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Economic Policy in the EU - Lecture 2 (2020)
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Economic Policy in the EU, Lecture 2. 2020
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Integration of product marketsThe free market of the EU gives both producers and consumers an advantage. Producers
now have a larger market and consumers have a wider range of products to choose from.
With the exchange of products across borders, you indirectly exchange factors of production
across borders. With the crossing of borders of products, you see countries specializing in
one product. This should lead to a higher overall production. The theoretical basis for this is
found in Comparative Static analysis. This was started with Adam Smith and his Absolute
cost advantages. This means that two partners who produce different things more
efficiently, they would benefit from specialization.
Example:
- Person A can produce per hour:
o 2X
o 1Y
- Person B can produce per hour:
o 1X
o 2Y
Without trade and specialization this would give us 3 X and 3 Y in two hours. With trade and
specialization this would give us: 4 X and 4 Y in two hours.
This position has been refined by Ricardo and Heckscher-Olin. They worked with Relative
cost advantages. For instance:
- Person A can produce per hour:
o 3X
o 1Y
- Person B can produce per hour:
o 2X
o 1Y
Again, it is beneficial to specialize and trade. This reallocates the factors of production. The
factors of production in one country will be useful for one product, while the factors of
production in another country will be useful for another product. Overall production
increases, which means both countries can benefit from this trade.
A third example of what we call comparative static benefits and of the allocation of
production comes from the economies of scale. If you are allowed and able to produce
larger units, which is stimulated when servicing larger markets, you can achieve lower
production costs. In general, when producing more, the average costs drop. This to, is
merely allocation of production factors. This is also one of the benefits of free trade.
A slightly different benefit of economic integration comes from a dynamic perspective. If we
join markets, producers from market A can suddenly supply in market B. At the same time
however, the producer in country B can enter the market of producer A. This means
competition. It forces firms to be on their toes. It stimulates firms trying to be more efficient.
These are the general benefits of integration.
Within the EU, there is an enormous amount of trade. 25% of world trade takes place within
the EU countries. This is between distinct products, because of comparative costs and, as a
consequence, specialization. You can also see different countries producing similar products.
This is a consequence of economies of scale For example, German car parts could be going
to France to be used in French cars, while at the same time French car parts could be sent to
Germany to be used in German cars.
, To discuss the effects of trade policy, specifically the introducing or banning of tariffs, we use
welfare analysis. A measure is introduced: surplus.
In this figure you can see the equilibrium at
Quantity * and Price *. Also visible are the
consumer and the producer surplus. These
indicate welfare. The consumer surplus is the
difference between the willingness to pay
(indicated by the demand) and the price. For
the very first unit of a product, some people
are willing to pay a very high price. However,
they will only have to pay the equilibrium
price. The difference is a consumer surplus.
Similar, there are producers willing to offer a
product at a low price, as demonstrated by the
supply curve. They will receive the equilibrium price. The difference is the producer surplus.
Those triangles indicate the welfare in society at this particular equilibrium.
In this figure, trade is allowed. As a consequence, a
product can be bought for the lower world price (Pw)
than the domestic price (Price *). This means that the
consumer will consume more, which is indicated by Qd.
The domestic suppliers however, will produce less, as
indicated by Qs. The consequences in surplus are that
the consumer surplus increases, whereas the producer
surplus decreases. Overall there is a gain in welfare.
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