1 Economic Integration and the European Union

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3 Introduction to Economic Integration  Forms of integration  Gains from integration  EU structures -Institutions -Decision making

4 Forms of Economic Cooperation between Nations  Regional economic associations vs. global efforts (WTO)  Trade liberalization vs. economic integration -economic integration goes further and is more discriminatory

5 Forms of Economic Association  Free trade area (FTA) -Free trade between the members  Customs union (CU) -FTA + common external tariffs on trade with non-members  Common market (CM) -CU + free mobility of factors of production  Economic union (EU) -CM + common economic policy

6 Gains from Integration  More trade  Stop wars!  Better use of existing resources -specialization (comparative advantage) -lower prices (intensified competition) -increasing returns to scale  Greater negotiation power -Better terms of trade Assumption: more trade is good – see International Economics for trade theories

7 Let’s consider the effects of economic integration  Trade effect -trade creation and trade diversion  Pro-competitive effects  Economies of scale effects  Growth effects

8 Trade Effects of a Customs Union between Two Countries b) Country B ptpupwptpupw w wtwt pBpB SASA SBSB DADA DBDB Q 1 Q 2 Q 3 Q 4 Q 5 Q 6 Q 7 a b c d g Two small price-taking countries, A and B, facing increasing production costs One homogeneous product, no close substitutes. Trade creation g Trade creation a + c Trade diversion d a) Country A

9 Trade Effects of a Customs Union between Two Countries continued  A and B form a CU, liberalizing trade between them and adopting a common external tariff (CET) CU provides B’s producer with a higher selling price and an expanded market, so B’s producers increase production for exports to meet A’s demand  But at rising production costs and therefore rising prices, B’s excess supply for exports originates, first, from an increase in production and, second, from decrease in domestic demand  This process will continue until the integrated market of the CU reaches equilibrium and the combined supply of the two countries equal their combined demand

10 Trade Effects of a CU between Two Small Countries continued Before CU After CU Country A B A B Price p t p w = p B p u p u Demand Q 3 Q 6 Q 4 Q 5 Supply Q 2 Q 6 Q 1 Q 7 Imports Q 2 Q 3 - Q 1 Q 4 =Q 5 Q 7 - Import price p w - p u - Tariff revenue b + d Exports Q 5 Q 7 =Q 1 Q 4 Export price p u Trade creation - - a + c g Trade diversion - - d -

11 Pro-Competitive Effects of a CU  If the size of a country’s market is limited and competition imperfect, participation in a CU will increase competition welfare benefits An Example: Let’s assume a monopoly market in country A, with demand curve D A and supply S A. Then D A = AR and S A = MC profit maximizing quantity = Q A and price = p A, which is much higher than p U.

12 Pro-Competitive Effects of a CU continued  Depending on the relative cost conditions country A may end up as exporter or importer after joining a CU  For simplicity we assume that A remains competitive at same quantity as before, but A’s price falls to the CU price p U A’s consumers choose to buy more and the difference will be imported  Result will be a welfare increase of A’s consumers

13 S A = MC SUSU MR D A = AR pApA pUpU QAQA QUQU c d g z h Production Welfare changes ProducersConsumers Monopoly - (c + d) Perfect competition - (c + d) c + d + g + z Pro-competition effects g + z Pro-Competitive Effects of a CU

14 Economies of Scale Effects in a CU  So far we have assumed increasing production costs in the countries forming the CU and constant production costs in the world market  In small countries with protected national markets it is possible that demand is not sufficiently large to allow production plants of the most efficient size  However, access to the enlarged market of a CU may provide the conditions for optimum size production and opportunity for cost reductions from exploiting economies of scale (in the real world, much trade takes place because of economies of scale rather than comparative advantage)

15 An Example  Assume existence of economies of scale in production of a commodity x produced in Country A  The domestic demand is too small to allow the producer to reach an efficient scale  Assume that due to restrictions in trade, exports would not be large enough either  When Country A joins a CU, restrictions are lifted and now there is enough demand -For sake of convenience we assume that the CU market allows volume of production that exactly matches A’s minimum average cost

16 Economies of Scale Effects continued Country A DADA D A+U S A = AC pUpU Q 3 Q 4 Q 5 pApA Before customs union, A protects domestic production by a tariff.

17 Factor Mobility in Common Markets  So far we have assumed that factors of production are immobile between countries (in CU international trade takes place in goods and services only)  CM’s entitle the free mobility of capital and labor between member countries

18 Effects of Factor Mobility in CM continued  The advance of integration from CU to CM intensifies the tendency towards a single price for each commodity (service) and a single price for each factor of production  Common markets improve the allocation of factors across country boundaries as well as efficiency and welfare -The other effects mentioned before assume that factors of production are immobile. However, if they can move accross borders, economic growth increases

19 Institutions of EU  Council of the EU (NB! Not the same thing as European Council!) -Main legistalitive body comprising of ministers  Commission -Proposes new legislation, oversees execution  Parliament -Approves commission -Works together with council in legislative issues  Court of Justice -Oversees that national legislation is aligned with EU law

Democracy in EU: Parliament  Parliament has 751 members  Elected directly by citizen of each member country every 5 years  The number of MEPs per country is proportional to population size -Not linearly, though, but according to ”degressive proportionality”: the larger the country the fewer MEPs proportionally  Most legislation has to be approved by the parliament as well as the council (”two chambers”) 20

Democracy in EU: Council of the EU  Main decision-making body of the EU  Members of the Council are ministers from the member countries – who is sent depends on the policy area under discussion  Chair of the council is the relevant minister of the country holding the presidency (which rotates every 6 months)  Council members represent their home countries and can make binding decisions on behalf of their countries 21

Democracy in EU: The Commission  Excecutive body of the EU -Proposes legislation (c.f. national governments) -Implements legislation  Commissioners are chosen from member countries (and approved by the parliament)  Commissioners are not supposed to advocate national interests 22

Democracy in EU: Council voting rules  New voting rules in 2014: In order for a proposal to be passed -Majority of countries: 55% if acting on a proposal from the Commission or else 72%, and -Majority of population: 65%. -Also, there have to be at least 4 countries voting against the proposal (and therefore the 3 biggest countries do not have an automatic veto right) -Exception: sensitive topics like foreign policy and taxation require a unanimous vote (all countries in favour).  The old Council voting rules (can be used until 2017): In order for a proposal to be passed -50% (if proposal was made by the Commission) or 67% (all other cases) of the members states, -74% of the voting weights, which are based on the country’s size (Germany and France have 29, Finland only 7), and -62% of the EU population 23

24 EU Policies and Legislation  EU legislation supercedes national legislation -EU wide legislation needed in order for the single market to function -E.g. differences in environmental and social policy would distort competitive advantage, social dumping  EU policies only in sectors that affect cross borders

25 EU Policies  Social policy  Regional policy  Agricultural policy  Environmental policy  Competition policy  Industrial policy  Transportation policy  Trade policy (vis à vis rest of the world)