Transcript 20 KEYS FOR BETTER SIMULATING

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
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 economy
Do we need optimization?
Open Economy
Basic 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
Equilibrium with linear demand & supply curves
can be mathematically derived easily

70
New D
D Initial
60
New S
S Initial
40
30
20
10
Quantity
30
28
26
24
22
20
18
16
14
12
10
8
6
4
2
0
0
Price
50
International Trade with
Partial Equilibrium
Models and Optimization
Strategies:
A basic Approach
But it turns complex if only linearity is lost
300
Supply
250
Demand
200
Prices

STARTING POINT: CLOSED ECONOMY
150
100
50
0
0
5
10
15
20
Quantity
25
30
35
International Trade with
Partial Equilibrium
Models and Optimization
Strategies:
A basic Approach
OPEN ECONOMY: BASIC DEFINITIONS
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)

International Trade with
Partial Equilibrium
Models and Optimization
Strategies:
A basic Approach
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).


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 Approach
FINANCIAL 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 Approach
FINANCIAL 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 Approach
FINANCIAL 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 Approach
OPEN 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
Transport farm - reference market
Domestic wholesale reference market price (at farm-gate)
$32,00
$1,50
$30,50
EXPORTS (for crops with NO industrial transformation)
Exporter-Border Price (FOB)
Transport Farmer-Port
Export Taxes
Export Subsidies to exporter (not to producer)
Exporter Port charges (taxes, storage, loading)
$34,00
$2,00
$1,00
$2,00
$1,00
Financial export parity price (at the farm-gate)
$28,00
International Trade with
Partial Equilibrium
Models and Optimization
Strategies:
A basic Approach
OPEN 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
Transport farm - reference market
Domestic wholesale reference market price (at farm-gate)
$32,00
$1,50
$30,50
IMPORTS (for crops with NO industrial transformation)
Border Price (CIF - €)
Nominal Exchange rate $/€
Border Price (CIF - $)
Domestic Tariff (ad valorem)
Other Taxes+Fees
Transport from Port to Reference Market
28,00 €
1,26
$35,28
5%
1%
$2,00
Financial import parity price (at the reference market)
Financial import parity price (at the farm-gate)
$39,40
$37,90
International Trade with
Partial Equilibrium
Models and Optimization
Strategies:
A basic Approach
OPEN 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)

70
60
D Initial
S Initial
Pep
Pip
40
30
20
10
Quantity
30
28
26
24
22
20
18
16
14
12
10
8
6
4
2
0
0
Price
50
International Trade with
Partial Equilibrium
Models and Optimization
Strategies:
A basic Approach
OPEN 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
Transport farm - reference market
Domestic wholesale reference market price (at farm-gate)
$32,00
$1,50
$30,50
EXPORTS (for crops with NO industrial transformation)
Exporter-Border Price (FOB)
Transport Farmer-Port
Export Taxes
Export Subsidies to exporter (not to producer)
Exporter Port charges (taxes, storage, loading)
$45,00
$2,00
$1,00
$2,00
$1,00
Financial export parity price (at the farm-gate)
$39,00
International Trade with
Partial Equilibrium
Models and Optimization
Strategies:
A basic Approach
OPEN ECONOMY: EXPORTABLE GOODS
Exportable goods: The financial export parity price
“Pep" is higher than the domestic price

70
S Initial
D Initial
60
Pep
40
30
20
10
Quantity
30
28
26
24
22
20
18
16
14
12
10
8
6
4
2
0
0
Price
50
International Trade with
Partial Equilibrium
Models and Optimization
Strategies:
A basic Approach
OPEN 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
reduces
Supply is higher at this prices
….going
now both to domestic and
export markets
Producers
gain more money and
producers surplus grows

International Trade with
Partial Equilibrium
Models and Optimization
Strategies:
A basic Approach
OPEN 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
Transport farm - reference market
Domestic wholesale reference market price (at farm-gate)
$32,00
$1,50
$30,50
IMPORTS (for crops with NO industrial transformation)
Border Price (CIF - €)
Nominal Exchange rate $/€
Border Price (CIF - $)
Domestic Tariff (ad valorem)
Other Taxes+Fees
Transport from Port to Reference Market
18,00 €
1,26
$22,68
5%
1%
$2,00
Financial import parity price (at the reference market)
Financial import parity price (at the farm-gate)
$26,04
$24,54
International Trade with
Partial Equilibrium
Models and Optimization
Strategies:
A basic Approach
OPEN ECONOMY: IMPORTABLE GOODS
Importable goods: The financial import parity price
“Pip" is lower than the domestic price

70
S Initial
D Initial
60
Pip
40
30
20
10
Quantity
30
28
26
24
22
20
18
16
14
12
10
8
6
4
2
0
0
Price
50
International Trade with
Partial Equilibrium
Models and Optimization
Strategies:
A basic Approach
OPEN 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 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 Approach
OPEN 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 Approach

OPEN 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 Approach

OPEN 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
imports
Parameters to move: tariff level
Restrictions: none (apart from logical mathematical
restrictions such as non negativity )

International Trade with
Partial Equilibrium
Models and Optimization
Strategies:
A basic Approach

OPEN ECONOMY: OPTIMIZATION SCHEME
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 Approach
REFERENCES
•(***) 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.