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Economics of European Integration
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Economics of Economic Integration
WHAT IS THIS COURSE ABOUT?
DURING THE LAST DECADES, THE CONTINUOUS PROCESS OF
ECONOMIC INTEGRATION HAS BEEN THE LOCOMOTIVE FOR
SHAPING THE FUTURE OF THE EUROPEAN COMMUNITY ON ITS
STONY AND INTRICATE JOURNEY TO SURPASS THE RUINES OF
WW2 AND REACH THE OPEN BORDERS OF THE EUROPEAN
SINGLE MARKET. DRIVEN BY MILE-STONES SUCH AS MUTUAL
TRADE INTEGRATION IN GOODS AND SERVICES, FREE CAPITAL
FLOWS, LABOR MOBILITY AND A COMMON CURRENCY, THE
EUROPEAN UNION SINCE THEN IS SEEN AS A SYMBOL FOR
FREEDOM, SECURITY AND PROSPERITY. BUT RECENTLY DARK
CLOUDS HAVE RISEN OVER THE RING OF STARS THREATENING
THE COHESION AND SOLIDARITY OF OUR EUROPEAN COM-
MUNITY. ECONOMIC TURMOILS, THE RISE OF ANTI-EU PARTIES,
THE REFUGEE CRISIS, THE BREXIT VOTE & THE COVID-19 CRISIS
CALL FOR NEW SOLUTIONS TO THE THREATS & CHALLENGES
WHICH ARE STILL WAITING ON THE ROAD AHEAD TO (E)UTOPIA
TOO FAST?
OKAY, LET’S START WITH THE ”BASICS”

DESCRIPTION ENTRY QUIZ
INTRO TOUR VISION

OUTLINE OF THIS COURSE
Course Participants:
 SDU students (mostly 5. semester, elective course)
 Exchange Students (ERASMUS)
 Timo Mitze (ØI, instructor)
ROI: 10 ECTS
Aim of the course:
This course equips students with general knowledge in the field of the economics of international
integration linked to the main economic policy issues that arise in this context - thereby giving
specific reference to the European Union. The course thus enhances the students’ skills in analyzing
international economic issues with special reference to issue of international trade, economic
growth and development as well as cross-national labor markets. Further, the course provides
insight into the principles of monetary integration among countries and discusses advantages and
problems therein. When dealing with these issues, strong emphasize is given to the institutional
dimension and economic policy.
Format:
Lectures, Supervisions, Examination (Term Paper & Oral Exam)
OUTLINE OF THIS LECTURE
Course description
(https://odin.sdu.dk/sitecore/index.php?a=searchfagbesk&bbcourseid=b540027101-od-e21)
Lecture plan
(Document can be found in the Resources)
List of potential term paper topics

(Document can be found in the Resources section)
Registration of term paper topics and supervisions

(Editable Google document – Link will be uploaded to ItsLearning)
Further Resources
(Will be built up in ItsLearning during the term)
Lecture 2, 08.09.2021
Institutions & Decision Making in EU

(based on: Ch.1-3 in Baldwin & Wyplosz, 2019)
Timo Mitze
Department of Business and Economics
Email: tmitze@sam.sdu.dk
State-of-the-Union speech by EU Commission President von der Leyen:
“The pandemic reminded us of many things we may have forgotten or taken

for granted.
We were reminded how linked our economies are and how crucial a fully
functioning Single Market is to our prosperity and the way we do things.
The Single Market is all about opportunity - for a consumer to get value for
money, a company to sell anywhere in Europe and for industry to drive its
global competitiveness.
And for all of us, it is about the opportunity to make the most of the
freedoms we cherish as Europeans. It gives our companies the scale they need
to prosper and is a safe haven for them in times of trouble. We rely on it
every day to make our lives easier – and it is critical for managing the crisis
and recovering our strength.”
https://ec.europa.eu/commission/presscorner/detail/en/SPEECH_20_1655
State-of-the-Union speech We
by EU Commission
must make President von der Leyen:
this Europe's
Digital
“The pandemic reminded us of many Decade
things we may have forgotten or taken
for granted.
We were reminded how linked our economies are and how crucial a fully
functioning Single Market is to our prosperity and the way we do things.
The Single Market is all about opportunity - for a consumer to get value for
money, a company to sell anywhere in Europe and for Theindustry to drive its
European
global competitiveness.
Infrastructure: Green Deal is
This
And for all of is
us,aithuge
is about the opportunity to makeourthe
blueprint
most oftothe
opportunity make that
freedoms we cherishand as Europeans. It gives our companies the scale they need
the and
prerequisite transformation
to prosper is a safe haven for them in times of trouble. We rely on it
every dayfortorevitalising
make our lives easier – and it is critical for managing the crisis
rural areas
and recovering our strength.”
https://ec.europa.eu/commission/presscorner/detail/en/SPEECH_20_1655
https://ec.europa.eu/info/strategy/strategic-planning/state-union-addresses/state-union-2021_en
 Concepts of International Integration (≈ Globalization)
 Research on its logic, dynamics, impacts and governance
Global Global
Global Framework UN, G-7/8
Regional Integration Sectoral Integration

(Coverage: Specific geographical area) (Coverage: Specific functional issues)
Sectoral General Regional General

(EEC/EFTA) (CoE) (OAPEC) (IMF)
(NAFTA) (Nordic Council) (EURATOM) (GATT/WTO)
EU
Regional Functional/Sectoral
7
History
8
 Nowadays, advances in European integration are very much
promoted through advances in economic integration
 Nonetheless, European integration has started from a strong
political goal which is not solely focussed on improving
economic conditions (“United States of Europe”)
 In May 1945, Europe lay in ruins. How to go on?
 "Yet all the while there is a remedy . . . It is to re-create the
European Family, or as much of it as we can, and to provide it with
a structure under which it can dwell in peace, in safety and in
freedom.We must build a kind of United States of Europe.“
(Winston Churchill, 19 September 1946)
9
As historical experiments have shown, accomplishing this political
goal seems to be best done via economic integration
⇒ Failure of European Political Community (EPC), European Defence Community
(EDC) in 1950s
1. Locomotive theory
Economic and Monetary Union as strong driver of “finalité politiqué”
2. Coronation Theory
A common currency & complete economic integration only introduced at end of long
process of real economic & political convergence
⇒ Are economic integration forces strong enough to trigger political and social integration?
vs.
10
 Today’s shape of EU institutions can be characterized as the
result from a continuous struggle between
 Federalism (Supranationalism)
 Intergovernmentalism
 Federalist point of view: National sovereignty and nation-

state constitute fragile systems prone to warfare
 Nations should be embedded in a federalist structure with a supranational
organization, which is embodied with some of the power that has traditionally
been exercised by nations
 Intergovernmental point of view: Nation states as most
effective and stable form of government
 European integration should take the form of closer cooperation
 Power in the hand of nations, cooperation to be agreed unanimously
11
 Struggle led to an “dual” approach to integration
 By the 1960s, both political lines were operating
 Intergovernmental: OEEC (1948), Council of Europe (1949), Court of
Human Rights (1950) and EFTA (1960)
 Federalist: ECSC (1951): Belgium, France, Germany, Italy, Netherlands and
Luxembourg (the ‘Six’) place their coal and steel sectors under the control of
a supranational authority, EEC (1957): riding on the success of the ECSC, based
on the Treaty of Rome, ‘Six’ committed to form a customs union, promise free
labour mobility, capital market integration, free trade in services and a range of
common policies
 Which political line will eventually succeed?

 “Domino Effect” in favour of federalist approach (EEC grew constantly), but
 Struggle is still reflected in current multi-pillar structure of EU decision making
12
 Two non-overlapping circles in the late 1960s
Source:
Baldwin & Wyplosz
(2015), chapter 1.
13
 “Domino Effect” of Integration: UK joins in 1973
Source:
Baldwin & Wyplosz
(2012, 2915),
chapter 1.
14
 Time line of (E)EC enlargement by new member states
Hungary, Poland,
Czech Republic,
UK, Ireland, East Germany Slovenia, Slovakia,
Denmark
Estonia, Lithuania,
Greece Latvia, Malta, Cyprus
1957 1973 1981 1986 1990 1995 2004 2007 2013
Portugal, Austria, Romania,

France, West Germany,
Spain Sweden, Bulgaria
Italy, Netherlands,
Finland
Belgium, Luxembourg
Croatia
Candidates: Iceland, Macedonia, Montenegro, Serbia, Turkey
15
 “Reverse Domino Effect” of Dis-Integration? (Wall Street J)
 UK triggered Article 50 of Lisbon Treaty in March 2017
 Article 50 governs how a member leaves the EU:
1. Any Member State may decide to withdraw from the Union
in accordance with its own constitutional requirements.
2. A Member State which decides to withdraw shall notify
the European Council of its intention. (…) the Union shall
negotiate and conclude an agreement with that State, setting out the
arrangements for its withdrawal, taking account of the framework for its
future relationship with the Union…
3. The Treaties shall cease to apply (…) from the date of entry into force of the
withdrawal agreement or, failing that, two years after the notification referred
to in paragraph 2, unless the European Council, in agreement with the
Member State concerned, unanimously decides to extend this period…
16
 What is the current EU-UK situation?
 Brexit happened on 31 January 2020
 EU-UK Trade & Cooperation Agreement
in force since May 1, 2021 set out
preferential arrangements in areas:
 trade in goods and in services,
 digital trade,
 intellectual property, Free Trade Agreement:
 public procurement, zero tariffs and zero quotas
 aviation and road transport, (but market access falls below what
 energy, fisheries, the Single Market offers)
 social security coordination,
 law enforcement and judicial cooperation in criminal matters,
 thematic cooperation and participation in Union programmes
17
Institutions
18
Steps in Economic Integration
Sorry, but… I shacked it like a Polaroid picture…
Customs
Union Common
Market
Free
Trade
Area
Complete
Economic & Economic
Monetary Integration
Union
19
No visible Common Common
Complete Common
internal external monetary policy,
factor economic
trade tariff/trade harmonized
mobility policy
barriers barriers economic policy
Free Trade
Area
Customs
Union
Common
Market
Economic
and Mone-
tary Union
Complete
Economic
Integration
Source:
Robson (1987), Hansen et al. (1992).
22
Back to Prezi: https://prezi.com/view/GZ6e6KlTlvD3VpMAOZKa/
27
 Single Market / Single European Act (1987) aims to create
“an area without internal frontiers in which the free movement of
goods, persons, services and capital is ensured” (i.e., the four
freedoms promised by the Treaty of Rome)
 Established by end of December 1992
 Key elements:
 Goods trade liberalization
 Streamlining or elimination of border formalities; harmonization of VAT rates within wide
bands; liberalization of government procurement; harmonization and mutual recognition of
technical standards in production, packaging and marketing
 Factor trade liberalization

 Removal of all capital controls; liberalization of cross-border market-entry policies, including
mutual recognition of approval by national regulatory agencies
 European Political Cooperation (later: Common Foreign and Security Policy)

28
 1992 was not only important because of the Single Market
 Maastricht Treaty paved the way for next level of integration:
 Monetary union and single currency (€)
 European Central Bank (ECB)
 EU-citizenship = Right to move, live and vote in any EU state
 Social Chapter
⇒ Maastricht Treaty drew a clear line between supranational and

intergovernmental policy areas: 3-pillar structure
⇒ Lisbon Treaty has a roof and only 2 pillars: one for
supranational issues and one for intergovernmental
issues
29
Pre-Lisbon
TEC = Treaty of Rome
TEU = Maastricht Treaty
Post-Lisbon
TEU = Maastricht Treaty Source:

Baldwin & Wyplosz
TFEU is an amended and (2012), chapter 1.
renamed version of the TEC
30
 Supranationality in the EU arises in three main ways:
1. Commission can propose new laws that are the voted on by Member States
(the Council) and EU Parliament
2. Commission has direct executive authority in a limited number of areas – the
most prominent being competition policy
3. Rulings of the European Court of Justice can alter laws, rules and practices in
Member states, at least in limited areas
 Which level of government is responsible for policies in EU?

 Exclusive competences: EU decides alone
 Shared competences: Responsibility shared between EU and Member states
 Supporting, coordinating or complementary competence, where the EU can pass
laws that support action by members
 National competences: National or sub-national governments alone decide
31
Support, coordinate
Exclusive Shared
or supplement
Customs union Certain health policies

Exclusive if EU has policy:
Competition  Cohesion policy
 Agriculture and fiseries Industry
Policy  Environment
Eurozone  Consumer protection Culture & Tourism
Monetary  Transport & Energy
 Certain social policies Education & Training
Policy  Certain public health policies
Conservation Civil Protection

of marine Non-exclusive:
 R&D policies Common Foreign, Security
resources  Outer space policies
 Development cooperation
and Defense Policies
Common  Humanitarian aid
Commercial Source:
Policy Baldwin & Wyplosz (2012),
chapter 3.
32
Decision Making
33
 The allocation of tasks shall be guided by two principles:
 Subsidiarity: Keep decisions as close to the citizen as possible without
jeopardizing win–win cooperation at the EU level (i.e., EU action only if it is
more effective than action at national, regional or local level)
 Example: Local provision of basic education, social transfers etc.
 Proportionality: EU should undertake only the minimum necessary actions

 Example: Very tight VAT harmonization to reduce cross-border shopping
 ‘Burden of proof’ lies on the instigators of EU legislation

 They must make the case that there is a real need for common rules and
common action
 National parliaments serve as ‘subsidiarity watchdogs’
34
 Theory of Fiscal Federalism

 Understanding the allocation of tasks in a systematic way
 Optimal allocation of tasks depends on trade-offs:

 Diversity and local informational advantages: If people have different
preferences, centralized decisions create inefficiencies
 Scale economies: cost savings from centralization
 Spillovers: negative and positive externalities of local decisions argue for
centralization (or, at least, cooperation)
 Democracy: control mechanism that favours decentralization
35
Price (€)
 Diversity and local A: Supply overhang
(times price)
information advantage
B: Demand overhang
 One-size-fits-all policies may lead (times price)
to suboptimal results when
people have diverse preferences
 Central government could set
MVc,2
different local policies but local
B
government likely to have an MC
A
information advantage
 Instrument for analysis: Demand
MVc,1 D2
curves and marginal utility
 MV = Marginal Utility Davg
 MC = Marginal Costs
 Law of diminishing marginal D1
utility (Gossen’s first law)
QD1 Qc,1&2 QD2
Quantity
36
Price (€)
 Scale Economies
 Producing public goods at higher
scale reduces average costs
 This leads to centralization:
transport, medical services, etc.
 Size of shift in MC curve versus
MC
turning of demand curve
(decentralized)
determines whether gain from
scale economies outweighs the C MC
loss from a “one-size-fits-all” (centralized)
decision making D
Davg
D1
QD1 Q’D1 Qc,1&2

Quantity
37
 How does the EU makes decision today?
 EU has several different decision-making procedures
 80% of EU legislation passed under ordinary legislative
procedure = Equal power executed by Council and EU Parliament
 Council adopts legislation by a qualified majority voting (QMV)
and the European Parliament adopts it by a simple majority
 QMV rules from Nice Treaty were applied until November 2014
 Lisbon Treaty simplifies rules but member states can invoke Nice Treaty rules for
particular vote up to 2017)
 Each Member state’s minister casts a certain number of votes (increasing in
population but less than proportional);
 Example QMV: Council requires the approval of 55% of EU
Member States, which must represent at least 65% of the EU's
population (Lisbon treaty voting rules)
38
 New voting rules introduced by Lisbon Treaty (came into effect in 2014)
Population (in total) 2015 Percent

Germany 82,562,004 16.3%
France 64,982,894 12.8%
UK 63,843,856 12.6%
Italy 61,142,221 12.0%
Spain 47,199,069 9.3%
Poland 38,221,584 7.5%
Source: European Commission.
39
 How efficient is EU decision-making?
 In EU decision-making, efficiency means ‘ability to act’
 A perfect measure of efficiency would predict all possible issues to be
voted, decide how members would form coalitions, and use this to develop
an average measure of how easy it is to get things done in the EU
 Such predictions, of course, are impossible
 Passage probability measures how easy it is to find a majority under a given
voting scheme (for a given issue)
 Passage probability = number of possible winning coalitions

number of possible coalitions
 Let’s do a little example on this…
40
 Passage probability in a simple example
A B C Total Votes for yes Qualified majority at
1 1 1 30 15 1
0 1 1 20 15 1
1 0 1 20 15 1
1 1 0 20 15 1
0 0 1 10 15 0
1 0 0 10 15 0
0 1 0 10 15 0
0 0 0 0 15 0
1=yes Votes A 10 Majority threshold Passage probability 0.5

0=no Votes B 10 0.5
Votes C 10
To modify example click here
41
 How has EU’s efficiency changed over time as a result of
reforms and enlargements?
Source: Baldwin & Wyplosz (2012), chapter 3.
42
Trust
43
 Have institutional reforms, policy actions, crises etc. have
influenced the citizens’ trust in the EU?
 How do citizens (in member states) evaluate the Future of
the EU?
Eurobarometer
The Special EB500 “Future of Europe” (FoE) was conducted
between 22 October and the 20 November 2020 in the 27 EU
Member States, as a Joint survey by the European Commission
and the European Parliament. This is the ninth report in the
Future of Europe (FoE) series, initiated by the European
Commission in 2006.
Get the data: https://op.europa.eu/en/publication-detail/-/publication/d3e77637-a963-11eb-9585-01aa75ed71a1/language-en
44
Eurobarometer – first results
Source: https://europa.eu/eurobarometer/surveys/detail/2256
45
EU Budget
46
 Annual EU spending about MULTIANNUAL FINANCIAL
≈ 1% EU27 GDP FRAMEWORK (MFF) 2014-2020
 Main expenditure items:
1. Farming (about half of the budget)
2. Poor regions (about a third of the
budget)
3. Internal and external policies
4. Administration
 EU’s budget must be
balanced every year (by law)
 Main revenue items:
1. Tariff revenues
2. ‘Agricultural levies’ (tariffs on
agricultural goods)
3. ‘VAT resource’: like a 1% value
added tax (reality is complex)
4. GNP based: tax paid by members
based on their GNP
47
 MFF for 2021-2027:
1.211 trillion EURO
(plus: ≈ 800 billion EURO
temporary instrument to
power the recovery)
Details:
https://op.europa.eu/en/p
ublication-detail/-
/publication/d3e77637-
a963-11eb-9585-
01aa75ed71a1/language-en
48
Appendix
49
European Commission
 Executive branch of the EU (≈ Government of EU)
 Enforces Treaties and is driving forward European integration:
1. it proposes legislation to the Council and Parliament
2. it administers and implements EU policies
3. it provides surveillance and enforcement of EU law in
coordination with the EU Court
 Commission is made up of one Commissioner from each EU
member (including the President and two Vice-Presidents).
 Commissioners are appointed and serve for five years
Back
50
Council of the EU (of Ministers)
 EU’s main decision-making body
 One representative from each EU member authorized to
commit its government to Council decisions = members are
government ministers responsible for relevant area
 Council has responsibilities in all first-pillar areas
European Parliament
 Lisbon Treaty boosted power of Parliament making it equal to
the Council on most types of EU legislation (e.g. EU budget)
 About 750 members (MEPs) directly elected
Back
51
European Council
 European Council is highest political-level body in EU
 it provides political guidance at the highest level (i.e., initiates
most important EU initiatives and policies)
 Consists of leaders of each Member State, President of the
European Council and President of the European Commission
 Lisbon Treaty created the ‘President of the European Council’
who chairs the European Council for two and a half years and
is selected by qualified-majority voting in European Council
 One peculiarity is that European Council has no formal role in
EU law-making: its political decisions are translated into law
following the standard legislative procedures
Back
52
 Many EU institutions but the core ones are the “Big-5”
Source:
Baldwin & Wyplosz (2015),
chapter 2.
53
Source:
Baldwin & Wyplosz
(2015), chapter 2.
54
Week 3, 15.09.2021
Trade,Tariffs and Trade Liberalization

(based on: Ch.4+5 in Baldwin & Wyplosz, 2015/19)
Timo Mitze
Take-home message for today:
“If one were to sneak into the bedroom of almost any

famous international economist, shake the famous economist
awake and shout loudly ‘Free trade area – good or bad?’, the
first words out of the economist’s mouth would surely
include ‘trade creation and trade diversion’.”
(Taken from Baldwin & Wyplosz, 2015, p. 121)
9
Take-home pictures for today:
Geographical map of international Trade blocs
Note: Trade blocs = Free trade areas, customs unions, common markets and economic and monetary unions.
10
Free Trade agreements of the European Union
CETA
EU-JAPAN
11
Expected gains
from EU-JPN trade
agreement:
Exports ↑
GDP ↑
Jobs ↑
12
Loss in GDP relative to remain (in %)
Brexit effects
Exports ↓ GDP ↓ Jobs ↓

?
13
Source:
European
Union (2018)
14
Complete Common
factor economic
mobility policy
Free Trade
EFTA
Area
Customs
EEC EEC
Union
Common
Market
Economic
and Mone-
tary Union
Complete
Economic
Integration
Source:
Robson (1987), Hansen et al. (1992).
15
FTA vs CU
 Relative Advantage of a FTA
 Participating countries remain with more political
autonomy (can decide independently on tariff levels for
non-members)
 Relative Disadvantage of a FTA
 Non-members may exploit differences in tariff levels to
export into the FTA (possibly undermine tariff levels set by
destination country of exporting non-member firms)
 Solution: Rules-of-Origin principle
16
 Microeconomics of Economic Integration
 Lecture will introduce the basic tools needed for analysis
of Economic Integration
 Microeconomic tools from International Trade Theory
 Institutional Economics and Game Theory
necessary
---------
 In order to highlight the key issues, we use some (helpful)
simplifications
 Consumers are rational, consumers’ preferences fixed
 Diminishing marginal utility of consumption
 Firms are rational and perfectly competitive, no scale economies
 Markets are complete, every product can be traded
 Countries are symmetric, their products are perfect substitutes
17
 Open-economy supply and demand diagram
 Essential tool for studying European economic integration
 Import Demand Curve (MDH)
 Export Supply Curve (MSH or XSF)
 Home Production (S) and Home Demand (D)
 Import Demand Curve (MDH)

 Presumes imports and domestic production are perfect substitutes
 Import price (PIM) will fix domestic price (PIM=>P*)
 Domestic producers must match the import competition
⇒ Imports equal the gap between domestic consumption and domestic
production
⇒ MDH shows amount of imports that the nation wants at any given
domestic price
18
 Home Import Demand Curve (MDH) Hyperlink
Price Home price
Home
supply
1
P* 2
Excess demand E=B+D
P’’ P’’
Producer Consumer
A
Surplus B C
Surplus D C E 3
P’ P’
Home
demand MDH
Z’ Z’’ C’’ C’ M’’ M’ Home

Quantity
Imports
19
 Welfare analysis: Drop in import price (PIM)

 What happens if price decreases from P′′ to P′?
1. Consumer surplus increases by A + B + C + D
2. Producer surplus decreases by A
3. Country (Society) net gain is B + C + D = C + E
Notice that:
 C is the border price effect = Lower price for imported units
 E is the import volume effect = Gain from increase in imports
20
 Export Supply Curve (MSH)
Price Price
Foreign
supply F=C+E XSF or MSH
3
P’’ Consumer C Producer E F

A
Surplus B
D
Surplus
D
P’
2
P*
1
Foreign
demand
C’’ C’ Z’ Z’’ X’ X’’ Foreign

Quantity
Exports
21
 Export Supply Curve (MSH or XSF)
 How much would the foreign country export for particular price?
 Welfare Analysis:
 What happens if export price increases from P′ to P′′?
1. Consumer surplus decreases by A + B
2. Producer surplus of foreign firms increases by A + B + C + D + E
3. Foreign country net gain is C + D + E = D + F
 Notice that:
 D is the border price effect = higher price for exported units
 F is the trade volume effect = gain from increase in exports
22
 MD-MS Diagram
 Putting together import supply curve and import demand curve
 Allows us to find equilibrium price and quantity of imports
 Again: Import and domestic production are perfect substitutes
 Domestic price set at point, where import demand and supply meet
(PFT)
 Two-panel graphical analysis:
 MD-MS diagram does not allow to see impact of price changes on domestic
consumers and firms separately
 Can be augmented by open-economy D-S diagram
 Import volume can be assessed from both diagrams
23
 MD-MS Diagram and open-economy D-S Diagram
Price (€) Home price (€)
Home
supply (S)
MSH
PFT
Home
Imports Imports demand (D)
MDH
M Home Z C Quantity
Imports
24
Impact of Tariffs on International Trade
25
 MFN Tariff Analysis
 Introduction of a tariff that is applied to all trade partners
 MFN = ‘Most Favoured Nation’ Tariff
 Removing this trade barrier = non-discriminatory liberalization
 What is the effect of the introduction of a tariff of T euros per unit?

 Work out how the tariff changes the MD–MS diagram:
 Introduction of tariff has no effect on MD
 Introduction of tariff shifts MS curve up by T
 Exporters would need a domestic price that is T higher to offer the
same exports since they earn the domestic price minus T
 Graphical analysis:
 Start with pre-tariff import demand and supply
 Left-hand panel: MS=XS
 Right-hand panel: MS-MD
26
 MFN Tariff Analysis (step-by-step)
Border price Home price
MS with T
XS MS
P’
PFT PFT
P’-T
MD
T
Foreign Home
Exports Imports
X’ = M’ XFT = MFT M’ MFT
27
 MFN Tariff Analysis

 New equilibrium:
1. Domestic price rises from PFT to P′
2. Price differences between domestic and border price:
1. border price (i.e., the price home pays) falls to P′ – T
2. this also means that the price received by Foreigners falls to P′ – T
3. Home import volume falls from MFT to M′
 Moreover, the higher domestic price stimulates Home production

and discourages consumption (not visible in MD-MS diagram)
28
 Welfare Effects of a Tariff (step-by-step)
Home price Home price MS with T Foreign price
Net Home welfare: E-B-D
S
(Condensed: L-K) FS
MS
Net Foreign welfare: -G-H-I
K=B+D (Condensed: -L-M)
B
D G I
P’
A C J
E PFT L F H
P’-T
M=G+I World welfare: -K-M
D In a symmetric MD world,
if both countries put a FD
tariff, loss for each
country is: -K-M
=> Protection is worse
Quantity than zero-sumHome Imports
game Quantity
[Compare with Figure 4.7 in Chapter 4 of Baldwin and Wyplosz (2019)]
29
 Welfare Effects of a Tariff (step-by-step)
Home price Home price MS with T Foreign price
S
FS
MS
K=B+D
B
D G I
P’
A C J
E PFT L F H
P’-T
M=G+I
D MD
FD
Quantity Home Imports Quantity

30
 Welfare Effects of a Tariff
 Home
1. Home consumers lose A + B + C + D
2. Home producers gain A
3. Home government gains tariff revenue C + E
 Net Home welfare effect is E − B − D
 Positive or negative depending upon the size of the tariff;
 Foreign
1. Foreign consumers gain F
2. Foreign firms lose F + G + H + I
 Net Foreign welfare effects is −G − H − I
 Negative regardless of the tariff’s size
31
 Tariffs as a tax on foreigners
 A tariff might make the Home country better or worse off
 There are two parts of Home’s net welfare impact: L − K
 L is the border price effect (i.e., gain from paying less for imports)
 L represents Home’s gain from taxing foreigners
 K is the trade volume effect (i.e., impact of lowering imports)
 K represents an efficiency loss from the tariff
⇒ If T raises Home welfare, tariff allows Home government to indirectly tax
foreigners enough to offset tariff’s inefficiency effects on Home economy
 Types of protection
 Many ways to categorize trade barriers. Focusing on trade rents:
1. DCR (domestically captured rents) like tariffs, import licenses
2. FCR (foreign captured rents) like price undertakings, export taxes
3. Frictional (no rents) like regulations and red-tape
32
 GVC analysis
 Single-good analysis may be too simple in light of complex global value
chains (GVC) and intra-firm trade
 Country produces a final good Z which uses an intermediate good
(parts) in its production (with one Y needed for one Z)
 Y and be produced domestically or imported from world markets
P P DZ SZ1
SY SZ2
PW
P1Y MCZ
(local production)
P2Y
(import of Y) Quantity, Quantity,
DY parts final good
Q2 Q1 SP1Y DP1Y SP2Y
34
Preferential Liberalization
35
A world full of
“Protectionism”
Tariffs
Quotas
TBTs
Smith’s Certainty
Custom Union /
Preferential Haberler’s Spillover Frictional
Liberalization
Barriers
Viner’s Ambiguity
Trade Effects of Economic Integration (Trade creation / diversion)
36
 Unilateral discriminatory liberalization

 Basic elements for analysis of preferential liberalization:
 Smith’s certitude: Foreign firms gain (i.e., higher price and more
exports) when tariffs against them are eliminated
 Haberler’s spillover: Third nations – those excluded from the
preferences – must lose
 Viner’s ambiguity: Preferential liberalization might harm the
preference-giving nation because
 discriminatory liberalization is both ‘liberalization’, which removes some price
wedges and thus tends to improve economic efficiency and Home welfare
 ‘discrimination’, which introduces new price wedges and thus tends to harm
efficiency and welfare
37
 PTA diagram
 Analysing preferential liberalization is more complex since it requires
at least 3 nations in the analysis
 Home
 Partner
 RoW = Rest of the World
 Extend workhorse MD–MS diagram to allow for 2 sources of imports
 Aggregate export supply curves of two sources (Partner and RoW)
 Free trade equilibrium at intersection of MS and MD
 Level of imports from two sources read from each supplier’s graph
 What happens when Home imposes a tariff T on all imports?
38
 PTA diagram (step-by-step)
Border price Border price Home price
MSMFN
MSRoW MSP
MS
1 2 1 + 2
P’
PFT PFT
P’-T
T MD
RoW Partner Home
Exports Exports Imports
X’RoW XRoW X’P XP M’ M=XP+XRoW
39
 Discriminatory Liberalization
 What happens when Home removes tariff T only from Partner?
 MSPTA: MS curve shifts down but only halfway between MS (free trade)
and MSMFN because liberalization affects only half imports
 kinked MSPTA curve since for very low prices only Partner country is
exporting
 New equilibrium:
 New domestic price is lower
 Partner-based firms see border price rise from P′ – T to P′′
 RoW firms see border price fall from P′ – T to P′′ – T;
 RoW exports fall,
 Partner exports rise more than RoW exports fall
 Domestic imports rise (supply switching)
40
 Discriminatory Liberalization
Border price Border price Home price MSMFN
MSPTA
MS
P’
P’’ P’’
T
T
Pa
P’’-T
T MD
RoW Partner Home
X’’RoW X’RoW X’P X’’P M’ M’’
41
 Supply Switching Effect of EEC
42
 Supply Switching Effects: Empirics
43
 Welfare Effects of Discriminatory Liberalization

 What happens when Home removes tariff T only from Partner?
 Home’s welfare changes by (A + B – C)
positive or negative (Viner’s ambiguity)
 Partner gains area D (Smith’s certitude)
 RoW loses area E (Haberler’s spillover)
44
MSPTA
MS
A
P’
P’’ P’’
D C
P’-T P’-T
E B
P’’-T P’’-T
MD
RoW Partner Home
X’’RoW X’RoW X’P X’’P X’’RoW M’ M’’
45
MSPTA
MS
RoW loses: -E Partner gains: D Home: A+B-C
(Haberler’s spillover) (Smith’s certainty) (Viner’s ambiguity)
A
P’
P’’ P’’
D C
P’-T P’-T
E B
P’’-T P’’-T
MD
RoW Partner Home
X’’RoW X’RoW X’P X’’P X’’RoW M’ M’’
46
 Home Welfare Effects (in detail, step-by-step)
Home price Home price Change in
S Consumer
Surplus:
D+A1+A2+A
A2 A3
A=A2+A3 Change in
P’ P’ Producer
A1 D A1 Surplus: -D
P’’ P’’
B B
C C
1 1
Change in
P’-T P’-T Tariff
B B Revenue:
P’’-T Surplus:
MD D B-A1-C
X’’RoW M’ M’’ Home Imports Z’ C’ Quantity

X’’RoW
47
 Analysis of a Custom Union
 European integration involved a sequence of reciprocal preferential
liberalizations
 Both Home and Partner eliminate T on each other’s exports
 Assume that three goods are traded (goods 1, 2 and 3)
 Each country produces all three goods, but cost structures are such
that each nation exports two of the three goods while importing the
remaining one
48
 Analysis of a Custom Union
 Price and quantity effects:

 Impact of Home’s discriminatory liberalization is as seen before
 Impact of Partner’s discriminatory liberalization of imports of good 2 from
Home can also be seen using the PTA diagram
 Price of good 2 in Partner falls from P′ to P′′ but border price for Home
exporters when they sell good 2 to Partner rises from P′ – T to P′′
 No change to domestic prices in RoW since they did not liberalize, but
RoW exporters face a lower border price for their exports to Partner
 Welfare effects:
 Adding up effects illustrated before
49
 Welfare effects of a Custom Union (step-by-step)
Border price Home price

Loss C is split
into two parts:
C1+C2
C1 is just a transfer
A between CU members;
Home’s loss of C1 on
imports of good1 will be
D C C
P’’offset by a gain of D1=C1
D1 on its exports of good 2
2 2 1
to Partner.
B P’-T
D2 as gain in Home’s
export market
MD
Partner Home Home
Net gain to Home is
Exports Imports Imports
+A+B+D2-C2
X’P X’’P X’ M’ M’’
X’’RowP
50
Appendix
i) Welfare Analysis
 Welfare Analysis
 How much value do markets create for society?
 Society = consumers + producers
 Consumer surplus
 Demand curve reflects consumers’ evaluation of happiness from consuming a good
 Consumers buy up to the point where there marginal utility just equals price
 For all other units bought, marginal utility exceeds the price
 Producer surplus
 Supply curve reflects firms’ evaluation of cost of production
 Producers produce up to the point, where marginal costs just equal price
 For all other units produced, marginal costs fall below price
 Graphical analysis can visualize consumer & producer surplus
 Consumer surplus is the triangle between demand curve and price paid
 Producer surplus is the triangle between marginal cost curve and price received
53
Consumer and producer surplus
Price Price
1
Supply
curve
a
3 b 3
2 2
P* P*
d
c
1
Demand
curve
1 2 3 4 c* Quantity q* Quantity
54
 Welfare Analysis
 Notice that a price rise increases producer surplus and decreases
consumer surplus
 A price drop does the opposite
 In analysing welfare effects, we are particularly interested in visualising
the change in producer and consumer surplus for different scenarios
Back
55
ii) Game Theory
 Game Theory
 Welfare implications of tariffs & trade integration can also be analysed
by means of Institutional Economics and Game Theory
 The Prisoner’s dilemma
 Two guys commit a crime and are arrested by the policy
 They have to make a decision (confess or not) without contacting each other
 Each can confess and become state witness, which earns him a reward (4),
while the other gets the full punishment if he does not confess (1)
 If both confess, they will be punished but get reduced sentences for helping
the policy (2)
 If neither confesses, they are set free (3)
 It turns out that confessing is the “dominant strategy” in the game
=> Actors do not cooperate, even if it appears that it is in their best
interests
57
 Game Theory
Guy B No confession Confession

Guy A
No confession (3,3) (1,4)
Confession (4,1) (2,2)
 Social optimum “No confession”: 3+3 = 6

 Individual strategy irrespective of what the other does:
 If I confess and the other not = 4 versus
If I do not confess and the other not = 3
 If I confess and the other does too = 2 versus
If I do not confess but the other does = 1
 Solutions: Communication, repeated games, commitments, institutions
Back
58
iii) Frictional Barriers
 Frictional barriers: the 1992 Programme
 Since the mid-1970s and especially since the 1986 Single European Act,
most economic integration in Europe has involved the removal of
“frictional” barriers to trade
 Frictional barriers can be conceptualized as tariffs where the tariff revenue
is thrown away
 For such barriers, Smith’s certitude and Haberler’s spillover still hold
 Viner’s ambiguity disappears
 Reciprocal preferential frictional barrier liberalization leads to:
 Lower Home and border price
 Higher price for Partner exporters and lower price for RoW exporters
=> Home imports rise and Partner exports rise while RoW exports fall
=> Supply switching still occurs
60
 Frictional barriers: the 1992 Programme
Viner’s ambiguity
has disappeared since
there is no loss in tariff
revenues in this case
61
 ‘Deep’ trade agreements
 ‘Deep’ trade arrangements go beyond mere tariff cuts
 Preferential trade arrangements have the character of the Single
Market reforms discussed before
 TTIP (Transatlantic Trade and Investment Partnership):
62
iv) WTO Rules
 WTO Rules
 A basic principle of the WTO/GATT is non-discrimination in
application of tariffs => FTAs and CUs violate this principle
 However, Article 24 permits FTAs and CUs subject to conditions:
 Substantially all trade must be covered
 Intra-bloc tariffs must go to zero within reasonable period
 In case of CU, the common external tariff must not on average be higher
than the external tariffs of the CU members were before
 In EEC, the CU meant that France and Italy lowered their tariffs,
Benelux nations raised theirs while German tariffs were about at the
average
64
21.09.2021
The Further Logic of Economic

Integration: Beyond Trade Effects
- Part I: Labour Markets
Timo Mitze
Department of Economics
Take-home message for today
Economic integration comprises more than just trade effects:
1. Market size effects and efficiency gains
2. Accumulation effects trough investments
3. Labour market effects and migration
5
Take-home message for today
Liberalization opens up markets and

 Market size effects: increases competition
=> Least efficient firms exit, P↓,Q↑
Large and competitive firms demand

 Growth effects: higher investments => “Net” capital
accumulation => Economy grows
Given the type of production function,

 Labour market effects: capital accumulation also impacts labour
demand and wages => Mobility
6
What have we analysed so far?
EU
Institutions
European
Integration
Federalist
Intergovern-
mental
Treaties
(TEU,TFEU)
2.Trade
… 3. Round
Effects…
Effects
Labor
Trade
Markets
Effects 2. Labor
Markets
2. Efficiency
& Industry EU
Structure
Efficiency
& Industry
Growth
Structure
2. Growth
EU labor markets: Brief characterization
 Differently from goods markets, national labor
markets are still very heterogeneous in EU
 Limited migration within the EU
 Very different legislations and practices across countries
 Main reason is that “labor” is a very specific
production factor
 Economists look at labor market flexibility to analyse
the degree of labor market integration
EU labor markets: Brief characterization
Source: Baldwin & Wyplosz (2019)

EU labor markets: COVID-19 Crisis
Monthly
Unemployment Rates (in %)
Source: Gros & Ounnas (2021)

A new labour market instrument?
Economics of wage compensations:
250000
Why and how the state should bear most of the

economic cost of the COVID lockdown, see:
100000 150000 200000
https://voxeu.org/article/economics-wage-
compensation-and-corona-loans
(sum) wagecomp
Moral
hazard
problems?
50000
0
Source: Own figure based on

2020m1 2020m7 2021m1 2021m7 data from STATBANK (2021)
mdate
Taxonomy of Labor Market Flexibility
Source: Adapted from Monastiriotis (2003).

Demand & Supply on Labour Market
SColl
Wages
SInd
Involuntary
Unemployment
w
B C
w0 Demand
A
Employment
_
0 L L0 L
Equilibrium on Labour Market
 Point A: equilibrium with perfectly flexible labour market
= full employment (with only voluntary unemployment)
 Point B: equilibrium with involuntary unemployment (BC),
due to:
 salaries are collectively negotiated;
 agreements hold for long periods thus, labour markets react slowly to
changing conditions;
 wage contracts, conditions for hiring and firing are regulated;
 unemployment benefits
→ Labour market rigidities lead to involuntary unemployment
Effect of trade integration on Labour Market
Source: Baldwin & Wyplosz (2019)

Effect of trade integration on Labour Market
 If the labour markets are fully flexible,
 …wages should rise in the industries that expand and they
should decline in the industries that shrink
 Workers would move from shrinking to expanding industries,
until wages are equal in both = no involuntary unemployment
 But with rigidities…
 … unemployment and inequalities are likely to rise since
the expanding sector does not see more unemployment, but
the contracting sector does
 Important to create safety nets to compensate losers
Taxonomy of Labor Market Flexibility
Source: Adapted from Monastiriotis (2003).

Why is geographic mobility important?
 Sufficiently high geographic mobility as source for
welfare gains (e.g. job matching quality)
 Responses of labor migration to regional labor
market shocks relevant for economic policy making
(on top of Lisbon agenda and Europe 2020)
 Regional mobility rates: How well does the EU
compared to other integrated labour markets such
as the USA?
 Direction of mobility and regional welfare effects
Immigration and demographic trends
Regional net in-migration rates in EU
Average 2008-2012 Average 2003-2007
Economics of Labor Market Integration
 A simple model of 2 nations (”Home”, ”Foreign”)
 Closed labor markets, no migration allowed
 Workers in ”Home” earn initially higher wages
compared to workers in ”Foreign”
 Full employment in both nations
 L = Employment ”Home”
 L* = Employment ”Foreign”
 Total employment in both nations = L+L*
Wages
“Home” Marginal Productivity of Labor (MPL):
Describes firms’ demand for labor and is
downward sloping since a firm’s
Payment to
productivity decreases with higher
Home Capital
employment levels
=> “Too many cooks spoil the broth”
w
Payment
MPL
to Home
Labor
Employment
L
Wages Wages
“Home” “Foreign”
Initial Post-migration
Migration situation
situation
w Q
w’ w’
w*
Q*
0 L L+L*
Wages Wages
“Home” “Foreign”
Loss of Migration Gain of Foreign

Home workers workers staying
(A) Net Gain Gain of abroad (F)
(B+C) migrants
w (C+D) Loss of
A B
w’ w’ Foreign
C capital
Gain of DF w*
Home capital (D+F)
(A+B) 0 L L+L*
 In short, while migration creates winners and losers

in both nations, collectively both nations gain
 Migration improves the overall efficiency of the EU
economy and the gains from this are split between
“Home” and “Foreign”
 Too short? (for a convincing argumentation)

 In the simple migration model home and foreign
workers are seen as close substitutes
 More realistic: Unskilled workers complement skilled
workers/capital as immigrants often have a skill mix
that is very different from that of domestic workers
→ Complementarity of migrants and native
factors of production may provide a win-win situation
 Empirical studies find that one per cent rise in the
supply of workers via migration…
 … changes the wages of native workers by between
1 and –1 per cent, with most studies putting the
figure in the even narrower range of ±0.3 per cent.
Barriers to Mobility
 Results provide a strong endorsement for
fundamental principle of freedom of movement of
workers within the EU
 Still, there is low mobility within EU:
 Restrictions for new EU members’ international mobility
 Differing Pensions systems
 Unemployment benefits
 Regulated professions
 Language, housing, health systems, etc.
Labor markets in a broader context

 Europe 2020
⇒ Flexible labor markets
 Modernize European social models
⇒ Employment security and social security
Can flexibility and social security reinforce each other?

Scandinavian Model
Short periods of notice High compensation rate of
Active search on labor
and low firing costs unemployment benefits
market to take job at
Non-regulated hiring: short notice Unemployment benefits for
low hire costs a sufficiently long period
Flexibility Workfare Security
Flexicurity
Flexicurity as conceptual model in EU?
 Flexible and reliable contractual arrangements
 Comprehensive lifelong learning strategies
 Effective active labour market policies
 Modern social security systems
⇒ In mid 2000s, flexicurity model introduced by EU commission
⇒ “Mission for flexicurity” urges member states and trade unions
to give up on job protection in exchange for adequate
unemployment benefits and active labour market policies
(see http://ec.europa.eu/social/main.jsp?catId=102&langId=en)
Flexicurity as conceptual model in EU?
Protection of regular workers against individual and collective dismissals, 2013
OECD average
Source: http://www.oecd.org/employment/emp/oecdindicatorsofemploymentprotection.htm
Flexicurity as conceptual model in EU
Demo-
graphics
?
Labor Social
Market Security
29.09.2021

Integration: Beyond Trade Effects
- Part II: Investment and Growth
Timo Mitze
What does this picture have to do with our last lecture?
3
Take-home message for today (again)
Economic integration comprises more than just trade effects:
1. Market size effects and efficiency gains
2. Accumulation effects trough investments
3. Labour market effects and migration
4
Time Series of real GDP & GDP growth in EU
Bn. € GDP (in 2010 prices)
16000.00
European Union (28 countries)
15000.00
14000.00
13000.00
12000.00
Market
11000.00
value
10000.00
of final
9000.00 goods &
8000.00 services
7000.00
6000.00
1995 2000 2005 2010 2015
Source: Eurostat at: http://ec.europa.eu/eurostat/

Time Series of real GDP & GDP growth in EU
Bn. € GDP (in 2010 prices) GDP growth (in %)
16000.00 8%
15000.00 6%
14000.00
4%
13000.00
12000.00 2%
11000.00 0%
1995 2000 2005 2010
10000.00 -2%
9000.00
-4%
8000.00
7000.00 -6%
6000.00 -8% European Union (15 countries)
1995 2000 2005 2010 2015
Source: Eurostat at: http://ec.europa.eu/eurostat/

Interactive Task
Graph GDP growth trends in EU

economies since 2010
The Eurostat database
Principal European Economic Indicators

Consumer prices <
National accounts <
Short-term business statistics <
Labour market <
External trade <
Housing indicators <
www.ec.europa.eu/eurostat
13 June 2009
GDP growth in EU-27 and Euroarea-19 (current prices, in €)
4.00%
2.00%
Growth rate in % (1=100%)
0.00%
2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
-2.00%
-4.00%
GDP growth (EU-27)

-6.00%
GDP growth (Euroarea-19)
Source: Own figure based on data from Eurostat (2021)
Is economic growth an iron law?
 In historical terms, continuous economic
growth is a rather recent phenomenon
What are the factors of production?
Labor (L)
Capital (K)
Technology
(A)
The Production Function
 Combination of factors determines economy’s
output level (Y)
 We call this a production function
(1) Y = F(A,K,L)
(2) Y/L = F(K/L)
 Study relationship between output-per-worker
(Y/L) and capital equipment per worker (K/L)
 Combination of factors determines economy’s
output level (Y)
 We call this a production function
When working with “real data”:
(1) • Y =YGross
= F(A,K,L)
Domestic Product (GDP)
(2) • WhenY/Leconomists
= F(K/L)work with real data they call
this “Empirics” (opposed to “Theory”)
 Study relationship between output-per-worker
(Y/L) and capital equipment per worker (K/L)
Euro/L The Production Function
Y/L
K/L
Euro/L The Production Function
Y/L
Why does it have this shape?

• When a firm provides its workers with more and
better equipment,Y/L rises
• But, we observe a diminishing return to one
factor (K) if we hold other factor constant (L)
K/L
Source:
Baldwin & Wyplosz (2019)
Solow Growth Model
 Now we put in a bit of economic reasoning

 And this was even worth a Nobel Prize
 Robert Solow assumed that
 People save a constant fraction s of income
each year => s· (Y/L) => Investments
 At the same time capital depreciates by δ
Euro/L Solow Growth Model
Y/L
(Y/L)*
δ*K/L
s*Y/L
(Y/L)0
Capital
Inflow >
Outflow
K/L
(K/L)0 (K/L)*
Solow Growth Model
 Approaching the equilibrium ”*” from below,

results in medium-term growth effects
 Why medium-term?
 An economy only grows investment-driven only
until a ”natural” equilibrium level is reached (Y/L*)
 In ”*” any potential growth rate is determined
outside the model
Economic Integration and Growth
 Having understood this, now we can analyse
the link between Integration and Growth
 European leaders have long emphasized the
pro-growth aspects of European integration
Transmission channel
European integration → Improved efficiency → Better
investment climate → K/L↑ →Y/L↑ as well
Source:
 Integration improves efficiency of European
economy by encouraging more efficient
resource allocation
1. Shifts up Y/L curve
2. Shifts up s*(Y/L) curve and higher inflow of
investment for any K/L
=> Medium-term growth bonus from European
integration
Euro/L Induced capital formation effect,
medium-term growth bonus
(Y/L)** Y/L
Allocation effect Y/L

(Y/L)*
δ*K/L
s*Y/L
s*Y/L
Improved efficiency: Same

amount of capital and labor
can produce more output
K/L
(K/L)* (K/L)**
Sounds good. But we should (critically) ask:
 Do we observe these theoretically predicted
results in “reality”?
 What are the “empirical facts” for the
Integration-Growth-Link?
 Is this relationship “causal” in the sense of
Integration → Growth?
1. Look at computer simulations
2. Look at computer simulations
Synthetic Controls:
Weighted Average of
comparison countries
with similar characteristics
as the ‘treated’ countries
UK and Spain in Fig. 7.2
(expect that they need
to be non-EU members)
Source:
2. Look at some data for accession countries
in a “natural experiment”
 Countries experienced a rather sudden and well-defined
increase in economic integration when they joined
 We would expect to observe the following:
1. Stock market prices should increase
2. Aggregate investment to GDP ratio should rise
3. Net direct investment should improve
Growth effects: Spain and Portugal
33
Growth effects: Baltic States
Source:
34
Long-term effects of growth

 Would it also be possible to achieve
permanently higher growth rates?
 Yes, but not by further capital investments
 Long-run drivers of economy’s technology level
 Human Resources
 Public Infrastructure
 Knowledge Capital (Patents, Research & Development)
 Exhibit a long-lasting positive externality for economy
35
Long-term effects of growth

 Less empirical evidence so far, but underlying logic is
important for many European Policies
 Regional Policy
 Examples: ERDF & ESF
 Cross-border infrastructure projects
 Examples: INTERREG, TEN-T
 R&D and Cluster policy
 Examples: European Cluster Alliances
36
Regional Growth & Convergence
 Let Y/L in Flensburg be equal to 25,000€ and in
Hamburg be equal to 45,000€
 Let both incomes increase by 1,000 €
Growth, %
Relation:
4 Growthi = β0 – β1Incomei
2.22
Income per
capita €
Flensburg Hamburg
25,000 € 45,000 €
=> Growth will be higher in Flensburg than in Hamburg

Implications for Growth & Convergence
 In the Solow-Model, Flensburg converges to HH
 But is this really going to happen?
 Keep in mind that Hamburg exhibits a
 Large industrial base (with many enterprises)
 Industrial clusters of specialized producers
 Good university system, Research & Development
 Good public infrastructure (roads, railways, harbours)
Interactive Task
Graph regional per capital GDP

level differences in 2019
Per capita
Which are the GDP level in
Top-5 richest EU-27 NUTS-2
and the Low-5 Regions
poorest regions
in terms of
GDP per capita
in 2018?
Table: Per Capita GDP EU-27 NUTS-3 Regions in 2018
GEO GDPPC
GEO (Labels)
(Codes) (in Euro)
DE913 Wolfsburg, Kreisfreie Stadt 180,900
DE211 Ingolstadt, Kreisfreie Stadt 126,900
DE21H München, Landkreis 111,400
FR101 Paris 109,000
FR105 Hauts-de-Seine 108,000
(…)
DEA36 Recklinghausen 26,000
(…)
BG312 Montana 4,600
BG314 Pleven 4,500
BG425 Kardzhali 4,300
BG311 Vidin 4,100
BG342 Sliven 3,900
Source: Own table based on data from Eurostat (2021).
Histogram of Per Capita GDP EU-27 NUTS-3 Regions
20
15
Percent
105
0
0 50000 100000 150000 200000

gdppc
Source: Own figure based on data from Eurostat (2021).

Regional Income Levels
(GDP per capita) in EU-27
(28800,157700] (27250,161933.3]
(22566.67,28800] (21791.67,27250]
(16200,22566.67] (15316.67,21791.67]
[2400,16200] [1950,15316.67]
Regional Income Growth Rates
(∆GDP per capita) in EU-27
(.022,.195]
(.05,.25]
(.005,.022]
(.03,.05]
(-.01,.005
(.02,.03]
[-.11,-.01]
[-.04,.02]
EU budget
framework
2014-2020
EU
Regional
Policy
Source:
Typology of EU Policies
Micro
 Regional Policy (incl. CAP)
 R&D and Innovation Policy
 EU Competition Policy
 EU Trade Policy
 (Harmonized) Fiscal Policy
 (EMU) Monetary Policy
Macro
Scope of EU (Micro) Policies
 Economic policy can have two goals
If Solow model is right,
 Market Allocation redistributing EU-Funds
 (Re-)Distribution to poorest regions is also
best allocation strategy
 Thus, often policy makers hope for a “double

dividend”, that is one policy instrument
achieves both of these goals
Role of EU Regional Policy
 Importance of EU Regional Policy due to
 Aim of reducing income inequality and equalizing
“standards of living” among European Regions
 Lack of any other fiscal transfer mechanism at
inter-governmental level
 “Compact for Growth and Jobs” to fight
consequences of recent economic crisis
Theoretical Models of “Regional Policy”

 But: Other theories predict regional “divergence”
due to agglomeration forces
 That is, rich large urban agglomeration will also
tend to grow faster in the future
 This would speak against a “double dividend” when
giving money to “poor” regions
→ Allocational efficiency vs. redistribution?
 In 2008, the U.S. Economist Paul Krugman received the Nobel
prize for his contributions to the new trade theory and new
geographical economics
 In these models, the geographical environment of a firm and new
forms of market organization (monopolistic competition) play
an important role
”But economic geography has always been important; if it has
been notably neglected by the economics profession, this is not
because economists have been uninterested in the subject, but
because they have regarded it as intractable.”
(Paul Krugman, Nobel Prize winner, 2008)
New geographical economics (NGE)
 Why is economic activity is not equally distributed in space,
why do we observe increasing trends in urbanization and economic
agglomeration and how stabile are such trends
Region 2
Region 1
Firm
Employee
Agriculture
Firm
Employee
Industry
Region 2
Region 1
Consumers
Region 2
Region 1
Mobile firms
Mobile employees
 „Core Periphery“ model by Paul Krugman (1991)
 Model has its name because of economic forces that may
render some regions „peripheral“ while others turn into
economic „core“ regions
 Key model assumptions and results:
 Transport costs („Iceberg Type“)
 (Partial) Mobility of production factors
 Increasing returns to scale and monopolistic competition
⇒ Multiple (stable) equilibria, path dependence of economic development
⇒ „Lock-in“ effects and potentially catastrophic agglomeration
 Logic of „Core-Periphery“ model rests on two pillars
 Agglomeration forces
 Dispersion forces
Agglomerations forces
 A given concentration of economic activity creates forces that encourage
further spatial agglomeration
 With increasing returns to scale, each firm only chooses one location
 Demand-linked circularity
 Firms want to located where they have access to large markets (since
transport costs makes it cheaper to sell nearby customers)
 „Circularity“: If market in R1 is slightly bigger than R2, firms tend to
locate in R1 => Relative higher real wage in R1 so that employees have
incentive to move to R1 => market size ↑ => firms ↑ => employees ↑
Demand-linked circularity
Share of firms
in region R1
When firms & jobs

To reduce shipping move to R1, workers’
Production Expenditure
costs, firms prefer to local spending makes the
shifting shifting
locate in big market market in R1 bigger and
market in R2 smaller
R1 market as
Source: Baldwin & Wyplosz share of total
(2012), Chapter 10. market
Agglomerations forces (continued)
 Cost-linked circularity
 Firms benefit from cost advantages and wider range of intermediate
goods if suppliers are located nearby
Dispersion forces
 Support geographic dispersion of economic activity
 Immobile farm employees
 Congestion costs (land prices, traffic intensity, air pollution etc.)
 Local competition force
 Firms are attracted to markets where they face few local competitors
 European integration affects balance of agglomeration and
dispersion forces in complex ways
A very simple analytical framework:

 One pro-agglomeration and one pro-dispersion consideration:
1. Firms would, all else equal, prefer to locate in the big
market in order to save on trade costs
2. Firms would, all else equal, prefer to be in the market where
there are few local competitors
Distribution of firms in Region R1 relative to strength of
agglomeration and dispersion force
Strength of agglomeration Dispersion
and dispersion force Force
Agglomeration
Force
1/2 S1 1 Share of
Firms in R1
Distribution of firms in Region R1 relative to strength of
agglomeration and dispersion force
 Agglomeration force is flat for share of firms in R1
 Dispersion force line is rising for share of firms in big region
since benefit from staying in small region rises as more firms
move to the larger market R1
 Location equilibrium is given by the intersection of these lines
 Economic integration reduces trading costs and weakens
dispersion forces  more concentration of economic activities
Effect of Economic Integration on spatial distribution of
firms in different regions
Dispersion
Strength of agglomeration Force
and dispersion force Dispersion
Force (with free
Trade)
Agglomeration
Force
1/2 S1 S2 1 Share of
Firms in R1
”Tomahawk” diagram plots equilibria for transportation costs (TC)
Share of mobile workers in region 1
λ1
1
With lower TC „Basin of attraction“ for
clustering equilibrium with dispersed
becomes economic activty
stable EQ
0,5
Instable EQ
Stable EQ
0
1 1,5 2 2,5 3 TC
A Tale of Two Economies (Italy)
Source:
The Economist (2015)
EU Regional Policy
 Concern for Europe’s disadvantaged regions has always been part
of EU priorities (i.e., part of Treaty of Rome preamble)
 Still, major EU funding for less-favored regions was introduced only
when first ‘poor’ member (Ireland) joined in 1973
 European Regional Development Fund (ERDF) was set up to
redistribute money to poorest regions, but budget was minor
 Situation changed in the 1980s when Greece, Spain and Portugal
joined: these nations were substantially poorer and did not benefit
from CAP funding
 Voting power of Greece, Spain, Portugal produced a major
realignment of EU spending priorities
EU Regional Policy
Range of intra-national per capita GDP levels in EU (2008)
Source: Eurostat (2011).

Is EU Regional Policy successful?
 Meta analysis by ”What Works Centre for Local Economic Growth”
1. EU support has positive impact on regional GDP per capita in
roughly half of the evaluations that consider GDP effects
2. Studies which look at employment effects show a positive effect
of EU support on employment
3. Evidence on a range of other outcomes is mixed
4. Positive impact is bigger in relatively more developed regions
5. Consistent with this, two out of three studies that consider the
‘dose’ (e.g. expenditure per capita) suggest an optimum ‘level’ of
treatment
(see: http://www.whatworksgrowth.org/policies/area-based-initiatives/)
13.10.2021

Integration: Market Efficiency and EU
Competition Policy
Timo Mitze
Relevant textbook chapters – Part 1 (6. edition 2019)
(Complementary to lecture slides)
Chapter Sections Pages

1 – History All pp. 1 – 37
2 – Facts 2.1. – 2.4., 2.7. pp. 39 – 58, 63 – 67
3 – Decision Making 3.1., 3.2. pp. 71 – 82
4 – Tariff Analysis 4.1. – 4.5, pp. 97 – 118
5 – Preferential Liberalization 5.1., 5.2., 5.5. pp. 119 – 127, 134 –135
6 – Market Size and Scale Effects 6.1 – 6.4. pp. 143 – 153
7 – Growth effects 7.1 – 7.4. pp. 159 – 176
8 – Labour markets & migration 8.1., 8.4. pp. 177 – 199
11 – Competition Policy All (excl State Aid?) pp. 255 – 274
Relevant textbook chapters – Part 1 (6. edition 2019)
(Complementary to lecture slides)
Chapter Sections Pages

1 – History All Term pp.
Paper:
1 – 02.12.2021
37
2 – Facts 2.1. – 2.4., 2.7. Oralpp.
Exam
39 –Exchange
58, 63 – 67
Students: 10.12.2021
3 – Decision Making 3.1., 3.2. pp. 71 – 82
Oral exam Regular
4 – Tariff Analysis 4.1. – 4.5, pp. 9710.01.2022
Students: – 118
5 – Preferential Liberalization 5.1., 5.2., 5.5. pp. 119 – 127, 134 –135
6 – Market Size and Scale Effects 6.1 – 6.4. pp. 143 – 153
7 – Growth effects 7.1 – 7.4. pp. 159 – 176
8 – Labour markets & migration 8.1., 8.4. pp. 177 – 199
11 – Competition Policy All (excl State Aid?) pp. 255 – 274
+++ Newsflash +++
Europe can’t agree on how to regulate
tech giants like and Google
Digital Market Tech giants could
Act (DMA): be required to
Limit Power provide
of ”gate- evidence that
keepers”, proposed
who run acquisitions
dominant would not be
online stores anti-competitive
+++ Newsflash +++
Merger control by EU competition policy
“Prohibition decisions are rare, and it's the first time we
announce two prohibition decisions on the same day.
The large majority of mergers we review are cleared,
either because they don't pose a problem to
competition or because the companies are willing to
offer sufficient remedies.
In fact, over the past ten years, the Commission has
approved over 3,000 mergers and blocked only seven.
Today, we are increasing this number to nine.
The mergers we are prohibiting are Wieland's takeover
of Aurubis' rolled copper products business and Statement by Commissioner
Siemens' takeover of Alstom's rail transport business.” Vestager, February 6, 2019
Market Size Matters
 European leaders always viewed economic integration
as compensating mechanism for small size of
European nations
 Implicit assumption: Market size is good for the
economic performance of businesses
 Tearing down intra-EU barriers assumed to bring a
‘pro-competitive effect’, which puts pressure on
profits and the market’s response is ‘merger mania’
Market Size Matters
 That is, pro-competitive effect squeezes least efficient
firms, prompting an industrial restructuring…
 … so that Europe is left with a more efficient
industrial structure, with fewer, bigger, more efficient
firms competing more effectively with each other
 Schematically: liberalization → defragmentation →

pro-competitive effect → industrial restructuring
Market Size Matters: Some Evidence
”Mark-up” Study on French manufacturing firms shows
that implementation of Single Market
Programme and Economic and Monetary Union
(Maastricht Treaty) lowered price–cost ratio
margin by 4 to 5 percentage points
Mergers and Acquisitions in the EU
 M&A activity in EU rose drastically in the 1990s
 In 1999, 45% of worldwide M&A deals done in EU
Source:
OECD (2001).
 Ranking European deals in Top-10 M&As in all times
Rank Volume Year Sector Deal
1. $202.8bn 1999 Telecom Vodafone AirTouch's buys
Mannesmann AG
2. $160bn 2015 Pharma Pfizer acquires Allergan
(collapsed)
(…)
4. $117bn 2015 Food AB InBev buys SAB Miller
(…)
9. $98.5bn 2007 Banking Royal Bank of Scotland‘s buys
ABN-AMRO
Note: Taken from www.investmentweek.co.uk/, www.livemint.com

 So what exactly is a (cross-border) M&A activity?
 Merger (of equals) = Two (or more) firms agree to go forward as a
single new company rather than remain separately owned and operated
 Acquisition (takeover) = Purchase of one business or company by
another company or other business entity (can be friendly or hostile)
 We can distinguish three types of M&A deals
 Horizontal (involving firms in the same industry)
 Vertical (between firms at different stages of production chain)
 Conglomerate (between firms in unrelated industries)
 Most foreign direct investment (FDI) is carried out through M&A
activity rather than founding new subsidiaries
 Imagine, you are the head of a telecommunication corporation in 1990
 Except for the UK, all European nations had state-owned monopolies
Country Indicator for Deregulation 1990 1995 2005
Germany Market share of new entrants (in %) 0 0 43
Government share of incumbent (in %) 100 100 37
France Entrant 0 0 40
Government 100 100 43
Italy Entrant 0 0 27
Government 100 50 0
Spain Entrant 0 0 20
Government 35 21 0
UK Entrant 8 19 43
Government 50 1 0
Note: Taken from Clifton et al. (2011)

Theory of imperfect competition
 In imperfect competition, firms are aware that they
can influence prices of their products and that they
can sell more only by reducing their price
 Occurs when there are only few major producers
of a particular good or when each firm produces a
good that is differentiated from that of rival firms
 Each firm views itself as a price setter
 Only constraint is downward sloping demand curve
Monopoly: A briew review

 Monopoly is an industry with only one firm
 Oligopoly is an industry with only a few firms
 In these industries, marginal revenues from selling
more products is less than price charged for product
 To sell more, a firm must lower the price of all units, not just
the additional ones
 Marginal revenue function lies below the demand function

 Assume that demand curve for good is a straight
line P = A – B(Q), where Q is number of units the firm
sells, P the price per unit, and A and B are constants
 Marginal revenue equals MR = A – 2×B(Q)
 Suppose that total costs are C = F + c(Q), where F is
fixed costs independent of the level of output, and c is
the constant marginal cost

 Average cost is the cost of production (C) divided by
the total quantity of production (Q)
AC = C/Q = F/Q + c
 Marginal cost is the cost of producing an additional
unit of output
 Larger firm is more efficient because average cost
decreases as output Q increases

 Profit-maximizing output occurs where marginal
revenues equals marginal costs
 At intersection of the MC and MR curves, revenue gained
from selling extra unit equals the cost of producing that unit
 Monopolist earns monopoly profits when P > AC

Monopolistic Competition
 Monopolistic competition is a simple model of
an imperfectly competitive industry that assumes
that each firm
1. Can differentiate its product from the product of
competitors and
2. Takes the prices charged by its rivals as given
 A firm in a monopolistically competitive industry is
expected to sell
 …more as total sales in the industry increase and
as prices charged by rivals increase
 …less as the number of firms in the industry
increases and firm’s price increases
Qi = S[1/n – b(Pi – P*)]
 Qi is an individual firm’s i sales
 S is the total sales of the industry
 n is the number of firms in the industry
 b is a constant term representing the responsiveness of a
firm’s sales to its price
 Pi is the price charged by the firm itself
 P* is the average price charged by its competitors
 Assume that firms are symmetric (no price difference)
 All firms face same demand function and have the
same cost function
 Thus, all firms should charge the same price and
have equal share of the market Q = S/n
 Average costs should depend on the size of the
market and the number of firms
AC = C/Q = F/Q + c = n F/S + c
P Monopoly P Duopoly
P*Mono
P*Duo P*Duo
D D
RD
MC MC
MR RMR
Q* Q x* 2x* Q
BE-COMP Diagram
µ BE-COMP
Mark-up (µ): Elevation of price over
marginal cost (zero for perfect competition)
µMono
I. As number of firms n in industry
increases => more intensive
BE competition drives down price
mark-up over costs (COMP curve)
µDuo
II. The higher the price mark-up over
costs => the more firms will be able
µ’ E’ to survive / break-even (BE curve)
COMP III. Long-run equilibrium (E’)
determines number of firms in
industry as firms have no incentive
n=1 n=2 n’ No. of to enter or exit the industry
firms
BE-COMP Diagram
 From equilibrium in BE-COMP diagram, we can determined the equilibrium
number of firms, mark-up, price, total consumption and firm size
Source: Baldwin & Wyplosz (2015), Chapter 6.

Analysis of Economic Integration
 European integration involved gradual reduction of trade barriers
 Basic economic effects of this gradual reduction can, however, be
illustrated by taking a completely closed economy and making it a
completely open economy
 To keep things simple, we suppose that there are only two identical
nations, Home and Foreign
 Immediate impact of the no-trade-to-free-trade liberalization is to
provide each firm with a second market of the same size and to
double the number of competitors in each market
 How does this change the outcome?
µ BE-COMP µ BE-COMP’
µMono
BE
BE
BEFT
µDuo
µ’ E’ µ’ E’
E’’
COMP µ’’
µA COMP
A
n=1 n=2 n’ No. of n’ n’’ 2n’ No. of

firms firms
30
µ BE-COMP µ BE-COMP’
Shift BE: Since market size increases the
µMono sales per firm => higher profit at any given
mark-up => more firms can break even
BE
BE
BEFT
µDuo
µ’ E’ µ’ E’
E’’
COMP µ’’
µA COMP
A
n=1 n=2 n’ No. of n’ n’’ 2n’ No. of

firms firms
31
 Defragmentation:
 Initially, typical firm has 100% sales at home, 0% abroad (general: 1/n’, 0)
 After integration: 50%-50% (for symmetric countries, general: 1/2n’, 1/2n’ )
 Pro-competitive effect
 Equilibrium moves from E′ to A with firms losing money (below BE)
 Mark-up falls and thus, in the short-run prices, too
 Industrial restructuring:
 From A to E′′, number of firms reduces from 2n′ to n′′
 Firms enlarge market shares and output, and reduction in average costs
 Mark-up rises and profitability is restored
 After restructuring, P↓, Q↑ and average firms size is larger

 Welfare effects: Four-sided area marked by p′, p′′, E′ and E′′ corresponds to gain
in consumer surplus (both at Home and in Foreign)

EU Competition Policy
and State Aid Policy
EU’s Role in Competition Policy

Cartel fines imposed by European Commission (in €)
Notes: Adjusted for court judgements, Source: Cartel Statistics (2021)


Ten highest Cartel fines per case (since 1969)
Source: Cartel Statistics (2021)


Ten highest Cartel fines per undertaking


 Founders of EU understood that pressures to collude and subsidize
would arise in the course of economic integration
 Anticipation of such unfair practices could reduce political support
for economic integration in all nations
 Thus, Treaty of Rome includes broad prohibitions on private and
public policies that distort competition
 European Commission has sole power to regulate the EU’s
competition policy (i.e., its decisions are not subject to approval by
the Council or the European Parliament but they can be overturned
by the EU Court)

 Examples for power of EU Commission in Competition Policy:
1. Commission has right to make on-site inspections without prior
warning
2. With a court order, the Commission can even inspect the homes of
company personnel
3. Commission has the right to impose fines on firms found guilty of
anti-competitive conduct, with a maximum of 10% of the firm’s
worldwide turnover
4. When it comes to subsidies, the Commission has the power to force
firms to repay subsidies it deems to be illicit
Fines imposed on Cartel undertakings as % of global turnover


 To prevent anti-competitive behavior, EU policy focuses on:
 Antitrust and cartels
 EU Commission tries to eliminate behaviour that restrict competition
(e.g. price-fixing arrangements and cartels)
 EU Commission tries to eliminate abusive behaviour by firms that have a
dominant position
 Merger control
 EU Commission seeks to block mergers that would create firms that
would dominate the market
 Merger Regulation, introduced only in the late 1980s
EU Law on Anti-competitive Behaviour
 Article 101:
 Forbids practices that prevent, restrict or distort competition
 Typically prevents horizontal or vertical anti-competitive agreements
 Exemptions possible if benefits exceed anti-competitive effects (e.g.,
R&D agreements)
 Article 102:
 Restricts the abuse of a dominant market position
 Practices banned: Refusal to supply, unfair prices and conditions,
predatory pricing, loyalty rebates, exclusive dealing, abuse of intellectual
property rights
Economics of Anti-competitive Behaviour

 Collusion among firms result in high prices leading to lower demand
and production
 It is illegal under EU law and economically harmful for Europe as a
whole
 Perfect collusion in the BE-COMP diagram:
 firms co-ordinate prices and sales perfectly
 maximum profit at monopoly price and split sales among firms
 assume that firms all have equal market share
 Collusion is good for firms’ profits, but results in higher price level
 Moreover, since firms are smaller → average costs are higher, so the
industry is less efficient

Welfare Effects of Cartels
 Special case of explicit collusion
 Suppose price without a cartel
would be P=AC while the cartel
raises price to P′:
 ∆Consumer Surplus = -a - b
 ∆Profit = a
 Net welfare effect = -b
 Outcome:
 ‘rip-off’ effect
 Inefficiency effect
Cartels within the EU
 In 2011, EU Commission fined Procter & Gamble and Unilever for operating
a cartel with Henkel in market for household laundry powder detergents in
8 EU countries
 Henkel was part of the cartel, but got immunity for revealing the cartel to
the Commission
 EU Commission convicted 4 brewers (Heineken group, Grolsch, Bavaria, and
InBev group) of running a cartel in the Netherlands
 Cartel was discovered when a similar cartel in Belgium was uncovered
(when InBev gave evidence to the Commission in order to reduce its fine)
 In 2010, the Commission concluded that 10 DRAM producers (only one
European) were running a cartel between 1998 and 2002
Exclusive Territories
 More common anti-competitive
practice is ‘exclusive territories’
(e.g., one company would agree
to sell only in its local market in
exchange for a similar promise
by its foreign competitors).
 Segmenting the market:
 Example Nintendo’s sales strategy
for Europe based on demand curves
 But: In an integrated market,
‘traders’ could arbitrage price gap
(‘parallel trade’)
Abuse of Dominant Position
 Dominant position not a problem per se: it may reflect superior
products and/or efficiency
 However dominance may tempt firm to extract extra profits from
suppliers or customers
 ‘Abuse of dominant position’ is illegal under EU law
 Examples:
 Microsoft refused to supply information to Sun Microsystems for the
communication with its operating system. During investigation the
Commission found evidence of additional illegal behaviour with most
recent case in 2008 involving Office and Internet Explorer
 Google case in 2013 (see Box 11.4 in Baldwin & Wyplosz, 2019)
Why Merger Control?
 Initially P=AC
 Merger of firms lowers AC
to AC’ but raises price to P’:
 ∆CS = -a – b
 ∆PS = a + c
 Net welfare = -b + c (transfer
from consumers to firms)
 With free entry, P eventually
driven down to AC’, boosting
efficiency for consumers (c+d+e)
State Aid
 Consider subsidies that prevent restructuring where each government
makes annual payments to all firms exactly equal to their losses:
 BE-COMP: all firms break even, taxpayers pay for inefficient small firms

State Aid
 Welfare effects of liberalize-and-subsidize policy:
 ∆PS = 0
 ∆CS = A + D
 subsidy cost = A – C (drop in operating profits by producers)
 Net welfare = D + C (gain from partially redressing a market power distortion)
 EU members’ governments differ over how much they can or want to
subsidize loss-making firms
 If only some governments subsidize their firms, the outcome may be ‘unfair’
since restructuring is forced upon the firms in nations that do not subsidize
 This may create impression that European economic integration gives an
unfair advantage to some nations’ firms (disciplines on state aid allows
governments to proceed with painful and politically difficult reforms)
State Aid
 Treaty of Rome bans state aid (broadly defined) that provides firms with an
unfair advantage and thus distorts competition
 Exceptions relate to social policy, natural disaster aid, economic
development aid to regions
 Example: Airline industry
 Restructuring of the European airline industry has been exacerbated by the
terrorist attacks of September 2001
 Subsidies could only cover the ‘exceptional losses’ due to the attacks
 Commission has managed to resist the desire of several Member States to
support their national airlines as done in the US, also because low-cost airlines
(e.g., Ryanair and easyJet) have done well without subsidies
 Support to inefficient national carriers hinders expansion of low-cost airlines
State Aid and the Global Crisis
 Global financial and economic crisis started in the USA in 2008 and
spread rapidly to Europe
 EU policy makers responded by providing massive state aid to banks
 All these measure had to be approved by the EU Commission under its
state aid policy
 In the first 5 years of the crisis, the EU Commission authorized over 400
state-aid measures to the financial sector (600bn. Euro, 5% of EU GDP)
 Massive state aid triggered worries of the financial markets about
sustainability of government interventions
 … this eventually translated into the Euro-Debt Crisis
Appendix
P, C
Monopoly Profits
D
P’
A
P’’
P*Mono
Monopoly
profits
AC B
AC
MC
MR
Q’ Q’+1 Q* Q
27.10.2021
Theory of Monetary Integration, the

European Monetary Union and the EURO
Timo Mitze
Economics of International Integration
Take home message for today:

In or out? The EU member
states and the single currency
Complete Common
factor economic
mobility policy
Free Trade
EFTA
Area
Customs
EEC EEC
Union
Common European European European
Market Single Market Single Market Single Market
Economic
and Mone- EMU EMU EMU EMU
tary Union
Complete to be to be to be to be to be
Economic established established established established established
Integration
Source: Robson (1987), Hansen et al. (1992), Baldwin & Wyplosz (2015).
Barter vs Monetary Economy
 Monetary system with economic efficiency gains via
1. Medium of exchange
2. Unit of Account
3. Store of Value
 Until end of 19th century, money was metallic (=coins)

and many currencies were circulating
 “Gold standard” restored a country’s external balance
 Country with rising price level is uncompetitive; runs trade deficit:
 Spend more gold on imports than it receives on exports
 stock of money declines
 long-run monetary neutrality implies that prices will decline and the
process will automatically go on until competitiveness is restored
Hume’s mechanism
 Long-run neutrality of money
 Long-run PPP (Purchasing Power Parity) holds
(a) Balance of payment = ∆M
Price level
A
Current account
E deficit E Gold money
P
Current account
surplus A
Gold money (b)

M M’
Interest rate (c)

Financial account
E surplus
(a) = Goods market i*
(b) = Balance of payment Financial account
A deficit
(c) = Financial market
Gold money
Gold exchange standard
 By late 19th century, paper money started to exist

 “Gold exchange standard” allowed paper money to circulate inter-
nationally, but each banknote represented certain amount of gold
 Automatics of gold exchange standard relied on adherence to three
principles, known as the ‘rules of the game’:
1. full gold convertibility at fixed prices (i.e., fixed exchange rate)
2. full backing where central bank holds at least as much gold as it has
issued banknotes (i.e., no monetary policy autonomy)
3. freedom in trade and capital movements (i.e., full capital mobility)
 Gold exchange standard was suspended in 1914

Bretton Woods
 After WW2, Bretton Woods conference established
new international monetary system for currencies
 Gold as ultimate source of value, but U.S. dollar as the anchor of the
system (with US government guarantying its value in terms of gold)
 All other currencies defined in terms of the dollar
 IMF supervising compliance and providing emergency assistance
 System unraveled with lifting of capital controls (1960s)

 Exchange rates had to be made flexible or authorities had to give up
monetary policy autonomy
 Dollar gradually became overvalued
- USA ‘suspended’ the dollar’s convertibility into gold in 1971
- ‘fixed but adjustable’ principle was officially abandoned in 1973
After Bretton Woods
Taken from: Baldwin & Wyplosz (2015), Chapter 14.

Europe’s snake in the tunnel
 First European response to the collapse of
Bretton Woods: ‘European Snake’
 Regional version of the Bretton Woods system to limit intra-European
exchange rate fluctuations
 Very loose arrangement and when inflation rose due to the first oil
shock of 1973–74, divergent monetary policies led several countries
to leave the Snake
 ‘Snake’ brought about two innovations:
 Determination to keep intra-European rates fixed, irrespective of what
happened elsewhere in the world;
 European currencies needed to be defined vis-à-vis each other
 Snake was meant to be ‘an island of stability in an ocean of instability’
 Next move was the European Monetary System (EMS)
Europe’s snake in the tunnel
Tunnel of dollar pegs
Snake of bilateral
exchange rates
under dollar peg
2. If DM per dollar and Franc per 3. To reduce wide band of bilateral

1. In 1971, in an effort to rescue Bretton
dollar are at points A in upper panel exchange rate flucturations, EC
Woods, margins vis-a-vis U.S. dollar were
but change to points B, then DM per members, Denmark, Ireland, Norway
widened from fluctuations of 1% to
Franc exchange rate fluctuates with and UK decided to limit bilateral
2.25% ….allowing for more flexible
9% – as consequence of pegging to exchange flucturations among their
exchange rate determinantion
U.S. dollar with each peg allowing currencies to 4.5% …’snake in the
variation of 2x2.25% tunnel’ of pegs to U.S. dollar
Taken from: Baldwin & Wyplosz (2015), Chapter 14.

European Monetary System
 Heart of EMS is Exchange Rate Mechanism (ERM):
Taken from: Baldwin

& Wyplosz (2015),
Chapter 14.
 Several realignments during 1979 and 1995

 Often triggered by differences in inflation rates
 Particularly as capital controls were lifted, realignments
became increasingly destabilizing
 Thus, high-inflation and ‘depreciation-prone’ countries tried
to reduce inflation to converge to the lowest rate:
 Germany’s Bundesbank became the “standard” for price stability and
inflation rates started to converge
 (Almost) no realignment between 1987 and September 1992
 But countries resented the Bundesbank’s de-facto leadership and
asymmetric decision making power of monetary policy
 Germany was unwilling to give up leadership but accepted a political
deal in 1991: Monetary union in exchange for reunification with the
former East Germany
 …but inflation rate differentials persisted
 German reunification was costly and induced inflationary
pressure → contractionary German monetary policy
 When other countries did not follow and referendum in
Denmark rejected the Maastricht Treaty…
 … speculative attacks targeted less competitive countries:
- Banca d’Italia & Bank of England intervened to support their currencies
- Attacks became so massive lira and pound withdrew from the ERM
- George Soros as ”man who broke the bank of England”
- Speculation shifted to the currencies of Ireland, Portugal and Spain;
contagion then spread to Belgium, Denmark and France
- Monetary authorities adopted new ultra-large (±15 per cent) bands of
fluctuation:  tight ERM was dead
Maastricht Treaty
 Post-crisis ERM agreed on in 1993 differed little from floating
exchange rates (i.e., bilateral parities could move by 30%)
 Condition in Maastricht Treaty for joining the monetary union:
 At least two years of ERM membership  ERM is still in use as a
temporary gateway but it has been re-engineered (ERM2)
 Maastricht treaty paved the way for European Economic
and Monetary Union (EMU)
Step 1 Step 2 Step 3

Foundation of supra-
Maastricht Treaty national institutions Euro as single currency
enforced in 1993 (EMI, ECB) up to 1998 in 1999 (notes in 2002)
Maastricht Treaty
 Established the European Monetary Union, specifically:
 It described institutional setup including the statutes of the ECB
 It set the conditions under which monetary union would start
 It specified entry conditions (mostly at German request)
 Fulfillment of these criteria to be evaluated by late 1997
 In the end, all countries that wanted to adopt the euro were
qualified (with exception of Greece)
 On 4 January 1999, the exchange rates of 11 countries were
‘irrevocably’ frozen
 Power to conduct monetary policy was transferred to the European
System of Central Banks (ESCB), under aegis of ECB
 Euro banknotes and coins were introduced in January 2002
Maastricht Treaty: Entry Conditions
 Accession countries have to fulfill five convergence criteria:
1. Inflation: Not to exceed by more than 1.5 percentage points the
average of the 3 lowest inflation rates among EU countries
Taken from: Baldwin

& Wyplosz (2015),
Chapter 16.
 Countries have to fulfill five convergence criteria:
2. Long-term nominal interest rate: Not to exceed by more
than 2 percentage points the average interest rate in the 3 lowest
inflation countries (long-term interest rates mostly reflect markets’
assessment of long-term inflation)
3. ERM membership: At least 2 years in ERM without being forced
to devalue
4. Budget deficit: Deficit less than 3% of GDP. Historically, all big
inflation episodes born out of runaway public deficits and debts!
5. Public debt: Debt less than 60% of GDP (average of countries)
Public
Debt
Budget
Deficit
ESCB & Eurosystem
 N countries with N National Central Banks (NCBs) and a
new central bank at the center: European Central Bank (ECB)
 European System of Central Banks (ESCB): ECB and all EU
NCBs
 Eurosystem: ECB and NCBs of euro area member countries
Christine Lagarde as current

ECB president
ESCB & Eurosystem: Objectives
“The primary objective of the ESCB shall be to maintain price stability.Without
prejudice to that objective, it shall support the general economic policies in the Union
in order to contribute to the achievement of the latter’s objectives.” (Article 282-2)
 Eurosystem has chosen to interpret it as follows:

 ‘Price stability is defined as a year-on-year increase in the
Harmonized Index of Consumer Prices (HICP) for the
Eurozone of below but close to two per cent.
Price stability is to be maintained over the medium term.’
⇒ Commonly understood as between 1.5 and 2%

⇒ Commonly understood to refer to a 2–3 year horizon
ESCB & Eurosystem: Objectives
Interactive Task
Visualize Eurozone inflation rate

(HICP) since 2014
(You can find it in the ECB Statistical Data Warehouse)
ECB’s Monetary Policy Strategy
 Strategy relies on three main elements:
1. Definition of price stability as the primary goal: “change in HICP below

but close to two per cent”
 … and two ‘pillars’ to identify risks to price stability:

2. First pillar = ‘economic analysis’. It consists of a broad review of
recent evolution and likely prospects of economic conditions (e.g.,
growth, employment, prices, exchange rates, foreign conditions)
3. Second pillar = ‘monetary analysis’. It studies the evolution of
monetary aggregates (M3, in particular) and credit
Monetary Policy Fiscal Policy
Actor: Central Bank Government
Goals: Price stability, Well-functioning of
(eventually support national labor markets
economic growth and (full employment), high
reduction of economic growth,
unemployment), lender investment climate,
of last resort education system,
Instruments: (Short-term) interest National Budget

rates, Minimum expenditures w.r.t.
reserves, Exchange rate infrastructure, R&D,
targeting education, labor market;
taxation
European European System of Limited; Examples:
Coordination: Central Banks (ESCB), Stability and Growth
European Exchange Pact (SGP); Compact
Rate Mechanism (ERM) for “Growth and Jobs”
Instruments of Monetary Policy
 Eurosystem uses the short-term interest rate as main target:
 Changes have a knock-on effect on…
 …longer-term interest rates (and thus on the cost of credit)
 …on asset prices (and thus on capital costs of firms) and
 …on the exchange rate (and thus on foreign demand for
domestic goods and services)
In % 5
4.5 ECB Main refinancing
4 operations
3.5 [Variable rate tenders
3 (minimum bid rate) (date
2.5 of changes)]
2
1.5
1
0.5
0
Source: Data from
ECB (2016).
Exogenous
Official Interest Rate shocks:
Changes in
Money market risk premia
Expectations interest rate
Changes in
bank capital
Money, Asset Bank Exchange
credit prices rates rate
Changes in
global
Wage and Price Supply and demand in goods, economy
setting services and labour market
Changes in
fiscal policy
Domestic Price Import Price
Changes in
Price commodity
Source: ECB (2010). development prices
Eurosystem: First years (until crisis of 2007/08)
 A difficult time period to start for Eurosystem:

 Burst of ‘dot.com’-bubble in 2000
 Oil shock in 2000
 September 11 attacks in 2001
 Oil prices to record level and US financial crisis start in mid-2007
 Result: inflation almost always above 2% but close to target
(until 2007) and lower than perceived
 Bad reputation for Euro currency (=perceived high inflation)
 ”Pizza” effect (jump in price level for some goods)
 Old currencies often viewed as ”national traditions”
 Growth has been generally slow in the Eurozone, prompting
criticism of the ECB
 Large inflation differentials within Eurosystem have occurred:
 lower than average: Germany, France and Finland
 higher than average: Ireland, Spain, Portugal, Netherlands
and Italy
 Possible causes:
 catching up in productivity levels
 wrong initial conversion rates
 autonomous wage and price setting
 policy mistakes, such as fiscal expansion
 asymmetric shocks, such as oil price effects
⇒ Is Europe an Optimal Currency Area?

OCA Theory
 Next week
Marginal costs and benefits
Marginal cost
Marginal benefit
Area size
03.11.2021
Optimum currency areas (OCAs): Theory

and application to the Eurozone
Timo Mitze
Take home message for today:

If the Eurozone is not an optimal currency
area yet, should we worry about it?
++ Review – the impossible trinity principle ++
= Choice of a
Eurozone
member How about Denmark?
= Choice of UK
Bits of Theory
 To understand the forces behind the impossible trinity
principle, we need to use some macroeconomic tools
1. Goods market equilibrium (IS curve)
2. Monetary policy schedule (MP curve)
3. Interest rate parity condition (IRP curve)
 Goods market equilibrium: Y = C + I + G + X – Z

→ in an open economy, production (Y) is determined by consumption (C),
investment (I), government expenditure (G) and trade balance (X – Z)
→ Interest rate (i) determines level of domestic investment and credit-financed
consumption decisions, which links Y to i along the IS curve
Bits of Theory
 Monetary policy schedule builds on supply & demand
framework in financial markets:
→ Increasing (lowering) money supply lowers (rises) interest rate i
→ Central bank actions positively correlated i and Y, e.g., a higher interest
rate is chosen for high output levels to prevent ”overheating” of economy
i MP
A
i0
Y0 IS
Y
Bits of Theory
 Interest rate parity condition (IRP) links domestic and
foreign interest rate as
i MP MP’
Capital
inflow A Fixed exchange rate
(common currency)
B
i*+dep IRP
Capital
outflow IS
Y
Bits of Theory
 Example: Fiscal policy under fixed exchange rates
2. Central bank
1. Expansive fiscal
would like to increase
policy associated with
interest rate
move from A to B
i 3. Interest rate
MP rises: Inflow of
foreign capital
Capital B
inflow A
4. Central bank
C needs to give up
i*+dep IRP MP schedule
Capital IS’
outflow IS
Y
Optimum Currency Area Theory
“The European countries could agree on a common piece of paper,

they could then set up a European monetary authority or central
bank. . . . This is a possible solution, perhaps it is even an ideal
solution. But it is politically very complicated, almost utopian.”
Robert Mundell (1973)

Benefits of a Currency Area
1. Elimination of transaction costs and comparability of prices
2. Elimination of exchange rate risk (for transactions and FDI)
= less uncertainty
3. Price transparency and intensified competition (also affects
wage setting) - kilo potato cost 1 DEM in Germany, but 10
DKK in Denmark….where to buy at lowest price?
4. Intensified trade – more trade improves total welfare
(comparative advantage)
5. More central bank independence and better quality of
monetary policy – not: 1 government + 1 central bank
but: 19 governments + 1 central bank
Costs of a Currency Area
 One-size-fits-all policy? Diversity in a currency area is costly
because a common currency makes it impossible to react to
each and every local particularity
 The theory of optimum currency areas (OCA) aims at
identifying these costs more precisely
 We proceed in three steps:
1. define and examine the effects of asymmetric shocks with respect to
the need for independent monetary policy;
2. study the problems of asymmetric shocks in a currency area – to
which extent are asymmetric shocks present among countries
3. examine how the effects of asymmetric shocks can be mitigated
when national exchange rates are no longer available
 AS-AD model setup:
 AD: From IS-MP-IRP model – increase in prices P leads to
a real appreciation through EP/P*
When domestic price
level rises, output is
reduced
 Starting point: Increase in P leads to a real appreciation through EP/P* ↑

 Drop in competitiveness: Exports decrease and imports increase
 Reduction in aggregate demand (movement along AD curve): IS curve
shifts inwards
 AS curve: for given production costs, higher prices P will
lead firms to supply more production to market, i.e.,
higher Y. Supply upwards sloping curve
 Starting point: Assume that preferences
shifts away from the goods produced
in a given country
 This leads to a shift in the demand
curve from AD to AD’ – at a given
relative price EP/P* at say λ, the demand
drops from point A to point C
 The consequence is that a quantity
corresponding to the distance from
point A to point C are unsold – how
should a country adapt?
Shocks and the exchange rate
How should a country adapt?

 Adapt through reducing P (flexible prices) – the price of
goods produced in the country. Given wages is an important
cost factor of production, the price can only be reduced if
wages are also reduced. This may be conceived as painful, why
price and wage rigidities may prevail (rather than move to λ’)
 Adapt through reducing E (real depreciation) – for
given price levels P and P*, reduction in E would reduce price
of domestic goods relative to price of foreign goods
measured in same currency → country is more competitive
 … but this is not possible in a currency union…
There are two outcomes in figure:
 Country adapts through either
reducing P or E as on previous
slide, which renders a new
equilibrium at point B
 Country does not adapt through
either P or E, with the result that
supply is at A and demand is a C
→ As firms will not continue producing
unsold goods, the recession as
measured by the reduction in output
becomes even larger than in the first
outcome above
→ But eventually prices will drop in the
long run (following a deep recession)
 Consider the situation, where two countries A and B are hit by
the same shock - symmetric shocks - shifting AD1 to AD2 in both
countries: Adjust the exchange rate vis-a-vis the rest of the world
Country A Country B
 Consider the situation, where only country A is hit by the shock
– an asymmetric shock – shifting AD1 to AD2 only in country A:
Short-run with sticky prices How should central bank react?
Long-run
adjustment to λ2
AD2 AD2
OCA Criteria
 OCA theory derives practical criteria to understand which
countries should share the same currency
Two types of criteria – classic (economic) or political:
Type 1 - three classic (economic) Type 2 - three political criteria:

criteria:
- Criteria 1: “Mundell” - labour - Criteria 4: Fiscal transfers

mobility
- Criteria 2: “Kenen” – - Criteria 5: Homogeneous
diversification preferences
- Criteria 3: “McKinnon” - - Criteria 6: Solidarity vs.

openness nationalism
OCA I: Labour Mobility
Criterion stated formally: Optimum currency areas
Why?
are those within which people move easily
 After shock, unemployment in country A (AS and AD’ at λ2) and inflationary
pressures in country B (AS and AD at λ2)
 Emigration shifts S to S’ in country A; immigration shifts S to S’ in country B
Cross-border
mobility leads to
new (point C)
equilibrium in
currency union at λ2
 Intercept of AD’ and S’ in country A and AD and S’ in country B are both at λ2

OCA I: Labour Mobility
 Caveats or why Criterion 1 may not resolve problem anyway:
1. Inter-regional mobility higher than international mobility: mobility

among countries in Europe is much smaller than within countries due
to e.g. culture, language, institutional differences etc.
2. Skill mismatch: A countries production requires skills that are not

available in other countries: in presence of country specialization, skills
also matter. Moving labour to a country that does not have the right
skills to the countries’ specialization will not increase production
3. It takes time to create production facilities: Moving labour from

country A to B also requires capital mobility to provide all
production factors in country B. Machines and financial capital may be
mobile, but plants/buildings must be built first
OCA II: Production Diversification
Countries whose production and exports are widely
diversified and of similar structure form an OCA
Why?
 The idea is that shocks are symmetric and so the D curves in country A and
B move in same direction of same magnitude
 If countries have firms that produce the same types of goods or services and
exports the same type of goods or services, then sudden demand shift will
be the same in the two countries – shocks are symmetric over countries
 This is a very stringent requirement, but a slightly weaker one is that production in
both countries is diversified as such that they not focus on production of a few
products, but on production of a wide set of products – even is some
production is relatively more important in country A than B
→ shock to this production only matters little for the whole production, as the
production of all other goods are unaffected
→ In this case, there are few asymmetric shocks and each of them is likely to be of
small concern
OCA II: Production Diversification
 Caveats or why Criterion I1 may not resolve problem anyway:
1. A very broad statement: When are countries sufficiently diversified in

production structures?
2. When are production structures among countries sufficiently similar?
OCA III:Trade Openness
Countries that are very open to trade + trade heavily
with each other form an optimum currency area
Why?
 If all goods and services are traded extensively among a set of countries,
the distinction between domestic and foreign goods becomes less
significant
 With traded goods and services, the prices are set jointly for the
whole market consisting of both countries and prices will be the same in
both countries
 If all goods and services are traded, domestic good prices must be
flexible and the exchange rate does not matter for competitiveness
Is Europe
an optimum Sequencing:
currency 1. Asymmetric
shocks?
area? 2. Flexible labour
markets?
3. Labour mobility?
4. Political support
for transfers/
homogenous
Notice: There is a preferences/
sequence of using solidarity?
the criteria to
determine of we
have an optimum
currency areas
Is Europe an optimum currency area?
Classic - criterion 1
(Mundell): Labour
mobility
 Europeans move little! 0.2
percent of population
migrates across borders
in EU15, but around 2.3
percent of population
migrates interstate in US
 Even within EU-15
countries an average of 1
percent of the population
migrates within the
country
Classic - criterion 2 (Kenen):
Production diversification
 Diversification & trade
dissimilarity = trade dissimilarity
index (Germany as benchmark)
 Even enthusiastic countries w.r.t
monetary union like Netherlands
have considerably different trade
relative to other Eurozone
countries….natural gas exports
 No clear pattern of Eurozone
members being more similar -
but in general in many countries
relatively small differences in trade
at 0.1-0.2
Classic - criterion 3
(McKinnon): Openness
 Openness = openness to
trade (exports as
percentage to GDP)
 Most European countries
very open….particularly
the smaller countries by
nature, so most countries
seem to qualify according to
McKinnon criterion
Political - criterion 4: Fiscal transfers
 Up until the debt crisis, there was no transfer system in the EU
 EU budget is small (slightly above 1% of GDP) and almost entirely
spent on operating expenses, CAP, and Structural Funds
 Crisis led to the creation of the European Financial Stability Fund (EFSF),
which recognizes that monetary union needs transfers
Political - criterion 5: Homogeneous preferences

 Based on past inflation rates, it does not seem that country share similar
views on monetary policy – low-inflation Germany and formerly high-
inflation Italy or Greece
 Similar story when looking at public debts – very different approaches to
fiscal policy in European countries
 The response has been to setup common institutions – inflation prone
countries get more “monetary discipline” through institutions
Political - criterion 6: Solidarity vs. nationalism
 Solidarity vs. nationalism

= feeling European?
(opinion pole 2006 – do
you feel European?)
 European citizenship is
not a widely felt
sentiment – on average
16 percent of respondents
indicated to feel this way
often
 So, is Europe an optimum currency area? Mixed performance:
OCA Scoreboard
 Single currency project has been and remains controversial

 Partial fulfillment of the OCA criteria implies that, given that the
decision to go ahead has been taken, there will be costs
Are the OCA criteria endogenous?
 Endogeneity issue – does fulfillment of criteria lead to
optimal currency areas or does optimal currency area lead to
fulfillment of criteria?
1. OCA criteria presented above refer to country
characteristics, but these characteristics may change over
time
2. A puzzling question is whether they can change because of
membership of a currency area
3. Put differently, can an area that is not an optimum currency
area become one as a consequence of being one?
4. Possibility is called the endogeneity of the OCA criteria
Future expectations on endogenous development:
 Criterion 1 – Labor mobility: few expect labour mobility to increase
dramatically in the near future, but single market may encourage reforms
to make European labour markets more flexible – (?)
 Criterion 2 - more trade may lead to specialization in production to gain

comparative advantage – more specialization in trade. Alternatively, it may
lead to more intra-industry trade (each country producing different
brands of same product) – less specialization in trade (?)
 Criterion 3 - Baldwin et al. (2008) conclude that, so far, the Euro has
probably increased trade by some 5% – more openness
 Criterion 4 - fiscal transfers: much the same applies to fiscal transfers –

extensive and automatic intra-European transfers seems to have little
support – not more transfers (?)… 750bn Euro COVID-19 package
10.11.2021
The Eurozone in crisis
Timo Mitze
Economic Crises – An Overview
 Economic crisis can be defined as a period significant
negative economic development (GDP, unemployment, firm
closure)
 Economic crisis may have its root within the economic system
itself or may be the result of an exogenous event
 Examples of exogenous shocks are:
 Political conflicts / war
 Natural disasters (earthquake, flood etc.)
 Epidemic / Pandemic
 …
Types of shocks
 When a crisis hits the economy, it may translate to an
overall economic slump through a…
 …supply side shock
 …demand side shock
 …combination of both
 An example for a supply side shock is depletion of physical
capital through a natural disaster → lower quantity
supplied
 Demand side shocks lead to a reduction in aggregate
demand, e.g., burst of U.S. real estate bubble in 2007
European Perspective
 While process of EU integration was relatively “smooth” up
to early 2000s, EU was subject to frequent “shocks”
afterwards
 Global financial crisis (2007-08)
 Euro debt crisis (2010-13)
 European refugee crisis (2014-16)
 Ukraine crisis (2014- )
 BREXIT (2018- )
 COVID-19 (2020- )
 Crisis management often associated with increase state

regulation, market interventions (monetary & fiscal
policy)
European Perspective
 Mainly 2 episodes since 1980 with significant economic slump
Source: Baldwin & Wyplosz (2021).

Part I:
From the global
economic crisis
of 2007/08 to the
Euro debt crisis
Take home messages for crisis management:
“We knew that a storm was brewing but, admittedly, we did not know exactly where. Neither
did we know what would trigger it, or when it would come.”
Jean-Claude Trichet, President of the ECB. Keynote address in 2009.
“The euro is like a bumblebee. This is a mystery of nature because it shouldn’t fly but instead
it does. So the euro was a bumblebee that flew very well for several years. Probably there
was something in the atmosphere, in the air, that made the bumblebee fly. Now something
must have changed in the air, and we know what after the financial crisis.
The bumblebee would have to graduate to a real bee.”
Mario Draghi, President of the ECB, 2012.

Stage one: Global financial crisis
Historical backbone: Following the Great Depression in 1929, strict
regulations was designed to limit risk taking by banks and financial institutions
 Important act in that respect is the Glass-Steagall Act of 1933, which limits
securities, activities and affiliations between banks and securities firms
 Securities firms (brokers) are firms that provide transaction services related to
financial investments, which are quite distinct from the services provided by
traditional depository institutions
Deregulation phase started in the 1980s, followed by a rapid expansion

of financial sectors in the USA and Europe – banks included activities not
directly related to a traditional depository institution. This created two
mismatches as banks became active investors:
 Maturity mismatch between short-term borrowing from deposits and in interbank
markets and long-term investment
 Currency mismatch from borrowing and lending in different currencies implying a
mismatch if a currency changes value fast
 The result was that banks took major risks, implicitly borne by their
governments – governments being lenders-of-last-resort
 Example is house mortgages in the US to risky people (subprime
mortgages) but subject to securitization: Financial crisis – the property value of
everybodies property drops fro index
 Relied on reduced risk from 200 to 140….systematic risk hitting
ever increasing house prices even top tranches…..
in combination with
diversification argument of
risky people not being
systematically risky.
 And these loans were sold
to banks in ranked tranches
(shares), with lowest
tranches being subject to
default first – and so top
tranches less risky
 Housing prices in the USA
(Index: January 2000 = 100):
The consequences of a collapse in the US housing market
 When house prices stopped rising, securities lost their ratings and
many of the world’s largest banks (especially in US, UK, France, Germany)
faced heavy losses
 April 2007: New Century Financial Corporation (one of the largest US
mortgage lenders) declared bankruptcy
 July 2007: Bank Bears Stearns announced that it would stop honoring the
commitments of one of its funds
 Banks became suspicious of one another and stopped their mutual lending that makes
up the interbank market.
 Central banks provided liquidity directly to their banks
 September 2007 – spring of 2008: Several major banks failed

 15 September 2008: Failure of Lehman Brothers triggered the
worst financial crisis since 1929
Assets of central banks (Index: January 2007 = 100):
 As central banks provide
liquidity directly to private
banks, this implies that
private banks borrow
liquidity from the
central bank → the
central banks assets
therefore increases
 FED very early increases
liquidity, while ECB was
more hesitant due to
fears of inflation – with
ECB being more anti-
inflationary
 Policy makers (governments and central banks) followed the
lessons learned from the Great Depression of 1929:
1. rescue large financial institutions
2. deep distress in the financial system is soon followed by a
profound and long-lasting recession (twin crisis)
3. Central banks must provide liquidity to the financial system and
adopt sharply expansionary policies
4. Governments must bail out banks and other financial institutions
5. Governments must use fiscal policy to prevent a vicious cycle
of recession and large budget deficits
 The London G20 Summit in 2009 called upon all
governments to urgently adopt expansionary policies
Stage two: Public debt crisis in Eurozone
 Actions had dramatic impacts on budget deficits (e.g., in 2010,
Irish government spent ∼30% of its GDP on bank bailouts).
 Budget balances 1993–2014 (% of GDP) increasing public

debt: resulting in debt crisis in Southern European countries:
From bad to worse –

3 percent threshold
to be in EMU…
Greece in 2008 at
16 percent of GDP
budget deficit
 The recession has been deep but relatively short-lived for the
US and Eurozone in general!
 Is it a V or W crisis?
 GDP growth
2006–14:
Two years shock and

then recovery already in
2010… on average in US
and across countries in
Eurozone
 However negative growth and large budget deficits have led
to a fast increase in public debts:
 Financial crisis has led governments to run budget deficits
 Deficits have led financial markets to worry about the sustainability of public
finances making it harder to refinance public debts
 GDP falling and public debt increasing led to increases in public debt to
GDP ratios beyond the 60 percent threshold in EMU
 Example of Greece:
1. Late 2007: public debt at 105% of GDP
2. Late 2009: public debt at 127% of GDP
3. Early 2010: Greek government in desperate situation in terms of
refinancing
4. May 2010: IMF–EU–ECB (called Troika) rescue operation & creation of
European Financial Stability Facility (EFSF)
5. Early 2011: new package from the Troika (conditional loans)
 Timeline of financial assistance from EFSF – the bailout of
countries:
 Bailout of Greece in May 2010 was motivated as way to avoid

highly dangerous contagious effects, but this goal proved
elusive:
 Ireland received loan in Nov. 2010; Portugal followed with loan in May 2011
 Contagion of debt crisis within the Eurozone is highly troubling since

public indebtedness is not enough to explain why these countries
were hit – other developed countries outside Eurozone were not
 Problem in construction of the Eurozone?
 Possible additional explanations of possible problems of
construction of EMU:
1. No lender-of-last-resort: Membership in monetary union may be a
weakness → national central banks cannot help government to
provide re-financing by buying government bonds… monetary policy
not determined by national central bank but by ECB
2. Competiveness issue: Some countries had too high wages relative
to productivity → Locking-in their wages at a given level measured in
euro from a monetary union constitutes a problem of competition, as
currency can no longer devalue to become competitive
3. Policy mistakes: Bailouts signaled to markets that the countries
being subject to bailout were unable to obtain loans on market
conditions indicating a high risk of borrowing to these countries →
making it even harder/impossible for the countries to obtain market
loans
No lender-of-last-resort: Public Debt in 2009 and 2014 (as % of GDP):
US and UK had even

higher public debt levels,
but could finance these
through national central
buying government bonds
for money… not possible
for Ireland as no
independent national
central bank…
Ireland had quite high public

debt level and was not able
to refinance it….needed
bailout from EFSF as no
national central bank as
lender-of-last-resort
Competitiveness issue: Increases in the unit labor costs 1999 - 2009:
Unit labour cost:

average cost of Consumer
producing one price index -
unit of GDP – price
wage inflation… inflation…
Two observations:
1. Countries with lower labor costs see lower prices – firms demand higher
prices if wages are higher…
2. Real exchange rate=E*P/P*, for given P* then fixing E (Eurozone), the increases
in P in figure above implies a real appreciation and so less competitive – real
appreciation highest in Greece due to low productivity
Competitiveness issue: Current Accounts 1999 – 2009 (as % of GDP):
Countries that
experienced a real
appreciation from
Eurozone fixing E and
thereby loss of
competitiveness see
increasing current
account deficits…
like Greece
Policy responses
Policy mistake: Step increases in interest spreads (below) is due to policy
decisions that markets perceived bailout as ‘too little, too late’ policy (e.g.,
EFSF). Only Outright Monetary Transactions (OMT)
announced by ECB in 2012 reduces spreads….
Interest rate spreads (basis points): ECB buying bonds of specific governments
The bailout in
2010 did not
reduce spreads of
Southern
European
countries, but
rather was taken
as a signal of risk
and so increases
spread…
Policy responses
Policy mistake: Fiscal policy strategy: fiscal austerity as a mean to return to
economic growth.
Forecasts of real GDP consistenly
IMF real GDP forecasts at different points in time: follow the same pattern….recession
and then recovery…this applies for
Forecasts of real forecasts in April 2009 and in April
GDP initially 2011
wrong predicting
recovery… and
forecasts become
increasingly more
negative…
austerity right
policy?
Policy responses
Policy mistake: Fiscal policy was much less expansionary in the Eurozone.
Source: BBC.
Structural deficit after having taken out cyclical EU Commission focuses on Growth and Stability
component (automatic stabilizers) is large in Pact of Eurozone with 3% threshold… thereby
UK and US reflecing expansioary fiscal policies allowing fo much less expansionary policy…
policy mistake?
Policy responses
Policy mistake: Monetary Policy – ECB with full sterilization of policies,
which did not apply for FED and BoE…
Only ECB pursued full sterilization… as it lends

ECB, FED, BoE all set interest rate targets that approach money to some part of the market (OMT) it
zero… thereby approaching possible liquidity trap… absorbs this money through auctioning deposits
other places in the market… to prevent inflation…
Policy responses
“Bailout Institutions” created by Troika (IMF-EU-ECB) in 2010:
- European Financial Stability Fund (EFSF) for availability
of financial resources in case of contagion
 Lending capacity of 250 billion euro
 Lending only allowed directly to countries, and so no purchase of existing
debts (owned by others than the countries)
- EFSF replaced by European Stability Fund (ESM) in 2012:

 Based in Luxembourg
 Lending capacity of 500 billion euro
 Capital can be increased from 80 billion euro up to 700 billion euro
contributed by Eurozone countries
 It borrows money that it lends, but cannot lend more than its capital
The Outcome
Outcome: The output gap… did growth recover?
The difference
between broken line
and blue output line
increases for Euro-
zone and UK…
larger output gap…
The difference
between broken
line and blue line
increases for US
tends to stabilize…
stabilizing output
gap…
The Outcome
Outcome: Has the Eurozone seen more price stability
reflecting the prioritization of the ECB?
No clear tendency to
increasing and higher
inflation in US relative
to Eurozone following
monetary expansion
of FED – increasing
assets…
Rather tendency for

inflation to move
towards zero… fear
of deflation...
What have we learned from the crisis?
What have been the challenges from the crisis?
1. Fiscal discipline: very high debt creates serious difficulties
 Limits countercyclical fiscal policy, as cannot borrow money to expand
fiscal policy in times of crisis!
 Challenges monetary policy independence
 Short run downturn stronger than if countercyclical fiscal policy was
possible, may have permanent/long-run growth effects
2. Eurobonds may have appealing features (but politically unfeasible)
 Element of solidarity – pooling risks across countries
 Single Eurobond market might challenge US Treasury Bonds (as
international reserves) and attract more financial resources
 End fragmentation of Eurozone financial market – with a lot of different
risks patterns making is difficult as an investment object
What have been the challenges from the crisis?
3. Debate on debt restructuring – imposes costs on
bondholders, possibly create instability to the extent national
bonds are held by private banks and it makes it difficult for the
governments subject to restructuring to borrow in future
4. Bank fragility – crisis has led to fragmentation of banking

system as Single Supervision System (SSM) only applies to large
banks. And ECB does still not see itself as lender-of-last-resort
5. Governance – crisis shift to intergovernmentalism… not

Commission as vehicle to solve crisis, but different national
governments…Eurozone needs its own system of governance…
not that of the European Union?
Arguments for breakup:
1. Failure to establish fiscal discipline
2. Gap between well-functioning North and badly
wounded South
3. Many international investors do not believe that the
euro can survive (self-fulfilling process)
Arguments against breakup:
1. Breakup would have catastrophic implications
2. New currency would have to be printed and
reintroduced
3. No legal procedure for a country to leave the Eurozone
4. Problem has been political mismanagement of crisis
Part II:
COVID-19 Crisis
COVID-19 Crisis
 COVID-19 pandemic is one those historic events that change
the world (Baldwin & Wyplosz, 2021)
 Fast global spread with no medial cure available at first (2020)
 To mitigate viral spread, drastic non-pharmaceutical inventions
have been implemented in almost all countries over the world
 Public health interventions have been proven to be quite
effective but extremely costly, i.e., full lockdowns, and difficult to
maintain
 Stringency index (University of Oxford) helps to map severity of
public interventions and identify social costs
COVID-19 Crisis
800
80
new_cases_smoothed_per_million
600
60
stringency_index
400
40
200
20
0
0
01apr2020 01oct2020 01apr2021 01oct2021 01apr2020 01oct2020 01apr2021 01oct2021

date date
entity = Denmark entity = Germany entity = Denmark entity = Germany

entity = Sweden entity = Sweden
Source: Data from the COVID-19 Government Response Tracker, University of Oxford.
COVID-19 Crisis
 Recap: Economic toll of pandemic unparalleled in historical
perspective in terms of GDP → What is about inflation rate?
Source: Baldwin & Wyplosz (2021).

COVID-19 Crisis
 V-shape growth indicates a deep fall in 2020 followed by a
sharp rebound and then economies are predicted to return
to “normal” growth rates
 But forecasts may be overly optimistic in the light of new
pandemic developments and economic side effects (fragile
global supply chains)
 Sharp decline in 2020 mainly the result of two effects:
1. Many people reduce their mobility sharply, either to reduce the risk of infection
or because they have to (e.g., lockdowns): Consumption falls → Investment
spending by firms are discouraged → decline in aggregate demand
2. Non-pharmaceutical interventions impose severe restrictions on firms and
employees (reduction or complete stop of business activities) → decline in
aggregate supply
AD: Aggregate Demand = amount of total spending on
AS-AD analysis domestic goods and services in an economy (resulting from
wealth effects, interest rate, and foreign price effects)
Inflation AS: Aggregate Supply = total quantity of output firms will
produce and sell—in other words, the real GDP
AS1
AS2
AS0
∆P2
∆P0
AD2
AD0
AD1
Y1 Y0 Y2 GDP
COVID-19 Economic Policies
 Governments adopted a broad variety of measures to
support the demand and supply side of the economy
 Frequently used demand-support schemes:
 Wage compensations (Kurzarbeit): Pay firms to not lay off their
employees even if they could not come to work spells
 Extended unemployment benefits
 Consumption vouchers
 Frequently used supply-support schemes:
 Cost compensation, tax deductions etc.
 Targeted subsidies, e.g., for investment, research & innovation (R&I)
activities
 Innovation is considered as the key to economic development
 A major threat to innovation during times of crisis is the slowdown of
R&I funding and investments
 Governments struggle with diminishing tax revenues and/or increased
need for spending on short-term solutions
 Firms might be forced to enter a survival mode postponing future-
oriented R&I investments
 Surviving a crisis requires governments to design policies that
encourage innovation
 Rehman et al. (2020: p.349): “public support to R&I is a good strategy
for an economy to confront economic crisis effectively by increasing the
technological innovation in the private sector”
 Finnish response = massive R&I funding (Business Finland)
 Funding for business development in disruptive circumstances (over
990 mill. Euros)
Source: Data from Business Finland (2021).

 Estimated contribution of BF funding varies between 0.4% and
1% in terms of regional GDP growth
Panel A: Total growth rate Panel B: National growth rebound Panel C: BF funding intensity
.1
Out-of-
sample
.05
Growth rate (1=100%)
-.05 0
-.1
1995 2000 2005 2010 2015 2020

(1=100%) (1=100%) (1=100%)
(mean) regional GDP growth (mean) regional forecast (0.040,0.052]
(0.028,0.040]
(0.019,0.023]
(0.016,0.019]
(0.012,0.014]
(0.009,0.012]
(0.015,0.028] (0.013,0.016] (0.007,0.009]
[0.003,0.015] [0.010,0.013] [0.004,0.007]
95% regional forecast range (mean +/- 2*SD)
Source: M & M (2021).

COVID-19 Labor Markets
 Monthly unemployment rate in Denmark 01/2007 to 05/2021
7
Seasonally adjusted unemployment
5
rate (in %)
Source: Data from Statistik Danmark (2021).

COVID-19 Labor Markets
 Reopening labor
market in Jutland/
20 40 60 80 100
90 100 110
Wage compensation (index)

Unemployment rate (index)
Funen (treat=1), not
in Copenhagen and
80
Zealand (treat=0)
70
in late May 2020
0
2020m1 2020m4 2020m7 2020m10 2021m1 2020m1 2020m4 2020m7 2020m10 2021m1
 Treatment: Opening treat = 0 treat = 1 treat = 0 treat = 1
of public workplaces
20 40 60 80 100
COVID incidence rate (index)

500 1000 1500 2000
Mobility reduction (index)
as important public
service on labor
market
0
0
2020m1 2020m4 2020m7 2020m10 2021m1 2020m1 2020m4 2020m7 2020m10 2021m1
treat = 0 treat = 1 treat = 0 treat = 1

Source: Data from
Statistik Danmark (2021).

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Economics of European Integration

Our Journey to the heart of European

OKAY, LET’S START WITH THE ”BASICS”

DESCRIPTION ENTRY QUIZ

INTRO TOUR VISION

List of potential term paper topics

Registration of term paper topics and supervisions

Institutions & Decision Making in EU

“The pandemic reminded us of many things we may have forgotten or taken

Regional Integration Sectoral Integration

Sectoral General Regional General

 Federalist point of view: National sovereignty and nation-

 Which political line will eventually succeed?

1957 1973 1981 1986 1990 1995 2004 2007 2013

Portugal, Austria, Romania,

 Factor trade liberalization

 European Political Cooperation (later: Common Foreign and Security Policy)

⇒ Maastricht Treaty drew a clear line between supranational and

TEC = Treaty of Rome

TEU = Maastricht Treaty

TEU = Maastricht Treaty Source:

 Which level of government is responsible for policies in EU?

Customs union Certain health policies

Conservation Civil Protection

 Proportionality: EU should undertake only the minimum necessary actions

 ‘Burden of proof’ lies on the instigators of EU legislation

 Theory of Fiscal Federalism

 Optimal allocation of tasks depends on trade-offs:

QD1 Q’D1 Qc,1&2

Population (in total) 2015 Percent

Source: European Commission.

 Passage probability = number of possible winning coalitions

 Let’s do a little example on this…

1=yes Votes A 10 Majority threshold Passage probability 0.5

To modify example click here

Source: Baldwin & Wyplosz (2012), chapter 3.

Get the data: https://op.europa.eu/en/publication-detail/-/publication/d3e77637-a963-11eb-9585-01aa75ed71a1/language-en

Trade,Tariffs and Trade Liberalization

Take-home message for today:

“If one were to sneak into the bedroom of almost any

(Taken from Baldwin & Wyplosz, 2015, p. 121)

Exports ↓ GDP ↓ Jobs ↓

 Import Demand Curve (MDH)

Z’ Z’’ C’’ C’ M’’ M’ Home

 Welfare analysis: Drop in import price (PIM)

P’’ Consumer C Producer E F

C’’ C’ Z’ Z’’ X’ X’’ Foreign

Impact of Tariffs on International Trade

 What is the effect of the introduction of a tariff of T euros per unit?

 MFN Tariff Analysis

 Moreover, the higher domestic price stimulates Home production

Quantity Home Imports Quantity

Trade Effects of Economic Integration (Trade creation / diversion)

 Unilateral discriminatory liberalization

 What happens when Home imposes a tariff T on all imports?

 Welfare Effects of Discriminatory Liberalization

X’’RoW M’ M’’ Home Imports Z’ C’ Quantity

 Price and quantity effects:

Border price Home price

Guy B No confession Confession

 Social optimum “No confession”: 3+3 = 6

The Further Logic of Economic

Take-home message for today

Economic integration comprises more than just trade effects: