theory of economic integration -...

Theory of Economic Integration

Dynamic effects

De-fragmentation and industrial restructuring

Gravity model

Katarzyna Śledziewska

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

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

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.

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

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


• 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


•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


• 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


•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


• 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

BE-COMP diagram

Mark-up (µµµµ)

COMPcurve

BE (break-even) curve

µ’

n’

µmono

µduo

n=1 n=2 Number of firms

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

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

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

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

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

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)

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’


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


• 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


• 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”

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

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”.

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)

Economics: restructuring prevention

Number of firms

Mark-up

COMP

BEFT

BE

2n’ n” n’

E’

A

1

E”µ'

µA


• 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


• The too-many-too-small firms problem

• Firms continue to be inefficient

• The subsidies prevent the overall improvement in

industry efficiency

• Do nations gain?

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’

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’

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

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

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.

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

Economic effects

Number of firms

Mark-up

COMP

BEFT

Perfectcollusion

Partialcollusion

E”

nB

µmono

B

n=1 n”

A

2n’

pB

p”

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”

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

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.

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

Remarks

• Dynamic effects include various and completely

different phenomena

• Apart from economies of scale, the possible gains

are extremely long term

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

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.

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.

Gravity equation

• “the workhorse for empirical studies” in

international economics

– Eichengreen, Irwin 1997

– responsible for the eruption of the empirical works

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

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.

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.


• 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.


• 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.

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

Gravity modeling of RTAs

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.

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.

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