THE ECONOMY OF

THE EU AND TURKEY

LECTURE-3:
T H E M I C R O E C O N O M I C S O F T H E E U – S U P P LY & D E M A N D
TODAY’S PLAN:

• The Microeconomics of the European Integration –

Open Economy Supply & Demand
– Readings:
• Baldwin & Wyplosz Ch 4*
• Neal, Ch 3
ESSENTIAL MICROECONOMIC TOOLS
• Assumptions: perfectly competitive market, small size firms (price takers), no scale economies (for now).
• Preliminary supply and demand analysis
– A demand curve: how much consumers would buy at any particular price
– Utility: happiness in euros
– Marginal utility: money value of consuming one more of a good.
– The extra joy would fall with the number of goods.
– Buying the good up to the point where the last one is just worth the price.
– A supply curve: marginal cost is upward – the additional production costs more (no scale econ)
– Production is up to the point where the marginal cost is equal to price. (otherwise losses or possible additional
profits).
• Welfare analysis:
– Consumer surplus: marginal utility-price
– Producer surplus: price – marginal cost
– A price rise decreases consumer surplus, while increasing the producer surplus.
ESSENTIAL MICROECONOMIC TOOLS
• Preliminary open economy supply and demand analysis
• The import demand curve: without international trade, a nation can consume accordingly with
its own supply and demand curves (and eq price). Any p below d>s, and d-s is import demand
– Welfare analysis – what happens when the import p rises? Consumer losses + producer gain. The net
effect is a loss.
– the net effects consists of two effects: border price effect (coming from paying more for the quantity)
+ import volume effect (coming from reduced quantity)
• The export supply curve: foreign supply and demand curves – difference between supply –
demand creates the export supply curve.
– Welfare analysis of a price increase: consumers lose and producers gain in the foreign country. The
net effect is gain.
• Bringing the xs and md curves together: free trade price & quantity of the good
TARIFF ANALYSIS
• For simplification, first analyzing non-discriminatory liberalization (applied to imports from all
trade partners – ‘most favoured nation’ (MFN) tariff.
• What happens when a tariff is imposed? No effect on MD but shifts up the MS by T (domestic price
must be higher by T to get foreign to offer the same quantity).
• As a result: the price facing home firms and consumers rises, home import volume falls. Higher
domestic price stimulates production and discourages consumption. Consumers lose, producers gain
(less than what consumers lose), there is government revenue. The overall effect on home is
ambiguous.
• Tariff reduces foreign wealth – producers lose, consumers gain (less than what producers lose)
• The overall effects of a tariff on foreign and home together is negative.
• Tariff is also a way of taxing foreigners as these tariffs are partly paid by foreign consumers (as the
price there increases) and partly by the foreign producers (as they pay the tax to home government).
GVC ANALYSIS
• One important recent development in trade is the rise of global value chains (GVC): supply
chains that cross borders.
• Assume a part Y has to be used in the production of a final good Z – one Y for each one Z.
• First case: free trade for Z but not for Y
– supply of Z curve also has to include the cost of Y. Without imports, this cost of Y comes from the
determined price of Y by the cross-section of home demand and supply curves for Y. Then the supply
curve of Z is the vertical sum of marginal cost of Z plus the p of Y.
– If there is free trade for Z - then the supply and demand curve determines the q and p for z. But this q
of Z also determines the q of Y. if there’s more demand at the world price, then the country ends up
importing.
• Second case: (if the country can import the part). ft price of Y is low, supply curve for Z also
shifts down (compared to the no imports of parts case).
– Reduces its own Y production – increases its own Z production and becomes an exporter of Z instead
of an importer.
TYPES OF PROTECTION
• As the tariff reduces the p at home and increases at foreign (the difference is the tariff) one can
buy it from where it’s cheaper and sell it at where it’s more expensive – trade rent
• Three types of trade barrier: domestically captured rent (DCR) barriers, foreign captured rent
(FCR) barriers, and ‘frictional’ barriers.
• DCR: the home government gets the trade rents (as a result of imposed tariffs). Some forms of
quotas are DCR barriers as well (import licenses).
• FCR barrier: price undertaking in the context of an anti-dumping tariff. Under EU law, the
Commission can impose a tariff on a non-member if it’s sold below the cost in the EU
market(dumping). Either an anti-dumping tariff is imposed or the exporter firm promises to
raise the p (price undertakings). Then they get the rent.
• Frictional barriers: technical barriers to trade (a whole range of policies that increase the real
cost of buying the foreign goods): health and safety regulations for ex.
COMPETITIVENESS DIFFERENCES
• Traditional comparative advantage theory: labor productivity differences
• Relative productivity changes slowly,
• general level of scientific and technological know-how, product quality, reliability etc.
• management efficiency
• relative wage differences
• Exchange rate – but it’s locked in for Eurozone nations – then only adjustment is through
wages.
• But also intra-industry trade. Cars in between for example (based on super-micro
specialization) – these goods are not entirely identical.
• Also scale economies
NEXT WEEK:

• The Microeconomics of the European Integration

Liberalization and Market Size
– Readings:
• Baldwin & Wyplosz Ch 5*, 6
• Neal, Ch 7
 THE ECONOMY OF
THE EU AND TURKEY

LECTURE-4:
T H E M I C R O E C O N O M I C S O F T H E E U - L I B E R A L I Z AT I O N
TODAY’S PLAN:

• The Microeconomics of the European Integration

Liberalization and Market Size
– Readings:
• Baldwin & Wyplosz Ch 5*, 6
• Neal, Ch 7
PREFERENTIAL LIBERALIZATION
• Preferential liberalization: by 1968 the EU removed the tariffs imposed on imports for each
other, but not for others (significant tariffs on US imports for example).
• Starts with a simple analysis – unilateral preferential liberalization (removing the tariff only
one way for one country) then moving onto more complicated cases.
• Political economy of regionalism – Smith’s certitude and Haberler’s spillover
– assume our country trades with Georgia and Bulgaria while imposing tariff only on Georgia and not
on Bulgaria.
– Smith’s certitude: Bulgaria’s producers win as they face with higher prices and increased sales to us
– Haberler’s spillover: Georgia’s producers lose (x supply curve is pushed down) lower prices and less
sales to us (identified by Gottfried Haberler in 1937).
– Viner’s ambiguity (Jacob Viner, 1950) – the net effect of trade creation and trade diversion is
ambiguous.
PREFERENTIAL LIBERALIZATION
• First start with MFN (most favored nation): a country imposes the same tariff rate for everyone
(2 for simplification), then apply preferential (discriminatory) liberalization (remove the tariff
from one)
• The overall effect is:
– Higher border price (the price the exporters receive after tariffs) for the partner, and more imports
supplied
– Lower border price for the exporter still pay the tariff, and less imports supplied.
– For home country: lowered price (compared to the price with MFN) for home and increased quantity
of imports (home production falls and home consumption rises with lower p).
– Diagram!
– Higher q coming from partner and lower q coming from the tariff paying country is called supply
switching (trade diversion). After EEC6 removed internal tariffs in 1958, the share of imports from
each other has risen from 30 to 45% by 1968.
WELFARE EFFECTS OF
PREFERENTIAL LIBERALIZATION
• For the country still pays the tariff: producer loss (border price effect + trade volume effect –
they are both negative)
• For the partner country (pays no tariff): producer gain (border price effect and trade volume
effect – both positive).
• And home country: as the p now is lower than the p with MFN – consumer gain + producer
loss. The total is positive. The tariff revenue is more complicated as now the tariff is received
only from one country. The net effect together with tariff revenue is ambiguous: Viner’s
ambiguity.
• diagram!
ANALYSIS OF CUSTOMS UNION
• Up until now we assumed unilateral preferential liberalization, but the EU is a customs union (both partners
remove their tariffs for each other). This time home exports also gain, as they won’t pay tariffs when selling to
partner as well.
• Assume home removes tariffs for the partner and vice versa, while they have the same MFN rate for the other
country (common external tariff).
• Good 1 from home to partner
• Good 2 from partner to home
• Both goods are also offered by the 3rd country
• Now 3rd country faces lower border price together with decreased q of supplied imports in both goods.
• The welfare effect on home:
– decreased p and increased q of imported goods – consumer gain
– Increased border p and increased q of good that home imports to partner – producer gain
– There is less tariff revenue (a part of it compensated by the producer gain – as they also no longer pay t)
– But there is also less tariff revenue caused by supply switching – not compensated
– The overall effect is still ambiguous, but it is for sure larger than the overall welfare effect of no customs union case.
CUSTOMS UNION VS
FREE TRADE AGREEMENT
• EEC 6 was a customs union, not only because they removed tariffs for each other, but also they
harmonized the external tariff to non-members. On the other hand, EFTA was a free trade area as they
removed the tariffs for each other while not harmonizing their external tariff rates for others.
• Trade deflection & rules of origin: one possible problem with free trade area is that it can lead to tariff
cheats (trade deflection). If I live in a country which imposes higher tariff, then I can order the good to
partner country and then get it from there duty-free. This can be prevented if there are rules about the
origin (duty-free only if it is made in the partner country). But then figuring the origin is complicated as
the production is highly globalized.
• basic rule of origin: at least 50% of the product should have been made in the partner if it’s going to be
duty-free (based o the final price vs components – value added).
• EU has an advantage because they don’t have to check the rule of origin while the product is distributed
within EU.
• Customs union also requires some level of political integration as they have to decide about a common
external tariff (CET).
FRICTIONAL BARRIERS
• Tariff liberalization was only the beginning of the agenda while forming EEC and EFTA and
the free trade agreements between them.
• Since the mid 70s or especially since the 1986-1992 Single European Act the focus was on the
frictional barriers (subtle forms of trade barrier - health, safety, environmental regulations etc).
• Removing these barriers, Smith’s certitude and Haberler’s spillover still hold, while Viner’s
ambiguity disappears when analyzing the effects.
• assume that the frictional barrier causes a ‘tariff equivalent’, home and partner removes this for
each other but for the 3rd country (preferential frictional barrier liberalization).
– P and q effects are the same.
– Welfare effects: there is still supply switching, but this time this doesn’t cause a welfare loss.
Because before it was caused by lowered tariff revenue (in this case, we don’t have tariffs). The
overall welfare effect is therefore, unambiguously positive.
DEEP REGIONALISM
• Now that many countries removed barriers (there are trade agreements for example, in between
EU and Canada) – we also need to focus more on ‘beyond-tariff’ issues.
• The introduction of euro: electronic currency in 1999, and physical currency in 2002 – a
massive reduction in frictional barriers among euro-using countries.
• Empirical studies show, the introduction of euro not only helped the euro-using countries, but
also others (negative trade diversion). Removing a frictional barrier. An export now doesn’t
have to deal with many currencies mark, franc, lira – but only with euro.
• Empirical studies also show trade creating effect is larger than the trade diverting effect.
• Normally, WTO’s agenda is MFN – but has a loophole for free trade agreements and customs
unions – common external tariff shouldn’t be higher than before forming the union.
MARKET SIZE AND SCALE EFFECTS
• One rationale for European integration to create big market to be able to compete with Japan
and the US.
• The bigger market allows firms to produce more quality and cheaper goods - gain
competitiveness (by taking advantage of scale economies).
• Fewer, larger companies also created some policy responses (EU) to prevent unfair
subsidization of firms and anti-competitive behavior.
• Even when tariffs were removed, there were still frictional barriers – result: firms held their
dominance in their home market and stayed as marginal players in others (market
fragmentation). Higher prices, too many (and possibly less efficient) firms.
• Tearing down the frictional barriers – elimination of these inefficient firms (as a result of
putting pressure down on prices) also accompanying reallocation of employment.
• Liberalization > defragmentation > pro-competitive effect > industrial restructuring (fewer,
bigger, more efficient firms).
NEW TRADE THEORY
• Krugman – imperfect competition as a cause of trade
• BE – COMP diagram (break-even & competitiveness)
• The COMP curve: imperfectly competitive firm charges a price that is higher than the marginal cost to
be able to max profit. The COMP curve shows the relationship between the number of firms and
mark-up (p-mc).
– P decision: if higher than less quantity (trade-off). The monopolist balances these two offsetting effects.
Lower sales means sales lost to competitors. More competition means more downside effects of a price hike.
– Lower mark-up & more firms: COMP is downward sloping.
• The BE curve: also the relationship between n and mark-up
– The more increasing returns to scale (larger fixed cost) you need higher mark-up to be able to survive. If
mark-up is low, then there will be less firms (upward sloping)
• BE and COMP together determines the mark-up. That is added to MC and p is determined. P
determines the level of consumption. And also firms produce at p = ac total zero profit (total cost =
total revenue) – then we find the produced q per firm.
THE IMPACT OF
EUROPEAN LIBERALIZATION
• European integration involved gradual reduction of barriers – however for simplification, we will
assume a shift from a completely closed economy to a completely open economy. (other
assumptions, identical home and foreign)
• The immediate effect is an access to an additional same size market, and number of competitors are
doubled.
• The increased number of competitors force firms to lower their mark-up. BE curve shifts right (more
firms can break even at the same mark-up rate as the market size increases the sales per firm). The
competition forces a new mark-up rate that is below the rate all (2n) firms can survive. Hence, some
of them are pushed out of the competition.
• No trade to free trade liberalization results in fewer and larger firms. (with lower average costs).
• What is adjustment mechanisms that lower the number of firms in real life: mergers and buy-outs,
bankruptcies.
NEXT WEEK:

• The Microeconomics of the European Integration

Labor Markets & Migration
– Readings:
• Baldwin & Wyplosz Ch 8*
• Neal, Ch 8