Theory of Economic Integration
Dynamic effects
De-fragmentation and industrial restructuring
Gravity model
Katarzyna Śledziewska

Major dynamic effects:
1.
Reaping benefits of economies of scale and learning effects
2.
Reducing the monopoly power
3.
Reducing levels of x-inefficiency
4.
De-fragmentation and industrial restructuring
Gravity model

Liberalization, defragmentation and industrial restructuring
• Europe’s national markets – separated by a whole hst of barriers
• Tariff and quotas – until 1968
• Technical, physical and fiscal bariers – until 1992
– When barriers – firms can be dominant in their home market – market fragmentation
• Reduces competition
• Raises prices
• Keeps too many firms in business
• Tearing down intra-EU barriers
– defragments the markets
– produces extra competition
• The pro-competitive effect squeezes the least effecient firms – industrial restructuring,
• Europe’s weaker firms merge or get bought up

Economic Logic Verbally
• liberalisation
→
• de-fragmentation
→
• pro-competitive effect
→
• industrial restructuring (M&A, etc.)
• RESULT: fewer, bigger, more efficient firms facing more effective competition from each other.

Theory
• Economic logic: background
• BE-COMP diagram
• Details of COMP curve
• Details of BE curve
• Equilibrium in BE-COMP diagram
• No-trade-to-free-trade integration
• State Aids
• Collusion
• We start with the simplest form of imperfect competition: monopoly, duopoly, oligopoly

P’
P”
Economic logic: background
•Monopoly case
Price
Demand
Curve
Price
A
Marginal
Cost Curve
P*
B D
C E
Q’ Q’+1 Sales
Marginal Revenue
Curve
Demand
Curve
Q*
Marginal
Cost
Sales

Economic logic: background
• Monopoly
– Easy case (instructive)
– Avoids strategic interactions
– The only restraint – the demand curve
– Consumers – price takers
– The trade off between prices and sales depend only on the demand curve

Economic logic: background
•Duopoly case, example of non-equilibrium price price
Firm 1’s expectation of sales by firm 2, Q
2
Firm 2’s expectation of sales by firm 1, Q
1 p
1
’
A
1 x
1
’
Demand
Curve (D)
Residual Demand
Curve firm 1 (RD1) p
2
’
Residual Marginal Revenue
Curve firm 1 (RMR1)
MC
Firm 1 sales
Demand
Curve (D)
A
2
Residual Demand
Curve firm 2 (RD2)
MC x
2
’
Residual Marginal Revenue
Curve firm 2 (RMR2)
Firm 2 sales

Economic logic: background
• Duopoly
– Most European firms faced competition as firms have the same marginal cost curves
– No equilibrium – the outcome not consistent with expectations
– The easiest way – assumption – symmetry of firms, each firm sale the same amount

Economic logic: background
•Duopoly & oligopoly case, equilibrium outcome price Typical firm’s expectation of the other firm’s sales price Typical firm’s expectation of other the other firms’ sales p*
D
RD
A x*
Duopoly
RMR
MC
2x* sales p**
D
RD’
A
RMR’ x**
Oligopoly
MC
3x** sales

Economic logic: background
• Duopoly & oligopoly
– More firms competing in the market
– The residual demand curve facing each one shifts inwards
– Number of firms continues to rise
• Lower prices and lower output per firm

BE-COMP diagram
Mark-up (
µµµµ
)
µ mono
µ duo
µ
’
BE (break-even) curve
COMP curve n=1 n=2 n’ Number of firms

BE-COMP diagram
• The impact `of European integration on firm size and efficiency, number of firms, prices
• Price – cost gap
– „mark-up” of price over marginal cost curve

p' price
Details of COMP curve
A’ p"
B’
Mark-up
µ mono
µ duo
MC
Duopoly mark-up
D
Monopoly mark-up
R-D (duopoly)
B A
Marginal cost curve
R-MR MR (monopoly) x duo x mono
Typical firm’s sales n=1 n=2
COMP curve
Numbe r of firms

Details of BE curve euros p o
=µ o +MC price
Home market
Demand curve
AC>p o
A
AC o =p o p o
B
AC<p o
AC
MC x”= C o /n”
Sales per firm x’= C o /n’ x o = C o /n o
C o
Mark-up
(i.e., p-MC)
µ
Total sales o
B n” n o
BE
A n’ Number of firms

Details of BE curve
• The positive link between mark-up and the breakeven number of firms
• A – firms are not covering their fixed cost, there would be the tendency for some firms to exit the industry (mergers and bankruptcies)
• B – firms are making pure profits, more firms to enter the market

Equilibrium in BE-COMP diagram euros Price
Home market
Demand curve
Mark-up
E’
µ
' p’
E’ p’ x’
AC
MC
Sales per firm
C’ Total sales n’
E’
BE
COMP
Number of firms

Equilibrium in BE-COMP diagram
• The COMP curve – firms would charge a mark-up of µ’ when there are n’ firms in the market
• The BE curve – n’ firms could break even when the markup is µ’
• Let us determine the equilibrium number of firms, markup, price, total consumption and firm size (all in one diagram)

euros
No-trade-to-free-trade integration price
Home market only
Demand curve
Mark-up p’ p”
E’
E”
AC
MC p’ p” p A x’ x”
Sales per firm
E’
E”
A
µ
'
µ
A
C’ C” Total sales
BE
BE
FT
E’
E”
1
A
COMP n’ n” 2n’
Number of firms

euros
No-trade-to-free-trade integration price
Home market only
Demand curve
Mark-up p’ p”
E’
E”
AC
MC p’ p” p A x’ x”
Sales per firm
C
E’
E”
A
µ
'
µ
A
C’ C” Total sales
BE
BE
FT
E’
E”
1
A
COMP n’ n” 2n’
Number of firms

No-trade-to-free-trade integration
• Reduction of trade barriers
• Assumptions:
– H & P identical
– We focus on H’s market
• The immediate impact:
– Second market of the same size
– Double the number of competitors
– Lower µ
• More firms, BE curve shifts out (to point 1)
– At any given mark-up more firms can break even

No-trade-to-free-trade integration
• Pro-competitive effect:
– Equilibrium moves from E’ to A: Firms losing money (below BE)
– Pro-competitive effect = markup falls
– short-run price impact p’ to p A
• Industrial Restructuring
– A to E”
– number of firms, 2n’ to n”.
– firms enlarge market shares and output,
– More efficient firms, AC falls from p’ to p”,
– mark-up rises,
– profitability is restored
• Result:
– bigger, fewer, more efficient firms facing more effective competition
• Welfare: gain is “C”

Empirical evidence
• Little direct evidence in Europe
• More direct evidence linking market size with efficiency and competition
– Campbell Jeffrey R., Hugo A. Hopenhayn. 2002. „ Market Size
Matters” . NBER Working Paper No. 9113
• The impact of market size on the size of distribution of firms in retailtrade industries across 225 US cities
• In every industry examined – establishment larger in larger cities
• Competition is tougher in larger markets and this accounts for the link between firm-size and market-size

State aid (subsidies)
• 2 immediate questions
– “As the number of firms falls, isn’t there a tendency for the remaining firms to collude in order to keep prices high?”
– “Since industrial restructuring can be politically painful, isn’t there a danger that governments will try to keep money-losing firms in business via subsidies and other policies?”
• The answer to both questions is “Yes”.

State aid (subsidies)
• Profit losing firms to leave the industry:
1.
Can be bought out
2.
Merge with other firms
3.
Go bankrupt
– Job losses
– Reorganization – workers change job or locations
• Painful
• Governments seek to prevent them (firms government owned, trade unions)

Economics: restructuring prevention
Mark-up
µ
'
µ
A
BE
BE
FT
E’
E”
1
A
COMP n’ n” 2n’
Number of firms

Economics: restructuring prevention
• Consider subsidies that prevent restructuring (in H&P)
• Specifically, each governments make annual payments to all firms exactly equal to their losses
– i.e. all 2n’ firms in Figure from slide 28 analysis break even, but not new firms
– Economy stays at point A
• This changes who pays for the inefficiently small firms from consumers to taxpayers.
Mark-up
µ
'
µ
A
BE
BE
FT
E’
E”
1
A
COMP n’ n” 2n’
Number of firms

Economics: restructuring prevention
• The too-many-too-small firms problem
• Firms continue to be inefficient
• The subsidies prevent the overall improvement in industry efficiency
• Do nations gain?

restructuring prevention: size of subsidy euros p A p’
AC p A
A
MC x’ x A = 2C
Sales
A /2n’ per firm
Price a b
Demand curve
E’ c
A
Mark-up
COMP
E’
A
C’ C A
Total sales
BE
FT
2n’ Numbe r of firms

restructuring prevention: size of subsidy
• Pre-integration: fixed costs = operating profit = area “ a+b ”
• Post-integration: operating profit = b+c
• ERGO: Breakeven subsidy = a-c
– NB: b+c+a-c=a+b euros p A p’
AC p A
A
MC x’ x A = 2C
Sales
A /2n’ per firm
Price a b
Demand curve
E’ c
A
Mark-up
COMP
E’
A
C’ C A
Total sales
BE
FT
2n’ Numbe r of firms

restructuring prevention: welfare impact
• Change producer surplus = zero (profit is zero pre & post)
• Change consumer surplus = a+d
• Subsidy cost = a-c
• Total impact = d+c euros p A p’
AC p A
A
MC x’ x A = 2C
Sales
A /2n’ per firm
Price a b
Demand curve
E’ d
A c
Mark-up
COMP
E’
A
C’ C A
Total sales
BE
FT
2n’ Numbe r of firms

Only some subsidise: unfair competition
• If Foreign pays ‘break even’ subsidies to its firms
• All restructuring forced on Home
• 2n’ moves to n”, but all the exit is by Home firms
• Unfair
• Undermines political support for liberalisation

EU policies on ‘State Aids’
• 1957 Treaty of Rome bans state aid that provides firms with an unfair advantage and thus distorts competition.
• EU founders considered this so important that they empowered the Commission with enforcement.

Anti-competitive behaviour
• Collusion is a real concern in Europe
– dangers of collusion rise as the number of firms falls
• Collusion in the BE-COMP diagram
– COMP curve is for ‘normal’, non-collusive competition
– Firms do not coordinate prices or sales
• Other extreme is ‘perfect collusion’
– Firms coordinate prices and sales perfectly
– Max profit from market is monopoly price & sales
– Perfect collusion is where firms charge monopoly price and split the sales among themselves

Economic effects p B p”
Mark-up
µ mono
A
BE
FT
Perfect collusion
E”
B n=1 n” n B
2n ’
Partial collusion
COMP
Number of firms

Economic effects
• collusion will not in the end raise firm’s profits to above-normal levels.
– 2n’ is too high for all firms to break even.
– Industrial consolidation proceeds as usual, but only to n B . Point B Zero profits earned by all.
• prices higher, p B > p”, smaller firms, higher average cost
Mark-up
µ mono p B p”
E”
B n=1 n” n B
2n ’
A
BE
FT
Perfect collusion
Partial collusion
COMP
Number of firms

Economic effects
• The welfare cost of collusion (versus no collusion)
– four-sided area marked by p B , p”, E” and B.
price p mono
Demand curve Mark-up
µ mono p B p”
B
E”
E”
B
A
BE
FT
Perfect collusion n=1 n” n B
Partial collusion
COMP
Number of firms
C B
Total sales

EU Competition Policy
• To prevent anti-competitive behavior, EU policy focuses on two main axes:
• Antitrust and cartels. The Commission tries:
– to eliminate behaviours that restrict competition (e.g. price-fixing arrangements and cartels)
– to eliminate abusive behaviour by firms that have a dominant position
• Merger control. The Commission seeks:
– to block mergers that would create firms that would dominate the market.

Other dynamic effects
• The polarization effect
– Benefits of trade creation becoming concentrated in one region
– An area may develop a tendency to attract factors of production
• The influence on the location and volume of real investment

Remarks
• Dynamic effects include various and completely different phenomena
• Apart from economies of scale, the possible gains are extremely long term

Major dynamic effects:
1.
Reaping benefits of economies of scale and learning effects
2.
Reducing the monopoly power
3.
Reducing levels of x-inefficiency
4.
De-fragmentation and industrial restructuring
Gravity model

Gravity equation
• often used as an instrument to measure different aspects of trade effects.
• In the standard gravity model we assume
– economic power of trading partners
• can be measured as GDP
– trade costs
• can be measured as distance between them
• the key variables to explain the volume of trade.

The theoretical application
• Helpman (1987)
– Helpman’s theorem proclaims that the volume of trade relative to GDP will be proportional to the relative size of countries.
• can explain the expectations:
– bigger and more similar in terms of size countries tend to trade more intensely with each other than the smaller and different ones.

Gravity equation
• “the workhorse for empirical studies” in international economics
– Eichengreen, Irwin 1997
– responsible for the eruption of the empirical works

Gravity equation
• Attractiveness
– a possibility to obtain the transparent answer to most important questions about the determinants of bilateral trade
– strong fit to the data and the possibility to test a variety of hypothesis by adding proxies of trade costs.
• in order to evaluate the trade effect of economic integrations, can be added
– dummy variables for membership in particular agreement

The traditional version of a gravity model
• value of export is a function of bilateral trade for pair of countries, their GDPs and the distance between them ln EXPORT ij t = β
0
+ β
1 ln( GDP i t
)
+ β
2 ln( GDP j t
)
+ β
3 ln GDPpc i t −
GDPpc t j
+ β
4 ln dist ij
+ ε ij t
+
EXPORT ij t
GDP i t
- exports from country i do j , time t
- nominal GDP of country i
GDP j t
- nominal GDP of country i
GDPpc i t −
GDPpc t j
- difference of GDP per capita between i and j dist ij
- distance between country i and j.

The gravity equation & theory
• can be derived from a variety of theoretical models based on
– neoclassical or monopolistic competition approaches
– for homogenous and differentiated goods
– with the representation of the role of
• technology,
• factor endowments
• demand differences.

The gravity equation & theory
• Anderson (1979), Bergstrand (1985, 1989),
Helpman and Krugman (1985), Deardoff (1998),
Anderson and van Wincoop (2001) Eaton and
Kortum (2001)
– have given the theoretical background for this popular tool for measuring the trade effects.
• Anderson (1979)
– a theoretical foundation for the gravity model based on constant elasticity of substitution (CES) preferences and goods that are differentiated by the region of origin.

The gravity equation & theory
• Bergstrand (1989, 1990) and Deardoff (1998)
– have preserved the CES preference structure and added monopolistic competition or a Hecksher-Ohlin structure in order to include the specialization effect.
• Anderson and Wincoop (2001)
– provided the theoretical explanation of how border effects effect trade.
• Bergstrand (1989)
– the first to derive the gravity equation including per capita incomes as independent variables.

The gravity equation & variables control the impact of regionalism on exports
• PSA dummy variable indicating whether both trading countries are the members of a partial scope agreement, data obtained from WTO database
• PSA&EIA dummy variable indicating whether both trading countries are the members of a partial scope agreement and economic integration agreement, data obtained from WTO database
• FTA - dummy variable indicating whether both trading countries are the members of a free trade area
• FTA&EIA - dummy variable indicating whether both trading countries are the members of a free trade area and economic integration agreement
• CU - dummy variable indicating whether both trading countries are the members of a customs union, variable controls the impact of regionalism on exports
• CU&EIA - dummy variable indicating whether both trading countries are the members of a customs union, variable controls the impact of regionalism on exports and economic integration agreement

Gravity modeling of RTAs

The gravity model
• The choice of proper estimation method
• to adopt one of the typical panel data based estimators
– fixed or random effects approach.
• the main disandvantage of the fixed effects approach is the unavailability of parameter estimates on the variables that are constant over time for
– example of this kind of variables is a distance between a reporter and its trade partner.

The gravity model
• follow most authors and assume exogeneity of the regressors, without testing it with some particular test
• one solution to be applied
– the Hausman-Taylor estimation method
• it allows for the use of both time-varying and time invariant variables
– it is allowed that some of them can be endogeneous in the sense of correlation with individual effects, but still exogeneous with respect to idiosyncratic error term.