Question

E.U. Agrees to Trade Deal with South Korea Italy has dropped its resistance to a E.U. trade agreement with South Korea, which will wipe out \(\$ 2\) billion in annual duties on E.U. exports. Italians argued that the agreement, which eliminates E.U. duties on South Korean cars, would put undue pressure on its own automakers. a. What is a free trade agreement? What is its aim? b. Explain how a tariff on E.U. car imports changes E.U. production of cars, purchases of cars, and imports of cars. Illustrate your answer with an appropriate graphical analysis. c. Show on your graph the changes in consumer surplus and producer surplus that result from free trade in cars. d. Explain why Italian automakers opposed cuts in car import tariffs.

Short answer

An FTA eliminates trade barriers to encourage trade. Tariffs raise import prices, reducing imports and increasing domestic production. Free trade increases consumer surplus but decreases producer surplus, which Italian automakers oppose.

Step-by-step solution

Define a Free Trade Agreement and its Aim

A free trade agreement (FTA) is a treaty between two or more countries to reduce or eliminate barriers to trade, such as tariffs, quotas, and import restrictions. The main aim of an FTA is to increase trade between the countries involved by making it easier and less costly to exchange goods and services across borders.

Explain the Impact of a Tariff on EU Car Imports

A tariff on EU car imports makes imported cars more expensive than domestically produced cars. This leads to a decrease in the import of cars and an increase in the production and purchase of domestic cars. The graphical analysis involves a supply and demand diagram where the supply curve of imported cars shifts upwards by the amount of the tariff, leading to a higher equilibrium price and a lower equilibrium quantity for imports.

Graphical Analysis of Tariff Effects

In a supply and demand graph, the vertical axis represents the price of cars and the horizontal axis represents the quantity of cars. The domestic supply curve meets the domestic demand curve to determine the equilibrium price and quantity. Adding a tariff shifts the supply curve of imported cars upward, raising the price of imported cars, reducing their quantity, and increasing the market share of domestic cars.

Changes in Consumer and Producer Surplus

With free trade, the removal of the tariff on imports of South Korean cars lowers their price. Consumer surplus increases because consumers pay less for cars and can buy more of them. Producer surplus for domestic car makers decreases because they face more competition from lower-priced imports. Graphically, the area between the demand and supply curves increases for consumers and decreases for producers.

Reason for Italian Automakers' Opposition

Italian automakers opposed cuts in car import tariffs because it would lead to increased competition from lower-priced South Korean cars. This could reduce their market share and profit margins. The increased competition makes it difficult for Italian automakers to compete on price, potentially leading to lower sales and profits.

Key concepts

Tariffs

Tariffs are taxes placed on imported goods to make them more expensive than domestic products. Their primary purpose is to protect local industries by making foreign products less competitive in price. For example, in the EU, placing a tariff on South Korean cars means these cars would cost more than EU-made cars. As a result, EU consumers might prefer buying domestic vehicles because they are cheaper by comparison. This leads to reduced imports, increased local production, and higher sales of domestically-produced cars.

Consumer Surplus

Consumer surplus is the difference between the maximum price consumers are willing to pay for a good and the actual price they pay. In a scenario with free trade, the removal of tariffs on South Korean cars would lower their prices. As a consequence, consumers benefit by paying less for cars, and they might buy more cars than they would have if tariffs were in place. This increased satisfaction and saving is known as an increase in consumer surplus. However, when tariffs are in place, consumers generally end up paying more than they would under free trade conditions, reducing their consumer surplus.

Producer Surplus

Producer surplus is the difference between the price at which producers are willing to sell a good and the actual price they receive. With tariffs applied, domestic producers benefit because imported goods become more expensive, making locally made products more attractive to consumers. This increase in demand allows producers to sell more at higher prices, increasing their producer surplus. When tariffs are removed due to a free trade agreement, producers face tougher competition from cheaper imports. This often results in a decrease in producer surplus as they may need to reduce prices and lose market share.

Import Restrictions

Import restrictions are regulations and barriers imposed by a country to limit the amount of goods that can be brought in from abroad. These restrictions can take many forms, such as quotas, tariffs (taxes on imports), and outright bans. The primary goal is to protect domestic industries from foreign competition. For example, Italy opposed the EU's decision to remove tariffs on South Korean cars fearing it would harm local automakers. By restricting imports, countries try to nurture and grow their own industries, albeit sometimes at the cost of higher prices and fewer choices for consumers.