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European Economics

A lot of the answers to these questions can be found in the history of European economic integration. The scale of the devastation of the Second World War is the key to understanding the post1945 drive for European integration. The economic, political and humanitarian situation in Europe was dire (=sinistre) in the year 1945-45: - Food production was low, and 46-47 winter was especially harsh, hunger was widespread - Much of Europes infrastructure lay in ruins - Many Europeans were dependent on humanitarian aid - Governmental and constitutional crises in Western Europe HOW TO AVOID ANOTHER WAR?

1) Germany was to blame = Morgenthau plan

Not a solution (the cause of the second world war) solution = communism

2) Capitalism was to blame 3) Nationalism was to blame European integration The third solution prevails in Western Europe but far from clear in the late 40s: most European nations were either struggling to re-establish their governments and economies or were under direct military occupation. Moreover, the idea capitalism was to blame took place in many European countries. Cold War: USSR pushes communism in the East. The Soviets imposed the Berlin Blockade on 24 June 1948. Western powers countered with the Berlin air Bridge. In 949, the Federal Republic of Germany was established. UK, French and US zones merged by 1948 in moves towards creation of West German government. The merger of the French, US and UK zones was a defining moment in Europe. Tentative and ideologically based support for European integration came to be reinforced by western European nations pursuing their own interests. Neuter Germany solution abandoned for strong West Germany + European integration to the defense of liberal democracy in Western Europe. o Position France: looking for an ally (Franco-German integration as a way of counterbalancing US-UK influence on the Continent)

o Position UK-USA: against communism


o Position Germany: back to normality First steps of the OEEC and EPU From the perspective of UE integration, the most important result of the western European effort to resist communism was the Marshall Plan (financial assistance) and the OEEC. - OEEC = Organization for European Economic Cooperation was created to help administer the Marshall Plan by allocating American financial aid and implementing economic programs for the reconstruction of Europe after World War II. OEEC coordinated aid distribution and prompted trade liberalization (reducing intra-European trade

- EPU = European Payments Union. Trade was based on US dollar reserves (the only acceptable reserve currency), which Europe lacked. Therefore, the transfer of money (immediately after each transaction) increased the opportunity cost of trading. This situation led the OEEC to create the EPU. The EPU multilateralized the bilateral deals.
Each month, EPU members added up the deficits and surpluses in their bilateral trade accounts with other EPU members. These were offset against each other so that each nation remained with an overall surplus or deficit with respect to EPU. The great advantage of this was that no longer debt to one country in particular so no (dis)incentive to import and export to a particular partner. The trade surplus with the US allowed European national central banks to accumulate dollar reserves.

It facilitated payments and fostered liberalization The OEECs trade liberalization was important in 2 ways: - The liberalization fostered a rapid growth of trade and incomes - The thinking of policy markers changed! In the 1930s: nationalism for economic competition. In the 1940s and 1950s: see than liberalism fostered growth trade liberalization Two strands of European integration: federalism and intergovernmentalism Immediate disagreement about depth of European integration: - Federalism: supranational institutions
To prevent another third world war, nations should be embedded in a federalism structure. (Belgium, the Netherlands, Luxembourg, France, Austria, Germany and Italy)

Intergovernmentalism: nations retain all sovereignty

Nation-states are the most effective and most stable form of government (the UK, Denmark, Norway, Iceland, Ireland, Sweden, Switzerland)

Intergorvernmentalism initially dominated the post-war architecture. In part, this was simply a matter of timing. Indeed, the only major European nation with a truly effective democratic government before 1947 was Britain, a firm believer in intergov.

The first 3 organizations (OEEC, the Council of Europe and the Court of Human Rights) follow the intergov tradition. The first big federalist step came in 1951with the ECSC (European Coal and Steel Commodity). This Plan was promoted by French Foreign Minister, Robert Schuman as a way to prevent future war and make them materially impossible. This created a group a nations known as The Six (France, Germany, Belgium, Luxembourg, the Netherlands and Italy), a group that has been the driving force behind European integration ever since.
By the time the ECSC was in operation, Europe was a very different place from what it had been in 1945. Cold war tensions were high. Economically, the Six managed to get their economies back on track, having experienced miraculous growth.

Failed integration: The Six as a whole, but especially Germany grow spectacularly, while East-West tensions continued to mount German rearmament was essential. In 1995, the ECSC might not be enough to ensure that another Franco-German war remain unthinkable. In 1995, Germany joined the NATO (North America Treaty Organization, the Western Europes main defense organization). (Vs. the Warsaw Pact) Federalism track: The treaty of Rome (1995) Having failed to move directly to political or military integration, European leaders turned their minds to broader economic integration. Treaty of Rome = the EEC (the European Economic Community), signed by the Six and came into force in 1958. It committed the Six to extraordinarily deep economic integration. - Forming a customs union (removing all tariffs and quotas on intra-EEC trade and adopting a
common tariff on imports from non-members nations)

- Free labor mobility - Capital market integration - Free trade in services - A range of common policies Some of which were to be implemented by a supranational body. Intergovernmental track: EFTA Fearing the discrimination of the EEC, 7 of the outsiders countries reacted by forming their own bloc in 1960: the EFTA, the European Free Trade Association (led by UK)

2 non-overlapping circles Evolution to two concentric circles: As barriers began to fall within the EEC and within EFTA but not between the 2 groups, discrimination appeared ( lost profit opportunities for exporters). The relative economic weight and economic performance of the 6 EEC nations was much bigger: the GDP of the 6 EEC was more than twice that of the 7 EFTA. The EEC was far more attractive to exporters so that the pressures on EFTA members to adjust were much greater. Domino theory of regional integration: the preferential lowering of some trade barriers creates new pressures for outsiders to join the trade bloc and as the trade bloc is bigger, the pressure to join grows.

In 1961, UK applied for EEC membership. Other countries (Ireland, Denmark and Norway) followed in order not to face discrimination in an even larger market. Germany was in favour of UK membership (and others) but France was not (twice non from Charles de Gaule). They (excluding Norway) finally enter the EEC in the 1973. = 1st enlargement To avoid more disadvantage for remaining EFTA nations, they set bilateral free trade agreements (FTAs) between each remaining EFTA and EEC. By the mid-1970s, trade agreements in Western Europe had evolved into two concentric circles.

Euro-pessimism (1975-1986) Political shocks The spectacular good economic performance of Europes economies in the 1950s-1960s, teamed with the manifest success of European economic integration, went restoring the confidence of Europeans in their governments ability to govern. So much so that some nations began to regret the promises of deep integration they made in the Treaty of Rome. This was the case of the French president, Charles de Gaulle in 1966. With the Luxembourg Compromise, he forced the other EEC members to accept his point of view and transformed the majority voting in unanimity. It had enormous impact: all progress on economic integration was blocked due to unanimity until the new majority voting in 1986. Failure of monetary integration US inflation was transmitted into inflation in Europe. This led to gradual breakdown of the global fixed exchange rate system. The EEC searched for ways of restoring intra-European exchange rate stability and established the Werner Committee (=plan for European monetary union) in 1971. But oil shock + US inflation European nations adopted expansionary monetary and fiscal policies stagflation = falling of income and rising inflation monetary integration failure Failure of deeper trade integration As tariff barriers fell, Europeans created new trade tariffs: Technical barriers to trade TBT. They tried in 1969 to remove this TBT but failed. It had the effect of fragmenting the European market. Harmonization proceeded much more slowly than the development of new national barriers. + Highly interventionist policies are one of the most important reasons for poor economic performance for 10 years. Little progress in European integration

BACK TO UE INTEGRATION- Bright spots: 2nd enlargement = 1981: Greece 3rd enlargement = 1986: Portugal and Spain EEC- 12 EMS (= European Monetary System) set up in 1979 and had good success in stabilizing intra-EEC exchange rates. Budget Treaties in 1970 and 1975

Starting in 1984, economic growth recovered.


Single Market Programme = EC92


Jacques Delors was chosen in 1985 to be President of the European Commission = the most important increase in European economic integration since the 1950s. The Single European Act reinstated majority voting on most economic integration issues. This led to a sweeping economic integration effort known as the Single Market Programme. The plan was framed to transform the Common Market into the Single Market. Goal of the Single Market Programme: reinforce the four freedoms (free movement of goods, services, people and capital) promised by the Treaty of Rome (that was far from being
reality due to national safety regulations: TBT).

Concrete steps: Goods trade liberalization o Streamlining or elimination of border formalities, o Harmonisation of VAT rates within wide bands o Liberalisation of government procurement o Harmonisation and mutual recognition of technical standards in production, packaging and marketing Factor trade liberalization o Removal of all capital controls o Increase in capital market integration o Liberalization of cross-border market-entry policies,

The EEA and the 4th enlargement: 1994 EC-12 integration strengthened the force for inclusion in remaining EFTAns = domino effect. Jacques Delors forced the decision in 1989 by proposing the EEA, European Economic Area agreement: an agreement that extend Single Market to EFTA economies. No: Switzerland, Norway, Liechtenstein and Iceland

Communisms creeping failure Anyone could see that the wests economic system (free markets and an extensive social welfare system) teamed with the multi-party democracy political system provided far better living standards than the easts system of planned economies and one-party rule. By 1980, the inadequacy of the Soviet system forced changes onside the URSS: The URSS adopted: a policy of timid pro-market reforms (perestroika) A policy of openness (glasnost)

which involved a marked reduction internal repression and diminished intervention. Pro-democracy forces in the CEECs (Central and Eastern European Countries) found resistance. By the end of 1989, democratic forces were in control in Poland, Hungary, Czechoslovakia and East Germany. 1990: Germany reunification. 1991: end of Soviet Union. Creation of the EU: the Maastricht Treaty The reunification of Germany raised many fears due to the size of the country. Jacques Delors proposed a radical increase in European integration: the Maastricht Treaty, signed by the EEC members in 1992. It is the result of the Soviet Union collapse (external) and success of the Single European Act (intern). The Maastricht Treaty proposes the formation of the monetary union. Europe Agreements: Each CEEC wanted to join the EU but the EU was reluctant in early 1990s. They concluded Europe Agreements, which established bilateral free trade between the EU and each individual CEEC. CEEC adopted some EU laws and practices that helped them to establish market economies faster. The Europe Agreements stopped short of offering EU membership. EU countries were not willing to enlarge towards eastern. Copenhagen criteria 1993: Decision of associating CEEC to UE conditional to the Copenhagen criteria: Political stability of institutions that guarantee democracy, the rule of law, human rights and respect for an protection of minorities A functioning market economy capable of dealing with the competitive pressure and market forces with the Union Acceptance of the Community acquis (EU laws in its entirety,..) and ability to take on the obligations of membership, including adherence to the aims of political, economic and monetary union.

Preparing for eastern enlargement Impending enlargement required EU to reform its institutions. The reform of EU institutions for enlargement began in 1993. 1 tries: - Amsterdam Treaty, 1997 o A tidying up of the Maastricht Treaty. More substantial role for the EU in social policy, flexible integration. o The treaty failed. Amsterdam leftovers: voting rules in the Council of Ministers, number of Commissioners, - Nice Treaty, 2000 o The goal is to solve problems not solved in the Amsterdam Treaty. o Seen as a failure - Draft Constitutional Treaty, 2003 - Constitutional Treaty 2004 o Improved decision-making rules for Council of Ministers and slightly more majority voting o Inclusion of Charter of Fundamental Rights o Moves towards more coherent foreign policy o France and the Netherlands reject the CT in 2005 o EU leaders decided to suspense the formal ratification timetable and declared a period of reflection.

Lisbon Treaty: 2007 The reforms in the Constitutional Treaty were the best reforms that were politically accepted to all EU members. The plan therefore was to include the main Constitutional Treaty reforms in the Lisbon Treaty but to package them very differently.

SUMMARY: European integration has always been driven by political factors ranging from a desire to prevent from another European war. While the goals were political, the means were always economic. 3 big increases in European integration: Formation of customs union from 1958 to 1968 eliminated tariffs and quotas on intra-EU trade The Single Market Programme implemented between 1986 and 1992 The Economic and Monetary Union

The 2 first had discrimination effects that trigger reactions in the non-members nations.


2.1. Facts
Population - 6 big nations (> 35 millions): Germany, UK, France, Italy, Spain and Poland - 8 small nations (8 to 11 millions): Greece, Belgium, Portugal, Sweden, Austria, Czech Republic and Hungary - 11 tiny nations (together make up less than 5% of EU 25 population) : Slovak Republic, Denmark, Finland, Ireland, Lithuania, Latvia, Slovenia, Estonia, Cyprus, Luxembourg and Malta Size of economies - 6 nations account for more than 80% of EU25s economy: Germany, UK, France, Italy, Spain and the Netherlands - Small (= between 1% and 3% of the EUs output): Sweden, Belgium, Austria, Denmark, Poland, Finland, Greece, Portugal and Ireland - Tiny (= less than 1%) : Czech Republic, Hungary, Slovak Republic, Luxembourg, Slovenia, Lithuania and Cyprus. Income per capita (a year) - The super-high income: Luxembourg (> 40,000) almost twice that of France. Average
income per worker = 100,000

11 high income (> 20,000): Denmark, Ireland, Austria, the Netherlands, Belgium, Finland, Italy, Germany, France, UK and Sweden 9 medium income (from 10,000 to 20,000): Spain, Greece, Portugal, Cyprus, Slovenia, the Czech Republic, Malta and Slovak Republic 6 low income (< 10,000): Estonia, Poland, Lithuania, Latvia, Bulgaria, Romania and Turkey (Turkeys income is half that of the richest-of-the-poor, Estonia)

2.2. EU laws structure:

The Maastricht Treaty drew a clear line between supranational and intergovernmental policy areas by creating the 3 pillars. EU = 3 pillars and a roof: 1st: Economics 2nd: Security and Foreign 3rd: Justice

EC law only applies to the 1st pillar

The clear distinction between supranational and intergovernmental cooperation allowed initiatives like Schengen to be brought under EUs wing without forcing every member to join.

2.3. EU laws type

Law EUROPEAN COMMUNITY EC law is now enormous mass of laws, rules, and practices Primary legislation: Treaties Secondary legislation: collections of decisions made by EU institution o 1. Regulation: applies to all member states, companies, authorities and citizens. Regulations apply as they are written, i.e., they are not transposed into other laws or provisions. They apply immediately upon coming into force. o 2. Directive May apply to any number of member states, but they only set out the result to be achieved. Member states what needs to be done to comply with the conditions set out in the directive (e.g. new legislation, or change in regulatory practice). o 3. Decision: is a legislative act that applies to a specific member state, company or citizen. o 4. & 5. Recommendations and opinions: These are not legally binding, but can influence behavior of, for example, the European Commission, national regulators, etc.

2.4. EU laws main principles

1. Direct effect: EC laws must be enforced by Member States courts, just as if it the law had been
passed by national parliament. It has the force of law in member states so that Community law can be fully and uniformly applicable throughout the EU.

2. Primacy of Community law: Community law has the final say. It is used to overturn Member
State laws.

3. Autonomy: entirely independent of the Member States legal systems. Necessary so Community law cannot be altered by national, regional or local laws.


2.5. EU institutions : the Big- 5

European Council Council of Ministers Commission Parliament EU Court

1. Council of the EU = Council of Ministers = the Council

= representatives at ministerial level from each Member State, empowered to commit his Government. Typically minister for relevant area. Is the EUs main decision-making body (almost every EU legislation must be approved by it) The Council has responsibilities in all first-pillar areas. Also decides on 2nd and 3rd pillar issues 2 main decision-making rules: On the most important issues: unanimity On most issues: majority voting Rarely votes, usual decides by consensus

2. European Council
= leader of each EU member (prime minister or President) + the President of the European Commission By far the most influential institution Provides broad guidelines for EU policy Talk about compromises on sensitive issues (reforms of the major EU policies, Treaty changes, enlargements,..) Meet at least twice a year. These meetings determines all of the EUs major moves Particularity of the EU: the most powerful body by far the European Council has no formal role in EU law-making. Its political decisions must be translated into law following the standard legislative procedures involving the Commission (3), the Council of Ministers (1) and the European Parliament (4).

3. European Commission
= the heart of the EUs institutional structure. It is the executive body of the EU. It is the main driving force behing deeper and wider European Integration. 3 main roles: o Propose legislation to the Council and Parliament o Administer and implement EU policies o Provide surveillance and enforcement of EU law (guardian of the Treaties) o + represent EU at some international negotiations Commissioners are chosen by their own national governments. Serve for 5 years

Each commissioner in charge of a specific area of EU policy. Manage the EU budget Decision making: almost all decisions on consensus basis or simple majority if vote

Commissions composition: Before Lisbon Treaty: enlargement: one Commissioner for each member From 2014: 15 commissioners. On basis of a rotation system (ex: President: Barroso,
Belgium: De Gucht trade)

4. European Parliament
2 mains tasks: Oversees EU institutions, especially Commission Democratic control (Members directly elected way for Europeans to have a voice) Shares legislative powers, including budgetary power with the Council and the Commission Organization: o 732 members o Directly elected in special elections organized by member nation o Number per nation varies with population but rises less than proportionally o The members are supposed to represent local constituencies, but generally organized along classic European political lines, as in Council. The Parliament is in Strasbourg, in Luxembourg and in Brussels

5. EU Court
Court settles disputes between Member States, the EU and Members States, between EU institutions and between individuals and the EU about interpretation of EU laws and decisions. The EU Courts supranational power is highly unusual in international organizations. Organization: o Located in Luxembourg o One judge from each member + 8 advocates general o Majority voting

2.6. Legislative processes

1. Decision-making European Commission 2. Commissions proposal is sent to the Council and to Parliament (in most case) for approval


Main procedure (80%), called codecision procedure, gives the Parliament equal standing with the Council after a proposal is mal by Commission. Codecision procedure requires: Commissions proposal to be adopted by the Parliament (deciding by simple majority) and Council (deciding by qualified majority) before it becomes law. If the Parliament and/or the Council disagree, proposal only adopted if a CouncilParliament compromise can be reached.


The Budget

About 100 billion = only 1% of total EU27 GDP Expenditure: 48% for farms, 32% for poor regions Historical development: The EUs spending priorities and the level of spending have changed dramatically since its inception in 1958. The Budget grew rapidly, but started at a very low level. Until 1965, the budget was spent mainly on administration. CAP spending began in 1965 and soon dominated the budget. For almost a decade, farm spending regularly took 80% or more of total expenditures. From the date of the first enlargement, 1973, Cohesion spending began to grow I importance, pushing down Agricultures share. Revenue: The EUs budget must be balanced every year. Main sources: tariff revenue (from common external tariff), agricultural levies, VAT, tax on the GNP base. (mainly VAT and GNP)
+ Miscellanenous (before 1970s): other revenue sources that include items such as tax paid by eurocrats, fines and earlier surpluses.

Budget contribution by members: EU funding amounts to about 1% of GDP per member regardless of per capita income ( not progressive). Lowest = the UK: due to the UK rebate: UK benefits to a smaller contribution because of its budgetary imbalance, i.e. they
funded much more than they receive due to the agricultural situation.

Net contribution: Germany is by far the largest net contributor. Belgium is a net recipient. UK and The Netherlands are also two big net contributors. Net contribution by member: The Netherland is the largest net contributor (then Germany) and Luxembourg is the smallest ( receive more!)


3.1.EU practice and principles Subsidiarity principle: Decision should be made as close to the people as possible. EU should not take action unless doing so is more effective than action taken at closer level. 3.2.Centralization or decentralization? 5 important considerations when thinking about appropriate allocation of policy-making: Argue for centralization: o Scales economies o Spillovers Argue for decentralization: o Diversity and local informational advantages o Democracy as a control mechanism o Jurisdictional competition


Economical view 1. Qualified Majority Voting (QMV)

80% of EU legislation is passed under Codecision Procedure. This requires the Council of Ministers to adopt the legislation by a QMV and the European Parliament to adopt it by a simple majority. QMV comes from the Nice Treaty and will be simply in the Lisbon Treaty (2014) The rule: more populous members have more votes, but fewer than populationproportionally. For a proposal to pass the Council, 3 criteria: o It needs at least 232 of the 321 votes (72%) o The number-of-member states that vote yes has to be at least 50% o The yes voters must represent at least 62% of EU population Problem with accession of new countries: Councils ability to act (efficiency) has decreased Under Lisbon Treaty: o The number-of-member states that vote yes has to be at least 55% o The yes voters must represent at least 65% of the EU population NB: Big nations gain and medium nations lose power implications


2. Decision-making efficiency
a) The Passage Probability: a quantitative measure of efficiency = likelihood of a randomly selected proposal being accepted. It measures how easy it is to find a majority under a given voting scheme. 3. Steps: 3.7.Work out all possible coalitions 3.8.Using actual voting weights and majority see how many coalitions would win, i.e. get proposal passed 4. If all coalitions equally likely, fraction of winning coalitions to all coalitions is an abstract indicator of how difficult it is to pass proposals; # winning coalitions/ # total coalitions 5. Imperfect measure: reduces the decision-making efficiency: To hard to find a coalition (72%) 6. The number of possible yes/no coalitions is 2n (n= number of votes). 7. Affected by number of members, the distribution of votes & the majority threshold. The evolution of the efficiency: Although efficiency has been declining, past enlargements have only moderately hindered decision-making efficiency. The 2004 enlargement greatly reduces the passage probability. In fact, the Nice Treatys complex rules made matters worse. This led to the Lisbon Treaty.

b) Normalise Banzhaf Indew (NBI): the distribution of power among EU members = Probability of breaking a winning coalition, likelihood that a Member State is influential This tries to protect likely coalitions and their power to block.



2 goals: - Impact of removal trade barriers on welfare of countries - Determine how prices + quantities exchanged on international markets are established How does a country decide? A nation will decide whether or not to impose a tariff (protection) in an industry by taking into account the interest of the different economic agents. Interests of firms and consumers go in opposite directions => comparing the importance of the changes for consumers and firms

4.1. Supply and Demand Curve

Demand Curve Show how much consumers would buy of a particular good at any particular price. Consumers behavior is driven by a desire to spend their money in a way that maximizes their material well-being (based on an optimization exercise). The price that consumers face reflects the marginal utility of consuming a little more. (Decreasing marginal utility). Market Demand is the horizontal sum of all consumers demand curves. Supply Curve

Show how much firms would offer to the market at a given price. Based on optimization The price that firms face reflects the marginal cost of producing a little more. Market supply is the horizontal sum of all firms supply curves. Welfare analysis: consumer and producer surplus Surplus measures the welfare impact. Consumers buy up to the point where the marginal utility from the last unit bought just equals the price. For all other units bought, the marginal utility > p surplus.


A price fall increases consumer surplus and decreases producer one. 2parts in the consumers surplus rise: Pay less for unit consumed at old price (rectangle) Gain surplus on the new units consumed (triangle) = sum of all new gaps between marginal utility and price

Idem for producer surplus

4.2. Open-economy supply and demand analysis

Import Demand Curve = tells how much a nation would import for any given domestic price M=CQ (domestic cons domestic prod) = excess D

1) P* = no open economies home C = home Q No import (1) 2) How much would the nation import if price were lower (P)? /!\ import price fixes domestic price C=C & Q= Z M= C- Z Meaning: M is the import D at price P (3)

Welfare analysis: Welfare analysis can be done by using Import and Export curves. Consider a rise in import price from P to P M from C to C & from Z to Z Consumer surplus: - (A+B+C+D); Producer surplus: + A net loss at home = B+C+D Right graph: how this appears in the import D diagram: net loss= C+E (E=B+D)


C= border price effect (the size of the loss ex: price rise is 2 and M is 100 200)
Home pays more for units imported at the old price

E= trade volume effect (home loss from importing less at P)

The marginal value of the first lost unit is the height of the MD curve at M, but Home paid P for it before, so net loss is the gap from P to MD

MDH is the marginal benefit of imports: the difference between the domestic marginal utility of consumption and domestic marginal cost of production is the net gain to the nation of producing and consuming one more unit. An extra unit of imports leads to some combination of higher consumption and lower domestic production. This leads to some combination of higher utility and lower costs. The nation imports up to the point where the marginal gain to do it, equals the marginal cost. Export Supply Curve X=Q-C = excess prod

1) P* = no open economies foreign C = foreign Q No export (1) 2) How much would Foreign export if price were higher (P)? C=C & Q= Z X= Z- C Meaning: X is the export D at price P (2)

Welfare analysis: Consider a rise in export price from P to P X from C to C & from Z to Z (Foreign would be willing to supply higher level of export for 2 reasons: higher price produce more and consume less) Consumer surplus: - (A+B); Producer surplus: (A+B+C+D+E) net gain = C+D+E Right graph: how this appears in the export S diagram: net gain= D+F (F=C+E) D= border price effect (Foreign gains from getting a higher price for the goods it sold before at P) F = trade volume effect (gains from selling more)


XSF curve gives the marginal benefit to Foreign of exporting MD-XS: Import D curve and Export S curve The MD-XS diagram permits to find the equilibrium price and quantity of exchange and allows easy identification of price and volume effects of a trade policy change. It enables to quantify the welfare effects in Home and Foreign. BUT it does not allow seeing impact of price change on domestic consumer sand firms separately. useful to use beside open economy supply and demand diagram. It allows tracking domestic and international consequences of a trade policy change

4.3. MFN Tariff Analysis

MFN= Most Favored Nation tariff: when tariff is the same on all imports, independently of origin

1st step: determine how tariff changes P and Q: tariff=T - no impact on MD curve (MD tells how much Home would like to import at any domestic price) - shift XS curve up by T (exporters would need a domestic price that is T higher for them to offer the same quantity as before the tariff, because they earn the domestic price T) 2nd: the new quantities equilibrium prices and

Tariff the new export supply curve new equilibrium (P > PFT free trade & M < MFT) Effects of the tariff on prices: 1. Price facing home firms and consumers rises to P 2. The border price (= price home pays for imports) falls to P-T; this also means that the price received by Foreigners fall to P-T Effects of tariff on quantities: 3. The home import volume falls to M +not seen here: - Home consumption falls - Home prod rises - Foreign cons rises - Foreign prod falls

3rd: welfare effects On Home: o Private surplus change (change in cons and prod surplus) = - (A+C) o Increase in tariff revenue = A+B Net effect = B C i. Border price effect: B ii. Trade volume effect: C

NB: If Home gain >0, it is because it exploits foreigners by making them to pay part of the tariff (B) On Foreign: o Private surplus change = - (B+D) Net effect = - (B+D) i. Border price effect : B ii. Trade volume effect : D World welfare change = - (C+D)

4th: distributional consequences Add the open economy D&S diagram.

If B> (C1+C2) + , otherwise - ; it depends by how much foreign prod agree to reduce their price


4.4. Typology for trade barriers

3 types of trade barriers: Tariff Quotas Price undertakings

Who captures the rent of a trade barrier? i.e. the gap between domestic and border price (A+B)? 3categories of trade barriers according to that: DCR (Domestic Captured Rents) FCR (Foreign Captured Rents) Frictional (no rents since barriers involve real cost of importing/exporting)

Net Home welfare change for: DCR: B C FCR & frictional: - (A+C)

Net Foreign welfare change for: DSCR & frictional: -(B+D) FCR: A-D

SUMMARY: The 2 most important diagrams are: The MD-XS diagram: provides a compact way of working out the impact of importing protection on prices, quantities and overall Home and Foreign welfare The open-economy D&S diagram: allows to consider the distributional impact of import protection



5.1. Unilateral discriminatory liberalization



PTA diagram= Preferential Trade Agreement diagram discriminatory effects a) Effects of elimination of tariffs on imports coming from all countries MFN tariff equilibrium: (like previous chapter)

b) Effects of elimination of tariffs only on imports coming from member countries 1st step: construct the new XS curve: XS PTA is halfway between the XS and XS MFN Pa = the minimum price at which the RoW exporters would be willing to sell due to the fact that they face a tariff of T. XSPTA is the XSP on the left of the kink and then XSR+ XSP
The tariff prevents RoW firms from exporting until the domestic price in Home rises above P a. When Homes domestic price is below Pa, the border price faced by RoW erxporters is below their zero-supply price (p*).

2nd step: impact on prices Domestic price Partner price RoW price PTA P P P- T < > > MFN P P-T P-T


Impact on quantities Domestic price Partner price RoW price PTA M XP XR > > < MFN M XP XR

The combination of + Partner sales and - RoW sales is known as supply switching or trade diversion.
Supply switching truly occurred in Europe; EEC6 share of exports to itself rose by about 15% within 10 years.

3rd: welfare effects Homes net change: A+B-C o A = net consumer price effect o B = gain from the fact that the foreign is forced to decrease its price C = tariff revenue loss May be + or The welfare effect depends on the size of T and the slope of curves. Big T leads to welfare gain Partners net change: D RoWs net change: - E (higher price and sell more) (lower price and sell less)



Analysis of a Customs Union (up to mid-1970s)

Up to now: unilateral tariffs cuts. European integration reciprocal preferential liberalization A customs union is a free trade area with a common external tariff. Europe integration = removal of tariffs on imports of partner + removal by partner of tariffs on exports by Home to Partner. A customs union is systematically more favorable for participating countries than unilateral liberalization schemes since Home exporters gain from Partner tariff cuts. Welfare analysis has to take into account that Home will be able to export more

5.2.1. Welfare effect: Identical welfare effect of Home and Partner: In market for good 1 (identical as 5.1): A+B C In market for good 2: D C = C 1 + C2 D = D1 + D2 C1 = D1 C1 identifies how much Home pays for the units it continues to import from Partner (M XP) C1 is just transferred between CU members. C1 loss is offset by a gain D1 on its exports of good 2 to Partner. Net impact: A+B+D2-C2

C2 identifies the direct cost of supply switching It might still be negative, but welfare change from CU is more positive than from a unilateral discriminatory liberalization Impact on RoW: 2E

5.2.2. Frictional barrier (from mid-1970s) No tariff revenues In market for good 1, home change = A+F In market for good 2 : D Net GAIN: A+F+D, unambiguously positive


Customs Unions VS. Free Trade Agreements

EEC = a customs union common external tariff EFTA = free trade agreement no common external tariff If all Home-Partner trade is duty-free, yet Home charges a 10% tariff on imports from RoW and Partner charges a 5% tariff on it, Home-based buyers of RoW goods would be tempted to import goods first to Partner and then to import them duty free to Home. = Trade deflection 2 solutions: Harmonizing their external tariff CU Remain FTA but restrict duty-free treatment to goods that are actually made by Home or Foreign = rule of origin (quite hard in application)

Despite the rule of origin problem FTAs, almost all preferential trade arrangements are FTAs.


WTO rules

A basic principle of the WTO/GATT is non-discrimination in application of tariffs (MFN) However, FTAs and CUs are allowed subject to conditions: Substantially all trade must be covered Intra-bloc tariffs must go to zero within reasonable period If CU, the CET must not on average be higher than the external tariffs of the CU members were before

EECs CU this meant France and Italy lowered their tariffs, Benelux nations raised theirs (German tariffs were about at the average anyway)



15.1. Facts
2/3 of EU25 exports are to other EU25 nations. (>90% is in EU15) of EU25 export are to European nations (EU25 + Switzerland, Norway, ) North America and Asia are the EU25s main market outside Europe (each < 1/10th EU exports) The pattern on the import side is very similar exports and imports within Europe, others: mainly North America and Asia

Differences among Member States

One of the things that makes EU trade policy a contentious issue is the fact that the various Member States have quite different trade patterns. Some members are landlocked and surrounded by other EU members, while others are geographically and/or culturally close to Africa, North America or Latin America. - Geography matters a great deal when it when it comes to trade partners non-EU Europe (ex: Russia) countries play a big role in the imports for the central European members (ex: Poland) - Iberians import a large share of their external trade from Latin America and Africa.

Composition of EUs external trade

What sort of goods does the EU27 import and export to and from the rest of the world? - Exports: 90% is manufactured goods - Imports: o 2/3rds is manufactured goods o EU25 is a big importer of fuel NB: EU has almost no tariff protection on imported manufactured goods. What with whom? - Exports: the share of manufactures in EU exports to all regions are fairly similar - Imports: this is much more varied on the import side: o Europe tends to import a lot of primary goods food and raw materials including fuel from continents that are relatively abundant in natural resources o The EUs import composition from non-EU Europe has a large share of raw materials


15.2. EU institutions for trade policy

Formation of a customs union which eliminates tariffs on intra-EU trade and adoption of a common external tariff was the EUs first big step towards economic integration. A customs union requires political coordination the Treaty of Rome granted supranational powers to the EUs institutions regarding external trade policy Trade policy is an exclusive competency of EU The European Commission has responsibility for negotiating trade matters with third nations. The EU trade Commissioner is responsible for conducting trade negotiations. These negotiations are conducted in accordance with specific mandates defined by the Council of Ministers that sets Directives for Negotiation. The Council has the final say (on basis of QMV) The European Commission is in charge of surveillance and enforcement of 3rd nation commitments to EU.

15.3. EU External Trade Policy

EU has special deals with 139 nations; often more than one per partner. In the 1960s and 1970s, many policy makers believed that rich countries could help poor ones develop by granting unilateral preferential tariff treatment for poor nation industrial exports. a) the European Mediterranean trade area o Euro-Meds: bilateral duty-free trade in industrial goods o PanEuroMed: removes tariffs and imposes a common set of rules of origin b) Preferential arrangements with former colonies o Opposition between colonial preferences and Common external tariff
At the end of colonial time, the former colonists wanted to remain preferential treatment for goods coming from their former colonies.

o However, EU made exception for the nations to avoid imposing tariffs on imports that had long been duty free. They signed unilateral PTAs. (Yaound
Convention and Arusha Agreement)

o When UK joined in 1974, this policy was extended to ex UK colonies = Lom Convention o This didnt help the ACP nations (Africa, Caribbean and Pacific countries) o When Lom Convention renewed in 2000, the EU and the ACP nations agreed to modernize the deal (= Cotonou Agrement) c) Preferences for poor nations: GSP = Generalized System of Preferences o Provided by the GATT o EU grants GSP to almost all poor nations. o In least developed nations super GSP most generous form of GSP, called Everything But Arms: grants zero-tariff access to the EUs market for all products, except arms.


15.4. Non-regional FTAs

Although the EU has preferential tariffs on imports from all but 9 nations in the world, this accounts for about 1/3 of EUs external trade (US, Japan,) For these nations, the CET matters! The average CET rate is 6.5% but high variation: - of the rates are set at 0 (mostly industrial goods) - The average CET rate on industrial imports is 4% - The average CET rate on agricultural imports is 16% (the highest: 210%) Enormous difference between agricultural goods and manufactured goods Granting zero-tariff status to the industrial exports has very little impact on the EUs market since the non-preferential rates are already very low!!



The idea behind European economic integration was the belief that unification of European economies would by allowing European firms access to a bigger market make European firms more efficient and this, in turn, would allow them to lower prices, raise quality and gain competitiveness in external markets.

6.1. Liberalization, defragmentation and industrial restructuring: facts

Mergers and acquisitions (M&As) is high in EU Much of this M&A activity consists of the mergers of firms within the same Member State. (about 55% of all operations were domestic type) The big 4 economies (France, Italy, Germany and UK) have the most operations but: their share of M&A activity < their share of the EU15s GDP (except for UK*) The problem of too-small market was most severe in the smaller EU members Integration produced the largest changes (in proportion to their economy) in the smallest members: small countries share of M&A activity >share of the EU15s GDP. Sectoral composition: during the early years: manufacturing. Now: 2/3 in services (banking)

*Why is the UKs share so large? Very liberal rules In some other countries: non-harmonized takeovers rules restructuring effects of integration have made very different impact in member states. Schematically steps: Liberalization defragmentation pro-competitive effect industrial restructuring Result: fewer, bigger, more efficient firms facing more effective competition from each other

6.2. Economic Logic,background: Monopoly, Duopoly and Oligopoly

Monopoly: Can choose how much to sell and what price to charge. The only restraint is the demand curve: downward-sloping trade-off between price & sales What is the profit-maximizing level of sales for the monopolist? MR = MC


Competitive market In competitive market Cournot- Nash eq= assume that each firm acts as if the other firms outputs are fixed. Since firms take as given the sales of other firms, the only constraint facing a typical firm is the demand curve shifted to the left by the amount of sales of all other firms. Each firms believes it is a monopolist on the residual demand curve. Duopoly: 2 firms producing the same good To find an expectation-consistent set of outputs, the easiest way is to use the assumed symmetry of firms.

- The optimal output for a typical firm is x*, given by the intersection of RMR and MC. - The total sales to the market is 2x* and at this level of sales the overall market price is consistent with the price each firm expects to receive given the residual D curve. -The outputs of the identical firms are equal in eq, market share firm 1+ firm 2 = market D

Oligopoly: What happens when the number of firms is increased? The new RMR = MC point occurs at a lower level of perfirm output and this implies a lower price.

What happens if doubling of firms AND market size? Same price, reduction of market share


6.3. The BE-COMP diagram in a closed economy

1. The COMP curve Answer the question: How wide is the mark-up (=the gap between price and MC)? Net result of adding additional firm: Pdrops from p to p Lower (1) Lowers the sales per firm (2) (1) + (2) Lower profits But!! Total duopoly qt > monopoly qt COMP curve downward-sloping: competition drives the mark-up down. Named COMP curve since the size of the mark-up, , is an indicator of how competitive the market is. 2. The Break-even (BE) curve To break-even= atteindre lq


The BE curve shows the number of firms that can earn enough to cover their fixed cost. For simplicity: assume flat marginal cost curve and a fixed curve of operating. Increasing returns to scale since AC falls as its scale of production rises. (left-hand panel) For the firm to survive: P= AC From the right to the left: 1. A given mark-up implies that the price is also given: p0= MC + 0 2. At this price, the D curve gives the level of total sales C0 3. level of sales per firm: C0/n 4. How many firms in can break even when mark-up is 0? those whose AC= P, meaning when sales equal x0 = C0/n


What happens if mark-up= 0 but number of firms > n0 (market size grows)? Sales per firms < x0 AC > p. not sustainable (losing money) (A) What happens if mark-up= 0 but number of firms < n0 ? AC < p such a situation would encourage more firms to enter the market. 3. Equilibrium prices, output, and firm size Firms are NOT always on the BE curve since they can earn above-normal or below-normal profits for a while. In long run however, firms can enter or exit the market. Firms are always on the COMP curve since they can change prices quickly in response to any change in n.

The intersection of the two defines the eq and the long-run n. COMP-curve tells that firms would charge a markup of when there are n firms in the market. BE-curve tells that n firms could break-even when the mark-up is . Eq price= + MC Let determine the eq number of firms, mark-up, price, total consumption and firm size


6.4. The impact of European integration

1. No trade to free-trade liberalization Doubling the size of the market

1) The market size increases (more consumers) BE shift to the right More firms are able to survive. At any given , more firms can break-even. The size of the rightward shift: if no change in , 2n could break-even point 1 2) Increase in competition: - In the short-run: pro-competitive effect push down to A from E to A Corresponding effect on prices: fall from p to pA But!!!! A< BEFT all firms will be losing money. A is not a long-term eq - In the long-run: industrial restructuring the number of firms fall from 2n to n from A to E In Europe, this process occurs via mergers and buy-outs or bankruptcies. During the process, firms enlarge their market shares, rises, profitability is restored. The impact of the combination of extra competition and restructuring for a typical firm: - From E to E - Price fall - Firms that remains increase their efficiency, i.e. lower their AC Price drop= efficiency gain Increasing returns to scale are the root of this efficiency gain. Scale rises from x to x Welfare effect: gain from paying less and from being able to consume more (from C to C) C= Homes long-term welfare gain. There is no offsetting loss to producers: non-profit before and after liberalization. But ignore the mid-term adjustment costs.


14.1. The economics of anti-competitive behavior and state aid
The key point as far as competition policy is concerned, is that deeper European integration will generally be accompanied by a long-run reduction in the number of firms. To avoid or postpone industrial restructuring (meaning the end of some firms), some firms decide to collude (= sassocier). This is however illegal under EU law. Collude = anti-competitive behavior. Problem of collusion: high prices low demand and production Illustration of collusion in the BE-COMP diagram: a) Perfect collusion on output monopoly level monopoly price and highest profit m, n=1, Pm Perfect collusion means allocating an equal share to all firms Perfect collusion line, always m If all firms charge m, from Em to A: new entry. OR remain on Em

Perfect collusion is difficult to maintain since the gains from cheating are quite high. b) Partial collusion The sort of partial collusion restricts sales of all firms but not all the way back to the monopoly level, so the < m but > the COMP partial collusion curve lies between the COMP curve and the perfect collusion curve. if 2n would be showed by A. But A below BEFT: some firms can not break even. In LR, firms adjust to restore zero pure profits B

Collusion is good for firms profit but bad for the society. Comparing with without collusion (E), higher price, consumption and production are lower. Less efficient.

Economic analysis of cartel P=Price before the cartel Cartel raises price to P Consumer surplus= -a-b = rip-off effect Producer surplus= + a-c Net welfare effect= -b-c = technical inefficiency The gain from firms < the loss from consumers, so the cartel is inefficient Economic analysis of exclusive territories One company would agree to sell only in its local market in exchange for a similar promise by foreign competitors. Ex for Nintendo: higher price where consumers had a higher ability to pay. Ex: German D is more inelastic than UK D, i.e. more unresponsive to price change. Abuse of dominant position Firms that possess excellent products can succeed in establishing very strong positions in their market. This is not a problem if the position reflects superior products and/or efficiency. However, once a firm has a dominant position, it may be tempted to use it to extract extra profits from its suppliers or customers or to arrange the market so as to shield itself from future competitors. ILLEGAL according to EU law

Ex: Microsoft Merger control Initially: P=AC Merger lower AC to AC and raise price to P 1. Welfare effect: CS = -a-b PS = +a+c Net welfare: -b+c 2. Laissez-faire = free entry and exit ! The long-run outcome will be drive the price down to: P= AC Net welfare: c+d+e There is a presumption that mergers will generally be of the type 2 that boosts efficiency.

State aid: restructuring prevention EX: Subsidies Governments make annual payments to all firms exactly equal to their losses Under this policy, all 2n firms will stay in business but no new entry because no extra profit. The economy remains at point A! Who pays for inefficiently small firms? Taxpayers Price from P to PA, consumption from C to CA, x from x to xA Welfare effect: How big will the subsidy be? Pre-integration: a+b Operating profit Post-integration: b+c Operating profit Breakeven subsidy=a-c

Welfare: CS= a+d Susidy (a-c) = d+c NB: PS = 0 (profit is zero pre & post (the gap between P and MC summed over the extra unit)



Economic means increase in output. (GDP) Previous chapter: competitionmore efficient firms produce more increase in output allocation effect European integrationallocation effectimproved efficiency better investment climate more investment in machines, skills and/or technology higher output per person (GDP/capita) European integration economic growth because more investment in human capital, physical capital and knowledge capital. Under long-run growth effects, the growth rate is forever higher

Some facts Continuous economic growth is a relatively recent phenomenon. 4 growth phases: 1890-1913: Belle poque 1913-1950: wars + Great Depression low growth 1950-1973: the Golden Age of growth (3.8% real GDP per capita) 1973-1992:first oil shock

Are growth and European integration related? How EU membership could yield a medium-term growth bonus? 7.2. Medium-term growth effects: induced capital formation with Solows analysis
1. Solow diagram Assume EU is a single, closed economy with fully integrated capital and labor markets and the same technology everywhere. Assume all firms have access to the same production function: GDP = F(K,L) Output and GDP depends on factors of production K & L

How output is measured: GDP/L = F(K,L)/L = F(K/L,1)

link between GDP-per-worker and capital-per-worker

The GDP/L curve shows what output per worker would be for any given K/L

Assume positive and diminishing marginal products and constant returns to scale

Assume households save a constant exogenous fraction s of their disposable income. Investment is made for accumulating K. 0<s<1 Assume that a constant fraction of capital stock depreciate each year: K , 0<<1 Net change in capital stock: K = sGDP K Net change in per capita stock: (K)/L = s(GDP/L) (K/L)

The steady-state = s(GDP/L) = (K/L) = intersection between s(GDP/L) & (K/L) The equilibrium K/L(= steady-state A) is where inflow of new investment just balances depreciation of K. If the s(GDP/L) > (K/L), then K/L rises. s(GDP/L) < (K/L),then K/L falls Depicts the levels of consumption and investment in a single figure B tells that output per worker in this equilibrium will be Y/L*


The main point: the accumulation of K is not a source of long-run growth. K/L increases until it reaches the equilibrium and then stops, unless something changes. 2.Impact of European economic integration European integration: more competition increased efficiency more output more efficient allocation of resources across EU increased efficiency more output = STATIC EFFECT Additional effect = DYNAMIC EFFECT

On the Solow diagram: While from the firm-level perspective (chapter 6), the improved efficiency means lower AC, from the economy-wide perspective, this means that the same amount of K & L can produce more output the positive allocation effect shifts the GDP/L curve upwards (rotated up) The impact of higher efficiency on output is shown by point C K/L* is no longer the eq capital/labor ratio

The shift up in the GDP/L curve to GDP/L also shifts up the investment curve to s(GDP/L) At K/L* , s(GDP/L) > (K/L) K/L rises, new eq = K/L.

The rise from K/L* to K/L = the induced capital formation This reflects the fact that improved efficiency will tend to stimulate investment.

The growth implications: K/L and Y/Lc increases to Y/L (from C to E) THE KEY: from C to E faster growth!!! higher growth rate. At E, growth rate returns to normality SUMMARY: intragation growth: Integrationimproved efficiency higher GDP/L higher investment per worker economys K/L ratio starts to rise towards new, higher eq value faster growth of output per worker during the transition from the old to the new K/L ratio = medium-term growth bonus from European integration

However, higher output is not a pure welfare gain. In order to invest more, save more


Higher C made possible tomorrow by higher K/L are partly offset by the forgone C of today Evidence from the poor four: Study the impact that EU membership had on the four relatively poor entrants that joined the EU between 1960 and 1995: Ireland, Greece, Portugal and Spain. 4kinds of footprints should be seen in data: Stock market prices should increase The aggregate investment to GDP ratio should rise The net direct investment figures should improve The current account should deteriorate as more foreign capital flows in.

a) Ireland, Portugal and Spain: clear case of integration-induced investment-led growth greater returns to K, better investment climate for foreigners, higher investment post accession b) Greece: after accession, Greece continued its pervasive state controls of the economy. Reason for no evidence of investment-led growth Integration may improve the investment climate but can be offset by other factors.

How to have economic growth in Europe today? Already high K/L low economic growth rates Technology = A : GDP= A F(K,L), if A increases economic growth

The objective of the Lisbon STRATEGY (and not Treaty): to make the EU the most competitive knowledge based economy, R&D, innovation



Up to here: the integration of nations but regions matters too.

Evolution over time: narrower national differences, wider regional differences While the dispersion of income levels across nation is still very high, the gaps among EU members have been steadily narrowing. However, income inequality across regions within each EU nation has been rising steadily. Ex: France: Paris has almost 1/3 of all economic activity, per capita incomes are 158% of EU15 average. Besides that, Mediterranean has 10% of GDP while 12% of population. Geographic income inequality: Becoming more equal at the country level Becoming less equal at the regional level

What are the determinants of this evolution? European integration may have encouraged a clustering of manufacturing by sector rather than by region. Geographic specialization: The Krugman index of specialization is the sum of absolute value of difference share sector country and EU. A higher index means that the country is more different industrial structure from EU average. Since almost all the changes are positive, this means that the industrial structures of most nations are diverging from the average EU industrial structure. EU economies seem to be specializing more in their comparative advantage.


2 Approaches that connects European economic integration and the change in the geographic location of economic activity: - Comparative advantage nations specialize in sectors in which they have a CA - New Economic Geography integration tends to concentrate economic activity spatially General idea: use CA approach to explain cross-nation facts Use NEG to explain within nation facts

Comparative advantage How are a nations productive factors employed across sectors within the same nation?
Countries have: o Different relative endowments of factors o Relatively more of certain factors and relatively less of other factors Goods (industries) use factors of production in different factor intensity, e.g. clothing requires relatively more unskilled labor

A country is more suited for industries which use intensively the factor that is relatively more abundant. Trade allows for a more efficient allocation of production across countries. Free trade induces nations to specialize in producing products that they are relatively good at and exporting those goods ; and importing products that they are relatively bad at producing. Economic resources get shifted between sectors within each nation and, as a result, it seems as if production is being reallocated sector by sector across nations. Explains why European integration was so associated with an increase in specialization by nation

Agglomeration and the new economic geography How does European integration affect the location of economic activity across regions within the same nation?
Scale economies and trade costs generate forces that encourage geographic clustering of economic activity. 2 kinds of clustering: Overall clustering: some areas with lots of economic activity and other empty Sectoral clustering: each sector clusters in one region, and most regions get a cluster

The logic of economic geography rests on two pillars: Dispersion forces: tend to encourage industry to disperse geographically
(Ex: land prices, few locally-based competition local competition force)

Agglomeration forces: tend to lead industry to cluster geographically: o Technological spillovers o Labor market pooling o Demand linkages: firms want to be in the big market the move to the big market makes the market even bigger (job creation,) and the small market smaller

spatial concentration creates forces that encourage further spatial concentration o Supply linkage cost-linkage

Cost-linked circular causality describes the way in which firms are attracted by the presence of many suppliers in the big market and how firms moving to the big market widens the range of suppliers and makes big market even more attractive from a cost-of-prod pt of view.

Agglomeration forces > dispersion forces. As trade costs fall, distance provides less protection from distant competitors.


The EE-KK Diagram

Study the impact of integration on geographical concentration Illustrates the logic of agglomeration and dispersion forces Relates relative market size to the relative number of firms Simplifying assumptions: 2 regions: N,S 2 factors: K (mobile), L (immobile) K is mobile and search out the region of highest rate of return 2 sectors : Service (L-intensive), industry (K-intensive) The economic activity (Service + industry) leads to income and expenditure


Point A: The same amount of K and the same amount of L in the 2 regions regional income levels are the same expenditure are the same

The EE curve Demand linkage: the relationship between the share of industry in the N and the norths share of expenditure. How income of a region depends on share of industry in that region: sK sE

EE upwards sloping: as North gets a larger share of industry, its market become larger in terms of income and expenditure relatively to that South EE steeper than 45: an 1% increase of the industry share implies a lower than 1% increase in the expenditure share. Industry is only a part of total economic activity.

In the north, local services lead to expenditure 0C; in the south: BD (B1)

What happens when south is fundamentally smaller than north? The green line assumes that north and south have half of the total supply of L (immobile factor). If north have more than half L, EE line is on the right side to the origin EE: where norths share of expenditure is more than half for any given sK, sE is higher. Trade costs dont influence position of EE The KK curve The goal of the diagram: determine sK and sE and to see how these change as trade costs fall The choice of location depends on: The size/attractiveness of the market Locating in large markets The intensity of competition Locating where competition is less intensive The division of industry sK adjusts to balance the agglomeration and dispersion forces

KK curve indicates combinations of sE and sK such that both aspects are balanced indifference of firms locating in N or S The intensity of competition in a geographical area depends on the number of firms in the same geographical area and the number of firms in other geographical areas.

Very high trade cost no trade Equal sales sE = , means an equal number of firms in each region sK = If N has 100% of expenditure 100% of firms

Zero trade cost Location does not influence intensity of competition locate where market is the largest Intermediate trade costs If sK increases by 10% in the N, the degree of competition in N will not rise by 10% because northern firms now face lower competition in their export market Restoring equal sales when there is trade will require the number of northern firms to increase by more than 10%. steeper than 45 due to the home market effect

Lower trade cost makes KK steeper. Effect= rotation of KK

EE-KK Diagram: locational equilibrium EE tells what sE will be for any given sK KK tells what sK will be for any given sE.

Point A: Below KK N is a large market with few competitors N is attractive entry of firms in N: from A to C Point C: left of EE given sK, expenditure in N increases from C to D

At the intersection, B, the returns to capital are equalized between regions. And given the equilibrium sK, the relative market size are given by EE.


EE-KK Diagram: European integration European integration lowers trade costs KK rotates counter clockwise around , . The reduction in trade costs protects markets less Makes small markets relatively less interesting for firms C to C Makes larger markets relatively more interesting A to A

Result: more industry moves to the bigger market: B to B Larger regions get larger share of income

Explains tendency of integration to foster geographic clustering of economic activity

EU regional policy

Creation of a new fund: the Cohesion Fund.

The EU spends about 1/3 of its budget on less-favored region. How is this money allocated? 3 priority objectives: 1. Convergence: 70% of structural spending

Ex: reducing income differences, o Regions with incomes < 75% of the EU average o About 20% of the EU population 2. Regional competitiveness and employment: 10% Ex: protects in regions whose economies are specialized in declining industries (coal mining,) Spending should support economic and social conversion o About 18% of the EU population 3. Territorial cooperation: 10% Measure to modernize national systems of training and employment promotion The impact of 2004 enlargement is worse: news members much poorer than EU15 Some regions pushed above 75% of average lose objective 1 status All of 2004 entrants have < 75% EU24 average (expect Cyprus)



The CAP is a set of policies aimed at raising farm incomes in the EU. The CAP is problematic. It accounts for almost half the EU budget but less and less farmers. The CAP started life in 1962 for keeping agricultural prices high and stable. Many reforms since then.

12.1. The old simple logic: price supports

Establishing a price floor by a tariff Goal: ensure that imports never pushed EU prices below the price floor At the beginning, EU was a net importer of most farm products could ensure S=D at high price.

The price floor was set above the world price PW. PSS = point of self-sufficiency Domestic price= PW + T (varying) price floor. At that floor, Zf is produced at home and Cf is consumed so that the difference in imported. Impact of having a high price floor > PW? More EU production: from Z to Zf : producer surplus = A Higher price less consumption: from C to Cf : Consumer surplus = -A C1 B C2 EU gov revenue: B o A= transfer from cons to prod o B= transfer from cons to gov Transfers are inefficient: C1+C2 = loss, inefficiency

Farms size, efficiency and distribution of farmer benefits The overall welfare analysis is good but hides a very important effect of price floors that is at the heart of one of the CAP problems: the distribution of benefits among farms. Distribution is very unequal: The price floor helps producers in proportion of their production so that big firms benefit more from the policy. The benefit of price supports go mainly to larger EU farms because they produce more and tend to be more efficient the benefits are biased in favor of large, rich farmers Since price floor are paid by consumers, food tends to be more important in the budget of poor families

12.2. Changed circumstances and CAP problems

The post-war period was revolutionary advances in the application of sciences to agriculture. Moreover CAP boosted output. EU became a net exporter. = the supply problem. The combination of high, fixed prices and rapid technological progress created a whole cascade of unintended consequences. The technological improvements shifted the supply curve down. Net exporter production Zf > consumption Cf The only way to sustain the price floor is that the EU buys the excess of production. o o o Producer surplus: A+C1+B Consumer surplus: -A-C1 Purchasing cost (-): C1+B+C2 Net effect <0 (-(C1+C2))

Surplus what to do with all that food? Sell at subsidized prices = DUMPING


Follow-on problems: World market impact: Disposing of EU surplus food created a foreign trade problem. The EUs food dumping drove down world food prices. A drop in the world price is a loss for the net exporters reaction from large food exporters: Agentina, Brazil, Non EU members were harmed. Even at the beginning, CAP harmed other nations: increase EU production reduce non-member share CAP reduced pwo to pw

When EU started dumping: non-members were further harmed

The farm income problem: The CAP fails to bring the reward to farming in line with the income of average EU citizens. Food= inelastic goods the quantity demanded does not react to price changes farm sectors total income falls with prices, so either average famer income must fall or number of farmers must fall. Other CAP problems: Pollution Animal welfare Nostaligia Bad image reforms

12.4. CAP reform

Lowering farm prices was not possible but buying all the excess food was too expensive. Found solution o 1980s: Supply control attempts to discourage production (failed) o 1992: MacSharry reforms: CUT PRICE supports to near the world-price level and COMPENSATE farmers with direct payments (still in application) From price support to direct payment o 2003: similar to MacSharry reforms + shift money from direct payment to rural development Problems remain the same: Reformed CAP support still goes mostly to big, rich farmers. Half the payments go to 5% of farms (the largest) Haf the farms (smallest) get only 4% of the payment Half the payments go to non-farming landowners (as the Queen Elisabeth)


12.5. Todays CAP

Todays CAP has 2 pillars: - Direct payments and price support - Rural Development First pillar: Single Payment Scheme is the backbone of the system: o The size of the single payment is based on historical payments in the old EU15 Condition of compliance with environmental, food, safety and animal welfare rules Sugar, vegetable and wine sector still use the old CAP system price support linked with production.

Second pillar (since 2003 reform): From direct payments to rural development Areas covered: o Quality incentives and support to meet standards and covering of animal welfare cost, technical advice o Improving agricultural competitiveness, sustainable land management, improving quality of life in rural areas.



8.2. Labour market: the principles

Labour Demand: The cost of hiring a worker = the hourly wage cost The benefit = the marginal productivity of labour (MPL) MPL downward-sloping: equipment shared Hire B? no, VMPL< w Best position: C where VMPL=w Firms will always hire the number of hours that corresponds to the MPL MPL curve represents the firms Dlabour Labor Supply: Labor supply is upward-sloping and is not flexible (wage rigidity). This implies unemployment in case of recession (D fall and S unchanged). Unemployment exists because D for goods vary so that D for labour vary as well while S for labour is rigid.

The role of collective bargaining: Higher wage Involuntary Unemployment = distortion from trade unions


8.3. Effects of trade integration

How does more foreign competition affect outcome on labour market? Trade opening separated out the economy into 2 broad sectors, an expanding one and a contracting one. Expanding sector (D increases) opposite for contracting sector Initial situation: A. With collective bargaining, invol unemployment = AB Increase in D from A to A. Effect on unemployment? Not clear: No reason to expect trade integration to raise or lower unemployment. The only clear effect: wage rise in expanding sector and wage fall in contracting one.

8.4. Migration Economics of labour market integration

Economic integration creates winners and losers. How does immigration affect the sending and receiving nations, and who gains and loses from it? Initial situation: -Home: w0, L0 -Foreign: w*0, L*0 L0 + L*0 = total available labour


Now, immigration: w0>w*0 labour will flow from F to H. This will push down wages in H and harms home workers while benefiting home capital owner. The opposite appears in F. If there is no impediment, migration will go on until wages equalize to each other. Welfare effect: In Home: o Workers: -A o Capital owners: A+B Net gain = B In Foreign: o Workers: + F o Capital owners: - D-F o Foreign workers abroad (in Home): C+D Net gain = C

(before they earn E, now: E+C+D)

While migration creates winners and losers in both nations, collectively both nations gain!!!



look at the relationship between the monetary policy and the exchange rate.

AD-AS diagram: output and prices (LR & SR)

Aggregate S: upwards sloping: When growth weakens, the output gap declines, market shrink and firms reduce employment. Unemployment rises so that workers accept wage moderation production costs grow slower and firms cut prices. Aggregate D: downward sloping: Higher prices erode purchasing power and external competitiveness output gap decreases. Change in AD: ex: Boom A to B (higher output AND higher p) =SR effect The long-run: neutrality of money A key principle of macroeconomics is that, in LR, money is NEUTRAL. The money shock does not affect real variables such as growth, unemployment, wealth, productivity or competitiveness. Instead, increases in the nominal money supply are absorbed by a proportional increases in the price level. The evolution of real variables is independent of the evolution of nominal variables. LR AS = vertical (zero output gap) = limit capacity of production LR effect: no LT growth, only a price effect. from B to C: prices increases in proportion to the money supply. Explanation: price double public requires double the amount of money to maintain purchasing power. once both double up, back to start in real terms.


The long-run: purchasing power parity The real exchange rate = the ratio of domestic to foreign good price = E x P/P* measure of the competitiveness When the real exchange rate increase (=appreciates), domestic good become more expensive relative to foreign goods and the competitiveness declines. The PPP asserts that: Change in nominal exchange rate = foreign domestic inflation rates

If inflation is durably lower at home, the currency should appreciate in the LR. The PPP asserts that the real exchange rate is constant.

IS-LM diagram: the role of the interest and exchange rates (SR prices cst)
IS-LM shows interaction of money and goods market IS: the SR goods market (downwards sloping): r rises discourages spending, reduces investment supply (output) drop (Y= C+I+G+X-M) LM: the Money market (upwards sloping): If Y increases D for money increases r rises A= initial eq when goods and money markets are both in eq.

Effects of fiscal and monetary policies Expansionary Fiscal policy: - IS shifts right to IS as AD strengthens - Economy moves to A Expansionary Monetary policy: - Central bank increases money supply - Interest rates declines at initial output (B) - LF shifts down to LM - Economy moves to C Output increases & interest rate decreases

Output & interest rate rise

Open economy and interest rate parity condition

Financial integration Free capital mobility Lower r because nominal exchange rate and financial outflows drop

Interest rate parity condition: r = r* + expected exchange rate depreciation Means that international financial markets are in eq when capital flows are unnecessary because the returns on domestic and foreign assets are equalized.

Monetary policy and the exchange rate regime

Monetary policy is deeply affected by the exchange rate regime Floating exchange rate = Exchange rates are continuously priced on foreign exchange markets Increase in money S shift of LM to the right Now: r & r* are linked by the interest rate parity condition. At B, r < r* capital flows out E depreciates more competitive X increase Y= C+I+G+X-M increase IS shift to the right from B to D (where r =r*) Fixed exchange rate = Gov keeps exchange rate fixed through reserves and buying and selling currency Increase in money S LM shifts right A to B capital flows out the Central Bank does not let E depreciates by buy its own currency LM shifts back (A). IS does not moves because E is fixed.--> competitiveness unchanged. Monetary policy works with floating exchange rates!

Fiscal policy and the exchange rate regime

Fiscal policy works with fixed exchange rate.

In EU: fixed exchange rate only fiscal policy is effective

When does the exchange rate regime matter? The choice of an exchange rate regime has mostly SR effects because prices are sticky. Arguments Flexible rates With sticky prices, need flexible exchange rate to deal with stocks Remove the exchange rate from politicization Monetary policy is too useful to be jettisoned Fixed rates Flexible rates move too much A volatile exchange rate is source of uncertainty Fixed rates is a way of disciplining monetary policy In presence of shocks, it is always possible to realign



The logic of the optimum currency area theory: The usefulness of a currency grows with the size of the area Marginal benefit is positive Yet, it is declining as the area expands because the extra benefit from
adding 1 more country to an already large currency area is smaller than when the initial area was small

Diversity is costly cost increase with the area size Marginal C is positive & rising Optimal currency area: marginal cost = marginal benefit The basic idea is that diversity translates into asymmetric shocks and that the E is very useful for dealing with these shocks. Ex: World D for homes export declines because tastes change World D for home goods depends on their prices relative to those of competing goods. EP/P* Adverse D shockD shifts left If the E is allowed to depreciate, SR effect: A to B If E is fixed & prices rigid SR effect: A to C where output declines deeper: At 0, home producers still produce A but only C is consumed AC= unsold LR effect: B: recession generates incentive to cut prices. The SR effect in fixed E and prices rigidity is more painful.


Asymmetric shocks
Diversity means that different countries face different shocks. With asymmetric shocks, monetary union is seriously constraining HYP: 2 member countries: A,B Prices are assumed to be sticky

Initial situation =A: 0 = E0PA/P* = E0PB/P* Assume an adverse shock affect country A D shifts left. No monetary union A can change its own E let E depreciate to 1 eq: B B has no reason to change its E, which remain 0 Monetary union they cannot have different E The central bank must make a choice. o If cares only about A E to 1 bad for B which faces a excess D (BB) o If cares only about B keep 0 bad for A which faces excess S (AA)
In the presence of an asymmetric shock, what suits one country hurts the other

o If the unions common external E floats freely, E to 2. The outcomes is a combination of excess S in A & excess D in B (CC and DD). Both countries are in disequilibrium. = Fundamental & unavoidable cost of forming a monetary union Disequilibria cannot last forever. Over time, prices are flexible and will do what they are expected to do. A cannot sell all of its production, so its price level must decline until E to 1 = recession B: price will rises = inflation

Recession & disinflation in A and Boom & inflation in B are the costs of a monetary union when asymmetric shocks occur.


Optimum currency area (OCA) criteria

When should a region share the same currency? 3 economic criteria: -

Labour mobility (Mundell)

Idea: the cost of sharing the same currency would be eliminated if the factors of production, capital and labour were fully mobile across borders. Initial problem: unemployment in A and inflation in B Both problems would be solved by a shift of the production factors. Shift of AS curves. This reallocation changes GDPs so that output gap is zero at both eq point C and D. Once factors of production have moved the currency areas E delivers 2 that is best for each one.

Not so easy: languages problem, cultural, skills, -

Production diversification ( Kenen)

Idea: Asymmetric shocks are trouble but are rare. The countries most likely to be affected by severe shocks are those that specialize in the production of a narrow range of goods. A country that produces a wide range of products will be little affected by shocks Countries whose production and exports are widely diversified and of similar structure form an optimal currency area -

Openness (Mc Kinnon)

Trade competition ensures that the prices of 2 same goods are everywhere the same and therefore, largely independent of the exchange rate. If an economy is small and very open to trade, it has little ability to change prices of its goods and giving up the E does not matter for competitiveness. Countries which are very open to trade and trade heavily with each other form an OCA

3political criteria -

Fiscal transfers

An important aspect of the analysis is that country B suffers from the adverse shock that hits country A. One possibility is for country B to financially compensate country A. Such a transfer mitigates both the recession in A and the boom in B. This gives time for the shock to disappear. Countries that agree to compensate each other for adverse shock form an OCA -

Homogeneous preferences

Countries must share a wide consensus on the way to deal with shocks -

Solidarity vs. nationalism

The people that form the currency union must accept that they will be living together and extend their sense of solidarity to the whole union. Countries that view themselves as sharing a common destiny accept the costs of operating an OCA

Is Europe an OCA?
Are there often and large asymmetric shocks in EU? Labour mobility: low unemployment bears much of the burden of adjustment to shocks Fiscal transfers : the overall EU budget is low (1% of EU GDP) and entirely used for administrative, CAP, regional and structural funds Openness: most EU countries are very open Diversification; Most EU countries have a diversified production structure


Will Europe become an OCA?

Effects of a currency union on trade: Living in a monetary union may help fulfill the OCA criteria over time. Some studies have reached the conclusion that eliminating exchange rate volatility by adoption a common currency raises trade. Currency union McKinnon criterion Effects of trade on specialization: Will diversification grow or decline Argument 1: among developed countries, integration leads to intra-industry trade: exports and imports include similar goodsgrow: McKinnon Kenen criterion Argument 2: Trade leads to more specialization as each country focuses on its comparative advantage decline ??? Effects of a currency union on labour markets: Mobility may not change much, but wages could become less sticky.

Beyond the OCA criteria:politics In the end, monetary union is not only about economics. The OCA criteria do not send a clear signal: The EU is not a perfect OCA A monetary union may function, at cost

The OCA criteria tells us only where the costs will arise: Unemployment Political tension if deep asymmetric shocks



Fiscal policy in the monetary union
In a monetary union, fiscal instrument assumes greater importance because it is the only macroeconomic policy left at the national level. In the IS-LM model: monetary and fiscal policies are good substitutes but in reality fiscal policy is more difficult to activate and less reliable than monetary one. A common problem with both instruments is that they affect spending largely through expectations: less tax today means more tax tomorrow. Fiscal problem: slow implementation: (= discretionary fiscal policy: a voluntary decision to change tax policy) Agreement within government Agreement within parliament Spending carried out by bureaucracy Taxes are not retroactive Countercyclical actions moves can have pro-cyclical effects: the delay may even be such that, when fiscal policy affects the economy, the problem that was meant to solve has disappeared.

Fiscal advantage: automatic stabilizers Fiscal policy has one important advantage: it tends to be spontaneously countercyclical. When economy slows down: indiv incomes, corporate profits low tax revenues declines spending on unemployment benefits, rises the budget worsen and fiscal policy is automatically expansionary

The cyclically adjusted budget balance = an estimate of what the balance would be in a given year if the output gap were zero. If actual budget balance (1) < cyclically adjusted budget balance (2) output below its potential (output gap negative) (1) - (2) = the footprint of the automatic stabilizers


Fiscal policy externalities

Fiscal policy by one country may spill over to other countries through a variety of channels: income and spending, inflation or borrow costs. = externalities Implies that countries stand to benefit from coordinating their fiscal policies On the one hand, the setting up of a monetary union strengthens the case for fiscal policy coordination as it promotes economic integration On the other hand, fiscal policy coordination requires binding agreements which would limit each countrys sovereignty. Cyclical income spillovers Business cycles are highly synchronized in Europe What does it mean for fiscal policy? Ex: if 2 member countries face recession, each gov will adopt an expansionary fiscal policy but to less extend because they rely on the others action. Borrowing cost spillovers Fiscal expansion increase public borrowing push interest rates up. Once they share the same currency, Eurozone member countries share the same interest rate higher interest rate for everybody deter investment and affect long-term growth. Excessive deficits (potential source of spillover) deficit bias Deficit bias = a disquieting tendency for governments to run budget deficits for political reasons What happens when a public debt becomes unsustainable? a) Heavy public borrowing is a sign of fiscal indiscipline that could trouble the international financial markets. If markets believe that one countrys public debt is unsustainable, they could view the whole Eurozone with suspicion capital outflows euro weakness b) If the country can no longer service it, it must default massive capital outflows, collapse of the exchange rate, deep recession and unemployment Answer to address risk: no-bailout clause in Maastricht Treaty: no official credit can be extended to a distressed member government Prevention procedure


In the end, should fiscal policy independence be limited? Arguments in favour of the limitation: o Serious externalities o A bad track record Arguments against o This is the only remaining macroeconomic instrument o National governments know better the home scene

The Stability and Growth Pact

The SGP meant to avoid excessive deficit upon entry into euro area. Admission to the monetary union requires: A budget deficit < 3% of the GDP A public debt < 60% of the GDP Or declining towards this benchmark

However, because fiscal policy remains a national competence, final word has to be given to ECOFIN, the council of Finance Ministers of the Eurozone. Recognizing that the Pact was too rigid to be enforceable, governments and the Commission prepared a reformulation of the Pact in 2005. The revised SGP seeks to avoid a situation where sanctions have to be applied prevention The Pact consists of 4 elements: 1) A definition of what constitutes an excessive deficit 2) A preventive arm, designed to encourage governments to avoid excessive deficits o Aims at avoiding reaching the limit in bad years o Calls for surpluses in good years o Submission budget forecast for next 3years, discussed at ECOFIN + Commissions assessment 3) A corrective arm, which prescribes how governments should react to a breach of the deficit limit 4) Sanctions

Recognition that the budget balance worsen with recessions o Exceptional circumstances when GDP falls by 2% or more: automatic suspension of the excessive deficit procedure o When GDP falls by > 0.75%, the country may apply for suspension o Leniency when slow growth continues over years Precise procedure that goes from warning to fine.

When the 3% is not respected: The Commission submits a report to ECOFIN ECOFIN decides whether the deficit is excessive or not If so, ECOFIN issues recommendation with an associated deadline The country must then take correction action ECOFIN decides whether to impose a fine The whole procedure lasts about 2years

How is the fine levied? The sum is retained from payment from the EU to the country (CAP, structural and cohesion funds) The fine is imposed every year when the deficit > 3% The fine is initially considered as a deposit: o If the deficit is corrected within 2 years, the deposit is returned

The role of prevention: Emphasis on precautionary measures to avoid warning and fines Each year, each country presents its planned budget for the next 3 years, along with its growth assumptions The Commission evaluates whether the submission is compatible with the Pact

Does the Pact impose procyclical fiscal policies? Budgets deteriorate during economic slowdowns and reducing the deficit in a slowdown may further deepen the slowdown. Moreover, a fine both worsens the deficit and has procyclical effect. Solution: a budget close to the balance or in surplus in normal years.

What room left for fiscal policy? The automatic stabilizers: The automatic response of budget balances to cyclical fluctuations is a source of difficulty for the SGP. The Pacts strategy is that, in normal years, budgets should be balanced to leave enough room for the automatic stabilizers in bad years. If the budget is balanced in normal years plenty of room left for automatic stabilizers

In practice, the Pact encourages aiming at surplus and giving up discretionary policy


The November 2003 decision: ECOFIN decides to suspend the Pact (pressure from France and Germany) The European Court of Justice recognizes the right of ECOFIN to interpret the pact but considers that the suspension decisions is illegal The governments commit to re-examine the pact

Limits of the Pact: Economic issues: o Annual deficit are endogenous o Annual deficit tell little about fiscal discipline o Evolution of debt is more important Political issues: o Fiscal policy remain national sovereignty

The March 2005 decision: Principles of the pact of upheld o 3% deficit limit o Fines to be decided by ECOFIN Flexibility introduced o Will take into account debt level o Will take into account growth over recent years Pact strengthened: add preventive arm to corrective arm Pact undermined: allows excess deficit when spending is good ECOFIN free to interpret the pact

Recent evolution: Bailout for Greece (May 2010), Ireland (November 2010), Portugal (May 2011) Creation of the EFSF: the European Financial Stability Facility