Difference Between Common Market and Custom Union

• George Walles

How does a common market differ from a custom union with respect to the dynamic effects of European economic integration? What may impede the transition from a customs union to a common market?

This essay will be looking to identify how a common market differs from a custom union in respect to dynamic effects of European economic integration. After that, the essay will be looking at the sort of factors, which may impede the transition from a custom union to a common market. A custom union is where all obstacles of free movement of goods and services are removed and a common external tariff is agreed. A common market is union of partners with free movement of goods, services, and the addition of free movement of labour and capital. The Treaty of Rome in 1957 set out the intension of a legal basis for the start of the EEC and to establish a Common market (Nello 2012).

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Custom union theory mainly looks at the static effects of European economic integration; this can be shown through the welfare effect diagram (figure 1). In the home country, based on their domestic supply and demand the price would be at Ph. World trade prices would be at P3 where world supply plus a tariff is equal. At P3 the domestic economy would Produce Q2 and import up to Q3. However once a custom union is established the price will fall to P2 as this is the price at which the union partners sell at. Yet they are still not as productive as the world supply because if you exclude the tariff they would produce the good more efficiently at a price of P1. At the price P2, the home country now produces only Q1 and imports up to Q4. However, the home country gains from being in the custom union, areas X and Y are gains and are trade creation of which are larger than the losses from trade, which is area Z, which is trade diversion. Area X is the gains to the consumer due to the lower prices, while area Y is the gains to the producer because of greater efficiency. However the gains from a custom union are only predicted to be with just 0.15 percent increase in growth.

The problem with this analysis is that it only shows the static effects of a custom union, and it is only looking at an individual industry and not the economy as a whole. There are a number of dynamic effects made by a custom union is respect of European economic integration. However, these dynamic effects are explicit to that of a firm or an industry and are similar or the same effects of which a common market has, due to both custom union and common market having free movement of goods and services. These effects are a reduction in Monopoly power and increased competition, reduction in the levels of x-inefficiency and the reaping benefits of economies of scale.

The difference between custom union and common market is the free movement of capital and labour, this essay is going to concentrate on the free movement of capital. The free movement of capital is where ‘capital controls and restrictions on the amount of currency that may be imported or exported are abolished ‘(Deutsche Bank 2013). Figure 2 is going to illustrate a situation where there is no capital mobility to free capital mobility in a common market to look at its welfare effects.

The native capital owners in Home lose since their reward has fallen from r0 to r’. The amount they lose is measured by the rectangle A. The Home labour increases its income by area A plus triangle B, thus the total impact on Home citizens is positive at equal to area D. The Home country also gains from the extra capital flows as it raises total output by area B+C+D+E, while payment to the new capital is only equal to C+D+E, which is r’ times the capital flows. Moreover, Foreign output drops by D+E, while capital remaining in foreign sees its rewards rise from r*0 to r’. The size of this gain is shown in the rectangle F, which is the change in r times the amount of capital left in the foreign country after integration. The total gains to foreign capital is area C+D+E, while the loss to foreign labour is area D+F. The Foreign country therefore gains from the capital outflow by an area equal to triangle C (Baldwin & Wyplosz 2009:557).

Thus to conclude from this diagram, Capital flows create winners and losers in both nations but collectively they both gain from free movement of capital. The main reason why is due to greater efficiency. For example, foreign capital was producing at r*0 which is inefficient but once there is free movement of capital it then produces at r0 in the Home country. Therefore, capital flows improve the overall efficiency of the EU economy of which the gains and losses are split between the member countries (Baldwin and Wyplosz 2009:558).

Furthermore, free movement of capital makes it more profitable to invest into other members economies, this is backed up by the fact that the EU is the ‘largest source and destination of FDI (Foreign Direct Investment) in the world ‘(European commission 2014). The main reason for greater investment this is due to heightened efficiency in the EU zone as the same amount of capital and labour can produce more output, as was explained in the figure 2.

Free movement of capital has positive dynamic effects, due to an increase in investment. The best way to show an increase in investment due to European economic integration is through the Solow growth mode. For example When Spain join the EU along with Portugal in 1986 they both had an increase in FDI, for example Portugal FDI was $274,036,105 in 1985 and by 1987 this almost doubled to $465,868,833 and in Spain FDI was $1,967,804,468 in 1985 and by 1987 it had increased dramatically to $4,570,700,793 (World Bank 2014). This increased investment because of the theory of the multiplier effect should lead to an increase in growth, which both Portugal and Spain experienced after EU entry. For example in 1985 Portugal’s growth was 2.8% by 1987 it had increased to 6.4% similarly Spain in 1985 growth was 2.3% and by 1987 it had increased up to 5.5% (World Bank 2014). Furthermore, Albu (2013) found that the EU, is characterized by complete liberalization of capital movement, foreign trade and economic growth in general were directly influenced by foreign direct investment increasing, this can be shown the diagram below.

(Baldwin & Wyplosz 2009)

If European integration raises investment from S to S2, the inflow of the curve S(GDP/L) will rotate upwards as shown in figure 3 to S2(GDP/L). This change would alter the equilibrium K/L (capital/labour ratio) and at point C. This can be seen also by the movement form K/L to K/L (2). Furthermore, the rising K/L ratio would raise the output per worker from Y/L to Y/L (2). The difference between point B and D show the medium run growth bonus from joining the EU (Baldwin & Wyplosz 2009: 224). This can be backed up by economist Richard Baldwin who predicted an increase in GDP within 3.1 percent to 8.1 percent in the UK and even higher in other EU economies once the single market was completed (Baldwin 1989: 265).

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The second part of this essay will be looking at what may impede the transition from custom union to a common market. It can be argued that the European union was a custom union right up to the late 1980’s because of the impediments of free movement of labour and capital, which some are going to be looked at now.

According to Pelkmans (2001: 184) the financial capital market has been completely liberalised since the late 1980’s. On the other hand, Molle (2006: 123) found a number of different forms of impediments to free movement of capital. For example the lack of tax harmonization, as differences in tax levels may distort the market as they induce investors to locate in countries which offer the highest tax adjusted profit rates. The European Commission (1996: 42) found that ‘insufficient liquidity of local markets, exchange rate risks, the tax treatment of non-residents, local prudential and incorporation requirements, and national differences in company law were reported as still inhibiting or distorting capital movements’.

A example of difficulty with free movement of capital is regarding to the banking system in the 1988, where the main obstacles to establishing banks in other member states was a mixture of authorization procedures, capital endowment requirements and restrictions on foreign acquisition. This restriction is proved, as only 1 percent of member states banks were foreign in 1988 (Nello 2012). However, the Maastricht Treaty outlined that ‘all restrictions on the movement of capital between member states and between member and third countries shall be prohibited’ (Molle 2006: 140).

Another issue which impedes the transition of a custom union to a common market is the free movement of labour. There are both cultural and social reasons and economic, the cultural are issues such as having to learn a new language and a new way of life and having to get used to new surroundings, while having to move away from family and friends is also an issue for people because of tight relationships.

The social problems exist due to the labour market being heavily regulated, and with member states having different laws on minimum wage, hiring and firing , flexible labour contracts and qualifications (Pelkman 2001:168). This diversity between members acts as a deterrent for people to migrate. Another form of impediment to a common market is diversity is the lack of mutual recognition of qualification completed by people at university or course of training has not kept up to pace with another members standard (The Social and Economic Council in the Netherlands 2001). There showing how a lack of common recognition of standards and qualifications can hinder labour mobility.

As free movement is crucial to common market as the EU created the Schengen group in 1985, the main aim was to eliminate border controls. The original members of the Schengen group were Germany and France with all the members later joining (Nello 2012). However, Ireland and England opted out and Demark partially opted out, therefore there is not complete free movement of labour. Furthermore, there are also restriction imposed by the EU itself, for example, migration in the EU is in principle free. Yet when the EU was expanded in 2004, special provisions were temporally imposed on the ten new members to limit migration from these countries to the EU15, with similar policies imposed on Romania and Bulgaria in 2007 (Baldwin & Wyplosz 2009: 250). Thus showing more examples of what can and has impeded the transition from a custom union to a common market. In addition to accept, a job a person must have accommodation, while a residence permit for foreigners can be refused or made hard to get (Molle 2009).

In conclusion this essay looks at identifying the main differences in respect of the dynamic effects of European economic integration of a common market and custom union, of which were found to be greater efficiency, and greater investment between member states as shown with the Spain and Portugal example. Furthermore, by using the Solow growth model demonstrated how these changes have led to higher economic growth within the EU. The Essay also demonstrates how custom union theory only explains the static effects of European economic integration and microeconomic effects within an industry and firms. The essay also outlines a number of potential impediments that moving from a custom union to a common market can have on both the labour and capital mobility, but also gave empirical examples of these impediments taking place in the contemporary European Union.

References

Albu, L (2013) ‘Foreign trade and FDI as main factors of growth in the EU’. Romanian Journal of Economic Forecasting, 16 (2), PP. 7-17

Baldwin, R. (1989) ‘The Growth Effect of 1992’. Economic policy, 4 (2), pp. 247-281

Baldwin, R,. Wyplosz, C,. (2012) The Economics of European Integration. 4th Ed. Maidenhead: McGraw-Hill

Deutsche Bank (2013) The Single European Market 20 years on. Frankfurt: DB Research

European Commission (1996) ‘Economic evaluation of the internal market’.no. 4. Brussels: Commission of the European Communities

European Commission (2014) Investment [online] available from < http://ec.europa.eu/trade/policy/accessing-markets/investment/> [25 October 2014]

McDonald, F,. Dearden, S. (2005) European Economic Integration. 4th Ed. Harlow: Prentice

Hall

Molle,W. (2009) The Economics of European Integration, Theory, Practice, Policy. 5th Ed. Aldershot: Ashgate

Nello, S. (2012) The European Union Economic, Policies & History. 3rd Ed. Maidenhead: McGraw-Hill

Pelkman, J. (2001) European Integration Methods and Economic Analysis. 2nd Ed. Harlow: Prentice Hall

The Social and Economic Council in the Netherlands (2001) Labour mobility in the European Union. Bezuidenhoutseweg: Social and Economic Council

World Bank (2014) Foreign direct investment, net inflow (BoP current US$) [online] available from < http://data.worldbank.org/indicator/BX.KLT.DINV.CD.WD?page=5> [25 October 2014}

World Bank (2014) GDP Growth (annual %) [online] available from <http://data.worldbank.org/indicator/NY.GDP.MKTP.KD.ZG?page=5> [02 October 2014]