Transcript POWER IN COMMITTEES - Univerzita Karlova v Praze

JEM081
ADVANCED ECONOMICS OF EUROPEAN INTEGRATION:
Microeconomic Aspects
Lecture 6: Economics of common market, free
mobility of factors
ECONOMICS OF COMMON
MARKET
Dr. Wadim Strielkowski
IES FSV CUNI
November 4, 2013
1
Outline
• Single market and common market.
• Free mobility of production factors.
• Partial equilibrium approach, one production
factor, two countries.
• General equilibrium approach, more production
factors, more countries.
• Welfare effects of common market (negative or
positive?).
2
Readings:




Hansen, J. D., Heinrich, H., Nielsen J., An Economic Analysis of
the EU, McGraw-Hill, 1997, chapter 4, pp. 67-94.
Holden, M., Stages of Economic Integration: From Autarchy to
Economic Union, Parliamentary Research Branch, PRB 0249B, 13th of February 2003.
Turnovec, F.: Political Economy of European Integration.
Karolinum, Charles University Press, Prague, 2003, chapter 6,
pp. 89-101.
Strielkowski, W., Turnovec, F., Labor migration and welfare
effects of free mobility of labor in the common market. In
Mejstrik, M. et al. (2008), Social-economic models and policies
to support active citizens: Czech Republic and Europe. Matfyz
Press, Prague, 2008. ISBN 978-80-7378-074-6
3
Terminology



Customs union: removal of internal tariffs and
quotas and establishing joint tariff protection with
respect to the rest of the world.
Common market: free mobility of goods (customs
union) plus free mobility of production factors and
financial assets.
Single market: common market plus removal of
non-visible barriers for free mobility of goods and
production factors, licenses, different standards and
certificates etc.
4
Basic Elements of the Stages of Economic Integration
Free Trade
Agreement
(FTA)
Zero tariffs between member countries and
reduced non-tariff barriers
Customs Union
(CU)
FTA + common external tariff
Common Market
(CM)
CU + free movement of capital and labor, some
policy harmonization
Economic Union
(EU)
CM + common economic policies and institutions
Economic and
Monetary Union
(EMU)
EU + common currency or linking of national
currencies through the fixed exchanged rates
Source: Holden (2003)
5
Customs Union and FTA: what
prevails in the world?
• FTA like CU but no Common External Tariff (CET)
– Opens door to ‘tariff cheats’: goods from RoW destined for
Home market enter via Partner if Partner has lower external
tariff (‘trade deflection’).
– Solution is ‘rules of origin’ to establish where a good was
made.
• Problems: Difficult and expensive to administer
• Rules often become vehicle for disguised protection.
• Despite the origin-problem in FTAs, almost all preferential trade
arrangements in world are FTAs
– Coordination cost in CU: Must agree on CET and how to
change it, including anti-dumping duties, etc.
– Usually solved through some form of political integration (in the
EU the Commission sets the CET)
6
Economic effects of economic
integration
• Static effects: Short-term effects (shift of
production)
– Trade creation: production shifts to more efficient
member countries from inefficient domestic or outside
countries.
– Trade diversion: production shift to inefficient member
countries from more efficient outsiders.
• Dynamic effects: Long-term effects
– Cost reduction due to economies of scale
– Cost reduction due to increased competition.
7
European Union: key dates (Pt.1)
• Establishment of a Customs Union (1957-1968)
– 1957: Treaty of Rome  EEC6 (F, D, I, NL, B, L)
– 1968: Staged reductions in inside tariffs completed, common
external tariff established
• Establishment of a Common Market (the Single Market Programme
1985-1992)
– 1985: List of 300 non-trade barriers (NTBs) => obstacles to intraEU trade and factor movement (product-safety standards; licensing
of professions; barriers to cross-border capital movements, etc.)
– 1988-1992: removal of most NTBs but some still remain
8
European Union: key dates (Pt.2)
• Maastricht Treaty establishing the ‘Economic and Monetary Union’
(EMU): commitment to long-run economic and political convergence
– 1992: Treaty of Maastricht signed, ratified by all members in 1993
– Not only about monetary union, also restrictions on fiscal policy (the
‘Stability and Growth Pact’)
– 1999: Euro introduced as common currency
• Various enlargements along the way: 1) UK, Denmark, Ireland; 2)
Greece; 3) Spain, Portugal; 4) Austria, Sweden, Finland; 5) Poland,
Hungary, Slovakia, Czech Republic, Slovenia, Estonia, Latvia, Lithuania,
Malta, Cyprus; 6) Romania, Bulgaria
9
EMU (Economic & Monetary Union)
• Common currency (Euro) area for 11 members
– Euro became the official currency unit on Jan. 1, 1999.
– Euro will be in circulation from Jan. 1, 2001
– U.K, Denmark and Sweden opted out.
– Greece was not qualified but joined (problems!).
– European Monetary System in 1979  European
Monetary Institute in 1994  European Central Bank in
July 1, 1998
• Convergence criteria
– Inflation (no more than 1.5% above the 3 lowest ave.)
– Long-term interest rate (no more than 2% above the 3 best
ave.)
– Budget deficit: no more than 3% of GDP
– Public debt: no more than 60% of GDP
10
Remaining Issues of EU
• Further elimination of barriers to common market
– Compatible standards and specifications
– No barriers to market access
– Coordination of VAT and other taxes
• Expansion
– European Economic Area: extension of customs union
privileges to EFTA member countries (Norway, Iceland
and Liechtenstein accepted. Switzerland voted not to join)
– Special agreements with Turkey and others
– Expansion to central and eastern European countries
• Fast-track applicants
• Other applicants
11
NAFTA
• North America Free trade Agreement
– Free trade area among the U.S., Canada and Mexico
– The largest trading bloc in terms of GNP
– A good example of trade diversion (production shifted
from Asia to Mexico)
• History
– Automotive products Trade Agreement (1965)
between the U.S. and Canada
– Canada-U.S. Free Trade Agreement (1989)
– NAFTA (1994)
12
Provisions of NAFTA
• Elimination of tariffs
– Most tariffs will be eliminated by 2004
– The remaining by 2008
• Elimination of nontariff barriers
• Harmonization of trade rules (subsidies,
antidumping, safety standards)
• Liberalization of capital movement (FDI)
• Protection of intellectual properties
• Dispute settlement
• Provisions on labor and environmental
standards
13
Economic Effects of NAFTA
• Trade
– Trade among members increased faster than trade
with the rest of world
• Investment
– Mexico is the main beneficiary (FDI not only from the
U.S. and Canada, but also from other countries)
• Employment
– Difficult to measure because of too many confounding
variables
– Overall employment effect in the area including the
U.S. has been positive
14
Issues related to NAFTA
• Rule of origin and local content
– Rule of origin: products must originate from North
America to get preferential treatment.
– Local content: the percentage of value of a product
that must be from North America to be considered as
North American origin
– Currently 50% for most products and 62.5% for autos.
Political pressure to increase this percentage
• Expansion of membership
– Potential entry by Chile, and some central and south
American countries
– FTAA (Free Trade Area of America) proposal in 2001
15
Other Regional Trade Blocs
• ASEAN and AFTA
– Originated in 1967
– Formation of AFTA in 1993
– Reduction of intrazone tariffs to a maximum of
5% by 2008 (by 2004 for some countries)
• Mercosur (Southern Common Market)
– Formed in 1991 by Brazil, Argentina,
Paraguay and Uruguay.
– Aim for a customs union, but not yet
16
Other Regional Trade Blocs
• Others
– Andean group (Andean Common Market)
– ALADI (Latin American Integration
Association)
– CARICOM (Caribbean Community and
Common Market)
– CACM (Central American Common Market)
17
APEC
• Asia Pacific Economic cooperation
• Formed in 1989 to promote trade and
investment
• 21 member countries that border the Pacific Rim
• APEC is not a trading bloc
• For trade liberalization and against protectionism
• Prefer open regionalism over closed regionalism
• Goal: Free and open trade
– by 2010 for the industrialized countries
– by 2020 for the rest of the members
18
Freedoms of movement
• Free movement of goods
• Free movement of factors:
–Capital
–Labour
• Welfare increase principle the same
in all cases
19
Free Movement of Labour
• Once labour barriers are reduced, labour will
move from low to high wage countries.
• Wages in the former will tend to rise due to a
reduced supply of labour, while in the latter they
will tend to fall due to a rising labour supply, i.e.
wage equalisation.
– But: cultural/language barriers in EU
20
Free Movement of Capital
• If the rate of return on investment is higher
in one country than in another, investment
funds will tend to move to the latter until
the rate is equalised.
– But, the capital flows can be influenced by uncertainty
and different monetary and exchange rate policies.
– The establishment of EMU with fixed exchange and
interest rates should remove such a distortion.
21
The Single European Act
• Programme towards a larger market
without frontiers
– Economic and social cohesion
– Common policy on
technological/scientific development
– EMS strengthening
– European social dimension
– Coordinated environment protection
22
Action focus for SEM
The elimination between EC states of:
• Physical
• Technical
• Fiscal barriers
New EC approach:
• ‘approximation instead of standardization’
• the removal of internal frontiers
• a binding timetable
23
Allocation effects revisited
• Real world
– perfect competition vs. imperfect competition
– understand why gains from customs union not
too high
–Fact: Intra-EU trade is 70-80% intraindustry, thus not driven by comparative
advantage.
–We need models with imperfect
competition.
24
Transaction costs and CMs
• Markets influenced by transaction
costs of firms
• Factors influencing the size of
transaction costs:
–Legal and regulatory framework
–Macroeconomic policy framework
–Fragmentation of markets
25
Understanding the European
market
Observation
–segmented markets, with prices
independent across countries
–policies that raise cost of entering
specific market (e.g. licensing)
26
Understanding the European
market
Evidence for fragmentation?
• Large variation in average prices
– for consumer goods 15.2% around mean
– telephone and telegram 50% around mean
• Conclusion?
– Too little competition, too many firms operating at
inefficient level
27
Effects of market integration
• Intensified competition, which
• Reduces firms monopoly power
• Lower prices
• Inefficient firms exiting
• Allows for more products to be
consumed
• Scale reduces costs of production
28
Effects of market integration…
• In sum:
Integration may turn previously
segmented markets in to a single
integrated market
29
Competition effects of SEM
Barriers to go by end 1992:
• Cost increasing barriers
– Fiscal barriers (taxes and subsidies)
– Quantitative barriers (quotas on steel)
– Different norms and technical regulations
– Real costs of trade (border checks, at 1.7% of
value of intra-EU trade)
30
Competition effects of SEM
• Market entry restrictions
– Protectionist public procurement
– Different service regulation (banking;
insurance)
– Capital controls (still in 8 out of 12
countries)
– Different legal frameworks
31
The Cecchini Report
• Study carried out for the European
Commission to estimate result of
completion of internal market
– A rosy view? Costs of integration?
32
The Cecchini Report
• A 4 stage assessment of benefits
from:
• Removing barriers to trade (e.g. frontier
controls)
• Removing technical barriers
• The creation of scale economies
• Reducing X-inefficiency and monopoly
power
33
Estimates of the benefits of removing
barriers to create the SEM
_______________________________________________________
ECU (billion)
as % of GDP of the EC
_______________________________________________________
(a)
(b)
(a)
(b)
Barriers affecting
8
9
0.2
0.3
trade (customs)
Barriers affecting
production (subsidies)
57
71
2.0
2.4
Barriers affecting the
reaping of economies of scale
(national procurement)
60
61
2.0
2.1
34
Estimates of the benefits of removing barriers to
create the SEM
_______________________________________________________
ECU (billion)
as % of GDP of the EC
_______________________________________________________
(a)
(b)
(a)
(b)
Barriers which
46
46
1.6
1.6
prevent competition
(subsidies, technical
specifications)
Total benefits
171
187
5.8
6.4
Note: (a) low estimate (b) high estimate
based on Cecchini (1988) and Emerson (1988)
35
Benefits revisited
• Improved supply-side of the EC
economy:
– higher aggregate demand by
increasing real purchasing power
– increased investment
– improved competitiveness of EC
relative to rest of the world
36
Benefits
• Improvements in public sector
budgets:
– reduction in cost of public procurement
– growth of GDP and tax revenue
– more public expenditure and reduced
unemployment through restructuring
37
Estimated macro-economic
benefits of creating the SEM
GDP (%)
Balance
+ 4.5
•
•
Prices (%)
Employment
External
- 6.1
(millions)
+ 1.8
(%) of GDP
+ 1.0
Time scale 6 + years from full implementation of
programme (1.1.93)
Estimates subject to a margin of error +/- 30%
38
Omissions of Report
• Location of activities:
– Peripheral location and low productivity trap
Difficult to face higher competition
• Income redistribution:
– Pressure on wages through
competitionneed for extra social provisions
39
Omissions of Report…
• Institutional setting:
– Need for policies on social issues - for even
distribution of benefits
• Effects on outside world
– Positive growth versus protectionism
40
Dynamic Effects of SEM
• Efficiency increase
– then: boost in savings and investment
• Static gain in GDP: from 1992
+ Expanded through continuous increase in
annual growth rate
• Baldwin estimation: extra 0.2-0.9% per
annum (so far: about 0.1%) on top of
static effects
41
Dynamic Effects of Single Market
• Translation into medium term effect:
– Dynamic effects add 30% to 100% to static effect
• Reality:
– New evaluation needed
– Reasons:
• Need to distinguish sector effects
• The distinction between what happened and what
would be without Single Market
• Political changes: e.g. German unification
• Long term effects!?
42
Dynamic Effect of Single
European Market
• Long term: growth of product per
worker is continuing
– Increasing returns to reproducible factors
(explosive growth)
– Constant returns to reproducible factors
(ongoing growth)
Thus:
Integration can have permanent
growth effect
43
SEM – A 1996 Review by the
Commission
• Effect of frontier control removal
– need of new taxation system
• Technical regulations
– slow acceptance of mutual recognition
• Public procurement
– lack of European standards and…success
44
SEM – A 1996 Review by the
Commission
• Accumulation effect:
– Estimated at 1.1-1.5% of GDP
– Extra 300,000-900,000 extra jobs
• Location effects
– Convergence of states
But: geography, institutions, quality,
technology matter!
45
10 years anniversary of SEM
• New Review by Commission in 2002
– Effects of SEM between 1992-2002:
• GDP: 1.8% higher (164.5bn Euro higher)
• Employment: 1.46% higher (2.5 million
extra jobs)
• FDI: intra-EU 15 times increase between
1995 and 2000 (from third countries 4 times
higher)
46
10 years anniversary of
SEM…
– Effects of SEM between 1992-2002
(continued):
• Downward price convergence (3.6%)
• Productivity immediately after 1992: up 2%
• Cross-border procurement: increase from
6% (1987) to 10% (1998)
• Export goods price convergence (50% of all
in EU)
47
10 years anniversary of
SEM…
– Areas with scope of further integration:
• Financial Markets (extra 1% of GDP,
and extra 0.5 million jobs)
–Higher liquidity increases companies
value added by 0.74%-0.92%
• Network industries (utilities): lower
costs
48
Additional readings:
• European Commission, 2003. The Internal Market – Ten
years without frontiers.
• European Commission, 1996. ‘Economic Evaluation of
the Internal Market’, European Economy. Reports and
Studies No. 4, Luxembourg: Office for Official
Publications of the European Communities.
• Checchini, P., 1988. The European Challenge: 1992.
The Benefits of a Single Market, Aldershot: Wildwood
House.
49
Common Market: A Simple One Factor Model
two countries H and P that have created customs
union, next integration step: common market, i.e.
removing obstacles for mobility of production factors
such as capital and labour
Let
q H = f H (y) and q P = f P(y)
be production functions of country H and country P
respectively
qH and qP is a product in H and P
y is a quantity of production factor, e.g. capital
partial equilibrium analysis assuming that the quantities
of other factors used as primary inputs are fixed
50
available quantity of the factor is fixed in each country
on the level y0H and y0P respectively
there is no free mobility of the factor
Let rH and rP be the price of the factor in H and P. Then
p f H (y) - r H y - c H
is the net product function of the factor in country H,
and
p f P (y) - r P y - c P
is the net product function of the factor in the country P
51
p is the price of the product (uniform in the both
countries because of the customs union)
cH, cP is the fixed cost in H and P
normalise prices setting p = 1 and consider real factor
prices
following product maximisation doctrine we can solve the
problems
max [ f H (y) - r H y - c H ]
max [ f P(y) - r p y - c P ]
52
equilibrium factor prices for each country
rH (y), rP (y) as functions of factor quantity
From first order conditions we have
df H (y)
df ( y )
- r = 0  rH ( y )  H
dy
dy
for country H and
df P (y)
df P ( y )
- r = 0  rP ( y ) 
dy
dy
for country P
factor price is equal to marginal factor productivity
53
Inverse factor demand functions rH (y ) , rP (y)
for a quantity y of factor they show the price for which
this quantity will be demanded by production sector
Direct factor demand functions yH (r ) , yP (r)
for each price r they show the quantity of factor
demanded by production factor at this price
actor supply function – available quantity
54
Equilibrium factor price in country H
rH*  rH ( y0H )
factor demand in H equal to factor supply (= to
available quantity of the factor in H)
Equilibrium factor price in country P
rP*  rP ( y0P )
factor demand in P equal to factor supply (= to
available quantity of the factor in P)
55
Why does international factor
mobility actually happen?
• International factor mobility increases welfare since
factors are rewarded depending on their marginal
productivity.
Q
Q
w  MPL  ; r  MPK 
L
K
• Production factors (e.g. labor (L), capital (K)) will only
move abroad if they get a higher reward. wd =MPL< wf
=MPL*
• Expected income differentials between host and source
countries is an important incentive for the international
factor mobility.
56
Production possibilities:
production function
57
Equilibrium in the sector
58
Income in the domestic economy
59
Neoclassical analysis: equilibrium
with no capital mobility
60
Equilibrium after integration of
capital markets
61
EXAMPLE
Assume production functions in H
f H (y) =
1 2
aH
yy
2bH
bH
f P (y) =
1 2
aP
yy
2bP
bP
and in P
Then we obtain linear inverse factor demand functions
f H aH 1
y


rH ( y ) 
y bH bH
rP ( y ) 
f P aP 1
 y

y bP bP
62
and
y H (r) = a H - bH r
y P(r) = a P - bP r
Equilibrium prices
0
0
a

y
a

y
P
H
rH*  H
, rP*  p
bH
bP
63
P
H
r
RP
RH
rp(y)
rh(y)
E
P
*
rP
EH
r*H
y
0H
yH0
N0
y0
P
0P
Fig 6.1
Equilibrium prior to common market
64
The horizontal axis represents the quantity of factor, the
vertical axis represents the factor price. Left side of the
graph describes the situation of country H and the right
side the situation of country P. Interval OHOP represents
the total quantity of the factor available in the both
countries.
Having no mobility of the factor, assuming linear factor
demand functions and factor supply such that available
quantity is fully used in each country, the interval OHN0
on the horizontal axis corresponds to the quantity y0H of
the factor used in country H, while the interval N0OP
corresponds to the quantity y0P of the factor used in
country P.
65
In the case of no mobility of the factor we have equilibrium
EH in country H and EP in country P and different
equilibrium factor prices in H and P, namely rH* and rP*
Interpretation of the graph
Definite integral!
Why do we have to use definite integral?
66
From calculus: as in previous welfare model let y = f(x)
be continuously differentiable function, then
b
 f ( x )dx
a
(definite integral) is equal to the shaded area
y=f(x)
y
a
b
x
`
67
Let u(x) is a function such that
du( x)
 f ( x)
dx
then

du ( x)
f ( x)dx  
dx  u ( x)  const
dx
(integral of a function is a function such that its
derivative is equal to the function we are integrating)
68
In our case
df H ( y )
 rH ( y )
dy
hence we have
0
yH
0
0
r
(
y
)
dy

f
(
y
)

f
(
0
)

f
(
y
 H
H
H
H
H
H)
0
so the shaded area in our graph represents the product in
H generated by the quantity of factor input y H0
69
Ip(H) income of
producers in H
H
r
RH
rh(y)
E
P
Ip(H)+Io(H) product
in H
Ip(H)
EH
r*H
Io(H) income
of factor
owners in P
Io(H)
0H
yH0
N0
y
Fig. 6.2
Product and income in country H
70
Io(H) area rH*0HN0EH represents income of factor owners in
country H
Ip(H) area RHrH*EH represents income of producers in
country H
Ip(H) income of
producers in H
H
r
RH
rh(y)
E
P
Ip(H)+Io(H) product
in H
Ip(H)
EH
r*H
Io(H) income
of factor
owners in P
Io(H)
0H
yH0
N0
y
71
The same for country P
P
Ip(P) income of producers in
country P
Ip(P)+Io(P) product in
country P
RP
rp(y)
E
Ip(P)
P
*
rP
Io(P)
EH
Ip(P) income of
factor owners in P
y
N0
y0
P
0P
Fig. 6.3
Product and income in country P
72
In our case
rP>rH
It means that the factor is more expensive in P than in H.
Allowing free mobility of the factor in the common
market, it will behave as any other good: will move from
the less expensive country too the more expensive
country, in our case from H to P (for example in the form
of investments, if the factor in question is the capital). So
the use of capital in the country P will expand and use of
the factor in the country H will contract until the factor
price is the same in the both countries.
73
Equilibrium equation in common market
yH (r )  yP (r )  y0H  y0P
total factor demand in both countries is equal to total
available quantity of the factor in both countries
Equilibrium factor demand price in the common market
– solution of this equation, in linear case
( aH  aP )  ( y  y )
r 
bH  bP
*
CM
0
H
0
P
74
H
r
P
dIp(P) increase of income
in P (producers)
EP
*
rP
ECM
r*
CM
dIp(P)
dIo(H)
r*H
EH
dIp(P)+dIo(H)
total increase
of income in
CM
dIo(H)
increase of
income of
factor
owners in
H
y
0H
yH0
N*
dy
N0
y0
P
0P
Fig. 6.4
Welfare effects of factor free mobility
75
The equilibrium in the free mobility regime of
common market is described in Figure that follows.
Equilibrium point in this case is ECM and corresponding
factor price rCM. What is the economic effect of the free
factor mobility in the common market?
More quantity of factor used in country P will lead to
increase of the product, equal to the area EPECMN*N0
and less factor quantity used in country H will lead to
decrease of the product equal to the area ECMEHN0N*.
76
Welfare effect
The total welfare effect for the common market we obtain
by subtracting the area ECMEHN0N* (the product
decrease in H) from the area EPECMN*N0 (the gain in P).
It is the area of the triangle ECMEPEH. We can see that
this welfare effect is always positive. It can be calculated
as
1
1
1
dy( r P - r CM ) + dy( r CM - r H ) = dy( r P - r H )
2
2
2
77
Effect in country H
H
r
P
dIp(P) increase of income
in P (producers)
EP
*
rP
ECM
r*
CM
dIp(P)
dIo(H)
r*H
EH
dIp(P)+dIo(H)
total increase
of income in
CM
dIo(H)
increase of
income of
factor
owners in
H
y
0H
yH0
N*
dy
N0
y0
P
0P
a) the net
domestic product
in H declines by
ECMN*N0EH
b) the factor
owners in
country H will
get additional
income from
country P for use
of factor in size
N*N0AECM
total welfare gain (income effect) is expressed by the area
ECMAEH
eH 
1
dy( r CM - r H )
2
78
Effect in country P
a) the net domestic product in P increases by ECMN*N0EP
b) the payment for factor owned by owners from H will
be EPArCMrP
H
r
P
dIp(P) increase of income
in P (producers)
EP
*
rP
ECM
r*
dIp(P)
CM
dIo(H)
r*H
EH
dIp(P)+dIo(H)
total increase
of income in
CM
dIo(H)
increase of
income of
factor
owners in
H
y
0H
yH0
N*
dy
N0
y0
P
0P
total welfare gain is expressed by the area ECMAEP
1
eP  dy( r P - r CM )
2
79
in fact, both countries are gaining
country H by additional revenues of factor owners by
their export to P, and country P by increasing the
product
total welfare effect of common market compared to
customs union is always positive for all participating
countries
80
Common Market: Two Factors Model
Let us consider now the two countries H and P and
two factors case. Knowing production functions in
countries H and P
qH = f H (x, y), qP = f P (x, y)
where x and y are production factors (such as capital and
labour), we can derive factor demand functions for each
country
81
product maximisation problem
p f H (x, y) - wH x - r H y - c H
for country H and
p f P(x, y) - wPx - r P y - c P
for country P
p is the uniform price of the product in the both
countries (because of customs un ion), wH, wP are the
prices of the factor x and rH, rP are the prices of the
factor y in countries H and P respectively.
82
We can normalise prices, setting p = 1, and then we have
product maximisation problems for H and P
max [ f H (x, y) - wH x - r H y - c H ]
max [ f P (x, y) - wP x - r P y - c P ]
Factor demand functions for countries H and P from
first order conditions for product maximization
83
for country H
x H (w, r)
y H (w, r)
could be obtained as a solution of the system of the first
order conditions
 f H (x, y)
- w= 0
x
 f H (x, y)
- r=0
y
84
for country P
x P(w, r)
y P(w, r)
as a solution of first order conditions
 f P(x, y)
- w= 0
x
 f P(x, y)
- r=0
y
85
EXAMPLE
f H (x, y) = 2xy + 8x - 2 x 2 - y
2
2
f P(x, y) = xy - 0.5 x 2 - y + 6y
Inverse factor demand functions in H
wH ( x, y )  2y +8 - 4x
rH ( x, y )  2x - 2y
Inverse factor demand functions in P
wP ( x, y)  y - x
rP ( x, y)  x - 2y + 6
86
Let
0
,
y
x
H
0
H
0
0
xP, yP
be the initial distribution of the factors (available
quantities of the factors in countries H and P).
Consider first the situation prior to common market.
Equilibrium factor prices in country H
wH , rH
we obtain as a solution of the system
0
x H (w, r) = x H
0
y H (w, r) = y H
87
equilibrium factor prices in country P
wP , rP
as a solution of the system
0
(w,
r)
=
xP
xP
0
y P(w, r) = y P
88
After the common market is established free mobility of
factors leads to the uniform factor prices in the union
wCM , r CM
given by the solution of the system
0
0
(w,
r)
+
(w,
r)
=
+
xH
xP
xH xP
0
0
y H (w, r) + y P(w, r) = y H + y P
For simplicity we shall assume that factor demand
functions are linear functions of factor prices
89
To evaluate welfare effects of the common market we have
to consider joint effect of the both factors mobility. We can
use the following procedure:
Without a loss of generality we can assume
wH  wP
then clearly
and
wH  wCM  wP
rP  rH
and rP  rCM  rH
let dx be an absolute value of the transfer of factor x and dy
be absolute value of the transfer of factor y in common
market
90
Welfare effect of free mobility of the factor x
1
1
1
e  dx(wP - wCM ) + dx(wCM - wH ) = dx(wP - wH )
2
2
2
x
CM
and welfare effect of free mobility of the factor y
1
1
1
e  dy(rH - rCM ) + dy(rCM - rP ) = dy(rH - rP )
2
2
2
y
CM
Total effect
1
1
eCM  e  e  dx(wP  wH )  dy(rH  rP )
2
2
x
CM
y
CM
91
Effects in countries H and P:
1
1
eH  dx(wCM  wH )  dy(rH  rCM )
2
2
in H and
1
1
eP  dx(wP  wCM )  dy(rCM  rP )
2
2
92
EXAMPLE
2
f H (x, y) = 2xy + 8x - 2 x 2 - y
2
f P(x, y) = xy - 0.5 x 2 - y + 6y
Corresponding product maximization problems:
a) for country H
max [ f H (x, y) - wH x - r H y] =
max [2xy + 8x - 2 x 2 - y 2 - wH x - r H y]
where wH and rH are the factor prices in country H,
b) for country P
max [ f P(x, y) - wPx - r P y] =
max [xy - 0.5 x 2 - y 2 + 6y - wPx - r P y]
where wP and rP are the factor prices in country P.
93
System for equilibrium factor demand (first order
conditions for profit maximization) in country H:
2y + 8 - 4x - wH = 0
2x - 2y - r H = 0
Solving this system for x and y we obtain factor demand
(given the factor prices wH and rH) in country H
Factor demand functions in H:
8 - wH - r H
2
8 - wH - 2r H
yH =
2
xH =
94
System for equilibrium factor demand (first order
conditions for profit maximization) in country P:
y - x - wP = 0
x - 2y + 6 - r P = 0
Solving this system for x and y we obtain factor demand
(given the factor prices wP and rP) in country P
x P = 6 - 2 wP - r P
y P = 6 - wP - r P
95
Assuming an initial distribution of the available factors
in the two countries
0
H
0
H
x = 3, y = 2.25
0
P
0
P
x = 3, y = 4
we can find the equilibrium factor prices in each of the
countries in no factor mobility case:
96
For country H by solving the system
8- w-r
=3
2
8 - w - 2r
= 2.25
2
we obtain equilibrium factor prices
*
*
wH = 0.5, r H = 1.5
97
For country P by solving the system
6 - 2w - r = 3
6 - w- r=4
we obtain equilibrium factor prices
*
P
*
=
1,
w
rP=1
98
Now, we can calculate the uniform equilibrium factor
prices in the full factor mobility case, considering the
system
8- w-r
+ 6 - 2w - r = 6
2
8 - w - 2r
+ 6 - w - r = 6.25
2
Solving this system we obtain equilibrium factor prices
in the common market arrangement
*
*
wCM = 0.863, rCM = 1.227
(All results of calculations rounded).
99
Comparing results we have:
factor prices
w
r
customs union
in H
0.5
1.5
in P
1
1
common market
in H and P
0.863 1.227
For the first factor
wH < wCM < wP
and therefore in the common market the factor will flow
from country H to country P. For the second factor
r P < r CM < r H
100
Use of the factors in countries H and P before and after
the common market is established:
use of the factor
x
y
before after
before after
in H
in P
dx
dy
3
3
2.955
3.045
2.25
4
2.341
3.909
0.045
0.091
101
Changes in product:
product
in H
in P
total
before CM
after CM
14.437 15.500
14.530 15.441
29.937
30.971
change
0.093
0.034
-0.059
net payments for factors to/from the partner in CM
(wCMdx-rCMdy) (-wCMdx+rCMdy)
net effect
-0.073 0.073
0.020 0.014
102
Analytically:
total welfare effect
1
1
eCM  e  e  dx( wP  wH )  dy(rH  rP ) 
2
2
0.5 * 0.045 * (1  0.5)  0.5 * 0.091* (1.5  1)  0.034
x
CM
y
CM
how the total welfare gain is distributed between H and
P?
103
effect in country H:
1
1
eH  dx(wCM  wH )  dy(rH  rCM ) 
2
2
0.5*0.045*(0.863  0.5)  0.5*0.091*(1.5  1.227)  0.0206
and in P
1
1
eP  dx(wP  wCM )  dy(rCM  rP ) 
2
2
0.5*0.045*(1  0.863)  0.5*0.091*(1.227 1)  0.0134
104
Questions?
105