Economics of Integration Lecture 1 Theoretical underpinnings

Economics of Integration Lecture 1: Theoretical underpinnings

Readings • TEXTBOOKS • Molle, W. The economics of European integration: theory, practice, policy, 5 th ed. (Aldershot, England ; Burlington, VT : Ashgate, 2006). • RECOMMENDED READING. • Neal, L. The economics of Europe and the European Union, (Cambridge ; New York : Cambridge University Press, 2007). • K. Anderson, R. Blackhurt, (ed. ) Regional Integration and the Global Trading System, (GATT Secretariat, 1993). • Ali M. El-Agraa – The European Union, (Prentice Hall 2004). • Mc. Carthy, D. International economic integration in historical perspective, (London, Routledge, 2006) • De. Grauwe, P. Economics of the Monetary Union, Oxford University Press, London, 2005, 4 th edition.

Rules • • • COURSE DELIVERY 30 hours (lectures 90%, discussion 10%) ASSESSMENT Final examination 60%; mid-term 40%.

The meaning • The word integration was first employed in industrial organizations to refer to combinations of business firms through economic agreements, cartels, concerns, trusts, and mergers—horizontal integration referring to combinations of competitors, vertical integration to combinations of suppliers with customers. • In the current sense the word integration refers also to combining separate economies into larger economic regions. • Definition of international economic integration: increasing scope and scale of economic links between separate national economies through removal of economic frontiers; • The use of the word integration in the international macro context can be traced back to the 1930 s and 1940 s.

Why integration? • Integration is not an end in itself, but rather a means to achieve other important benefits; • Economic benefits: improving welfare; • Political benefits: peace and security, democracy, human rights, international influence; • Cultural & civilization benefits;

Market integration vs policy integration • Market integration: removal of barriers in exchange of goods and services permits consumers to choose cheapest goods, widens the choice and allows for economies of scale and scope, while removal of barriers in movement of production factors permits optimal allocation of labour and capital, and allows for economies of scale; • Policy integration: governments intervene in modern economies with the aim to increase welfare, to correct market imperfections and to achieve important political goals such as equitable distribution of income. As the ways and means of these interventions differ from one country to another, policy integration (harmonization) may increase its effectiveness, reduce costs of compliance and other transaction costs borne by firms; • Passive vs active integration;

Stages of market integration • Integration of markets may take four stages: – Preferential trade area (PTA): some bariers to trade in some goods such as import duties and quantitative restrictions are reduced or abolished among partners, but each country apply its own customs tariffs with respect to third countries; – Free trade area (FTA): barriers to trade in goods are abolished among partners, so that internal trade is free, but each country apply its own customs tarifs with respect to third countries; – Customs union (CU): all barriers to internal trade are abolished and a common external tariff is adopted; – Common market (CM): free movement of goods and services, plus free movement of production factors (labour and capital), plus common external regulation both for products and production factors – the „four freedoms”;

Stages of policy integration • Integration of policies may take four stages (forms): – Economic union (EU): the common market is complemented with a high degree of economic policy coordination or unification, starting with market regulation, competition policy and other CM related policies, plus common policies towards third countries; – Economic and monetary union (EMU): this is EU plus a common currency; – Political union (PU): integration is further extended to encompass other policies such as foreign and scurity policy, justice and internal security policy, environmental policy, etc; – Full union (FU): full unification, including taxes, budget, social security – in practice this implies a federation or a confederation;

The subsidiarity principle • Th subsidiarity principle refers to the choice of the decision making level: there is a presumption that powers are best executed at lowest possible level of government, because needs and preferences of people are better taken into account, accountability of government is higher, and competition between different jurisdictions enhances innovation and progress; • But some decisions are better taken at higher levels – when externalities are high; this is the reason for centralised policies (defense, environment, monetary); • In the course of movement through the stages of integraton, competences are handed over from the member states to the union – but only when the lower level cannot take good decisions; • Important: the state (and a higher level – the union) is to serve the needs of its citizens, and not for its own sake!

The proportionality principle • The higher is the stage (form)of integration, the greater are restrictions on and loss of national competences and the more power is transferred from national to union institutions; • The proportionality principle requires that for applying union (common) policies the least constraining instruments should be used, provided that necessary effectiveness and efficiency is ensured (e. g. coordination vs supranational powers);

Instruments of policy integration • The following is the hierarchy of various forms of policy cooperation: – Information: partners agree to inform each other about the aims and measures of the policies they (intend to) pursue; – Consultation: partners agree that they are obliged not only to inform but also to seek opinion and advice of others about the policies they intend to pursue; this helps to promote coherence; – Coordination: partners are obliged to agree on actions needed to accomplish a coherent policy for the whole group, and to take measures that are consistent among partners; if goals are common, one can speak of cooperation; – Unification: implies either the abolition of national instruments and their replacement by common (union) instruments, or the adoption of identical instruments by all partners;

Compliance • An effective union requires that members comply with the commonly established rules and procedures; • There are different means for stimulating compliance of member states with Union laws and rules: – Coercion: this is done in hierarchical organizations where orders are given and are enforced, or fundamental human rights are violated (not in EU); – Reputation and „peer pressure”: member states want to be perceived as behaving in a correct way, „naming and blaming” may enforce compliance; – Sanctions: they may take form of financial fines, or of suspension of voting rights, or of expulsion from the „club”; – Incentives: the opposite to sanctions: the member himself wants to comply for reasons of benefits;

Reasons for centralization • There are several reasons for centralizing decision powers on a supranational level: • Transaction costs: the diversity of rules in a decentralized system is costly for firms, so it makes sense to assign this competence to a higher level of government; • Economies of scale: larger provision of public goods allows for economies of scale (e. g. provision of laws and regulations); • Spill-overs (externalities): if actions taken by one country affect other countries, there is a need for a higher authority; otherwise inefficiencies occur; • Credibility: if there is scope for free-riding under cooperative policies, credibility will be low, so it makes sense to have a higher authority; • Insurance: transfers between members may help in case of asymmetric shocks

Other reasons for policy integration • Theory of club goods (Buchanan, 1965; Olson, 1965): clubs are voluntary agreements created to let the members share in the benefits of an excludable public good – EU may provide such goods, e. g. price stabiliy or access to free internal market; • The constitutional economics (Buchanan, 1987) says that accepting constraints through an international agreement may be beneficial for a country because: a) by tying their own hands it also ties the hands of its partners, and b) harmful influences of interest groups and lobbies (rentseeking) can be limited, and thus public interest is promoted;

Integration dynamics • Integration deepening: further integration comes about in form of covering new policy areas and through increasing union competencies in the existing areas (extension of scope); • Integration widening: further integration comes about in form of covering new geographical areas, including new member states (territorial extension); • Can they go in tandem, or „either-or”? Deepening requires more homogeneity, while widening involves more heterogeneity: is there a contradiction? ; • Is there an optimal scope/area of integation? (e. g. OCA, regional integation); • Effects of further integration for outsiders? (stronger incentive to join because of opportuniy costs – look at the UK in 1973 and other EFTA countries);

Decision-making model • Inherent conflict between the sovereignty of independent states and the need to cooperate because of growing interdepenence; • Supranational model: competencies are transferred to a supranational authority (the community method): – More efficient decision process: less time-consuming, more optimal outcomes, lower transaction costs; – But not all members’ interests my be protected equally; • Intergovernmental model: governments negotiate and agree (or disagree) on every decision; • Historically, there has been a gradual shift from intergovernmental model to a supranational model;