Theory of Economic Integration -...
Transcript of Theory of Economic Integration -...
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Theory of Economic Integration
Dynamic effects
De-fragmentation and industrial restructuring
Gravity model
Katarzyna Śledziewska
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Major dynamic effects:
1. Reaping benefits of economies of scale and
learning effects
2. Reducing the monopoly power
3. Reducing levels of x-inefficiency
4. De-fragmentation and industrial restructuring
Gravity model
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Liberalization, defragmentation and industrial
restructuring
• Europe’s national markets – separated by a whole hst of
barriers• Tariff and quotas – until 1968
• Technical, physical and fiscal bariers – until 1992
– When barriers – firms can be dominant in their home market –
market fragmentation
• Reduces competition
• Raises prices
• Keeps too many firms in business
• Tearing down intra-EU barriers
– defragments the markets
– produces extra competition
• The pro-competitive effect squeezes the least effecient
firms – industrial restructuring,
• Europe’s weaker firms merge or get bought up
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Economic Logic Verbally
• liberalisation →• de-fragmentation →• pro-competitive effect →• industrial restructuring (M&A, etc.)
• RESULT: fewer, bigger, more efficient firms facing
more effective competition from each other.
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Theory
• Economic logic: background
• BE-COMP diagram
• Details of COMP curve
• Details of BE curve
• Equilibrium in BE-COMP diagram
• No-trade-to-free-trade integration
• State Aids
• Collusion
• We start with the simplest form of imperfect competition:
monopoly, duopoly, oligopoly
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Economic logic: background
Sales
Price
MarginalCost
Marginal RevenueCurve
DemandCurve
Sales
Price
Q’+1
P”
MarginalCost Curve
C E
D
DemandCurve
A
B
Q*Q’
P*P’
•Monopoly case
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Economic logic: background
• Monopoly
– Easy case (instructive)
– Avoids strategic interactions
– The only restraint – the demand curve
– Consumers – price takers
– The trade off between prices and sales depend only on
the demand curve
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Economic logic: background
•Duopoly case, example of non-equilibrium
Residual Demand Curve firm 2 (RD2)
Firm 2’s expectation of sales by firm 1, Q1
DemandCurve (D)
MC
Residual Marginal Revenue Curve firm 2 (RMR2)
x2’
p2’
Firm 2 sales
Residual Demand Curve firm 1 (RD1)
Firm 1’s expectation of sales by firm 2, Q2
DemandCurve (D)
price
MC
Residual Marginal Revenue Curve firm 1 (RMR1)
x1’
p1’
Firm 1 sales
A1 A2
price
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Economic logic: background
• Duopoly
– Most European firms faced competition as firms have
the same marginal cost curves
– No equilibrium – the outcome not consistent with
expectations
– The easiest way – assumption – symmetry of firms,
each firm sale the same amount
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Economic logic: background
•Duopoly & oligopoly case, equilibrium outcome
RD’
D
MC
x**
p**
sales
A
price
RMR’
3x**Oligopoly
RD
Typical firm’s expectation of the other firm’s sales
D
MC
x*
p*
sales
A
price
RMR
2x*
Duopoly
Typical firm’s expectation of other the other firms’ sales
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Economic logic: background
• Duopoly & oligopoly
– More firms competing in the market
– The residual demand curve facing each one shifts
inwards
– Number of firms continues to rise
• Lower prices and lower output per firm
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BE-COMP diagram
Mark-up (µµµµ)
COMPcurve
BE (break-even) curve
µ’
n’
µmono
µduo
n=1 n=2 Number of firms
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BE-COMP diagram
• The impact `of European integration on firm size
and efficiency, number of firms, prices
• Price – cost gap
– „mark-up” of price over marginal cost curve
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Details of COMP curve
Marginal cost curve
Typical firm’s sales
price
p"
Monopoly mark-up
Duopoly mark-up
D
R-D (duopoly)
xmonoxduo
MR (monopoly)R-MR
MC
p'
AB
A’
B’
Mark-up
Number of firms
COMPcurve
n=1 n=2
µmono
µduo
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Details of BE curve
Salesper firm
AC
price
Totalsales
Co
Demand curve
Number of firms
Mark-up (i.e., p-MC)
µo
xo= Co/no
MC
euros
BE
no
AC>po
AC<po
po=µo+MC
x’= Co/n’ x”= Co/n”
A
B
B Apo
ACo=po
n” n’
Home market
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Details of BE curve
• The positive link between mark-up and the break-
even number of firms
• A – firms are not covering their fixed cost, there
would be the tendency for some firms to exit the
industry (mergers and bankruptcies)
• B – firms are making pure profits, more firms to
enter the market
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Equilibrium in BE-COMP diagram
Salesper firm
AC
Price
Totalsales
Demand curve
Number of firms
Mark-upeuros
x’
COMP
BE
n’
C’
E’p’E’ E’
µ'p’
MC
Home market
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Equilibrium in BE-COMP diagram
• The COMP curve – firms would charge a mark-up of µ’
when there are n’ firms in the market
• The BE curve – n’ firms could break even when the mark-
up is µ’
• Let us determine the equilibrium number of firms, mark-
up, price, total consumption and firm size (all in one
diagram)
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No-trade-to-free-trade integration
Salesper firm
AC
price
Totalsales
Demand curve
Number of firms
Mark-upeuros
x’
COMP
BEFT
BE
2n’
x”
n” n’
E’
E”
C’ C”
E’
A
1
E”
A
MC
p”
p’
pA
µ'
µA
p”
p’
Home market only
E”
E’
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No-trade-to-free-trade integration
Salesper firm
AC
price
Totalsales
Demand curve
Number of firms
Mark-upeuros
x’
COMP
BEFT
BE
2n’
x”
n” n’
E’
E”
C’ C”
E’
A
1
E”
A
MC
p”
p’
pA
µ'
µA
p”
p’
Home market only
E”
E’
C
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No-trade-to-free-trade integration
• Reduction of trade barriers
• Assumptions:– H & P identical
– We focus on H’s market
• The immediate impact:– Second market of the same size
– Double the number of competitors
– Lower µ
• More firms, BE curve shifts out (to point 1)– At any given mark-up more firms can break even
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No-trade-to-free-trade integration
• Pro-competitive effect: – Equilibrium moves from E’ to A: Firms losing money (below BE)
– Pro-competitive effect = markup falls
– short-run price impact p’ to pA
• Industrial Restructuring– A to E”
– number of firms, 2n’ to n”.
– firms enlarge market shares and output,
– More efficient firms, AC falls from p’ to p”,
– mark-up rises,
– profitability is restored
• Result: – bigger, fewer, more efficient firms facing more effective competition
• Welfare: gain is “C”
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Empirical evidence
• Little direct evidence in Europe
• More direct evidence linking market size with efficiency and competition
– Campbell Jeffrey R., Hugo A. Hopenhayn. 2002. „Market Size
Matters”. NBER Working Paper No. 9113
• The impact of market size on the size of distribution of firms in retail-trade industries across 225 US cities
• In every industry examined – establishment larger in larger cities
• Competition is tougher in larger markets and this accounts for the link between firm-size and market-size
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State aid (subsidies)
• 2 immediate questions
– “As the number of firms falls, isn’t there a tendency for the
remaining firms to collude in order to keep prices high?”
– “Since industrial restructuring can be politically painful, isn’t there
a danger that governments will try to keep money-losing firms in
business via subsidies and other policies?”
• The answer to both questions is “Yes”.
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State aid (subsidies)
• Profit losing firms to leave the industry:
1. Can be bought out
2. Merge with other firms
3. Go bankrupt
– Job losses
– Reorganization – workers change job or locations
• Painful
• Governments seek to prevent them (firms government owned,
trade unions)
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Economics: restructuring prevention
Number of firms
Mark-up
COMP
BEFT
BE
2n’ n” n’
E’
A
1
E”µ'
µA
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Economics: restructuring prevention
• Consider subsidies that prevent restructuring (in H&P)
• Specifically, each governments make annual payments to all firms exactly equal to their losses
– i.e. all 2n’ firms in Figure from slide 28 analysis break even, but not new firms
– Economy stays at point A
• This changes who pays for the inefficiently small firms from consumers to taxpayers.
Number of firms
Mark-up
COMP
BEFT
BE
2n’ n” n’
E’
A
1
E”µ'
µA
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Economics: restructuring prevention
• The too-many-too-small firms problem
• Firms continue to be inefficient
• The subsidies prevent the overall improvement in
industry efficiency
• Do nations gain?
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restructuring prevention: size of subsidy
Salesper firm
AC
Price
Totalsales
Demand curve
Number of firms
Mark-upeuros
x’
COMPBEFT
2n’
p’
C’ CA
pA
xA= 2CA/2n’
pA
a
b c
E’
AA
A
MC
E’
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restructuring prevention: size of subsidy
• Pre-integration: fixed costs = operating profit = area “a+b”
• Post-integration: operating profit = b+c
• ERGO: Breakeven subsidy = a-c
– NB: b+c+a-c=a+b
Salesper firm
AC
Price
Totalsales
Demand curve
Number of firms
Mark-upeuros
x’
COMPBEFT
2n’
p’
C’ CA
pA
xA= 2CA/2n’
pA
a
b c
E’
AA
A
MC
E’
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restructuring prevention: welfare impact
• Change producer surplus = zero (profit is zero pre & post)
• Change consumer surplus = a+d
• Subsidy cost = a-c
• Total impact = d+c
Salesper firm
AC
Price
Totalsales
Demand curve
Number of firms
Mark-upeuros
x’
COMPBEFT
2n’
p’
C’ CA
pA
xA= 2CA/2n’
pA
a
b c
E’
AA
A
MC
E’
d
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Only some subsidise: unfair competition
• If Foreign pays ‘break even’ subsidies to its firms
• All restructuring forced on Home
• 2n’ moves to n”, but all the exit is by Home firms
• Unfair
• Undermines political support for liberalisation
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EU policies on ‘State Aids’
• 1957 Treaty of Rome bans state aid that provides firms with an
unfair advantage and thus distorts competition.
• EU founders considered this so important that they empowered
the Commission with enforcement.
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Anti-competitive behaviour
• Collusion is a real concern in Europe
– dangers of collusion rise as the number of firms falls
• Collusion in the BE-COMP diagram
– COMP curve is for ‘normal’, non-collusive competition
– Firms do not coordinate prices or sales
• Other extreme is ‘perfect collusion’
– Firms coordinate prices and sales perfectly
– Max profit from market is monopoly price & sales
– Perfect collusion is where firms charge monopoly price and split the sales
among themselves
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Economic effects
Number of firms
Mark-up
COMP
BEFT
Perfectcollusion
Partialcollusion
E”
nB
µmono
B
n=1 n”
A
2n’
pB
p”
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Economic effects
• collusion will not in the end raise
firm’s profits to above-normal
levels.
– 2n’ is too high for all firms to break
even.
– Industrial consolidation proceeds as
usual, but only to nB. Point B Zero
profits earned by all.
• prices higher, pB> p”, smaller
firms, higher average cost
Number of firms
Mark-up
COMP
BEFT
Perfectcollusion
Partialcollusion
E”
nB
µmono
B
n=1 n”
A
2n’
pB
p”
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Economic effects
• The welfare cost of collusion (versus no collusion)
– four-sided area marked by pB, p”, E” and B.
price
Totalsales
Demand curve
Number of firms
Mark-up
COMP
BEFT
pB
Perfectcollusion
Partialcollusion
E”
nB
µmono
B
n=1 n”
pmono
E”p”
B
CB
A
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EU Competition Policy
• To prevent anti-competitive behavior, EU policy focuses on two
main axes:
• Antitrust and cartels. The Commission tries:
– to eliminate behaviours that restrict competition (e.g. price-fixing
arrangements and cartels)
– to eliminate abusive behaviour by firms that have a dominant position
• Merger control. The Commission seeks:
– to block mergers that would create firms that would dominate the market.
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Other dynamic effects
• The polarization effect
– Benefits of trade creation becoming concentrated in
one region
– An area may develop a tendency to attract factors of
production
• The influence on the location and volume of real
investment
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Remarks
• Dynamic effects include various and completely
different phenomena
• Apart from economies of scale, the possible gains
are extremely long term
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Major dynamic effects:
1. Reaping benefits of economies of scale and
learning effects
2. Reducing the monopoly power
3. Reducing levels of x-inefficiency
4. De-fragmentation and industrial restructuring
Gravity model
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Gravity equation
• often used as an instrument to measure different
aspects of trade effects.
• In the standard gravity model we assume
– economic power of trading partners
• can be measured as GDP
– trade costs
• can be measured as distance between them
• the key variables to explain the volume of trade.
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The theoretical application
• Helpman (1987)
– Helpman’s theorem proclaims that the volume of trade
relative to GDP will be proportional to the relative size
of countries.
• can explain the expectations:
– bigger and more similar in terms of size countries tend
to trade more intensely with each other than the
smaller and different ones.
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Gravity equation
• “the workhorse for empirical studies” in
international economics
– Eichengreen, Irwin 1997
– responsible for the eruption of the empirical works
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Gravity equation
• Attractiveness
– a possibility to obtain the transparent answer to most
important questions about the determinants of
bilateral trade
– strong fit to the data and the possibility to test a
variety of hypothesis by adding proxies of trade costs.
• in order to evaluate the trade effect of economic integrations,
can be added
– dummy variables for membership in particular agreement
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The traditional version of a gravity model
• value of export is a function of bilateral trade for
pair of countries, their GDPs and the distance
between them
tijij
tj
ti
tj
ti
tij
dist
GDPpcGDPpcGDPGDPEXPORT
εβ
ββββ
++
+−+++=
ln
ln)ln()ln(ln
4
3210
tijEXPORT
tiGDP
tjGDP
tj
ti GDPpcGDPpc −
ijdist
- exports from country i do j, time t
- nominal GDP of country i
- nominal GDP of country i
- difference of GDP per capita between i and j
- distance between country i and j.
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The gravity equation & theory
• can be derived from a variety of theoretical
models based on
– neoclassical or monopolistic competition approaches
– for homogenous and differentiated goods
– with the representation of the role of
• technology,
• factor endowments
• demand differences.
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The gravity equation & theory
• Anderson (1979), Bergstrand (1985, 1989),
Helpman and Krugman (1985), Deardoff (1998),
Anderson and van Wincoop (2001) Eaton and
Kortum (2001)
– have given the theoretical background for this popular
tool for measuring the trade effects.
• Anderson (1979)
– a theoretical foundation for the gravity model based
on constant elasticity of substitution (CES) preferences
and goods that are differentiated by the region of
origin.
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The gravity equation & theory
• Bergstrand (1989, 1990) and Deardoff (1998)
– have preserved the CES preference structure and
added monopolistic competition or a Hecksher-Ohlin
structure in order to include the specialization effect.
• Anderson and Wincoop (2001)
– provided the theoretical explanation of how border
effects effect trade.
• Bergstrand (1989)
– the first to derive the gravity equation including per
capita incomes as independent variables.
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The gravity equation & variables control the
impact of regionalism on exports
• PSA - dummy variable indicating whether both trading countries are
the members of a partial scope agreement, data obtained from WTO
database
• PSA&EIA - dummy variable indicating whether both trading countries
are the members of a partial scope agreement and economic
integration agreement, data obtained from WTO database
• FTA - dummy variable indicating whether both trading countries are
the members of a free trade area
• FTA&EIA - dummy variable indicating whether both trading countries
are the members of a free trade area and economic integration
agreement
• CU - dummy variable indicating whether both trading countries are
the members of a customs union, variable controls the impact of
regionalism on exports
• CU&EIA - dummy variable indicating whether both trading countries
are the members of a customs union, variable controls the impact of
regionalism on exports and economic integration agreement
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Gravity modeling of RTAs
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The gravity model
• The choice of proper estimation method
• to adopt one of the typical panel data based
estimators
– fixed or random effects approach.
• the main disandvantage of the fixed effects
approach is the unavailability of parameter
estimates on the variables that are constant over
time for
– example of this kind of variables is a distance between
a reporter and its trade partner.
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The gravity model
• follow most authors and assume exogeneity of
the regressors, without testing it with some
particular test
• one solution to be applied
– the Hausman-Taylor estimation method
• it allows for the use of both time-varying and time invariant
variables
– it is allowed that some of them can be endogeneous in the
sense of correlation with individual effects, but still exogeneous
with respect to idiosyncratic error term.