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The Economic Rationale behind the European Single Market

Andr Feldhof Course: International Economics Course Paper, Final Draft 5 January 2012 Course Convenor: Prof. Roger Vickerman

In 1951, six countries pooled their coal and steel production to prevent the eruption of further wars in Europe. The European Coal and Steel Community (ECSC) was followed six years later by a groundbreaking agreement that proposed to gradually turn these countries into a single market. While the Treaty of Rome in 1957 and subsequent treaties like the Treaty of Maastricht in 1992 had a strong political motivation, there were also economic motives for stronger European integration. This paper sets out to explain the economic rationale for the completion of a Single Market in the European Union (EU). It could be argued that the EU underwent different steps of economic integration which started with a customs union (CU) and a common external tariff (CET) in 1968 (Altomonte & Nava, 2005, p. 70), scaled up to a single market by adding free movement of capital, goods, services and people by 1992 (ibid.) and culminated in an economic and monetary union with a common monetary policy and a coordination of fiscal policies (ibid.). For reasons of space, however, the last two policy changes, harmonization of monetary and fiscal policy, shall not be discussed in this paper. Instead, the paper will focus on the two steps of integration which brought about the Single Market, namely the CU with a CET and the introduction of factor mobility (Altomonte & Nava, 2007, p. 70). The paper will then point to the aspects that are not completed in the Single Market yet and briefly discuss why they are not completed yet.

1. The economic rationale for entering in a CU with a CET For a given country A, which could be any of the six European countries pondering to join the European Economic Community (EEC) in 1957, there is an economic choice to make before entering a CU: Will it gain from economic integration or will it lose? Several economic models can give an answer to this question. This paper distinguishes between static gains and dynamic gains from joining a CU (cf. Jovanovic, 2005, p. 436; p. 454; Altomonte & Nava, 2005, p. 63). To analyze the static gains, it uses a Vinerian analysis which opposes trade creation to trade diversion (Jovanovic, 2005, p. 442). It supports the findings from the analysis with a brief discussion of the terms of trade gains of joining a CU. To analyze the welfare effects of increased factor mobility and a reduction of non-tariff barriers (NTBs), this paper uses the BE-COMP model.

The Vinerian model assumes that there are three countries in the economy trading a single product: buyer country A, a partner country B which could be the cheapest producers within the CU and a third country C which could represent the rest of the world (Jovanovic, 2005, p. 436). The model depicted in Figure 1 assumes that a CU between A and B would produce two effects, trade creation between A and B and trade diversion from outside the CU inside the CU. Only if the combined effects of trade creation and trade diversion result in a welfare gain for country A will it have an incentive to join a CU. In the model, country A is assumed to produce at a supply curve without scale S economies 0S and to consume at a linear demand curve 0D. Without CU, it m PB+t PB PC a b e f g c h d j k D Q1 Q2 Q3 Q4 Q5 Q6 imposes a tariff on imports from both countries B and C which drives up the price for As consumers to PB+t where they would demand a quantity of Q4. At the given price, country A only produces at Q3, so that it

Figure 1: Static gains of economic integration (Viner); adapted from Jovanovic, 2005, p. 445

would have to import quantity (Q4-Q3) from country C. The government gains areas c+h, the difference between the consumer price and the producer cost, as tariff revenue. If country A were to enter a CU with country B, both countries would impose a CET upon country C. Without a tariff on goods from country B, the price for consumers in country A falls to PB. Consumers are therefore able to extend their demand to Q5 by relying only on trade within the CU; they gain consumer surplus in form of areas a+b+c+d. Consumer surplus can here be defined as the benefits for a consumer when she is able to buy a product at a lower price than the ultimate price that she would be willing to pay for it (Krugman & Obstfeld, 2003, pp. 192f). Producers in country A would see a loss of producer surplus in the form of area a. Producer surplus can be defined as the difference between the price level and marginal production cost (Krugman & Obstfeld, 2003, p. 193). From producing at Q3, they would fall back to Q2 and some producers might be forced out of the market.

The government in country A loses area c, its tariff revenue from country B. The overall result for country A is a net gain from trade in the form of areas b+d. Entering a CU, according to Viner, has therefore resulted in trade creation and therefore brought about a positive effect to overall welfare for country A (Jovanovic, 2005, p. 441). The underlying idea, according to Jovanovic (2005) is that country A gives up the production of a good in which it has a comparative disadvantage in order to acquire it more cheaply by importing it from a partner country (p. 441). The benefits of trade creation now have to be balanced against the cost of trade diversion. As mentioned, the Vinerian model assumes that country A has been trading the quantity (Q4-Q3) with country C (which is outside of the CU and can produce at PC). After entering into the CU, this quantity is now traded with country B and thereby diverted. The government of A pays the degree of trade diversion with a loss of tariff revenue in form of area h. If country C can produce far below the price levels of country B, area h will most likely outweigh areas b+d. In this case, country A would be badly advised to enter a CU to gain economic benefits. However, if there is only a small difference between PB and PC, entering the customs union would be beneficial for country A (Jovanovic, 2005, p. 447). Robson (2005) has shown that trade creation in a CU is larger the larger is the economic area of the customs union and the more numerous are the countries of which it is composed (Robson in Altomonte & Nava, 2005, p. 45); the European Economic Community with three large European economies may have provided better perspectives for economic integration than other economies at the time. An analysis of the Terms of Trade may support these findings. A countrys Terms of Trade are defined as its initial export prices divided by its initial import prices (Krugman & Obstfeld, 2003, p. 98; Jovanovic, 2005, p. 460). Krugman & Obstfeld (2003) argue that a rise in the terms of trade increases a countrys welfare, while a decline in the terms of trade reduces its welfare (ibid.). Hence, to increase a countrys welfare, a CU should help it to either increase its export prices or to decrease its import prices. There will be two different forces working against each other as a result of increased trade inside a CU. One the one hand, increased trade could induce export-biased growth of the national economy, thereby increasing the quantity of a product that can be sold and driving down export prices, thus decreasing the terms of trade (Jovanovic, 2005, p. 461). On the other hand, the European customs union is generally assumed to be so big that it can influence world prices in its own

favor (ibid.). In other words, third country exporters are more or less obliged to charge the CU price (subtracting the CET and their own transaction cost) if they want to sell goods to the customs union (ibid.). This essentially drives down import prices and improves a countrys terms of trade. Even though it is assumed that joining the European customs union provided terms of trade gains for its members, Jovanovic (2005) asserts that there are few official statements about the truthfulness of this proportion because it testifies of a desire to improve the EUs trade conditions at the expense of its trade partners (p. 462). 2. The Single European Act Reduction of non-tariff barriers Although tariffs between the member states had been abolished, NTBs such as local content requirements or the refusal to recognize foreign degrees remained a significant impediment for welfare creation in the CU because they restricted the mobility of capital, goods, persons and services. The European Court of Justice established de facto free movement of goods in the Cassis de Dijon case in 1979 when it ruled that
in those sectors which have not been subject to harmonisation measures at the Community level, or which are covered by minimal or optional harmonization measures, every member state is obliged to accept on its territory products which are legally produced and marketed in another member state (Altomonte & Nava, 2005, p. 71).

However, this did not mean a general blank check for factor mobility. In the Single European Act in 1985, the European member states therefore declared to implement all four freedoms by 1993 (Altomonte & Nava, 2005, p. 70). The four freedoms, it was hoped, could supplement the static gains from a CU with dynamic gains (p. 64). Dynamic gains comprise for example accumulation effects (competitive industries from different countries are able to form clusters) or technological advance (Jovanovic, 2005, pp. 454f). This paper considers two dynamic effects in particular, namely economies of scale effects and competition effects. Economies of scale are said to come inter alia from a firms ability to specialize further because of an enlarged market (Jovanovic, 2005, p. 456). Competition means a fall in the price level and thereby increased consumer surplus. Both effects are said to oppose each other (Baldwin & Wyplosz, 2006, p. 149) and can be captured by the Break even competition model (BE-COMP model, see Figure 2).

Figure 2: BE-COMP model. Source: Vickerman, 2011, p. 28

The BE curve in the right-hand panel of Figure 1 plots the number of firms in the market before trade liberalization against their profit margin or mark-up . It is assumed that the higher the number of firms in the market, the higher must be their mark-up in order to survive (Baldwin & Wyplosz, 2006, p. 147). The reason can be seen in the left-hand panel: With an increasing number of firms, a single firms sales will shrink, thereby driving up its average cost beyond the price level and eliminating its mark-up (ibid.). With trade liberalization, however, the BE curve shifts to BEFT and becomes flatter, meaning that at a given mark-up, economies of scale allow for a greater number of firms to remain in the market. At the same time, a bigger market brings about more competition since more firms will try to market their products, and economies of scale will allow them to underprice their competitors. This is captured in the downward sloping COMP curve in the right-hand panel. With every new firm entering the market, competition drives the price and the companys mark-up further down (Baldwin & Wyplosz, 2006, p. 147). The intersection between BEFT and COMP defines the number of firms that can sustain themselves in the enlarged market and the mark-up at which they will be producing. The result of the market restructuring, according to Vickerman (2011) will be that there are bigger, fewer, more efficient firms facing more effective competition (p. 27; cf. Altomonte & Nava, 2005, p. 64). At the same time, the decrease in the

price level from p before trade liberalization to p after trade liberalization will mean a gain in consumer surplus in form of the area pEEp (Vickerman, 2011, p. 27). The essence of the BE-COMP model is therefore that increased factor mobility brings about economies of scale and increased competition which can in turn increase overall welfare of the economy. The findings from this model could be supported with findings from the Solow growth model stating that a bigger market will unleash a greater amount of capital which, if it can circulate freely, will bring about increased growth rates of GDP (Altomonte & Nava, 2005, p. 66). However, this paper does not provide room to deepen the argument. Overall, the European Commission in 1988 estimated the gains from the completion of the Single Market at between 4.3 and 6.4 per cent of EU GDP in 1985 (Altomonte & Nava, 2005, p. 75). Baldwin has even argued that the Commissions analysis substantially underestimates the overall gain associated with the single market programme, since it lacks a proper measurement of the dynamic economic gains (Baldwin in Altomonte & Nava, 2005, p. 77). The real gains of the Single Market may therefore be even higher.

3. The aspects yet incomplete in the Single Market in 1993 Altomonte & Nava (2005) argue that for the completion of the Single Market, three areas had to be covered: completion of the regulatory framework, mutual recognition of standards and macroeconomic coordination (pp. 91f). The Single Market was to be completed by 1993 (Altomonte & Nava, 2005, p. 70) but not all of the required steps had been taken by then. Mutual recognition will here be considered as the successful implementation and enforcement of the regulatory framework, and therefore omitted from the analysis. The regulatory framework denotes the implementation of the four freedoms, meaning the implementation of EU substantive and competition law. Jovanovic (2005) asserts that EU standards are being developed on a large scale, about 1000 of them a year. However, too many national regulations are still being produced, making it as hard as ever to reach a truly homogeneous Single European Market (p. 302). As a result, the EU has adopted Decision 3052/95 which obliges member states to notify the European Commission of individual measures preventing the free movement of a model, type or category of a product that has been made or sold legally in another

country so that countries think again before making national regulation (Jovanovic, 2005, p. 303). The EU has also been working towards the harmonization of financial services and services in general (Jovanovic, 2005, p. 302; Altomonte & Nava, 2005, p. 79). It started a Financial Services Action Plan (FSAP) in 1999 and completed it in 2005 (Altomonte & Nava, 2005, p. 79). It also passed the so-called Bolkenstein directive in 2006 which aims at eliminating the obstacles to the freedom of establishment for service providers and the free movement of services [] between the Member States (Eurofound, 2010). With regard to macroeconomic coordination, the member states agreed in the Maastricht treaty in 1992 to align their policies. While monetary policy has been fully integrated since 1999 (Jovanovic, 2005, p. 141), fiscal policy has always remained a national prerogative (p. 148). To make the Single Market completely effective, economists agree that member states would need to devolve their budget policy to the European level. This is unlikely, however, since the authority to determine ones own budget touches the fundamentals of state sovereignty and of democracy (Jovanovic, 2005, p. 148). The failure of the Stability and Growth Pact which intended to harmonize fiscal policies (p. 129), and the eruption of the Eurocrisis moreover show that there are systematic failures in the coordination of fiscal policies. To improve the situation, the EU in 2011 passed a legislation that provides for ex ante coordination of national budgets (the so-called European Semester) and for automatic sanctions if a Eurozone government fails to stabilize its budget (European Commission, 2011, p. 4; pp. 5f). The coming decade will show whether these measures have been effective or not.

Conclusion Overall, it can be safely said that the Single Market has brought more prosperity to the European Union. In economic terms, European citizens are better off with the Single Market but they also enjoy several related freedoms such as the convenience of paying with their own currency in a different country that cannot only be seen in economic terms. The European Economic and Monetary Union (EMU) moreover has a strong symbolic value given that the EU was created out of the desire to make future wars logistically impossible. However, implementation of the Single Market is not complete yet and will demand more time in future still. The EMU, it becomes clear, remains a work in progress that will depend on continued political support of the national capitals and of public opinion in the member states.

List of references

Altomonte, C. & Nava, M. (2005). Economics and Policies of an Enlarged Europe. Cheltenham: Edward Elgar Publishing. Baldwin, R. & Wyplosz, C. (2005). The Economics of European Integration. Berkshire: McGraw-Hill Education. Eurofound (2010). Services directive. Retrieved on 5 January 2011 from http://www.eurofound.europa.eu/areas/industrialrelations/dictionary/definitions/servic esdirective.htm. European Commission (2003). Directive 2003/54/EC of the European Parliament and of the Council of 26 June 2003 concerning common rules for the internal market in electricity. Retrieved 5 January 2012 from http://eurlex.europa.eu/LexUriServ/LexUriServ.do?uri=CELEX:32003L0054:EN:NOT. European Commission (2011). EU Economic governance: a major step forward. MEMO/11/364. Retrieved 4 January 2012 from http://europa.eu/rapid/pressReleasesAction.do?reference=MEMO/11/364&format=P DF&aged=1&language=EN&guiLanguage=en. Jovanovic, M. (2005). The Economics of European Integration. Cheltenham: Edward Elgar Publishing. Krugman, P. & Obstfeld, M. (2003). International Economics Theory and Policy. Sixth Edition. Boston: Pearson Education. Vickerman, R. (2011). Economics of the EU I: Theory of Preferential Trade Areas. Lecture given at the University of Kent in Brussels on 16 December 2011.