COMMON MARKET THEORY
Lecture outline
Ref 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 CU
This 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
complete
non-traded goods
NTBs
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)=WnWS
real wage (w)
w
Wn
Ws
MPL South
ON
North Lo
MPL North
South
OS
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)
Wn
w
B
C
A
Ws
MPL South
ON
North Lo
MPL North
L1
South
OS
Relevant today- EU15 v CEECs
real wage (w)
Wn
W
c
w
B
D
C
W
c
Ws
A
MPL South
ON
North Lo
MPL North
L1
South
OS
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%
B
rs
A
rn
C
MPk South
ON
MPk North
Y
Ko
OS
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%
B
rs
A
ru
rn
ru
C
MPk South
ON
MPk North
Y
K*
Ko
OS
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
IF
No tax in S
50% tax on K in N (NO tax
harmonisation)
MPkN shown by X-Y
New equilibrium K1 rather than K*
real interest rate (r%)
r%
B
ru
rs
A
X
ru
D
rn
C
MPk South
ON
K1
MPk North
Y
K*
Ko
OS
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%
E
B
ru
rs
A
X
ru
D
rn
C
MPk South
ON
K1
MPk North
Y
K*
Ko
OS
(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)
Wn
w
B
Y
W
c
C
D
A
Z
MPL South
ON
North Lo
W
c
Ws
X
MPL North
L1
South
OS
2 Criticise perfect competition
would expect dynamic effects of integration
to lead to mergers
3 Neglects interaction of K&L
4 Second best
5 Tax distortions
6 Effect of multinationals in the EU?