COMMON MARKET THEORY

1. COMMON MARKET THEORY Lecture outline Ref com mkt oct08

2. 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

3. (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

4. 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

5. (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

6. See diagram • a) labour force in N = ON LO labour force in S = OS LO Difference in real wage(w)=Wn- WS

7. real wage (w) w Wn Ws MPL South MPL North O N O S Lo North South

8. b) Emigration S to N = LO L1 Equalisation of real wage = (Wc) Workers in S attracted by higher wages to N

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

10. real wage (w) w Wn B C A Ws MPL South MPL North O N O S Lo L1 North South

11. Relevant today- EU15 v CEECs real wage (w) w Wn B C D Wc Wc A Ws MPL South MPL North O N O S Lo North L1 South

12. 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 - N’s income rises by LoBCL1 & S’s income falls by LoACL1 • If ‘border’ workers live in S, N’s income rises by only BCD & S’s income rises by DCA

13. N is capital rich, K = On Ko In S, K = OsKo 3 Capital(K) mobility & labour immobile model

14. real interest rate (r%) r% B rs A rn C MPk South MPk North Y O N O S Ko

15. 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

16. real interest rate (r%) r% B rs A ru ru rn C MPk South MPk North Y O N O S K* Ko

17. 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*

18. real interest rate (r%) r% B rs A X ru ru D rn C MPk South MPk North Y O N O S K* K1 Ko

19. Welfare loss ADE, compared with optimal allocation • BUT, if tax in S > tax in N (not shown) • Further K could flow to K rich N • Ie. Flow the ‘wrong way’

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

21. (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

22. real wage (w) w Wn B Y C D Wc Wc Z A Ws MPL South MPL North O N O S Lo X North L1 South

23. 2 Criticise perfect competition • would expect dynamic effects of integration to lead to mergers • 3 Neglects interaction of K&L • 4 Second best • 5 Tax distortions • 6 Effect of multinationals in the EU?