Market integration: how it works 1

3
Market integration: how it works

Ulrich Koester

1. Introduction
The European Union is one of the few examples in the world where agriculture is included in
the integration of national markets. Its experience has shown that the integration of
agriculture causes special problems. Whereas most other sectors can be integrated by
removing tariffs (negative integration), the integration of agriculture necessitates an
adjustment of national policies (positive integration) and, hence, reduces national autonomy
in the area of agriculture and food policy. The experience of the Common Agricultural Policy
(CAP) shows that integration of the agricultural sector can lead to increased divergence in the
national interests of participating countries. The extent of this phenomenon depends largely
on the institutional framework that was set up when integration began.
“Integration is taken to denote a state of affairs or a process involving attempts to
combine separate national economies into larger economic regions” (Robson, 1990, p.1).
Integration as a means of stimulating trade and improving the division of labour amongst
countries has been recommended by many economists, from Ricardo on. The foundation of
the GATT in 1948 gave further impetus to integration by promoting greater acceptance of the
most favoured nation principle. Article 1 of the GATT states: "All contracting parties must
accord any advantage, favour, privilege or immunity granted to any product from any other
country immediately and unconditionally to all other members". This resulted in significant
integration of world markets in manufactured goods. Moreover, the eight GATT Rounds
have led to considerable tariff reductions for trade in manufactured goods, with average tariff
levels of less than 4 per cent for OECD countries in 1997. Exemptions for agricultural trade
were, however, accepted, although to a decreasing extent over time, in order to accommodate
national policies designed to protect farmers. Agriculture was dealt with comprehensively
only in the last GATT Round of 1986-93. The current Millennium Round of trade
negotiations will most likely reduce agricultural trade barriers further and restrict domestic
agricultural policies even more than has been the case so far. It can be assumed that
international agricultural markets will become yet more integrated in the coming years.
Apart from integrating world markets, there is an increasing tendency to create new
regional integration schemes. The European Union (EU) is one of the most prominent
examples. This chapter discusses the different stages of economic integration and their
impact on agricultural markets, welfare, income distribution and market instability.
Integration can be achieved by different means. Reducing non-tariff and tariff barriers to
trade can be the main tool for integrating markets. This type of integration is known as
negative integration. The term implies that a government’s only role is to withdraw from
interference in the movement of goods and factors of production across national borders.
Indeed, this may be sufficient to integrate some markets for manufactured goods, where
governmental regulations play a minor role. The situation is different for agriculture. Most
nations regulate their agricultural and food markets more intensively than other sectors.
2 Ulrich Koester

Hence, integration of agricultural markets requires more than negative integration. Instead,
the Government may have to adjust domestic policies and institutions and, moreover, there
may be a need to create some supranational arrangements. Integration of this type is called
positive integration (reasons for positive integration are presented in Molle, 1990, p.27).
Experience has shown that positive integration is more important for the success of an
integration scheme than negative integration. The EU offers examples of the different
elements of positive integration. Allocation of decisions in agricultural policy making
between the EU and member countries, the design of the EU decision making process, the
rules for financing the EU policies, and the agreement on the main pillars of agricultural
market organisations1 are the most important aspects of positive EU integration.
For analytical purposes, it is helpful to make a distinction between the following forms of
integration (see among others Swann, 1996, p.3):
a) a Preferential Agreement involves lower trade barriers between those countries which
have signed the agreement. For examples, see below.
b) a Free Trade Area reduces barriers to trade among member countries to zero, but each
member country still has autonomy in deciding on the external rate of tariff for its trade
with non-member countries. EFTA (European Free Trade Area) and CEFTA (Central
European Free Trade Area) are prominent examples (for further reading refer to
Wonnacott, 1966, pp.62-66).
c) a Customs Union represents a higher stage of economic integration than a Free Trade
Area as the member countries adopt a common external tariff. Until the end of 1992, the
European Community was basically a Customs Union, although the stage of integration
was somewhat higher in some respects, notably concerning the Common Agricultural
Policy.
d) a Common Market goes beyond a Customs Union in allowing for free movement of
labour and capital within the Union. Hence, the intention of a Common Market is to
integrate both product and factor markets of member countries. The Single Market of the
EU, which came into force on January 1, 1993, constitutes a Common Market.
e) an Economic Union is the highest form of economic integration. In addition to the
conditions of a Common Market, member countries also agree to integrate monetary,
fiscal and other policies.

It is obvious that the least developed forms of integration can rely on negative integration
alone. However, higher forms of integration demand agreement on adjustment or even
harmonisation of national policies. For example, internal free movement of goods and factors
not only requires removal of border restrictions (negative integration), but also removal of
non-tariff trade barriers caused by different legislation in the member countries (positive
integration). Thus, deeper integration necessarily implies surrendering some national
autonomy. This is, in fact, one of the main reasons why integration plans that include
agricultural markets tend to fail. Governments often believe that agricultural markets are too
important for society (mainly for misguided beliefs about food security) to be left entirely to
market forces, and they are unwilling to give up national autonomy in manipulating
agricultural markets. A recent example involves the Central European Free Trade Area
(CEFTA), the multilateral agreement between the Czech Republic, Slovak Republic, Poland,
Romania, Hungary and Slovenia that came into force on April 1, 1998. Already in July 1998,

1
"a) market unity – a single agricultural market, a common marketing system and common pricing; b)
Community preference – the competitiveness of Community producers should not be undermined by
third country imports; c) financial solidarity – expenses incurred to be financed by the Community,
and income generated as part of the Community’s own resources” (Ritson and Harvey, 1997, p.19)
 Market integration: how it works 3

Slovenia infringed the agreement by imposing an embargo on wheat imports from other
member countries in order to support its own internal wheat prices at a higher level.
Traditionally, the theory of economic integration has focussed on the consequences of a
Customs Union. However, in the recent European experience with integration, preferential
agreements have also become important and, hence, the effects of these agreements will be
presented before analysing the implications of a Customs Union. The last section will
consider the effects of a Single Market.

2. The effects of preferential agreements

Preferential agreements are often considered to be the first and smallest step on the road to
further integration (Bhagwati, and Panagariya, 1996, p.82). Such schemes imply that a
country or region like the EU grants other countries preferential access for imports.
Preferences can be given in the form of tariff reductions for unlimited volumes of imports
from specific countries or for specified import quantities. The latter are called tariff rate
quotas (TRQs); imports above the quota limit face the normal tariff rate that applies for non-
preferential imports.
The so-called Europe Agreements are preferential agreements whereby the EU granted
some Central and Eastern European countries easier access to EU markets. Preferential
access for imports from the preferred countries was seen as the first step towards membership
of the Union. The European Council agreed at the Copenhagen Summit in June 1993 that
"associated countries that so desire shall become members of the European Union"
(Buckwell and Tangermann, 1997, p. 308). Preferential agreements are more prominent for
agricultural than non-agricultural trade. As protection of EU agricultural markets is generally
much higher than in the case of markets in manufactured goods, the pressure for agricultural
trade preferences is higher than for preferences in other sectors.
Trade preferences may affect the joint welfare of both parties to a preferential agreement,
and may redistribute welfare between the trade-granting and preference-receiving country.
They may also affect third countries that are not parties to the agreement.

Welfare effects in the preference-receiving country

We assume, first, that products offered on the world market and in the individual countries
are homogeneous. Hence, there is only one world market price. Second, we assume that there
are no transport or other transaction costs. Hence, prices would be equal at all locations in a
free trade world. Any price difference between locations must be due to trade restrictions.
Third, producers try to maximise their profit under perfect competition. Countries are
relatively small and, hence, have no impact on the world market price. Consequently, they try
to adjust production so that domestic marginal cost equals market price. Profit maximisation
by producers leads to maximisation of total welfare. Fourth, there are no external effects in
production or consumption. Fifth, the preference-receiving country (A) is a free trader in the
pre-preference period and tries to maximise the welfare gain from trade preferences. The
preference-granting country (B) fixes the domestic producer and consumer price at pdG. In
order to secure this market price, imports face a tariff at least equal to the difference between
the domestic and world market prices. Thus, foreign supply is restricted onto the market of
country B. As country B produces a surplus, an export subsidy is paid equal to the difference
between its domestic price and the world market price.
The initial situation is presented in figure 1. Country A’s price is pd = pw0, and its
domestic production is qS0R, which is optimal since marginal cost equal to world market
price. Suppose
4 Ulrich Koester

Figure 1: Economic Effects of Preferential Agreements

Preference Preference
receiving country granting country World market
P P P RoW
Country A Country B
D
PdG PdG C
Pd2

Pd1R G‘ C‘ Pd1R F
E

PdoR=PWo PWo PWo

E‘ F‘ A‘ B‘ A B
PW1 PW1 PW1
R
qDo R
qSo q G
qDo Gq q q
qT So T
q
PWo = World market price without preferences
PW1 = World market price with preferences
qT = Tarriff quota
R
Pdo = Domestic price in preference receiving country (country A) in free trade situation
R
Pd1 = Domestic price in preference receiving country in protected situation
G
Pd = Domestic price in preferece granting country (country B)
RoW = Rest of the World
 Market integration: how it works 5

country A feels discriminated against by country B because of its protectionist trade barrier,
and demands preferential access, and assume that country B allows country A to export to B
without paying any duty on the quantity qT (=tariff rate quota). Hence, country A could
receive the revenue qT times pdG for the exported quantity qT, which is greater than the export
value without the preference by the amount equal to the area ABCD in the panel for country
B. This amount can be called an economic rent, as it exceeds the revenue received without
the preference. It represents A’s potential welfare gain.
However, it is by no means guaranteed that this economic rent will be captured by
country A. The Europe Agreements illustrate this point. Licenses are given by the
Commission to traders located within the EU, allowing them to import specific volumes of
products, either duty-free or at reduced tariffs. These EU traders buy in foreign markets at
market prices and sell on EU markets without paying import duties. If this type of trade
generates profits, they will generally accrue to the importer (that is, the trader), and only
exceptionally to the exporting country. The latter can only take advantage of trade
preferences if it sets up special trading rules that allow them to exploit the preference rents.2
Assume that country A is in fact able to extract the rents completely. The question is
whether the welfare gains could be increased by adjusting domestic production. Assume that
country A distributes the rent to producers by paying them a price above the world market
price, say price pd1. With this higher incentive, producers would expand production. Overall
welfare would increase if the change in production costs were less than the change in
revenue. The change in production costs is equal to the area below the supply curve. The
change in revenue due to the expansion of production is equal to the change in production
times the world market price. Note that the country would miscalculate the change in revenue
if it were to multiply the change in production by the price received in country B. The higher
revenue from sales in country B can be earned even without expanding domestic production.
Hence, the marginal revenue for exports of country A is not affected by the preference
agreement; the marginal revenue for a small country is always equal to the world market
price. Consequently, the expansion of production in country A would lead to a welfare loss
equal to the triangles under the supply curve and the demand curve3.
Based on our initial assumptions, trade preferences may not affect the welfare of the
preferred country at all if the importing companies of the trade-granting country capture the
rent completely. However, our initial assumptions do not always hold in reality. Hence, in the
following analysis we drop the assumption of product homogeneity. For example, it may be
that the products of country A are of inferior quality to those of country B and of other
competing countries. A zero tariff rate for the TRQ would allow country A to offer products
at discounted prices in country B. Even more important, country A could collect market and
product information in country B, might learn to produce high quality products at competitive
prices and would be able to establish trade links that lower transaction costs. It is more likely
this dynamic effect that makes trade preferences attractive for preference-receiving countries.
Above, it has been assumed that the law of one price prevails. However, due to product
heterogeneity, transport and transaction costs, there is more than one world market price for
each product. Suppose that country A is not competitive on some foreign markets. Tariff

2
Preferential beef exports from Botswana illustrate this point. The Botswana government levies a tax
on exports to the EU that is equal to the import duties levied by the EU on exports from non-preferred
exporters.
3
Welfare economics reminds us that there are always losses in welfare on the supply and demand side
if the domestic price differs from marginal export revenue or marginal import expenditure in a
country without domestic distortions.
6 Ulrich Koester

reduction for imports within a quota gives it a competitive edge and, hence, access to B’s
market may create potential for trade expansion.

Welfare effects in the preference-granting country

The situation of the preference-granting country (country B) is depicted in panel 2 of figure
1. If it sets a price domestically, its welfare loss is equal to the area ABCD. This loss might
be partly offset by a decline in the overall protection rate if preferred imports lead to lower
prices in the country. But this happens only if the domestic market price is not fixed by the
government, as on the EU markets for pork meat, vegetables and fruit. Lower prices on these
markets are beneficial to consumers, but reduce the income of domestic producers. An import
increase of as little as 2 % of domestic supply may lead to a steep decline in domestic prices
(by as much as 6 to 8 %), depending on the price elasticities of supply and demand.
In figure 1 it is assumed that the price fall to pd2 results in positive welfare effects equal to
the shaded areas. The total welfare effect will be positive or negative depending on the size
of the negative effect, i.e. the shaded rectangle, and the two positive effects, the trapeziums.
On EU agricultural markets, the negative effects tend to dominate, as prices are fixed or at
least not very flexible downwards. Country B has additional changes in welfare if output
expansion in country A increases total world production and depresses world market prices.
Country B, as an exporter, would suffer from the change in terms of trade, but it would gain
if it were an importer of the product.
It should be noted that the negative welfare effect in country B is probably higher than
the welfare gain to country A when the domestic price in country B is inflexible downwards.
Country A receives a higher price in country B than in other importing countries, however, it
has to incur transport and transaction costs.

Welfare effects in the rest of the world (ROW)

The ROW might be affected in two ways (see the right hand panel in figure 1).
First, preferences granted to some countries imply a relative increase in discrimination for
other countries. It might be that the preference-receiving countries were not competitive
exporters to the preference-granting country. Thus, preferences can divert trade flows (trade
diversion effect4). The supply curve on the world market shifts to the right and world market
prices decline. Exporters of the product will lose and importers will gain. A recent example
of such trade diversion concerns the agricultural imports of Slovenia. The country used to
import its wheat requirement from the cheapest supplier, which was Ukraine, whilst imposing
an import duty on these imports. When Slovenia became a member of the WTO it had to bind
its border measures and agreed to TRQs for member countries, replacing cheap wheat
imports from non-member countries by wheat from WTO member countries. Thus, the origin
of imports changed and import prices rose.
Second, if the preferred country passes on some or all of the revenue increase to its own
producers, thereby stimulating production and if, as a consequence, joint production in the
preference-receiving and granting countries is higher than without the preferences, then
world market price may fall, to the disadvantage of exporting countries and to the benefit of
importing countries.

4
“Trade diversion” occurs if a country replaces imports from low-cost producers by imports from
high-cost producers.
 Market integration: how it works 7

3. The effects of a Customs Union

In a Customs Union, countries agree to abolish tariff and non-tariff barriers to trade in goods
flowing between them. In addition, they agree to a common external tariff. This was in fact
the first phase of integration of the European Community on the way to the Common Market.
Regional market integration through a customs Union can contribute to an increase in
overall welfare (for a more detailed analysis see Smeets, 1996, pp.47-75). Depending on the
external tariff structure before and after creating the Union, relative prices in the member
countries will adjust to those on the world market. This will always happen if the countries
decide to average the tariff rates that prevailed in the pre-Union period. Actually, countries
that want to create a customs Union and that are members of the WTO are supposed to adopt
common tariff rates that are no higher than the average pre-Union rates. Integrating markets
and adjusting tariff rates leads to more or less equal price ratios in the member countries.
Whether countries will be better off after the creation of a customs Union depends on the
effects on production and consumption (for an empirical assessment see Frankel, Stein and
Wei 1996, p.52). Production effects are shown in figure 2. Price ratios in the pre-Union
period are given by the slope of the lines RI and RII. It is evident that country I protects
production of product A relatively more than country B. The creation of the Union leads to
the common price ratio RU . If the tariff rates have been averaged, the slope of RU deviates
less from the ratio of corresponding world market prices than the slopes of the curves RI and
RII. Figure 2 clearly shows that total production in the Union is higher than the combined
production in the two countries before the Union. Output of product A in country I increases
more than it declines in country II; and country II increases production of product B more
than the decline in output B in country I.

Figure 2 Production effects of a Customs Union

The welfare effects generated in the member countries depend largely on the extent of
protection in the pre-Union situation in the individual countries and their ability to adjust.
The importance of these factors can be illustrated with the case of France and Germany at the
time of the creation of the original European Economic Community. In the pre-Union
situation, France had more highly protected manufacturing industries and Germany had a
8 Ulrich Koester

more highly protected agricultural sector. It was hypothesised that France would gain mainly
in the agricultural sector and Germany in the manufacturing sector.
However, expectations were not fully confirmed. First, German manufacturers were
already highly integrated into the world market; hence, additional preferential access to other
Union partner countries did not matter much for the profitability of the industry. It seems that
the German manufacturing sector had already widely exhausted economies of scale through
world market integration and the additional gains of preferential access were marginal. The
opposite proved to be the case for France. Highly protected industries in France came under
pressure to adjust and gained significantly in efficiency. In total the sector did not shrink, but
grew even stronger than in the pre-Union period. Second, expectations that the German farm
sector would shrink and farmers’ income would fall did not materialise. The German
agricultural sector was already highly integrated into the German economy, and the booming
overall economy made it easier for some farmers to find higher-paid jobs outside the
agricultural sector, thus leaving a reasonable income for the remaining farmers. The sector
did not shrink, but expanded, because overall growth in the economy and price pressure
contributed to restructuring the sector. Hidden unemployment went down, underutilisation of
machinery became somewhat less wide-spread, and the introduction of new technologies was
stimulated. Consequently, the production possibility curve shifted outward. The last points
emphasise the importance of dynamic effects which are triggered by market enlargement.

Figure 3 Adjustment due to market integration

France Germany

T1
Industrial T1 T1 Industrial G
production F
production T0
T0

C
A
B
B
A

Agricultural Agricultural
production production

Figure 3 shows the adjustment processes following market integration. Both countries had
isolated their markets somewhat from the world market in the pre-Union situation and
produced at the points A on their transformation curves. Given its transformation curve,
France would have produced less industrial goods and Germany more industrial goods in the
pre-Union period. Price ratios differed between the two countries, as indicated by the slope of
the iso-revenue curves T0F and T0G . Price adjustment leading to the iso-revenue curves T1
would have had a highly depressing effect on the industrial sector in France and a slightly
stimulating effect for the industrial sector in Germany. Given the unchanged transformation
curves, factors of production would have had to move from the industrial sector to the
 Market integration: how it works 9

agricultural sector in France and vice versa in Germany. However, market integration
increased competition, especially for highly protected industries in France (given the use of
new technologies) and, thus, shifted the transformation curve outward. As a consequence,
both agricultural and industrial production could increase.
The stylised situation in figure 3 illustrates another important point. Market integration
brings pressures and incentives to adjust production and consumption patterns within Union
member countries (for the specifics of market integration among developing countries see
Langhammer and Hiemenz, 1990). Adjustment needs are stronger if price ratios prior to
integration differ significantly from price ratios after integration. As the pressure to adjust
may lead to the disappearance or contraction of some previously highly protected industries,
there is a danger of additional unemployment unless the expanding sectors absorb the labour
that has been released. Of course, adjustment will be faster if prices on product and factor
markets are flexible. Wage rate flexibility is of special importance, as integration not only
affects product price ratios, but also factor price ratios. This effect is of special importance
when countries at different levels of development integrate their markets. Reducing barriers
to trade will promote trade flows of labour-intensive products from the less developed
countries and of capital-intensive products from the more highly developed countries. As a
consequence, wages will go up in the less developed country, and may decline or increase at
a less-than-expected rate in the more developed country (if unemployment is to be avoided).
In contrast, prices for capital (interest rates) will adjust in the opposite direction in the
integrating countries. In summary, reducing barriers to trade in a Customs Union tends to
equalise product and factor prices amongst the member countries. If policies do not
adequately support the adjustment process, unemployment levels will rise.
Sectoral and overall welfare effects are shown in a partial equilibrium analysis in figure
4. The market situation is characteristic of the EC-6 at the beginning of the 1970s (country A
was characteristic of the EC-6 and country B of the UK). The price in country A was PA and
in country B PB, which was equal to the world market price Pw. After country B becomes a
member, the internal price for the two countries becomes PU.

Figure 4 Economic and distributive effects of a Custums Union

Country A Country B
P P

PA D
G
PU C H K
PU N

PW PB=PW M
A B E F I J L

Dq D Sq Sq q q
o q1 1 o Sq S
o q1
Dq Dq
o
1

Welfare effects show up as the net balance of changes in consumer surplus, producer surplus
and budget effects. In order to separate the welfare effects due to price changes from the
10 Ulrich Koester

effects due to market integration, we assume in the first step that the price changes were
undertaken in a nationally segmented market. Whether a country gains or loses in welfare due
to a price change on a specific market depends on the direction of the price change. If
domestic price moves closer to the level of world market price the country gains, otherwise it
loses. Obviously, country A gains: consumer surplus increases less than producer surplus
declines, but payments for export restitutions decline as the exportable surplus declines. The
total gain in welfare is equal to the areas ABCD and EFGH. Country B has to increase price
on the market under consideration. Hence, it loses in welfare. The change in consumer
surplus is higher than the change in producer surplus and the increase in budget revenue. The
total loss is equal to the two triangles below the supply and demand curves (IJK and LMN).
Changing protection rates may have different results for the member countries in a Union
than would have been the case in the pre-Union period. These differences can be due to four
effects. First, integrating markets implies that there are no tariffs on trade between the
member countries. Thus, country A (see figure 4) can sell part of its exportable surplus in
country B without paying export subsidies. Hence, country A has lower budget expenditure.
In contrast, country B has lower revenues. Hence, the common external tariff implies national
losses or gains as tariff revenue or export subsidies for intra-Union trade disappear.
Second, any customs Union needs a rule about how to allocate customs revenue. The EU
has agreed on a financial system which demands that countries have to hand over the customs
revenue (minus a charge of 10 per cent for administrative costs) to the EU Commission. The
revenue can be used to finance common policies such as the implementation of common
border measures. This rule implies that importing countries have to accept a higher welfare
loss if prices are above the world market level. Hence, country B in figure 1, which would
have some tariff revenue under national autonomy, has to give up all its tariff revenue.
Consumers in country B are partly taxed in favour of producers in country A. Consumers
were also taxed in the pre-Union situation, but the government could use the money either to
finance specific projects, which might have generated positive welfare effects for the society
at large, or it could have lowered the tax revenue from other sources. Hence, the tariff
revenue was not an economic cost for the country. However, market integration means
passing over the tax revenue to the Commission and renouncing the opportunity to raise taxes
on intra-Union trade. This increases welfare costs by the amount of tax revenue foregone.
Third, it might well be that the Union produces an exportable surplus of some
commodities at support prices and the revenue from tariffs is not sufficiently high to balance
the export subsidies. Hence, the Union needs to be financed. It might well be that even those
countries which contribute to the overall financing by tariff revenue foregone have to pay an
additional contribution to the common budget. This is currently the situation for some
member countries in the EU.
Fourth, by setting the common external tariff, the Union may influence world market
prices. The EU is certainly a large country according to the definition of trade theory. Hence,
raising domestic prices will either reduce imports or increase exports, both leading to
depressed world market prices. Concerning the budget effect in figure 4, the Union gains
revenue as a levy or tariff is imposed on imports from third countries. Country A may even
gain more from the Union if the revenue from the import levy is at least partly distributed in
favour of country A.
It should be remembered that the distributional effects of the CAP have always caused a
problem for agricultural policy decision-making in Brussels (Koester, 1996, p.146).
Moreover, the above analysis clearly shows that the national economic costs of the CAP (the
welfare effects) are not equivalent to the net financial transfers as calculated from official
statistics.
 Market integration: how it works 11

The analysis makes quite clear that the economic effects of a customs Union depend very
much on the decisions made at the outset. The level of the common external tariff is of
paramount importance. Forming a customs Union is supposed to improve the division of
labour among the member countries. However, as the Union will continue to trade with the
rest of the world, it is important to know how trade within the Union and with the rest of the
world will be affected. If the average tariff rate is higher after integration, there are likely to
be more trade-diverting effects than trade-creating effects5. Regional integration could lead to
a ‘Fortress Union’ which is more isolated from the world market than the national markets
were in the pre-Union situation. The potentially positive effects of regional integration would
be offset by segregation from the world market.
The effects of a customs Union also depend on the decision-making process in the Union
and the choice of instruments applied for border protection (see Koester, 1996, p.162). The
importance of these determinants can be highlighted by the case of the EU. The European
Union first agreed on a common price level for agricultural products taking into account the
prices prevailing on national markets in the pre-Union situation. However, the outcome was
not a simple average of national price levels. Instead, it took into account divergent national
interests. Second, variable levies were introduced as an instrument. The use of this instrument
meant that the external degree of protection has to rise when world market prices decline and
prices remain unchanged in the Union. The rules for the common market organisations set up
for individual agricultural products allowed the decision making body (the Council) to
change prices on a discretionary basis. The Council did this in most cases in the annual price
round. Unfortunately, the unwritten rule was accepted (the so-called Luxembourg
compromise, which began with the empty chair of France) whereby price decisions must be
unanimous if one country claimed its vital interests were at stake. This rule was applied for
more than 20 years. It is quite obvious that national interests involving price changes for
individual products diverge, and they are likely to diverge even more over time if economic
and political conditions change differently for countries over time. With the unanimity rule,
each individual country is likely to try and serve its own interest more than that of the Union.
Even worse, each Council member will not try to maximise the interest of his country, but
instead the narrow interest of his constituency, namely the agricultural sector; there is ample
evidence that the Council members pursue the perceived interests of farmers and not those of
the society at large. Hence, it should be no surprise to find that EU agricultural protection has
risen over time. It was only the Uruguay Agreement that changed the influence of the
agrarian lobbies in the annual price round. The message is: if a customs Union sets up rules
which allow for discretionary decisions in fields where there is a wide divergence in national
interests, the outcome will probably not be in the interests of the Union. The aggregate of
national interests is not equivalent to welfare maximisation of the Union.

Expected welfare effects in new EU member countries

The general analysis of the effects of a Customs Union has made clear that the welfare of
new member countries can be affected as follows:
• Changes in the rate of external protection will have positive or negative welfare effects;
• Accepting the common external tariff may have trade diversion effects, if the new
member country has to import at higher costs; this effect implies that there are invisible
transfers of real income among the member countries;

5
For “trade diversion” see footnote 4. “Trade creation” means that high-cost production will be
replaced by imports from lower-cost producers. These terms are due to Viner who is considered the
founder of market integration theory.
12 Ulrich Koester

• The system of common financing (financial solidarity) may affect new member countries
positively or negatively;
• Joining the Common Market implies enlargement of markets and enhances competition.
Transaction costs will decline and trade will expand. Hence, dynamic effects may give
rise to welfare gains.
These general findings allow us to draw some conclusions concerning the expected effects
faced by new member countries like those currently negotiating for EU membership.
• Existing members of the Union have adopted the acquis communitaire6. New member
countries are required to accept all the EU regulations when they enter. Hence, the rate of
protection in a new member country may go up or down depending on its rate of
protection prior to joining the Union. Concerning protection for agriculture, all Eastern
and Central European countries except Slovenia still have significantly lower border
protection than the EU for many products. Hence, agricultural producer and food prices in
these countries will increase if the Common Agricultural Policy (CAP) has not changed
up to the time of accession. Agricultural producer surplus will go up, but consumer
surplus will decline. The positive change in the first would overcompensate the negative
change in consumer surplus only in food surplus countries. In any case, rural income
would go up immediately after accepting the common price level, and resources would be
attracted into, or retained in, the agricultural sector. This implies a deterioration in
resource allocation.
• The negative effect of higher agricultural protection could be (over-)compensated by
transfers due to the Common Agricultural Policy. If the new member countries were to
receive the same payments per hectare of grain and oilseeds as the present member
countries, all new member countries would receive significant transfers. It should be
noted that these transfers are tied to area and, hence, would boost land prices. The main
gainers would be the landowners.
• All new member countries are likely to gain from becoming members, as they will
become more attractive to foreign investors. Foreign investment will promote growth in
these countries, partly due to the increase in the capital stock and partly due to the import
of new technology that is either embodied in capital or in imported human capital These
countries may enjoy similar effects as did Spain and Portugal, which attracted significant
amounts of foreign investment and have enjoyed increasing GDP growth.
• Increased intensity of competition and improved access to EU markets are likely to have
a positive effect on the efficiency of resource use in the new member countries. This
point is of special concern for small countries. However, the food industry in small
countries may come under strong pressure to adjust. If the industry is badly structured,
with too small enterprises and outdated equipment, it may be difficult to survive.
• The EU system of financing will mainly help low-income countries and those which
qualify for special assistance for disadvantaged regions.

5. Market Stabilisation Effect of Market Integration

The foundation of a customs Union can also contribute to stabilisation of markets. This is of
greatest importance for agricultural markets, which often suffer from supply shocks.
According to King’s law, fluctuations in market price depend on the magnitude of the supply
shock and the price elasticity of demand. Supply shocks are generally larger in small
countries than in large countries as diversity of climate and soil increases with the geographic
size of a country or region. Figure 5 clearly shows that fluctuations in production are larger

6
The acquis communitaire comprises all the EU legislation in force.
 Market integration: how it works 13

on the national level than on the regional level or in world production. Market prices in an
unstable production environment can be stabilised either by changes in stocks which have to
be negatively related to changes in price or by trade between regions with uncorrelated
fluctuations in production7. Market integration lowers barriers to trade and, thus, improves
the stabilising effect of trade.

Figure 5 Instability in wheat and corn production – MacBean-index 1960-1996

wheat c o rn

25
20
15
10
5
0
s

en
5

l
ce

ia
k

ain
ce
ux

UK
ly
ld

ga
nd
ar

an
-1

lan

Ita

str
or

ed
an
ee
l-L

rtu
Sp
nm
EU

rla
rm
W

Ire

Au

Sw
Fr
Gr
Be

Po
the
De

Ge

Ne

Source: PSD data from 1960 to 1996 (the Mac Beean Index measures the annual deviations from a
five year moving average)

4. The Effects of a ‘Single Market’

The EU created a ‘Single Market’ in 1993. There are two important differences between a
common market and a customs Union:
a) Movement of goods amongst the member countries is supposedly no longer controlled.
Such controls were needed before 1992 because value added taxes were not harmonised.
Harmonisation had yet to be achieved in 1993 (although it was intended and set high on
the policy agenda) but the member countries agreed to administer differences in the value
added tax without control of border trade. Value added tax has not been harmonised up to
2000 and there is no strict deadline fixed for achieving it.
b) The introduction of the Single Market officially liberalised movements of factors within
the Union.
The economic effects of the Single Market are more or less the same as discussed above
under the customs Union. The only difference is that the effects described above are
enhanced by lowering transaction costs across borders. Free movement of factors increases
the speed of factor price equalisation.
Due to lower transaction costs for cross-border trade, significant positive welfare effects
were expected. It was predicted that firms in the EU could expand their markets and thereby
gain through exploiting economies of scale. The Cecchini Report (1988) gave estimates of

7
Integration of regions will lower the coefficient of variation in market supply even if fluctuation in
production in the integrating regions are completely uncorrelated or even if they are somewhat
positively correlated. (Koester 1986).
14 Ulrich Koester

the aggregate benefits as 2.8 to 6.4 per cent of the EU’s GDP. Of course, it is difficult to
assess whether expectations have been realised. It has certainly not been a boom time for the
EU since 1993, but perhaps it would have been even worse without the Single Market.
The introduction of the Single Market had significant repercussions on agricultural policy
in the Union. An outside observer may have thought that agricultural markets were already
integrated, given the term “Common Market”. Actually, agricultural markets were not
integrated, as special border measures were applied even for intra-EU trade. These measures
- the so-called ‘Monetary Compensatory Amounts’ (MCAs) - were introduced in 1969 in
order to avoid the decline in intervention prices after currency re-evaluations and to postpone
rises in intervention prices after currency devaluations. MCAs disappeared with the
introduction of the Single Market. Thereafter, agricultural prices can only differ between
member countries by an amount that reflects transport and transaction costs. This stronger
linkage between agricultural prices among the member countries implies that the relationship
between intervention prices and market prices is even looser and more flexible than in
previous years.
The move to the Single Market narrowed the scope for autonomous agricultural policy
measures at national level. As long as transaction costs for border trade were fairly high,
national Governments could apply measures that raised domestic intervention and market
prices somewhat above the level found in other countries. In practice, it was usually the
German government that applied intervention rules more favourably for farmers. When
transaction costs are low, any differentiation in national measures will stimulate cross-border
flows of products and factors more strongly.
Granting free movement of factors will also have an impact on the equalisation of
agricultural income between neighbouring countries. Dutch farmers have illustrated how this
effect works. The reunification of Germany motivated farmers from the Netherlands to settle
in the former East Germany. Thus, German agricultural policy measures intended to support
German farmers accrued in part to farmers from the Netherlands. It can be assumed that the
process of farmer migration, which will contribute to the equalisation of farm income and
land prices, will increase in coming years following the completion of the Single Market.

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