Integrated markets

Analysis of price policies to integrated markets: Shows.

o How transfers occur in integrated markets
o What consequences such transfers have for the analysis
o Formulation of price policies.

Theory
Countries in a certain region integrate their markets, protecting them together against the rest of the
world.

In a regionally integrated free trade zone, internal trade is free of barriers and allows for free exchange of
production factors between the different countries.

However, the member states usually keep different tariffs against the rest of the world. Member states
typically protect their markets through a common tariff.

Like any individual country, this price policy is implemented through a tariff in an import case and an
export subsidy in an export case. However, unlike an individual country, trade policies no longer affect the
national but the common budget, and member countries have to finance the common budget through
financial contributions.

Consequently, trade transfers between the member states arise, which affects the impact and
assessment of price policies.

In an integrated free trade zone:

The importing country suffers a negative trade transfer and a negative indirect financial transfer to
the common budget of the union.
The exporting country suffers a positive trade transfer and a positive indirect financial transfer to
the common budget of the union.

Figure 7.1 shows a customs union such as the European Union, but with only two member states.

The common market price pu in this customs union is above the world market price pw.

Importing Country:
 Loses the tariff revenue as it has to pay the higher market price for imports from another member
state, leading to a negative trade transfer.
It also transfers the tariff revenue for imports from the rest of the world to the common budget of
the customs union, resulting in a negative indirect financial transfer.

The reverse situation applies for an export country.

Exporting Country
Does not need to finance export subsidies anymore. So, it receives a positive trade transfer for
exports to other member countries due to the higher international price
It also receives a positive indirect financial transfer from the common budget for exports to third
countries (i.e. the rest of the world).

The assumed net-trade situation for the customs union is overall positive, i.e. the price policy leads to a
financial burden of the common budget in terms of export subsidies. Depending on the share in the
financial contribution to the common budget, a negative direct financial transfer occurs for both countries.

For the customs union as a whole, however, such transfer effects represent a zero-sum game (in other
words, the sum of all, positive and negative, transfers in a customs union is 0), so that the protectionist
policy leads to an overall welfare loss for the union.

Function for this Transfer for any member country

=Transfer of the individual country (Supply price of country, Demand price of country, union price, world
price, share of financial contribution to the common budget of the union)
= {(Supply quantity*Supply price-Demand quantity*Demand price) (Union price-World price)}
[Contribution to Union Budget*{Summation of (Supply quantity*Supply price of other member countries-
Demand quantity*Demand price of other member countries)*(Union price-World price)}]

Hence, transfer of a member state is a function of the supply prices and demand prices of all member
countries as well as the customs union price, the world market price and the share of the financial
contribution.

If this member country does not follow national pricing policy, then Supply Price=Demand Price=Union
Price (psj = pdj = pu).
The transfer is thus a function of pu, pw and bi.

Therefore, the sum of all transfers in a customs union is 0 because we can write:

This transfer affects the foreign exchange and government budget functions of the member country and,
hence, also its welfare function.

Total benefit and cost as well as consumer surplus and producer surplus does not change for a member
country in a customs union.
Since the transfer is 0 for pu = pw, in both cases the transfer function intersects the abscissa at pw.

For country 1:
Transfer function is decreasing monotonically
Any increase in the customs union price would further deteriorate the transfer situation, and vice
versa.
So, a customs union price at world market price level would not lead to welfare maximisation.
Optimal outcome would be a lower price at which the marginal transfer gain would match the
marginal welfare loss.

For country 2
Achieve a maximisation of welfare at a customs union price, which is higher than the world
market price.

Product-tied transfers within a customs union thus result in conflicts between the member countries with
respect to a common price policy and create incentives for policy distortions from a unions point of
view.Furthermore, the cost of national policies can also be shifted to other member countries and the
union as a whole.

The extent of such externalisation opportunities in integrated markets depends, of course, on the share of
financial contribution to the common budget of the member countries.

A hypothetical share of 0, for example, would not affect the national budget as a consequence of an
externalisation policy. In this case, the customs union price would be the relevant shadow price for the
member country guiding the countrys allocation of resources and not the world market price. And if this is
an export oriented country, it would advocate an increasing customs union price at the expense of the
union.

On the other extreme, a hypothetical share of the financial contribution to the common budget of 1, would
mean the country, and only this country, has to bear all the consequences of not only its own national
policy, but also of policies implemented in other member countries.

Overall, the integration of markets leads to totally different conditions for an individual country to analyse
and formulate price policies.