Lecture 6' Dynamic effects of economic integration

1
Lecture 6. Dynamic effects of economic integration

• Objective
• To highlight the implications of inter-industry,
  rather than intra-industry trade, for the
  consequences of economic integration
• To discuss additional consequences of economic
  integration when markets are imperfect
• the pro-competitive effect and reduction of
  X-inefficiency
• the exploitation of internal scale economies
• greater product variety
• To highlight other possible dynamic gains through
  investment and productivity change

2
Intra-industry trade

• Intra-industry trade (IIT) two-way trade in
  similar, sometimes identical, products
• IIT arises because of differentiated goods
  (demand for variety) and because there are fixed
  costs to producing each new variety
• IIT between EU countries grew rapidly until the
  1970s, then slackened off
• IIT has the policy implication that adjustment
  costs may be lower, and thus political opposition
  to trade liberalisation is reduced

3
CU theory under imperfect competition

• Critique of traditional theory
• traditional theories based on assumption of
  perfect competition
• welfare effects are a consequence of cost
  differences between countries (see MacDonald and
  Deardon Figure 1.5, p. 48).
• size of the market that results from integration
  is not directly important
• Real world characterised by
• imperfect competition in industrial markets
  because of the existence of economies of scale
  and product differentiation
• demand and hence the size of the market are of
  central importance and affect welfare even where
  production and cost conditions are completely
  uniform for all the countries ....

4
CU theory under imperfect competition

• ... thus additional gains to a CU because of
• increased competition between firms erodes market
  power
• increased competition leading to greater
  technical efficiency (cold shower effect)
• the existence of more product varieties
• changes in efficiency as economies of scale are
  utilised
• These gains are grouped under the heading of
  dynamic gains from market integration in contrast
  to the static gains which arise from resource
  reallocation within countries

5
Integration and monopoly power

• In imperfect competition firms exercise market
  power to the extent that price exceeds marginal
  cost
• By increasing the size of the market, economic
  integration reduces the extent of monopoly
  pricing practices. Prices fall, and consumer
  welfare increases by more than producer surplus
  falls, as shown on the next overhead.

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Integration and monopoly power
MC1
A
MC2
Price and marginal cost
P2
P1
SG
DUK
MRUK
O
q1
q2
q3
Quantity
7
Integration and X-inefficiency
MC1
MC2
A
Price and marginal cost
B
C
P1
SG
DUK1
DUK
O
q1
q2
q3
q4
Quantity
8
Economies of scale

• Economies of scale in production for a firm imply
  that average costs fall as output is increased.
  This is shown by a fall in the long-run average
  cost curve of the firm (decreasing costs).
• Scale economies may be associated with the size
  of plant (engineering economies, or the length of
  the production run), or with the size of the
  firm, reducing per unit RD and marketing
  expenditure which are now spread over a larger
  output volume. Such economies are known as
  internal economies of scale.
• External economies of scale are associated with
  the expansion of an industry which lead to the
  cost curves of firms within the industry falling
  as total output is increased. They may be due to
  the development of specialised services or
  improvement of marketing facilities resulting
  from the expansion of industry output.
• Internal economies of scale imply imperfect
  competition and economic integration will have
  pro-competitive effects as segmented markets are
  brought together. External economies of scale do
  not imply any change in market structure and lie
  behind the next slide.

9
Customs unions and economies of scale
Trade creation effect
Cost reduction effect
PA
ACA
PB
Consumption effect
ACB
PU
PW
DA
DAB
DB
XA
X'A
XB
X'B
Home country
Partner country
10
Growth effects of market integration

• Higher economic growth brought about by the
  previous static and dynamic gains from
  integration will raise investment levels,
  ensuring greater capacity for economic growth in
  the future
• Trade acts as a conduit for technical change
  innovations embodied in capital goods imports,
  learning through commercial contacts
• Attraction of foreign investment

11
Summary The economic motives for economic
integration

• Traditional theory emphasises the static
  allocation gains of shifting resources in line
  with comparative advantage ...
• .. but move to customs union implies trade
  diversion as well as trade creation and is not
  necessarily welfare-improving. This is an
  example of the second-best theorem at work.
• Modern trade theory emphasises possibility of
  much larger welfare gains from integration due to
  pro-competitive effects, larger market size and
  the increase in product variety. In addition,
  theory points to a variety of positive growth
  effects. As with all gains from trade, it is
  assumed that resources displaced from one
  activity or sector are re-employed in other
  sectors.
• Note that all the benefits from CU integration
  can also be obtained by a move to free trade.
  But a CU may be attractive as a half-way house
  (to prepare for free trade) or because of
  political considerations.