EU 911, European Integration

1. EU 911, European Integration • Lecture 3: The welfare effects of Custom Union • Consumers' surplus is the total value to consumers of their consumption of a good less the amount they have to pay for it.

2. Producer surplus • Producers' surplus is the total revenue received less the cost of production. • S is the supply curve, and Q* is sold at price P*. The height of each point on the supply curve represents the marginal cost of an additional unit of production; so the total cost of production is represented by the area under the supply curve up to Q* (shaded in Figure B.1a). The total revenue received by producers is P*Q , rectangle P*Q* in Figure (a).

3. The Welfare effects of Tariff Make the following assumptions: • there are two countries, Home (H) and the rest of the world (W) • H is small relative to W - it cannot affect world prices • there is perfect competition within countries • factor markets clear within countries - no unemployment • factors are immobile - they cannot move between countries • there are no trade imbalances: value of exports = value of imports Consumers’ surplus -c-d-b-a Producers’ surplus +a Government revenue +d Total -c-b

4. The welfare effects of “Import Quotas” or “Voluntary Export Restraints”: Consumers’ surplus -c-d-b-a Producers’ surplus +a Government revenue 0 Total -c-b-d

5. Trade creation v.s. Trade Diversion • there are three countries, Home (H), Foreign (F), the rest of the world (W) • H and F are small relative to W - they cannot affect world prices, either separately or together. • trade creation - H’s total imports of Q have increased • trade diversion- H’s imports from W have decreased Trade creation increases welfare; trade diversion can decrease welfare because the origin of imports is determined by relative tariff levels, not by who is the lowest cost producer.

6. An Example of net welfare loss from trade diversion An example: Suppose before the customs union, H had a tariff of t against imports of Q, such that Pw < Pcu < Pw+t Suppose the customs union is formed such that imports from F are not subject to the tariff t. So before the customs union, H: produced Q2 imported no Q from F consumed Q3 imported Q3-Q2 from W The welfare effects of the customs union for H are: a fall in production Q2-Q1 reduces producer surplus by: -a a rise in consumption Q4-Q3 increases consumer surplus by: a+b+c+d a fall in government tariff revenue of: -(d + e) net change in welfare for H: b + c - e

7. Gains for the partner Pw

8. Summery • The welfare effects of a customs union depends on the extent to which it causes trade creation (positive welfare effect) and trade diversion (negative welfare effect). • The greater the degree of protection which existed before the customs union, the greater will be the trade creation effects. • Conversely, the closer the two countries were to free trade before the customs union, the greater will be the trade diversion effects. • Losses due to trade diversion are likely to be lower, the smaller the differences in costs of production between the partners and third countries. • If both countries lose, the customs union is unlikely to be formed (though possible with powerful lobby groups in each country gain). • However, the net gains to H & F may be positive even though one of them may lose; in this case one country may compensate the other in order to realise the gains.

9. A Large Custom Union • Consider the welfare for a large country, of imposing a tariff that causes the world price to fall from Pw to Pw’: Before the imposition of the tariff t: Q1 is produced Q4 is consumed Q4-Q1 is imported at world price Pw After the imposition of the tariff t: Q2 is produced Q3 is consumed Q3-Q2 is imported at world price Pw’ The welfare effects of the Tariff are: An increase in producers’ surplus of a A decrease in consumers’ surplus of a+b+c+d A creation of Government tariff revenue of d + e Net welfare change: e - (b + c)

10. Tariffs vs. quotas in a Large Custom Union Quotas and Monopoly Tariffs Demand Demand Shome Residual Demand Shome Pm Pw+t Q Pw MR=MC

11. Social Dumping Good social policy in B weak social policy in B Good social policy in A 3 3 4 0 Weak social policy in A 0 4 2 2 • National government may weak social standard to promote national producers • Social insurance • work-place safety • Maternity live “Social Dumping Game”.

12. Competition, static gains Pmon Pcomp Competition reduces deadweight loss and increase consumer surplus. Producer surplus may decline. But even producers gain due to decline in prises for input goods

13. Oligopoly • An oligopoly is a type of market structure in which there is competition among a few firm • Bertrand or price competition. • Cournot or Quantity competition Competitors behaves as a monopolist, facing residual demand Residual demand R Q1 1 Q2 2 Q1

14. Oligopoly under Cournot competition and Monopoly • Monopoly Q=A-P, Cost =0 R=Q(A-Q) MR=A-2Q=MC=0 Q=A/2; P=A/2 • Cournot competition Q2+Q1=A-P R(Q2)=Q2(A-Q1-Q2); MR=A-Q1-2Q2=0 Q2=(A-Q1)/2; Q1=(A-Q2)/2 Q1=Q2=A/3 Q=Q1+Q2=2A/3 P=A/3 • Higher consumer surplus • Lower deadweight loss

15. Gains from specialization cheese cheese wine wine cheese wine

16. Specialization • Ricardian model cheese cheese wine wine P Q

17. Gains from trade, Ricardian model cheese cheese wine wine

18. Economy of scale New demand

19. Dynamic effects of customs unions The larger market of a customs union may give rise to additional benefits: • increased competition may lead to an increase in the rate of innovation • the larger market may allow economies of scale • Because these effects are cumulative, they may facilitate faster growth and in time outweigh the negative effects of trade creation/diversion. • Like trade effects, they may accrue unevenly across countries, and some regions/countries may lose out. Again, this may suggest compensation is needed.

20. Competition: dynamic gains • Investment in research and development: • Quality improvement • Cost reduction • Solve for hold up problems Increase in demand Cost reduction