Economics of European Integration Course 2024-2025 PDF

ECONOMICS OF EUROPEAN INTEGRATION CARLOS III UNIVERSITY COURSE 2024-2025 Teacher Assistant: Joan Rodriguez i Salleras Lecturer: Juan Ignacio Diez Bidart GENERAL REMARKS Objective of the course: European Integration EU is a unique historical achievement...

ECONOMICS OF EUROPEAN INTEGRATION CARLOS III UNIVERSITY COURSE 2024-2025 Teacher Assistant: Joan Rodriguez i Salleras Lecturer: Juan Ignacio Diez Bidart GENERAL REMARKS Objective of the course: European Integration EU is a unique historical achievement Economies closely linked between them (trade, investment) More integrated that loosely federated nations (e.g. Switzerland) The EU is maintained by a cocktail of polices and institutions The emphasis of the course is on economics and economic integration Minimum knowledge (e.g. supply and demand diagrams) Possibility to change subject PRACTICAL LECTURES We will cover: Theory of Economic Integration slides & Problem Sets Real value (80% final grade): preparation of both midterm and final exams Class rules: Punctuality Active Participation Respectful Communication Technology Use Assignment Deadlines Plagiarism and Academic Integrity Consultation and Office Hours GENERAL COURSE RULES Students cannot change groups. No exceptions are allowed. 80-20 system: students doing internships in a company, or an academic exchange may opt, with prior authorization from their professor. 80% final exam / 20% individual essay (a 20-page essay instead of 10). Submission of the topic chosen for the essay: October 4th Team members must be from the same Group (you may opt to present it in class) You can discuss the topic with the Lecturer and/or me before the submitting date Submission of PS + active participation in class: extra 5% to the final grade. You can skip some/all classes, eventually you would only loose 5% of the grade. Real value of practical classes: preparation for the exams GENERAL AGENDA OF THE COURSE 1. Introduction: the integration process 2. Theory of Economic Integration 3. Institutions of the EU 4. European Monetary Integration 5. Common Agricultural Policy (CAP) and reforms 6. EU Regional Policy 7. EU Environmental Policy 8. The future of the EU: Political Integration? AGENDA: THEORY OF ECONOMIC INTEGRATION 1. Introduction 2. Trade protection in a Small Open Economy 3. Customs Union 4. Common Markets 5. EU Focus: Common Commercial Policy AGENDA: THEORY OF ECONOMIC INTEGRATION 1. Introduction 2. Trade protection in a Small Open Economy 3. Customs Union 4. Common Markets 5. EU Focus: Common Commercial Policy 1. INTRODUCTION (I): EU An economic and political union established in 1993: Amazing story (after many centuries of bitter wars) The EU today encompasses 28 countries with 447 million people. 340 million of them use the euro as their own currency. The EU’s economy (GDP 15$ trillion) rivals that of United States (GDP of 20$ trillion) and matches that of China ($16 trillion). Essential requirements for economic integration are: Comparable levels of economic development Similar but potentially complementary structures in production and demand The EU is pursuing these objectives through common policies. 1. INTRODUCTION (II): ECONOMIC INTEGRATION Since 1945, world economy has experienced unprecedented economic integration Economic integration is the process by which different countries decide to form larger units together Objective: improve their national & group welfare Theory of economic integration studies incentives and determinants Critical question: ¿policy raises well-being? Not a simple task: many factors at play Original framework: trade liberalisation 1. INTRODUCTION (III): REA Economic integration take the form of regional economic associations Economic integration has a number of effects: Short run effects from barriers to trade removal: Trade creation Trade diversion Medium run effects: Enhanced competition Cost reduction Factor mobility. Long run effects: growth effects 1. INTRODUCTION (IV): FORMS OF INTEGRATION Different forms of economic integration: Free Trade areas: United States, Mexico, and Canada Free Trade Agreement Rules of origin New Generation Free Trade Agreements (go beyond traditional issues) Customs Union: EU before 1992 New problem: policy coordination Common Market: MERCOSUR Economic Union: EU after 1992 Monetary Union: Eurozone 1. INTRODUCTION (VI): PROTECTIONISM Different types of protectionist measures: Import tariffs: a tax levied when a good is imported. Quotas: limitations on the quantity of imports. Export Subsidies: direct payment by the government to the exporter (usually in proportion to the volume of exports). Examples: More favorable credit conditions Insurance of certain risks Promotional activities organized by public agencies. Production subsidies: 1. INTRODUCTION (VII): PROTECTIONISM Other types of protectionist measures: Export Restraints: the exporting country curtails exports to the importing country. Popular today: China (e.g. rare earths) and US (advanced chips and chipmaking equipment) ¿Voluntary or not? Regulatory protectionism (Technical Barriers to Trade): norms that control the sale of goods in a particular market that can be used for protectionist ends. “Brussels effect” Embargo: the government of a country decrees that certain commodities must not be exported to certain countries (e.g. G7 ban on Russian oil) Exchange controls: government-imposed limitations on the purchase and/or sale of currencies. 1. INTRODUCTION (VIII): OBJECTIVES What are the objectives of trade protection? Raise domestic revenue: a tariff is probably one of the easiest taxes to collect. Protect domestic sectors: safeguard local businesses from foreign competition, especially in emerging or sensitive sectors. Protect Infant Industries: support new or growing industries until they become competitive globally. Prevent Dumping: shield domestic industries from unfair trade practices. Safeguard Jobs: preserve employment in domestic industries (e.g. America First). National security: Protect industries critical to national security and avoid dependence for manufacturers from outside producers (e.g. defense) AGENDA: THEORY OF ECONOMIC INTEGRATION 1. Introduction 2. Trade protection in a Small Open Economy 3. Customs Union 4. Common Markets 5. EU Focus: Common Commercial Policy 2. TRADE PROTECT (I): INTRODUCTION Objective: examine the various effects (consumption, allocation of resources,…) of the imposition of tariffs and non-tariff barriers on trade. Conclusion: welfare implications of trade policies have justified trade liberalization within EU Member States EU CP: tariff, quotas and subsidy rules are fixed by common EU rules As part of the European Community, the Member States have established a customs union (with common arrangements for imports from other countries). The Community's common commercial policy is therefore based on a common external tariff uniformly applied to all Member States. The are no trade barriers (such as tariffs, quotas) between Member States. However, non-trade barriers remain in place (Single European Act of 1986, Letta Report) 2. TRADE PROTECT (II): ASSUMPTIONS Import supply and import demand diagram Simplifying assumptions: Only two countries exist, country 1 (the home country) and country 2 (the rest of the world), Partial equilibrium, market for a homogeneous good X Price-taking country (i. e. "small" economy) There is perfect competition in factor and goods markets Production factors fully employed and mobile between industries but immobile between countries No transport costs 2. TRADE PROTECT (III): FREE TRADE Free trade equilibrium: 2. TRADE PROTECT (IV): EFFECTS FREE TRADE Free trade equilibrium: World market price is 𝑃𝑤 Consumers willingness to pay: 1+2+3+4+5+6 Consumers’ actual expenditures: 3+4+5 National production costs: 4 Consumer surplus: 1+2 Producer surplus: 3 Producer income: 3+4 Social Welfare: 1+2+3 2. TRADE PROTECT (V): TARIFF Tariffs are the simplest of trade barriers Its purpose was twofold: to provide revenue and to protect domestic sectors. Changes in tariffs represent the primary way in which countries either liberalize trade or protect their economies (“free trade”) However, the importance of tariffs has declined in modern times. In 2023, around 72 % of the imports that entered the EU did so at zero tariff Types of tariffs: Specific tariffs Ad valorem tariffs 2. TRADE PROTECT (VI): EFFECTS OF A TARIFF Effects of a tariff t on imports: 2. TRADE PROTECT (VII): EFFECTS TARIFF Effects of a tariff t on imports: Increase in domestic price: 𝑃𝑡 = 1 + 𝑡 𝑃𝑤 at the same world price 𝑃𝑤 Demand effect: domestic consumption decreases Production effect: domestic production increases Import effect: imports decrease by an amount equal to the sum of the two previous effects, Fiscal revenue effect: given by the absolute value of the tariff per unit of the commodity multiplied (that is, Pw 1 + t − Pw = tPw ) by the quantity imported (X2 X3 ). 2. TRADE PROTECT (VIII): EFFECTS TARIFF Redistribution effect of income from consumers to producers. Consumer surplus is reduced by 1+2+3+4 Producer surplus increases by 1 (redistribution from consumers, subsidy-equivalent of the tariff) Government receives import tariff by 3 (redistribution from consumers) Welfare loss compared to free trade 2: domestic production is more expensive than buying abroad 4: loss of consumption surplus 2. TRADE PROTECT (IX): EFFECTS TARIFF The cost of protection is actually greater than that found above. Other costs: Administrative cost (e.g. customs, border patrols, etc.) Displacement cost of the resources, since the tariff causes an increase in the domestic output and so a greater use of resources which will have to be shifted from other sectors Remember: we assume full employment Extreme case: prohibitive tariff 2. TRADE PROTECT (X): QUOTA Quotas are quantitative restrictions on trade Binding vs non-binding quota: excess supply or excess demand? Quotas are usually enforced through import licenses Auction: First-come, first served Subdivision of the licences among immporters EU example: textile and clothing quotas that existed under the Multifibre Arrangement (MFA) Today they are rare in the EU, but tariff rate quotas remain in place. 2. TRADE PROTECT (XI): EFFECTS QUOTA Effects of a quota on imports: 2. TRADE PROTECT (XII): EFFECTS QUOTA Effects of a quota on imports: Increase in domestic price: 𝑃𝑞 Demand effect: domestic consumption decreases Production effect: domestic production increases Import effect: imports decrease by an amount equal to the sum of the two previous effects 2. TRADE PROTECT (XIII): EFFECTS QUOTA Redistribution effect of income from consumers to producers. Consumer surplus is reduced by 1+2+3+4 Producer surplus increases by 1 (redistribution from consumers, subsidy-equivalent of the tariff) Welfare loss compared to free trade 2: domestic production is more expensive than buying abroad 4: loss of consumption surplus 2. TRADE PROTECT (XIV): EXAMPLE Effects of the US Import Quota on Sugar (real example, 2013) ¿What is the revenue of foreign importers? 2. TRADE PROTECT (XV): EXAMPLE ¿What is the revenue of foreign importers revenue? $453 million (subsidy) If we had the equations, we could also obtain: Producer surplus (1): $272 million Production loss (2): $68 million Consumption loss (4): $91 million Consumer loss (1+2+3+4): $884 million (2,5$ pc) The average American voter is unaware that the sugar quota exists, and so there is little effective opposition However, there are 6,500 farmers (Life-or-death issue, subsidy $42.000 per employee) Cost to consumers of every job “saved”: $432,000 2. TRADE PROTECT (XVI): QUOTA vs TARIFF ¿Are quotas and tariffs equivalent? An import quota always raises domestic price of imported good Equivalent tariff rate: 𝑃𝑞 = 1 + 𝑡 𝑃𝑤 However, the answer depends on the assumptions: ¿How are quotas licensed? ¿Do we need certainty in the desired quantity of imports? ¿Perfect competition? Moreover, quotas can have important effects into the market structure. This is the main difference that makes most economists advocate the imposition of tariffs rather than quotas. 2. TRADE PROTECT (XVII): QUOTA vs TARIFF Effects into the market structure: monopoly 2. TRADE PROTECT (XVIII): SUBSIDIES If the government subsidizes the domestic production of a commodity, this subsidy automatically becomes: An export subsidy as regards the exported part of the output, Or a subsidy to the importable sector if the commodity is importable Assumptions are important: Price-taking country (i. e. "small" economy) There is perfect competition in factor and goods markets Production factors fully employed and mobile between industries but immobile between countries No market failures 2. TRADE PROTECT (XIX): PRODUCTION SUBSIDY Effects of a production subsidy on imports: 2. TRADE PROTECT (XX): PRODUCTION SUBSIDY Welfare loss (orange triangle): inefficiencies are smaller since consumer price is not affected 2. TRADE PROTECT (XXI): PRODUCTION SUBSIDY Many subsidies can have effects on competition that go beyond the period in which the subsidy is actually provided For example, governments also frequently provide subsidies to finance wholly or partially the acquisition of fixed assets such as technology, plant, and equipment. They tend to have the effect of increasing investment by some firms in the relevant market, producing at greater scale. This may have an impact on the conditions of competition in world markets 2. TRADE PROTECT (XXII): PRODUCTION SUBSIDY Effects of a production subsidy on exports (large country case) Welfare gains: 1+2+3+4 However, producers loose 1 2. TRADE PROTECT (XXIII): MARKET FAILURES The impact of subsidies is relevant in market failure situations. When a difference exists between the actual price and the socially optimal price. This difference can arise from a number of sources (imperfect competition, information asymmetries, etc) Subsidy intervention is usually justified by economies of scale Internal: own expansion of the firm Average production costs decline the more units each company produces Large fixed costs: such costs may be due to significant investments in R&D or to the need for expensive and highly specialized capital equipment. External: expansion of the industry in which it operates (e.g. learning-by-doing) We will not study it here. 2. TRADE PROTECT (XXIV): MARKET FAILURES Assumptions: Two countries: EU, China produce solar panels Similar demand curves There is only one firm producing and production is subject to internal economies of scale Typical examples of such industries are the production of solar planes, advanced chips and the hydrogen industry. Without a subsidy, the Chinese firm is unable to produce profitably 2. TRADE PROTECT (XXV): MARKET FAILURES Initial equilibrium: China imports from the EU 2. TRADE PROTECT (XXVI): MARKET FAILURES Effects of a production subsidy on economies of scale Plan Made in China 2025 Effects: EU looses production Chinese firm produces Consumer gain Welfare gains? These factors shape dynamics of global solar industry Other factors: technological advancements, bankruptcy, control of key supply chains & policy-making mistakes 2. TRADE PROTECT (XXVII): MARKET FAILURES Subsidies as profit-shifting instrument (profits earned by the EU are transferred to CH) The case for free trade (“government failures”): High information requirements for appropriate intervention Rent-seeking on the part of beneficiaries Political Argument for Free Trade There are also international consequences in the form of subsidies, countervailing duties, or a legal dispute. However, a ramping up of subsidies by some of the world’s largest economies has contributed to a significant increase in global trade tensions 2. TRADE PROTECT (XXVIII): MARKET FAILURES 2. TRADE PROTECT (XXIX): MARKET FAILURES 2. TRADE PROTECT (XXX): LOOMING TENSIONS China booked a historic trade surplus with the EU of nearly €400bn in 2022. Many industries were developed with heavy state subsidies Example: Plan Made in China 2025 (targets in strategic industries) subsidies could account more than 50% of the cost of the product Growing clash between economic models (and political?): China: marries state policy and financial support with an aggressive private sector EU: market-oriented capitalism Concerns low-cost imports could flood EU markets and wipe out jobs in important industries. 2. TRADE PROTECT (XXXI): LOOMING TENSIONS Consequence: the EU are “de-risking” from China (in the US, “decoupling”) This implies: (1) diversification of sources of key products; (2) tightening FDI screening. In the EU, several measures have been approved: Diversification of suppliers of rare earths Inbound FDI screening (e.g. Telefonica – STC) Green Deal Industrial Plan NGEU Also in the US: Inflation Reduction Act, CHIPS Act,… However, Chinese experienced record “green exports” in 2023 (30% growth y-o-y) EU Anti-subsidy investigation into Chinese EV production (cumulative state spending in Chinese EV sector amounts for $125 bn). 2. TRADE PROTECT (XXXII): CONCLUSIONS Analysis of alternative trade policies using a partial equilibrium show important conclusions: Welfare loss of tariffs in a small country (free trade is optimal) Trade policy has winers and losers: producers vs consumers Difference between quotas and tariffs (e.g. market structure) Relevant effects of production subsidies (e.g. market failures) State support can backfire (e.g. incentives vs “picking” winners) This is relevant today as the EU is busy “de-risking” supply chains and pushing for greater strategic autonomy. The EU increased protectionism for industries deemed crucial to national security AGENDA: THEORY OF ECONOMIC INTEGRATION 1. Introduction 2. Trade protection in a Small Open Economy 3. Customs Union 4. Common Markets 5. EU Focus: Common Commercial Policy 3. CU (I): INTRODUCTION Since 1958, Europe has liberalized trade and factor markets... In 1957, the Treaty of Rome committed the six original EU members to eliminate all tariffs and quotas on trade among themselves But it also committed them to completely harmonize their tariff on imports from non- member nations. By 1968, EU members had established a customs union. No customs duties to be paid when goods are transported from one EU country to another. They impose tariffs on imports from the rest of the world (UK, Canada, Japan, US,…) Today, the customs duty from goods imported into the EU makes up around 14% of the total EU budget as part of its ‘traditional own resources.’ 3. CU (I): INTRODUCTION Since 1958, Europe has liberalized trade and factor markets... In 1957, the Treaty of Rome committed the six original EU members to eliminate all tariffs and quotas on trade among themselves But it also committed them to completely harmonize their tariff on imports from non- member nations. By 1968, EU members had established a customs union. No customs duties to be paid when goods are transported from one EU country to another. They impose tariffs on imports from the rest of the world (UK, Canada, Japan, US,…) Today, the customs duty from goods imported into the EU makes up around 14% of the total EU budget as part of its ‘traditional own resources.’ 3. CU (II): DEFINITION & WELFARE EFFECTS A customs union occurs when a group of countries agrees to eliminate tariffs among themselves and set a common external tariff on imports from the rest of the world Avoids the problem of developing complicated rules of origin but introduces the problem of policy coordination. With a customs union, all member countries must be able to agree on tariff rates across many different import industries. It might seem that, since a customs union represents a step towards the ideal situation of free trade, it will improve social welfare. Is this correct? 3. CU (III): THEORY OF SECOND BEST However, this is not the case, as demonstrated by the theory of second best When the Pareto-optimum conditions are violated, the elimination of part of these violations does not necessarily bring about an improvement. In other words, once one or more of the Pareto-optimum conditions is violated, it is not necessarily true that the (second) best situation is that in which all the remaining conditions are fulfilled. Intuition (Meade)  3. CU (IV): TRADE CREATION & DIVERSION We must therefore examine the effects of the formation of a customs union more closely. The original work is from Viner (1950), then completed by Johnson. Two key concepts in assessing the overall welfare effects of CU: Trade creation: enables a member country to import goods from a more efficient partner within the union rather than producing them domestically This brings about a better allocation of resources (producers & consumers) Trade diversion: a member country starts importing goods from a less efficient partner within the union, rather than from a more efficient country outside the union. This leads to a worse allocation of resources.  3. CU (V): INITIAL SITUATION Better to explain these effects, we must consider: The analysis uses a partial equilibrium framework We assume in each case that there are two countries (A, B) and the rest of the world. Two small countries A and B, which means that they take international prices as given. Draw supply and demand curves for Countries A and B before CU: o 𝑃𝑤 represent the free trade supply prices of the good from the rest of the world. o We assume that country A has a specific tariff, 𝑡 = 𝑡 ∗ 𝑃𝑤 , set on imports from the rest of the world to protect national production. ▪ The tariff raises the domestic supply prices to 𝑃𝑡. 3. CU (VI): INITIAL SITUATION  3. CU (VII): CUSTOMS UNION Countries A and B form a Customs Union with a Common External Tariff (CET). o Union Price is 𝑃𝑈 , o Country A would now import the product from Country B after the CU rather than the rest of the world. o All imports from country A are exported by country B.  3. CU (VIII): CUSTOMS UNION In both countries, equilibrium is reached at 𝑷𝑼 There are no imports from the rest of the world since 𝑃𝑈 is lower than the free trade supply prices plus the specific tariff. 3. CU (IX): EFFECTS ON COUNTRY A 3. CU (X): EFFECTS ON COUNTRY A Effects of the CU on the importing country A: Decrease in domestic price: from 𝑃𝑡 = 1 + 𝑡 𝑃𝑤 to 𝑃𝑈 Demand effect: domestic consumption increases Production effect: domestic production decreases Import effect: imports increase by an amount equal to the sum of the two previous effects, 3. CU (XI): EFFECTS ON COUNTRY A Welfare effects: Trade creation: creates trade that would not have existed otherwise. Positive production efficiency gain (+b) Positive consumption efficiency gain (+d) Trade diversion: diverts trade away from a more- efficient supplier outside the CU (the rest of the world) and toward a less-efficient supplier within the CU (country B). Imports from B are more expensive than from the rest of the world (-e) 3. CU (XII): EFFECTS ON COUNTRY A Redistribution effect of income from producers to consumers. Consumer surplus increases by 1+2+3+4 Producer surplus es reduced by 1 Government looses import tariff by 3 (redistribution to consumers) Welfare gains compared to free trade +2: domestic production is more expensive than buying abroad +4: consumption surplus -5: trade diversion 3. CU (XIII): EFFECTS ON COUNTRY B 3. CU (XIV): EFFECTS ON COUNTRY B Effects of the CU on the exporting Country B: Tariff removal in Country A enables Country B to export there at a price above 𝑃𝑤 Price increases to 𝑃𝑈 Production effect: domestic production increases Demand effect: domestic consumption decreases Export effect: export increase by an amount equal to the sum of the two previous effects, 3. CU (XV): EFFECTS ON COUNTRY B Redistribution effect of income from producers to consumers. Consumer surplus decreases by 1+2 Producer surplus increases by 1+2+3 Welfare gains compared to free trade: +3 Trade creation: +3: 3. CU (XV): EFFECTS ON COUNTRY B Redistribution effect of income from producers to consumers. Consumer surplus decreases by 1+2 Producer surplus increases by 1+2+3 Welfare gains compared to free trade: +3 Trade creation: +3:  3. CU (XVI): EMPIRICAL EVIDENCE Empirical evidence that the formation of the EEC lead to trade diversion (“supply switching”). o When the EEC eliminated tariffs on a discriminatory basis during the formation of the CU between 1958 and 1968, we see that the share of EEC imports from other nations fell. ▪ Part of the displacement occurred with respect to imports from other non-EEC European nations. As the dark bars show, the import share from six other West European nations (the UK, Ireland, Portugal, Spain, Denmark and Greece) feel by an small amount. ▪ The main displacement came from the rest of the world, mainly imports from the USA.  3. CU (XVII): TERMS OF TRADE Terms of Trade (ToT) are defined as the quantity of one good that exchanges for a quantity of another (𝑃𝑋 /𝑃𝑀 ) They are the relative prices of a country's export to import. An improvement in a nation's terms of trade means that it has to pay less in terms of exports for the imports it receives. A small economy has no impact on world market prices, ToT are given. … but a large economy has market power Its trade policy may influence relative prices.  3. CU (XVIII): TERMS OF TRADE Suppose A and B set a common external tariff that is not prohibitively high. o Imports will enter the CU at 𝑃𝑊 , domestic consumers pay the tariff.  3. CU (XIX): TERMS OF TRADE Now suppose A and B are small individually, but not jointly. Their joint trade policy will then have an impact on 𝑃𝑊 Demand reduction from CU leads to a reduction in 𝑃𝑊 , so the price in the Customs Union rises by less than the tariff. The imposition of a tariff reduces imports (compared to free trade) Reduces welfare by the two orange triangles (consumption, production effects) However, it improves Terms of Trade: Imports become relatively cheaper increases welfare by blue rectangle Part of the tariff now paid for by Rest of the World! 3. CU (XX): TERMS OF TRADE  3. CU (XXI): ECONOMIES OF SCALE Brief recap on economies of scale (remember Ch. 2) Two types: Internal: because of the own expansion of the firm Average production costs decline the more units each company produces Such costs may be due to significant investments in R&D or to the need for expensive and highly specialized capital equipment (large fixed cost of entry) Industries characterised by increasing returns to scale External: because of the expansion of the industry in which it operates (e.g. cluster effect) E.g. if you set up a chemical firm in the Ruhr Valley, Germany, it is efficient for suppliers to meet a larger base of purchasers) Other reasons: skilled labour, learning by doing. 3. CU (XXII): ECONOMIES OF SCALE Assumptions: Two countries: France, Spain produce good X Similar demand curves One firm producing and production is subject to internal economies of scale Initial equilibrium without a CU, The Spanish firm is unable to produce profitably. It imports good X from world market with tariff; no domestic production. The French firm produces good X with economies to scale Supply curve: average cost pricing rule (at marginal cost: losses!) Domestic equilibrium price 𝑃𝐹𝑅 protected by a tariff 3. CU (XXIII): ECONOMIES OF SCALE 3. CU (XXIV): ECONOMIES OF SCALE Now suppose that Spain and France form a CU: 𝑃𝑈 equalizes total demand and supply We assume that 𝑃𝑈 < 𝑃𝑅𝑜𝑊 + 𝐶𝐸𝑇 so there are no imports from the RoW. The fact that 𝑃𝑈 < 𝑃𝑅𝑜𝑊 is explained because a larger market size allows exploiting economies of scale Welfare effects? 3. CU (XXV): ECONOMIES OF SCALE 3. CU (XXVI): ECONOMIES OF SCALE Welfare effects of a CU with Economies of Scale: Spain. Consumers gain: A+B Government looses: C Trade Creation effect: B Trade Diversion effect: -C France: Consumers gain: D+E Producers still make zero profits Cost reduction effect: D+E  3. CU (XXVII): CU vs FTA The 1957 Treaty of Rome committed the six original EU members to eliminate all trade barriers and to completely harmonize their tariffs on imports. As a reaction other West European nations formed the European Free Trade Association (EFTA) in 1960. This was not a customs union, only a free trade area. Why did the EEC go for a CU while the EFTA went for a FTA?  3. CU (XXVIII): CU vs FTA In a FTA, trade deflection leads to the establishment of rules of origin. However, these rules have many problems: It is difficult to know where a product is made in today’s globalized markets. These rules are expensive to comply with: empirical evidence of Brenton and Manchin (2003) preferences schemes for developing countries (only one third). However, it is difficult to get a group of nations to agree on a CET. This requires all members to agree on a common negotiating position on every single product (e.g. dumping). As a result, most trade blocks such as the NAFTA are free trade areas rather than CU. Another way to solve the decision-making problem is for the members to let one nation decide everything (e.g. South Africa is the dominant nation in the Sothern African Customs Union). AGENDA: THEORY OF ECONOMIC INTEGRATION 1. Introduction 2. Trade protection in a Small Open Economy 3. Customs Union 4. Common Markets 5. EU Focus: Common Commercial Policy 4. CM (I): INTRODUCTION We will study the impact of the impact of a common market on trade, labour and capital flows. In the EU, after the removal of tariffs and quotas between EU countries in 1968 (CU), many technical, physical and fiscal barriers still made it easier for companies to sell in their local markets than in other EU markets. Moreover, there were many barriers to labour and capital flows. As a result, since the mid-1970s. (1986 Single European Act) the economic integration in Europe involved the establishment of a Common Market. Today, EU citizens have a common passport, can work in any EU member country, and can invest throughout the union without restriction. This integration process was seen as a form of cooperation between European countries that woud serve as pillar for further political integration. 4. CM (II): INTRODUCTION A common market establishes free trade in goods and services, sets common external tariffs among members, and also allows for the free mobility of capital and labour across countries. We will study the effects of higher mobility of (with an EU focus): Labour flows Capital flows Goods and services  4. CM (III): LABOR MOBILITY It assumes two countries (Spain, Germany) that produce the same good (cars) and that can allocate its labour supply between the countries. The production process uses identical technology and two factors (capital K and labor L). The total supply of K and L is fixed. Perfect competition (implicit in the construction of the diagram) We will use the specific factors model (Paul Samuelson & Ronald Jones). Diagram for Spain (from left to right) and one for Germany (from right to left) Initially there is no international factor mobility: supply of both factors is fixed in each country  4. CM (IV): LABOR MOBILITY The length of horizontal axis represents the total labor supply: 𝐿 The vertical axes represent the marginal product of labor 𝑀𝑃𝐿 and wage rate 𝑊 The demand curve for labor in each country is the marginal product of labor The equilibrium with full factor employment (labor demand = labor supply) The equilibrium wage rate and allocation of labor for each country Germany has less labor: has a higher equilibrium wage rate 𝑊𝐺𝐸𝑅 > 𝑊𝐸𝑆 Each country's national income (total output of Y) equals the area under the MPL-curve up to the point of equilibrium: National income of each country is distributed between the two factors of production, labor receiving the wage bill, (wage workers), and capital gets the rest; 4. CM (V): LABOR MOBILITY  4. CM (VI): LABOR MOBILITY Form a CM in which workers can move freely between countries (e.g EU). Since 𝑤𝐺𝐸𝑅 > 𝑤𝐸𝑆 , workers form Spain will move to Germany to work for a higher wage rate. This reduces Spain's labor force and increase Germany ‘s (and raises Spain's wage rate and reduces Germany ‘s). Until the wage rate in the two countries is equalized (𝑤𝐺𝐸𝑅 = 𝑤𝐸𝑆 ) and their marginal product of labor in the two countries is the same 𝑀𝑃𝐿𝐸𝑆 = 𝑀𝑃𝐿𝐺𝐸𝑅 Reallocating the labor force between the two countries has the following effects: Spain's income falls and Germany’s rises There is a net increase in the Common Market's income. Income of workers in Spain rises and its capital income falls (in Germany is the opposite) 4. CM (VII): LABOR MOBILITY 4. CM (VIII): LABOR MOBILITY COCLUSIONS Free international mobility of labor is beneficial for the CM as a unit But some member countries and income groups gain, others lose (as with commodity trade). While collectively both nations gains, migration creates winners and losers in both nations. This insight is crucial to understanding the real drivers of populist parties in the EU today. The 2015 wave of immigrants crossing from Turkey played a pivotal role in the rise of populism in many EU nations. In the Brexit debate, intra-EU immigration attracted a lot of attention in public debates. However, there are three main reasons why economists generally do not emphasise the income distribution effects of the EU's common market… 4. CM (IX): LABOR MOBILITY 1. Income distribution effects are not specific to the common market. ▪ Any change in a country's economy (including TP, consumer preferences, the depletion of old resources such as Russian gas, and so on) affects the distribution of income. 2. It is always better to allow trade and compensate those who are hurt by it than to prohibit trade. ▪ All modern industrial countries provide some sort of “safety net” of income support programs (e.g. subsidized retraining and relocation programs) that can cushion the losses of loosers. 3. Those who stand to lose from increased trade are typically better organized than who stand to gain (because the former are more concentrated within regions and industries). ▪ This imbalance creates a bias in the political process that requires a counterweight.  4. CM (X): LABOR MOBILITY IN THE EU The free movement of workers was a key element of the Treaty of Rome. Allowing workers to move freely within the EEC was meant to enhance economic efficiency (allowing workers to find the jobs that best suit their skills and experience, etc). On a political level, the architects of the EU hoped that mobility would foster understanding among the peoples of Europe. It was largely uncontroversial and in the early decades there was a lot of migration from, for example, Italy to the rest of the EU. This migration was welcomed by receiving nations since the booming EU economies in the late 1950s and 1960s created widespread labour shortages in many European nations. It was also welcomed in the sending nations as a “useful escape valve” to relieve the pressures of unemployment in, for example, southern Italy.  4. CM (XI): LABOR MOBILITY IN THE EU Labour mobility in the EU took a big step forward with the 1992 Maastricht Treaty. This created EU citizenship, and this in turn, gradually led to the right of any EU citizen to travel to, study in, retire in or live in another EU nation. In other words, the free movement of workers turn into the free movement of people. This right was consolidated in the “Citizenships Directive” of 2004. This European law gave, for example, British retirees the right to retire to Spain, a right that has been lost due to Brexit (it is still possible but no longer automatic) It also gave equal rights to all EU citizens when it comes to, for example, access to healthcare and education when they are in another EU state. This is why EU nations have to charge the same university fees to citizens from other EU nations, even when they charge higher fees to non-EU citizens.  4. CM (XII): CAPITAL MOBILITY If we assume that capital is internationally mobile, the analysis is similar to that of labor mobility. Difference between the two cases: a capital flow from one country to another does not necessarily mean that the ownership of capital has changed! This is the case of capital moving between countries as FDI: partly at least is repatriated as incomes to the owners of capital. Therefore, as the income earned on capital invested abroad is part of the national income, the benefits of capital reallocation in an integrated financial market may be shared between the partners in the common market. Similar considerations might apply if migrant workers repatriate their savings (or remittances). 4. CM (XIII): CAPITAL MOBILITY  4. CM (XII): CAPITAL MOBILITY Another difference takes into account differences in technology. We assumed that the two countries, Spain and Germany, share the same technology It is possible that the capital exporting country has a superior technology to that of the capital importing country. Capital can become the carrier of advanced technology leading to positive welfare effects. Capital market liberalization -> shifts upward the MPK of Spain -> further reallocation of the capital stock -> increase in income The transfer to technology in a common market would have consequences not only on the static effects of economic integration but also on the growth prospects of the participating countries (“pro-growth effect”) 4. CM (XIII): CAPITAL MOBILITY  4. CM (XIV): CAPITAL MOBILITY IN THE EU The Single European Act 1986 encouraged the free movement of capital by giving it as much importance as the free movement of goods and services. After 1 July 1990, fully liberalisation of capital movements (criterion for entry into EMU) The Maastricth Treaty (1992) required that all restrictions on the movement of capital between EU countries and between EU countries and non-EU countries be prohibited unless they are necessary to pursue legitimate public interests Examples: individuals (easy to buy shares of non-domestic companies) and companies (can invest in other EU businesses, FDI) Exceptions: pandemic, EU investment screening framework However, capital markets not fully integrated -> Capital Markets Union 4. CM (XV): MOBILITY OF GOODS AND SERVICES One of the key economic rationales for the Common Market was to achieve a market as large as that of the US by integration European nations economically. European leaders worried to often that Europe had a problem of “too many, too small” markets, especially compared to the US, Japan and China. Before the EU Single Market Act, EU firm used to dominate their home market while being marginal players in other EU markets It is called market fragmentation (MF): market shares of companies are very different across markets (companies having much higher market shares in their local market). A good example is the European car market, where one still sees the share of German cars in in Germany being much higher than the share of German cars in Italy. MF reduces competition which, in turn, raises prices in all markets. Barriers keep too many firms in business -> AC are high -> lack of competition -> inefficiencies  4. CM (XVI): MOBILITY OF GOODS AND SERVICES Launched in 1992 under the leadership of Jacques Delors, the SMA was intended to tear down may of the intra-EU barriers that had fragmented markets. The programme listed approximately 300 physical, fiscal and technical measures to reduce the real cost of selling across EU borders Mutual recognition: products lawfully marketed in one Member State may be sold in any Member State Harmonization of VAT: 1977,1993 The de-fragmentation of EU markets produced a “pro-competition effect” which put pressure on profits and the market’s response was a “merger mania”. That is, it squeezed the least efficient firms, prompting and industrial restructuring whereby Europe’s weaker firms merged or were bought out. Other effects: cost reduction, pro-growth effects, etc. 4. CM (XVII): MOBILITY OF GOODS AND SERVICES Ultimately, Europe was left with a more efficient industrial structure, with fewer, bigger, more efficient firms competing with one another. In some industries, restructuring was accompanied by a sizeable reallocation of employment, as firms closed inefficient plants, a painful process for workers. Governments very often attempt to offset this political pain by providing “state aid” to their national firms. Such state aid can be viewed as unfair and undermine the interest in European Integration. To avoid this problems, the Treaty of Rome established rules that prohibit state aid that distorts competition. In other industries, however, liberalization unleashed a virtuous cycle of more competition, lower prices, higher sales and higher employment.  4. CM (XVIII): MOBILITY OF GOODS AND SERVICES The empirical evidence has looked at the empirical behaviour of European mark-ups (Bellone et al., 2008) The authors concluded that the implementation of the SMA and its follow up in the EMU Treaty lowered the price-cost ratio of French manufacturing firms by 4 or 5 p.p.. The Office for Budget Responsibility looked at the impact of Brexit on the UK economy. Trade disruption from leaving the EU SM would reduce Britain’s: Exports and imports by around 15 per cent in the long run. Total income by one half of one per cent in the short run Long-run productivity growth by 4 per cent The reason is that they forecast an increase in non-tariff barriers on trade  4. CM (XIX): CONCLUSIONS Common markets benefit the unit as whole, but some member countries and income groups gain, others lose (as with commodity trade). New (and old) positive effects arising from CU: Cost reduction” effect “Pro-competition” effect Technology transfer “Pro-growth” effect These effects justified the EU Internal Market: Cecchini Report (1988) The Cost of Non-Europe in the Single Market (e.g. 4-6.5 p.p. growth rate in 6-years)  4. CM (XX): CONCLUSIONS Common markets benefit the unit as whole, but some member countries and income groups gain, others lose (as with commodity trade). New (and old) positive effects arising from CU: Cost reduction” effect “Pro-competition” effect Technology transfer “Pro-growth” effect These effects justified the EU Internal Market: Cecchini Report (1988) The Cost of Non-Europe in the Single Market (e.g. 4-6.5 p.p. growth rate in 6-years) Today, further integration is needed (Letta Report 2024, “The Single Market at 30: Nobody falls in love with a CM”)  4. CM (XXI): CONCLUSIONS The SMA lead to above-expected growth by inducing above-expected investment: Left chart: impact of GDP over time of the deepening of European integration after the SMA between 1986 and 1992 Right chart: GDP gains after Spanish accession to the EU (discl. other EU policies in place) AGENDA: THEORY OF ECONOMIC INTEGRATION 1. Introduction 2. Trade protection in a Small Open Economy 3. Customs Union 4. Common Markets 5. EU Focus: Common Commercial Policy  5. CCP (I): INTRODUCTION The EU has achieved such levels of integration through the development of external relations with third countries, many of them largely through the EU trade policy. EU trade policy one of the main instruments through which the EU plays its role in the world, because of: The EU influence on the global economy: the EU the world's largest common market, the largest exporter and importer, and the largest emitter of FDI. Can help address the current challenges facing the EU: questioning of multilateralism based on common rules by some countries; China's state subsidy policies; Russia's invasion of Ukraine; new protectionist tendencies in countries such as the US, etc.  5. CCP (II): MAIN ELEMENTS Trade policy is an exclusive EU competence. EU (EC) manages all aspects of trade on behalf of its member states, ensuring a unified and consistent approach to trade relations with non-EU countries Benefits of unified approach: act as a large economic bloc The EU manages trade relations with third countries in the form of: Autonomous trade policy: trade measures that the EU implements unilaterally, without the need for agreements with third countries. Conventional trade policy: based on bilateral or multilateral agreements negotiated between the EU and third countries or economic blocs  5. CCP (III): AUTONOMOUS TRADE POLICY CET: tariffs on imported goods Trade defence instruments means of protecting EU producers from harm and tackling unfair competition from foreign companies. E.g. Anti-subsidy (countervailing) measures to neutralize the effects of such subsidies. In response to rising concerns about state-backed industries, particularly from countries like China, the EU has been intensifying its scrutiny of subsidized imports Sanitary and phytosanitary regulations: standards the EU imposes unilaterally to control the quality and safety of products entering its market. Foreign direct investments (FDIs): EU coordination of scrutiny of FDI from third countries in strategic sectors in order to check that they do not threaten security  5. CCP (IV): CONVENTIONAL TRADE POLICY Trade Agreements: The EU negotiates various types of trade agreements to enhance economic cooperation. These agreements can include: Free Trade Agreements (FTAs) or CU: eliminate or reduce tariffs and other trade barriers. Economic Partnership Agreements (EPAs): designed to promote development via preferential access, mainly with African, Caribbean, and Pacific (ACP) countries. Investment Agreements: protect EU investments in third countries. WTO Rules and Multilateral Agreements: actively participates in multilateral trade negotiations within the WTO framework, aiming to create a global trading system based on fair rules  5. CCP (V): TRADE POLICY EU Trade policy can help achieve other EU goals: Development: Generalised Scheme of Preferences EU is the world’s largest provider of Aid for Trade Climate change: Carbon Border Adjustment Mechanism (in 2026) EU tariff to put a fair price on the carbon emitted during the production of carbon intensive goods that are entering the EU (carbon price of imports = carbon price of domestic production) Objetives: avoid carbon leakage & encourage cleaner industrial production in non-EU countries Strategic autonomy: Anti-Coercion Instrument: To protect themselves from economic coercion by third countries (also a deterrent and a countermeasure of last resort). EU’s ability to make its own choices