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Economics of the EU I: Lecture 6 1

17/10/2003

ECONOMICS OF THE EU

TOPIC 4

Aim to examine the argument that a CU provides the

opportunity for large producers to exploit economies of

scale and so increase welfare in the CU members

Objective to explain why welfare gains may require industrial re-

structuring as well as economies of scale

Economies of Scale and CU

Formation An assumption made in the standard analysis which has

been frequently challenged is that of increasing marginal

costs in the home and partner countries

It has been claimed that some industries are characterised

by falling marginal (and, hence, average) costs over a wide

range of output, and that some national markets might betoo small to absorb the output of a plant of optimum size

Membership of a CU would offer access to a larger market

tariff-free and would enable producers to operate at lower

average costs.

Corden's framework - 1

Cordens assumptions are similar to those set out earlier,

but with the following amendments:

There is a single actual or potential producer in each CU

country,with declining AC curve

That producer pays constant prices for factors whatever the

scale of output (there are thus no factor rents)

the price at which exports from H and P could be sold to

the ROW (export price) is below the price at which ROW

goods are available to H and P (import price) because of:

(i) transport costs, and (ii) the ROW tariff

Corden's framework - 2

the average cost curve in each country reaches its

minimum at a level above the export price, so that

exporting the product to the ROW is ruled out

pre-CU, the home and partner countries do not trade with

each other because of tariffs and the relatively high

production costs

The demand function facing the H producer is shown next:

Demand curve facing H firm - 1

Demand curve facing H firm- 2

Pre-CU, this curve is given by TQRUVYZsince

(a) no market exists for the home product at a

price in excess of T;

(b) below this price, the entire H market is

available to the H producer:

( c) at pricepm, H producer can capture the P

market (q2-q1= q3at the tariff-inclusive price T);

(d) the ROW market can absorb the entire H

production at pricepx.


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Demand curve facing H firm- 3

Post-CU, this curve is given byTQWYZsince

(a) no market exists for the home product at a

price in excess of T;

(b) below this price, the entire CU market is

available to the H producer:

(c) the ROW market can absorb the entire Hproduction at pricepx.

Profitability (AC = AR)

For the producer in H to operate profitably, the

AC curve must cut, or at least touch, the effective

demand (AR) curve facing the producer

As drawn the H producer can break even whilst

supplying all the home market requirements at

price T

Analogous arguments could be made for a

producer in the partner country.

Producer in each country - 1

A: Producer in each country - 1

P self-sufficient pre-CU at price T, this price being

maintained by the tariff T-pm

Note that in both countries the price is (by design)

just high enough to ensure P = AC

Assume that post-CU it is the firm in P that leaves

the market

The CU maintains a CET of T - pm so that the

price within the CU remains at T


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H firm meets all CU demand, producingq2, selling

q1in H as before, exporting q2-q1to P

AC in the H firm falls from TtoJas a result of the

expansion in output.

The firm now makes excess profits shown by the

areaJTWK= area + area No change in CS in H, and no tariff revenue in H

either pre- or post-CU

Welfare in H by area + area .


There is no CS change in P (the same price

prevails)

No tariff revenue pre- or post- CU

Firm which has just left the market was making no

PS

So the welfare position in P is unchanged

It follows that the CU as a whole must gain

Note that the welfare gain is associated with a

reduction in the number of firms

B: Producer only in H - 1

P has no domestic firm pre-CU

It imports from ROW at pricepm

By assumption P levied a tariff of T- pm, so that

the domestic price was T.

But this tariff still not big enough to allow a

producer to operate in P

The CU maintains a CET of T - pm so that the

price within the CU remains at T



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The welfare analysis for H is exactly the same as

in Case A - it gains area + area

P experiences TD, since q2imported pre-CU from

ROW at pricepmnow imported from H at price T.

The TD loss = loss in TR in P = area + area No change in CS in P Net welfare gain for the CU is therefore + (area

+ area ) - (area + area ) = area - area .


It is possible that Ps TD losses exceed Hs gain

So the existence of economies of scale is not

sufficient to ensure that there is a net welfare gain

for the CU

There has been no change in market structure - the

number of firms remains the same on CU

formation

C: No producer pre-CU - 1


Neither country had a producer pre-CU, but a

producer establishes in, say, H post-CU, protec ted

by a CET of T-pm

It producesq2, selling q1at home and exporting q2- q1to P

H loses its former TR (area + area ), but gainsthe excess profits of area + area .

H will therefore make an overall gain if area >

area , a loss otherwise


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P loses its tariff revenue of area + area There are no compensating gains since its

domestic price is unchanged

The CU as a whole must lose area + area We may regard the CU loss (and P's loss) as a TD

effect

The welfare loss is associated with an increase in

the number of CU producers

Changes in Industrial Structure

Case A: the number of CU producers falls, and

CU welfare rises

Case B: the number of CU producers stays the

same, and CU welfare may rise or fall

Case C: the number of CU producers rises, and

CU welfare falls

Increasing returns not sufficient for welfare gain -need a fall in the number of producers for

increasing returns to come into play?

Made to measure tariffs

So far we have assumed that the CET is the same

as the pre-CU national tariff rate

CU producer thus able to get excess profits

through lowering costs in the larger CU market

CU might set the CET such that CU price just

covers AC (the 'made-to-measure' tariff)

Then benefits of CU formation = in CS

Consumption in countries which had production

pre-CU (TC), but if TD occurred

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