COMMON MARKET THEORY

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COMMON MARKET THEORY

• Lecture outline
• Ref com mkt oct08

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Introduction

• If add free movement of all F of P to CU, result
  is common market (CM)
• So far assumed F of P immobile within CU RoW
• EU more than a CU
• This is one theory that underlies the single
  (internal) market

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(1) Heckscher - Ohlin (H O) theory

• Factor price equalisation
• occurs with free movement of goods, even without
  factor movements
• perfect competition assumptions!
• allocation of resources efficient
• lab abundant country - lab price low (K price
  high). Country specialises where it has a factor
  endowment - raising the price of lab (while
  scarce K falls in price as demand low)
• See handout for outline of H-O model

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• CU factor price equalisation
• before formation of CU tariffs other barriers
  prevented FP equalisation
• post- CU move to FP equalisation, but not
  complete
• non-traded goods
• NTBs
• but, if extend CU thru factor mobility, possibly
  achieve additional welfare benefits

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(2) Free factor mobility

• Assume
• 1. 1 factor (labour) mobile
• 2. 2 countries North (N) E.U. South(S).
  E.U.
• S - labour abundant
• 3. Perfect competition

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See diagram

• a) labour force in N ON LO
• labour force in S OS LO
• Difference in real wage(w)Wn- WS

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real wage (w)
w
Wn
Ws
MPL North
MPL South
O N
O S
Lo
North
South
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• b) Emigration S to N LO L1
• Equalisation of real wage (Wc)
• Workers in S attracted by higher wages to N

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• c) Welfare gain area ABC in EU due to
  reallocation
• as the MPL (N) gt MPL (S) before migration.
  Thus, increased production in N gt fall in
  production in S as lab is reallocated

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real wage (w)
w
Wn
B
C
A
Ws
MPL North
MPL South
O N
O S
Lo
L1
North
South
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Relevant today- EU15 v CEECs
real wage (w)
w
Wn
B
C
D
Wc
Wc
A
Ws
MPL North
MPL South
O N
O S
Lo
L1
North
South
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• d) Redistribution of rewards - depends where
  migrant workers live where their wages are
  spent
• Lab remaining in S receive higher real wages,
  while real wages fall in N
• If migrant workers reside spend in N - Ns
  income rises by LoBCL1 Ss income falls by
  LoACL1
• If border workers live in S, Ns income rises
  by only BCD Ss income rises by DCA

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3 Capital(K) mobility labour immobile model

• N is capital rich, K On Ko
• In S, K OsKo

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real interest rate (r)
r
B
rs
A
rn
C
MPk North
MPk South
Y
O N
O S
Ko
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• Free movement K from N to S (where higher r)
• Equilibrium K (move Ko to K)
• R ru
• Likely new investment
• Welfare gain area ABC

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real interest rate (r)
r
rs
B
A
ru
ru
rn
C
MPk North
MPk South
Y
O N
O S
K
Ko
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Tax distortions ( see case study)

• Assume (above) no tax or equal tax on K in N S
• If tax rates on K differ, investors aim for low
  tax country
• IF
• No tax in S
• 50 tax on K in N (NO tax harmonisation)
• MPkN shown by X-Y
• New equilibrium K1 rather than K

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real interest rate (r)
r
B
rs
A
X
ru
ru
D
rn
C
MPk North
MPk South
Y
O N
O S
K
K1
Ko
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• Welfare loss ADE, compared with optimal
  allocation
• BUT, if tax in S gt tax in N (not shown)
• Further K could flow to K rich N
• Ie. Flow the wrong way

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real interest rate (r)
r
E
B
rs
A
X
ru
ru
D
rn
C
MPk North
MPk South
Y
O N
O S
K
K1
Ko
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(4) Conclusions

• 1 EU wage differentials exist
• not full lab mobility
• partial welfare gain BYZA
• capital is more mobile
• You should research EU wage interest rate (eg.
  10yr bond yields) convergence over the last 20yrs
  - see Eurostat

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real wage (w)
w
Wn
B
Y
C
D
Wc
Wc
Z
A
Ws
MPL North
MPL South
O N
O S
Lo
X
L1
North
South
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• 2 Criticise perfect competition
• would expect dynamic effects of integration to
  lead to mergers
• 3 Neglects interaction of KL
• 4 Second best
• 5 Tax distortions
• 6 Effect of multinationals in the EU?