COMMON MARKET THEORY

Lecture outlineRef com mkt oct08

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 CUThis is one theory that underlies the

single (internal) market

(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

CU & factor price equalisation before formation of CU tariffs & other

barriers prevented FP equalisation post- CU: move to FP equalisation, but not

completenon-traded goodsNTBs

but, if extend CU thru factor mobility, possibly achieve additional welfare benefits

(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

See diagram

a) labour force in N = ON LO

labour force in S = OS LO

Difference in real wage(w)=Wn-WS

real wage (w) w

O N O S

MPL NorthMPL South

North South

Wn

Ws

Lo

b) Emigration S to N = LO L1

Equalisation of real wage = (Wc)

Workers in S attracted by higher wages to N

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

real wage (w) w

O N O S

MPL NorthMPL South

North South

Wn

Ws

Lo

A

B

C

L1

Relevant today- EU15 v CEECs

real wage (w) w

O N O S

MPL NorthMPL South

C

L1North South

Wc

Wc

Wn

Ws

Lo

A

B

D

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

3 Capital(K) mobility & labour immobile model

N is capital rich, K = On Ko In S, K = OsKo

real interest rate (r%) r%

O N O S

MPk NorthMPk South

Ko

rsB

C

A

rn

Y

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

real interest rate (r%) r%

O N O S

MPk NorthMPk South

Ko

rsB

C

A

K*

rn

Y

ru ru

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

IFNo tax in S50% tax on K in N (NO tax

harmonisation) MPkN shown by X-Y

New equilibrium K1 rather than K*

real interest rate (r%) r%

O N O S

MPk NorthMPk South

Ko

rsB

C

A

K*

rn

X

Y

Dru ru

K1

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’

real interest rate (r%) r%

O N O S

MPk NorthMPk South

Ko

rsB

C

A

K*

rn

X

Y

Dru ru

K1

E

(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

real wage (w) w

O N O S

MPL NorthMPL South

C

L1North South

Wc

Wc

Wn

Ws

Lo

A

B

D

Y

Z

X

2 Criticise perfect competition would expect dynamic effects of integration to

lead to mergers

3 Neglects interaction of K&L4 Second best5 Tax distortions6 Effect of multinationals in the EU?