Lecture # 5 Economics of European Integration

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1 Lecture # 5 Economics of European Integration Fall Semester 2008 Gerald Willmann Gerald Willmann, Department of Economics, KU Leuven

2 Market Size Matters European leaders always viewed integration as compensating small size of European nations. Implicit assumption: market size good for economic performance. Facts: integration associated with mergers, acquisitions, etc. In Europe and more generally, globalisation.

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

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

5 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 Demand Curve (D) Residual Demand Curve firm 1 (RD1) p 2 Demand Curve (D) Residual Demand Curve firm 2 (RD2) A 1 MC A 2 MC x 1 Firm 1 sales x 2 Firm 2 sales Residual Marginal Revenue Curve firm 1 (RMR1) Residual Marginal Revenue Curve firm 2 (RMR2)

6 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* RD D p** D RD Duopoly A RMR x* 2x* MC sales A RMR x** Oligopoly MC 3x** sales

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

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

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

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

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

12 Economic Logic Integration: no-trade-to-free-trade: BE curve shifts out (to point 1). Defragmentation: PRE typical firm has 100% sales at home, 0% abroad; POST: 50-50, Can t see in diagram. 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.

13 Facts M&A activity is high in EU. much M&A is mergers within member state. about 55% domestic. Remaining 45% split between: one is non-eu firm (24%), one firm was located in another EU nation (15%), counterparty s nationality was not identified (6%).

14 Facts Distribution of M&A quite varied: Big 4: share M&As much lower than share of the EU GDP. I, F, D 36% of the M&As, 59% GDP. Except UK. Small members have disproportionate share of M&A. M&A activity by nation, UK, 31.4% S, 5.3% NL, 6.5% I, 6.2% F, 13.5% D, 16.3% E, 5.0% B, 2.8% DK, 2.6% EL, 1.1% IRL, 1.7% L, 0.5% A, 2.1% P, 1.2% FIN, 3.9%

15 Facts Why M&A mostly within EU? Why UK s share so large? Non harmonised takeovers rules. some members have very restrictive takeover practices, makes M&As very difficult. others, UK, very liberal rules. Lack of harmonisation means restructuring effects very impact by member states.

16 Competition & 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 moneylosing firms in business via subsidies and other policies? The answer to both questions is Yes. See Chapter 11, 2 nd Edition.

Chapter 6: Market Size and Scale Effects

Chapter 6: Market Size and Scale Effects 1 Market Size Matters European leaders always viewed integration as compensating small size of European nations. Implicit assumption: market size good for economic