity prices)

International Trade with Partial Equilibrium

Models and Optimization Strategies:

A basic ApproachFINANCIAL 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).

If:

ImP > DP and ExP < DP: Non tradable good

ImP < DP : Importable good

ExP > DP : Exportable good

International Trade with Partial Equilibrium

Models and Optimization Strategies:

A basic ApproachFINANCIAL PARITY PRICES

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

International Trade with Partial Equilibrium

Models and Optimization Strategies:

A basic ApproachFINANCIAL PARITY PRICES: FExPP

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.

International Trade with Partial Equilibrium

Models and Optimization Strategies:

A basic ApproachFINANCIAL PARITY PRICES: FExPP

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.

International Trade with Partial Equilibrium

Models and Optimization Strategies:

A basic ApproachOPEN ECONOMY: NON TRADABLE GOODS

Non tradable good. (1) Exporting the good is not justified: the domestic price (Pd) is higher than the financial export parity price (Pep)

Domestic wholesale reference market price $32,00Transport farm - reference market $1,50Domestic wholesale reference market price (at farm-gate) $30,50

EXPORTS (for crops with NO industrial transformation)

Exporter-Border Price (FOB) $34,00Transport Farmer-Port $2,00Export Taxes $1,00Export Subsidies to exporter (not to producer) $2,00Exporter Port charges (taxes, storage, loading) $1,00

Financial export parity price (at the farm-gate) $28,00

International Trade with Partial Equilibrium

Models and Optimization Strategies:

A basic ApproachOPEN ECONOMY: NON TRADABLE GOODS

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)

Domestic wholesale reference market price $32,00Transport farm - reference market $1,50Domestic wholesale reference market price (at farm-gate) $30,50

IMPORTS (for crops with NO industrial transformation)

Border Price (CIF - €) 28,00 €Nominal Exchange rate $/€ 1,26Border Price (CIF - $) $35,28Domestic Tariff (ad valorem) 5%Other Taxes+Fees 1%Transport from Port to Reference Market $2,00

Financial import parity price (at the reference market) $39,40Financial import parity price (at the farm-gate) $37,90

International Trade with Partial Equilibrium

Models and Optimization Strategies:

A basic ApproachOPEN ECONOMY: NON TRADABLE GOODS

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)

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International Trade with Partial Equilibrium

Models and Optimization Strategies:

A basic ApproachOPEN ECONOMY: EXPORTABLE GOODS

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

Domestic wholesale reference market price $32,00Transport farm - reference market $1,50Domestic wholesale reference market price (at farm-gate) $30,50

EXPORTS (for crops with NO industrial transformation)

Exporter-Border Price (FOB) $45,00Transport Farmer-Port $2,00Export Taxes $1,00Export Subsidies to exporter (not to producer) $2,00Exporter Port charges (taxes, storage, loading) $1,00

Financial export parity price (at the farm-gate) $39,00

International Trade with Partial Equilibrium

Models and Optimization Strategies:

A basic ApproachOPEN ECONOMY: EXPORTABLE GOODS

Exportable goods: The financial export parity price “Pep" is higher than the domestic price

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International Trade with Partial Equilibrium

Models and Optimization Strategies:

A basic ApproachOPEN ECONOMY: EXPORTABLE GOODS

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 reducesSupply is higher at this prices….going now both to domestic and export marketsProducers gain more money and producers surplus grows

International Trade with Partial Equilibrium

Models and Optimization Strategies:

A basic ApproachOPEN ECONOMY: IMPORTABLE GOODS

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

Domestic wholesale reference market price $32,00Transport farm - reference market $1,50Domestic wholesale reference market price (at farm-gate) $30,50

IMPORTS (for crops with NO industrial transformation)

Border Price (CIF - €) 18,00 €Nominal Exchange rate $/€ 1,26Border Price (CIF - $) $22,68Domestic Tariff (ad valorem) 5%Other Taxes+Fees 1%Transport from Port to Reference Market $2,00

Financial import parity price (at the reference market) $26,04Financial import parity price (at the farm-gate) $24,54

International Trade with Partial Equilibrium

Models and Optimization Strategies:

A basic ApproachOPEN ECONOMY: IMPORTABLE GOODS

Importable goods: The financial import parity price “Pip" is lower than the domestic price

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International Trade with Partial Equilibrium

Models and Optimization Strategies:

A basic ApproachOPEN ECONOMY: IMPORTABLE GOODS

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 pricesComing from domestic producers but also from abroadDomestic supply is lower at this new priceProducers lose some money..but public revenues are collected from imports

International Trade with Partial Equilibrium

Models and Optimization Strategies:

A basic ApproachOPEN ECONOMY: IMPACT OF TRADE MEASSURES

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:

International Trade with Partial Equilibrium

Models and Optimization Strategies:

A basic ApproachOPEN ECONOMY: IMPORTABLE GOODS

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

International Trade with Partial Equilibrium

Models and Optimization Strategies:

A basic ApproachOPEN ECONOMY: OPTIMIZATION SCHEME

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 importsParameters to move: tariff levelRestrictions: none (apart from logical mathematical restrictions such as non negativity )

International Trade with Partial Equilibrium

Models and Optimization Strategies:

A basic ApproachOPEN ECONOMY: OPTIMIZATION SCHEME

Further complexity: Non linearity for every relation in the schemeNon small country assumptionNon perfect competitionImportable and exportable good at the same timeDifferent 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 ApproachREFERENCES

•(***) 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.