The Economics of European Integration (6 ed.) (Chapters 1-6) ISBN-10: 1526847213

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The Economics of European Integration (6 ed.) (Chapters 1-6)
 ISBN-10: 1526847213

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Citation preview

The Economics of European Integration Sixth edition Richard Baldwin & Charles Wyplosz

The Economics of European Integration, Sixth edition Richard Baldwin & Charles Wyplosz ISBN-13 9781526847218 ISBN-10 1526847213

Published by McGraw-Hill Education 8th Floor 338 Euston Road London NW1 3BH Telephone: 44 (0) 20 3429 3400 Website: www.mheducation. co. uk British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging in Publication Data The Library of Congress data for this book has been applied for from the Library of Congress

Portfolio Manager: Matthew Simmons Content Developer: Nicola Cupit Content Product Manager: Ali Davis Marketing Manager: Geeta Chandolia Cover design by Adam Renvoize Published by McGraw-Hill Education. Copyright © 2020 by McGraw-Hill Education. All rights resenred. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of McGraw-Hill Education including1 but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning. Fictitious names of companies, products, people, characters and/or data that may be used herein (in case studies or in examples) are not intended to represent any real individual, company, product or event. . b 0 ok cannot be © 2020. Exclusive rights by McGraw-Hill Education for manufacture and export. Th18 re-exported from the country to which it is sold by McGraw-Hill Education. Printed in Great Britain by Bell & Bain Ltd, Glasgow

Dedication For Sarah, Ted, Julia and Nicky - R.B. In memory of my parents, whose sufferings inspired my yearning for a

Europe at peace, and who taught me the pleasure of learning- C.W.

Brief Table of Contents About the Authors Preface Acknowledgements Gu ided Tour Online Learning Centre Study Skills

xiii xiv xviii xix xxi xxiii

2 3

Pa rt I Hi sto ry, Facts and Institutions History Facts, law, institutions and the budget Decision making

4 5 6 7 8

Part II The Microeconomics of European Integration Essential microeconomic tools and tariff analysis The essential economics of preferential liberalization Market size and scale effects Growth effects and factor market integration Economic integration, labour markets and migration

143 159 177

10 11 12

Part Ill EU Micro Policies The common agricultural policy Location effects, economic geography and regional policy EU competition and state aid policy EU trade policy

203 205 231 255 275

13 14 15

Part IV The Macroeconomics of Monetary Integration Essential macroeconomic tools The history of European monetary integration Optimum currency areas

287 289 323 347

Part V EU Monetary and Fiscal Policies The European monetary union Fiscal policy and the Stability Pact The financial markets and the euro The Eurozone in crisis Index

379 381 413 443 475 511



16 17 18 19

1 3 39 71

95 97 119

Detailed Table of Contents About the Authors Preface Acknowledgements Guided Tour Online Learning Centre Study Skills

xiii xiv xviii xix xxi xxiii

Part I History, Facts and Institutions


Chapter 1 History 1.1 Early post-war period 1.2 Two strands of European integration: federalism and intergovernmentalism 1.3 Evolution to two concentric circles: the domino effect part I 1.4 Euro-pessimism 1.5 Deeper circles and the domino effect part II: the Single Market Programme and the EEA 1.6 Communism's creeping failure and spectacular collapse 1. 7 Reuniting East and West Europe 1.8 Preparing for eastern enlargement: a string of new treaties 1.9 Global and Eurozone crises and institutional responses 1.10 The rise of Euroscepticism 1.11 Summary Self-assessment questions References and further reading

3 4 9

Chapter 2 Facts, law, institutions and the budget 2 .1 Economic integration in the EU 2 .2 EU structure pre- and post-Lisbon 2 .3 EU law 2 .4 The 'Big-5' institutions 2 .5 Legislative processes 2 .6 Some important facts 2 .7 The budget 2 .8 Summary Self-assessment questions References and further reading

15 17 18 21 23 23 26 29 35 36

37 39

40 46 49 52 58 61 63


68 69

Detailed Tabl e of Contents

71 72 75

Chapter 3 Decision making . . . . . . 3.1 Task allocation and subs1d1arity: EU practice and principles 3.2 Understanding the task allocation: the theory of fiscal federalism 3.3 Economic view of decision making 3.4 The distribution of power among EU members 3.5 Legitimacy in EU decision making 3.6 Summary Self-assessment questions References and further reading

90 90 91 92

Part II The Microeconomics of European Integration


Chapter 4 Essential microeconomic tools and tariff analysis 4.1 Preliminaries I: supply and demand diagrams 4.2 Preliminaries II: introduction to open-economy supply and demand analysis 4.3 MFN tariff analysis 4.4 GVC analysis 4.5 Types of protection: an economic classification 4.6 Sources of competitiveness differences 4.7 Summary Self-assessment questions References and further reading

97 101 105 109 110 113 116 116 117

Chapter 5 The essential economics of preferential liberalization 5 .1 Analysis of unilateral discriminatory liberalization 5 .2 Analysis of a customs union 5 .3 Frictional barriers: the 1992 Programme 5 .4 Deep regionalism, the Eurozone and 'soft preferences' 5 .5 WTO rules 5 .6 Summary Self-assessment questions References and further reading Annex: Discriminatory liberalization: small country case A5.1 Price and quantity analysis, liberalization with low-cost country A5 .2 Welfare analysis: liberalization with low-cost country A5 .3 Liberalization with high-cost country: supply switching A5.4 Welfare analysis: liberalization with high-cost country

119 120 127 131 133 134 135 135 136 139 140 140 141 141

Chapter 6 Market size and scale effects 6.1 Liberalization, defragmentation and industrial restructuring: logic and facts 6.2 The BE-COMP diagram in a closed economy 6.3 The impact of European liberalization 6 .4 Summary Self-assessment questions Essay questions References and further reading

143 144 146 149

82 86


152 152

153 153

Detailed Table of Contents


Annex: Detai ls on the COMP and BE curves A6 .1 COMP curve in detail A6 .2 BE curve in detail

155 155 157

Chapter 7 Growth effects and factor market integration 7.1 The logic of growth and the facts 7.2 Medium-term growth effects: induced capital formation 7.3 Long-term growth effects: faster knowledge creation and absorption 7.4 Summary Self-assessment questions Essay questions References and further reading

15 9 160 164 173 174 175 175 175

Chapter 8 Econom ic integration, labour markets and migration 8 .1 European labour markets: a brief characterization 8 .2 Labour markets: the principles 8.3 Effects of trade integration 8 .4 Migration 8 .5 Summary Self-assessment questions Essay questions References and further reading

177 178 181 187 190 199 200 201 201

Part Ill EU Micro Policies


Ch apter 9 The common agricultural policy 9.1 The old simple logic: price supports 9 .2 Changed circumstances and CAP problems 9.3 The simple economic logic of the new CAP 9 .4 CAP reform 9.5 Today's CAP 9.6 Remaining problems 9.7 Summary Self-assessment questions References and further reading

205 207 212 219 222 224 226 227 228 229

Chapter 10 Location effects, economic geography and regional policy 10.1 Europe's economic geography: the facts 10.2 Theory part I: comparative advantage 10.3 Theory part II: agglomeration and the new economic geography 10.4 Theory part Ill: putting it all together 10.5 EU regional policy

231 232 237 239 247 249 252

10.6 10.7

Empirical evidence Summary

Self-assessment questions References and further reading

253 253 253

Detailed Table of Contents

Chapter 11 EU competition and state aid policy 11.1 The economics of anti-competitive behaviour and state aid 11.2 EU competition policy 11.3 Summary Self-assessment questions References and further reading

25.) 256 269 273 274 274

Chapter 12 EU trade po licy 12.1 Pattern of trade and tariffs: facts 12.2 EU institutions for trade policy 12.3 EU trade policy: broad goals and means 12.4 EU trade policy: existing arrangements 12.5 Summary Self-assessment questions References and further reading

275 276 280 283 283 284 285 285

Part IV The Macroeconomics of Monetary Integration


Cha pter 13 Essential macroeconomic tools 13.1 The closed economy: a refresher 13.2 The open economy 13 .3 The impossible trinity principle 13 .4 The real exchange rate and the purchasing power parity principle 13.5 Applications: macroeconomic policies and the exchange rate 13.6 Summary Self-assessment questions Essay questions References and further reading Ann ex: Various exchange rate regimes

28 9 290 296 301 307

Chapter 14 The history of European monetary integration 14.1 Back to the future: before paper money 14.2 Bretton Woods as an antidote to the inter-war debacle 14.3 After Bretton Woods: Europe's snake in the tunnel 14.4 The European monetary system 14.5 The Maastricht Treaty 14.6 The crisis 14.7 Summary Self-assessment questions Essay questions References and further reading Annex: Hume's mechanism Chapt er 15 Optimum currency areas 15.1 The question, the problem and the short answer 15.2 Benefits of a currenc area


316 317 318 318 320 323 324 331 332 334 339 341 341 342 342 343 344 347 348 350

Detailed Table of Contents

15.3 Costs of a currency area 15.4 The optimum currency area criteria 15.5 Is Europe an optimum currency area? 15 .6 Is Europe becoming an optimum currency area? 15.7 Summary Self-assessment questions Essay questions References and further reading


354 358 364 371 373 375 375 376

Part V EU Monetary and Fiscal Policies


Chapter 16 The European monetary union 16.1 Principles 16.2 The five entry conditions 16.3 The Eurosystem 16.4 The monetary policy strategy 16.5 Independence and accountability 16.6 Instruments 16.7 The first years, until the Great Crisis 16.8 Summary Self-assessment questions Essay questions References and further reading

381 382 383 388 392 396 399 401 408 410 410 411

Chapter 17 Fiscal policy and the Stability Pact 17.1 Fiscal policy in the monetary union 17.2 Fiscal policy externalities 17.3 Principles 17.4 The stability and growth pact 17.5 The macroeconomic imbalance procedure 17.6 Summary Self-assessment questions Essay questions References and further reading

413 414 418 421 427 438 439 440 440 440

Chapter 18 The financial markets and the euro 18.1 Essentials of financial markets 18.2 Effects of a monetary union 18.3 Fragmentation during the crisis 18.4 The Eurozone and its banks 18.5 The international role of the euro 18.6 Summary Self-assessment questions Essay questions References and further reading

443 444 450 457

460 468 472 473 473 473


Detailed Table of Contents

Chapter 19 The Eurozone in crisis 19.1 Stage one: the global financial crisis 19.2 Stage two: the public debt crisis in the Eurozone 19.3 Policy responses 19.4 Banks and public debt 19.5 What have we learned from the crisis? 19.6 Summary Self-assessment questions Essay questions References and further reading Index

475 476 480 490

497 501

507 508 508 508 511

About the Authors Richard Baldwin is Professor of International Economics at the Graduate Institute, Geneva since 1991 a part-time visiting research professor at the Universitu of Oxford from 2012 to 2015, Director/President of CE_PR from 2~14 to 2018, and Editor-in-Chief of Vax since he founded it in June 2007. He was Co-managing Editor of the Journal Economic Policy from 2000 to 2005, Policy Director of CEPR from 2006 to 2017, and Programme Director of CEPR's International Trade programme from 1991 to 2001. He has previously been a Senior Staff Economist for the President's Council of Economic Advisors in the Bush Administration (1990-1991), on leave from Columbia University Business School where he was Associate Professor. He did his PhD in economics at MIT with Paul Krugman and has collaborated with him on several occasions. He was visiting professor at MIT in 2002/03 and has taught at universities in Australia, Italy, Germany and Norway. He has also worked as consultant for the numerous governments, the Asian Development Bank, the European Commission OECD World Bank EFTA and USAID. The author of numerous books ' include ' international ' trade, globalization, regionalism and European and articles, his research interests integration. 1

Charles Wyplosz is Professor Emeritus of International Economics at the Graduate Institute in Geneva where he also served as Director of the International Centre for Money and Banking Studies. Previously, he has taught at INSEAD and at the Ecole des Hautes Etudes en Sciences Sociales in Paris. He is a Fellow of CEPR and of the European Economic Association. His main research areas include financial crises, European monetary integration, fiscal policy and regional monetary integration. He is the co-author (with Michael Burda) of the leading textbook Macroeconomics, A European View and has published several books and many professional articles. He serves as consultant to many international organizations and governments and is a freq,uent contributor to public media. He was a Founding Managing Editor of Economic Policy. A French national, Charles Wyplosz holds degrees in Engineering and in Statistics from Paris and a PhD in Economics from Harvard University.

Preface What's up? When the first edition of this book was published in 2004, European integration was a process under wa During that year, ten countries joined the existing fifteen members of the European Union. Since then thr;~ more countries have gained membership. At that time, twelve countries had adopted the euro and seven have done so since then. As we close this edition, integration may sound like a misnomer as negotiations on the withdrawal of the UK are under way. In the mean time, the sover eign debt crisis has come close t o triggering a disintegration of the Eurozone. In addition, in many countries, newly influential political parties present themselves as Eurosceptics, and some of them are in power. European integration currentllJ seems more like a description of the existing situation than a continuing process, although seven countries have applied to become members of the European Union. Still, excluding the UK, currently 44 7 million people live in the European Union, far more than in the USA. Everyday , they produce and consume goods and services that move freely within the continent and 340 million of them use the euro as their own currency. Furthermore, some 400 million people can travel seamlessly within the Schengen Area without having to show passports or identity cards. Thus Europe exists. It constitutes a uniq,ue historical achievement. After centuries of bitter wars, the continent is peaceful and deeply integrated, in spite of sq,uabbles here and there. It is often said that Rome, its distant and vefl) different predecessor, was not built in one day. Likewise, Europe is still being built. This book describes and explains European integration, and its contents mirror the ever-changing situation. In the first three editions, we noted the many flaws in the integration process, especially those concerning the Eurozone. In the fourth edition, we were lamenting the policy responses to the crisis, pointing out what had to be done. At the time of the fifth edition, the crisis was coming to its end. Since then, much has been done often along the lines that we mentioned. The European Union has been transformed, and so has this book. As always with previous editions, most of the tables, figures and boxes have been updated with the most recent data and events. The most drastic changes of this sixth edition concern both the pedagogy and the content. In terms of pedagogy, we have retained the five-part structure - see below- but: _ Chapter 1 discusses Brexit but, since the manuscript had to be closed before the final 'divorce' deal was settled, the treatment was necessarily somewhat speculative. _ Chapter 8 offers an expanded treatment of migration, which has emerged as a major concern. _ Presentation of the macroeconomic theory in Chapter 13 has been streamlined, better motivated and ext ended. It now includes a new section that brings the main results together and present the theorl) of exchange rate determination. The section on monetary neutrality has been moved in a uccinct form to Chapter 15 where it is used to explain different views of monetary policy. _ Chapter 14 is now presented as a history of monetary integration in Europe, which make f~l us.e of the principles developed in Chapter 13. It is designed as a transition between th ory and applications developed in subseq,uent chapters. - Chapter 15, which presents the optimum currency area (OCA), has b n r d igned. It in~ludes ~e aggregate demand and supply framework that has been req,u st d hy many instructors, while makmg more use of the theory presented in Chapter 13. It pres nts a thorough dis ussion of the insurance role of transfers. .. d - Chapter 17 has been extended to include new developments, including regarding the Stability an Growth Pact and the macroeconomic imbalances procedure. . 1 - A new section has been introduced at the beginning of Chapter 18 to present the explain financia . the theory developed rn . Chapter 13. That theory 1s • a 1so use d t o explain risk and the markets usrng variety of interest rates (maturities and riskiness). . . • d d in context within Obviously, the latest developments are fully covered. The informat10n 1s me1u e every chapter.



What this book is This is a tex~book for c~urses on European economic integration. Its emphasis is on economics, covering both th~ _rmcroe~onom1cs and macroeconomics of European integration. Understanding European econormc integrat10n, however, req,uires much more than economics, so the book also covers the essential aspects of European history, institutions, laws, politics and policies. The ?ook is written at a level that should be accessible to second- and third-year undergraduates in econormcs as well as advanced undergraduates and graduate students in business, international affairs, European studies and political science. Some knowledge of economics is needed to absorb all the material with ease - a first-year course in the principles of economics should suffice - but the book is self-contained in that it reviews most essential economics behind the analysis.

What is in this book !he bo~k is organized into five parts: essential background (Part I), the microeconomics of European integratwn (Part II), microeconomic policies (Part III), the macroeconomics of monetary integration (Part IV) and macroeconomic policies (Part V) . Part I presents the essential background for studying European integration. • An overview of the post-Second World War historical development of European integration is presented in Chapter 1. The chapter should be useful to all students, even those who are familiar with

the main historical events, as this chapter stresses the economic and political economy logic behind the events. • A concise presentation of the indispensable background information necessary for the study of European integration is presented in Chapter 2. This includes key facts concerning European economies and a brief review of the EU's legal system and principles (fully updated to reflect the Lisbon Treaty changes). Chapter 2 also presents information on the vital EU institutions and the EU's legislative processes as well as the main features of the EU budget. • Chapter 3 presents an economic framework for thinking about EU institutions. The first part explains how the 'theory of fiscal federalism' can be used to consider the appropriateness of the allocation of powers between EU institutions and EU Member States. The second part explains how economic reasoning - game theory in particular - can be used to analyse EU decision-making procedures for their efficiency as well as their implications for the distribution of power among EU members. While these are not classic topics in the study of European integration, they are essential to understanding the current challenges facing the EU, such as the 2004 enlargement and the debates around the Lisbon Treaty. This is more relevant than ever as the Eurozone crisis is almost sure to produce a shifting of some competencies from the national level to the supranational level - or, at the very least, a serious debate over such shifts. Part II presents the microeconomic aspects of European integration. • An introduction to the fundamental methods of trade policy analysis is presented in Chapter 4. The chapter introduces basic supply and demand analysis in an open economy and the key economic welfare concepts of consumer and producer surplus, and then uses them to study th simple economics of tariff protection. • An in-depth analysis of European preferential trade liberalization is given in Chapter 5. The focus is on how the formation of a customs union or free trade area affects peopl , companies and governments inside and outside the integrating nations. • A thorough study of how the market-expanding aspects of European int_egration ~ffect th~ efficie~cy of European firms is presented in Chapter 6. The main line of reasoning explains ~ow mtegratwn in the presence of scale economies and imperfect competition can produce fewer, bigger and more efficient firms facing more effective competition from each other. Again, the ongoing enlargement of the European Union makes this sort of logic more relevant than ever.



• Chapter 7 gives a detailed study of the growth effects of E . economic logic linking European integration to medium-ruuropdealn mtegration. The emphasis is on th n an ong-run growth f e and endogenous growth theories are covered to the extent th t th e fects. Neoclassical growth-integration linkages. The basic facts and empirical e .da ey help students understand the v1 ence are also covered • Chapter 8 deals with the labour markets. It recalls the basics f 1 b . · o a our econorrucs in ord t O unemp1oyment and develop the notion that social reouirements h . er explain . b " may ave senously negative ff t erms o f JO s, wages and growth. The chapter uses these insights to study th ff . e ects in deal ·th t · · e e ects of mtegratio It s WI many con rovers1al issues such as social dumping and migratio t · h n. the f b f n, rymg ard to stay abov ray Y presen mg economic analysis as one logic, but not the only one. e Part III presents the main microeconomic policies of the EU. • Chapter 9 _looks at the Common Agricultural Policy (CAP), presenting the economics and facts that are essenti_al for understanding its effects. The chapter takes particular care to examine the economic forces behind recent CAP reform in the light of international trade negotiations (the Doha Round), the eastern enlargement and the reforms that are being discussed for the post-2013 financial period. • Chapter 10 presents the economics that link European integration to the location of economic activities. This includes a presentation of the main facts on how the location of economic activity has shifted both within and between nations. To organize thinking about these facts - and to understand how EU regional polky might affect it - the chapter presents the location effects of integration in the light of neoclassical theories (Heckscher-Ohlin), as well as the so-called new economic geographlJ. The chapter also presents the main features of the EU's regional policy and considers the implications of the eastern enlargement. •

Chapter 11 covers the basic elements of the EU' s competition policy and state aid policy (EU jargon for subsidies). Instead of merely describing the policies, the chapter explains them by introducing the basic economic logic of anti-competitive practices. It has been updated to include several recent cases that illustrate the difficulties of applying simple economics to the complex world of international business.

• Chapter 12 addresses EU trade policy, that is, its commercial relations with the rest of the world. While trade policy is not as central to the EU as are, say, the CAP and cohesion policies, it is important. The EU is the world's largest trader, and trade policy is probably the only EU 'foreign policy' that is consistently effective. The chapter covers EU trade policy by presenting the basic facts on EU trade covering the EU's institutional arrangements as concerns trade policy, and finally summarizing the EU's policies towards its various trade partners. It has been fully updated to reflect changes introduced by the Lisbon Treaty . Part IV continues the approach of Part II by providing the basic principles behind macroeconomic and monetary integration. • The essential principles needed for the macroeconomic analysis are pres nt d in hap~er 13. ~his chapter presents the macroeconomic theories and tools needed to analy ~10~ tary. mtegration. It is organized around the Mundell-Fleming model and establishes thr pn~c1ples: mterest rate parity, purchasing power parity and the impossible trinity tha~ aJf t th ~oice of _exchang~ rat~ regimes. This chapter can serve either as a refresher for conom1 tud nt 01 a (fast) mtroduction t economics for others. . th The long process of European monetary integration is r ount d in Chapter 14. It starts briefly Wi • cient times when Europe was a de facto monetary union under the gold standard, reviews the Bretton ~oods period when Europe's exchange rates were tied together via the US dollar and then i:noves to f ·s briefly reviewed the European Monetary System, past and present. The process of euro a d op 1011 1 · f k eded to think about the • Chapter 15 presents the optimum currency area theory, t h e ramewor ne . 13 working of a monetary union. The basis is provided by the principles developed 111 ~hapter ti. 1· · h · urrency the theory 1s essen a Looking at the costs and benefits resultmg from s armg a common c ' . . f rth · h E It 1·s used extensively m u er to understanding what works and does not work m t e urozone. cha ters.



Part V is the counterpart to Part III, as it presents the main macroeconomic policies of the EU. • The main features of the European monetary union are laid out in Chapter 16. This includes a description and analysis of the institutions created by the Maastricht Treaty and how they have evolved since, including during the crisis that started at the end of 2009. It explains the importance attached to price stability and the measures adopted to achieve this objective. The chapter also provides a review of the first decade of the euro up until the crisis. • Fiscal policy is the last national macroeconomic instrument remaining once national monetary policy has been lost. Chapter 17 looks at the Stability and Growth Pact, designed to deliver just enough budgetary discipline so as not to endanger the overriding price stability objective. Since the first edition of this book, we have underlined the pact's serious shortcomings; the crisis has led to a strengthening of the pact, but fundamental economic and political difficulties remain. • Chapter 18 deals with the financial markets. It starts with an analysis of financial markets in general. It then explains how and why the financial services industry was transformed by the Single European Act 1986 and by the adoption of a single currency and how it has been fragmented by the crisis. The measures taken to deal with this unexpected development are presented and evaluated, including the creation of the Banking Union. The chapter concludes by q,uestioning whether the euro can challenge the US dollar as a world currency. • Finally, Chapter 19 offers an overview of the Eurozone crisis. It looks at the global crisis that started in the USA and its transmission to Europe. The next step, the sovereign crisis, is then described and analysed, bringing together much of the material presented in earlier chapters. The policy responses are presented and critically evaluated. The chapter ends with a discussion of the remaining challenges and an analysis of what the break-up of the Eurozone would mean.

How to use this book The book is suitable for a one-semester course that aims at covering both the microeconomics and macroeconomics of European integration. If the course is long enough, the book can be used seq,uentially for two courses. Shorter courses may focus on the trade and competition aspects; they can use only Parts I, II and ID. Conversely, a course dealing only with the macroeconomic aspects can use Parts IV and V, and finish with labour market issues as covered in Chapter 8 (which does not really req,uire the previous microeconomic material). Eclectic courses that focus on theory and cover trade, competition and macroeconomics can use only Chapters 1-8 and 16-19 or just 4-8 and 16-19. Eclectic courses oriented towards policy issues can use, with some additional lecturing if the students are not familiar with basic theory, Chapters 1-2, 9-12 and 16-19. In general, all chapters are self-contained but, inevitably, they often refer to results and facts presented elsewhere. Each chapter includes self-assessment q,uestions designed to help the students check how well they master the material, and some chapters also provide essay q,uestions which can be given as assignments. We also provide additional readings that are easily accessible to undergraduate students. The fifth edition continues our tradition of providing many internet links that should allow students and lecturers alike to gain the latest information on the EU's many fast-developing areas. We have observed that the internet is an excellent way to stimulate students' interest by bringing classroom teaching to real issues they see every day in the media. The links we provide go well beyond journalist treatment in a way that allows students to realize the usefulness of the basics they have learned from the text.

Acknowledgements Our th anks go to th e following reviewers for their comments at various stages in the text's development: Benedicta Marzinotto, College of Europe John O'Hagan, Trinity College Dublin Michael Wycherley, Trinity College Dublin Maria-Roxana Radulescu, Newcastle University Yon~em Sonm~~' Manchester Metropolitan University Chns _van Ho01Jdonk, Radboud University Cat~nna Marvao, Dublin Institute of Technology Ennco Marvasi, Politechnic University of Milan Graciela Zevallos, University of East Anglia Liesbeth Dries, Wageningen University & Research Liviu-George Maha, Alexandru loan Cuza University of Iasi Michele Chang, College of Europe Rob Ackrill, Nottingham Trent University Roberto Palacios-Rodriguez, University of Hull Siobhan McCarthy, Dublin Institute of Technology Yves Segers, KU Leuven We would also like to thank Ralf Fendel for the material which he provided for the textbook and its accompanying online resources. We would like to thank Mathias Dolls, Clemens Fuest, Andreas Peichl and Christian Wittneben who accepted to share their latest estimates (on fiscal stabilizers) used in Figure 17.1. Each new edition lengthens our indebtedness to colleagues, former and present students and editors. It also increases our pleasure when the time has finally come to thank them all. In the current and previous editions a number of colleagues have made useful suggestions and identified mistakes. While we alone ' are responsible for the remaining old and new mistakes, we thank our reviewers for their no-holds-barred evaluations, which have been both challenging and most useful. We have tried hard to respond to each and every criticism and to follow the many constructive suggestions that we received. As always, McGraw-Hill has lined up a first-class editing and production team and we would like to thank everyone who was involved. Matt Simmons, the Portfolio Manager who arranged for detailed reports from the reviewers (whose names are revealed above but were anonymous for us), oversaw tJ.1e planning for changes in this new edition, and enforced the unavoidable agenda. Nicola Cupit, the ont nt Developer, and Ali Davis, the Content Product Manager diligently followed us after Ben King, ili Production Manager, taught the essentials of writing a book online. We would also like to thank the students who provided face-to-face f dba k whil we were teaching the fourth edition material. Richard Baldwin would in particular lik to thanl tl.1 tudents at tlle University of Geneva. Every effort has been made to trace and acknowledge own rship of copyright and to clear permission for material reproduced in this book. The publishers will be pleased to make suitable arrangements to clear permission with any copyright holders whom it has not been possible to contact.

Guided Tour Chapter introduction


Each chapter opens with an introduction outlining the ideas and

When this book was being wiitten, in 20 concepts that will be addressed in the following pages. economically and politically. Britain was q; everywhere, and explicitly anti-EU parties wei~a"l'IT...... - - - - - - - - - - - - - - - - - - - - - - - - - - - - - France, Gennany and Poland. The EU, however, w· crisis of 2008, the Eurozone crisis of 2010 and the new relevance, or purpose, that goes well beyond i whose aim was to avoid war in Europe. EU mem members thrive in a hostile global situation. Authoritarianism and aggressive nationalism practices and institutions that had long tlrreat. Emergi.J.1g powers such as Chi.J.1a and India a the old order's main architect - the United States decades of peace, Russian tanks were once agai.J.1 Figure 1.2 The four-way division of Germany neighbours. These are trying times for small pro authoritarian and uncompromisingly nationalisti Qb


d it i

1-2Ql · 'It is


lo ae


Maps and diagrams These are provided throughout the text to show the geographical impact of changes in EU integration across the continent.

1·Box U

The European Payments 11 " I




Most European nations were bankrupt bilateral agreements, often involving ba Each chapter contains a number of boxes that provide further another type, say food). The EPU 'multi examples and explanations of key facts, events or economic ideas nation's bilateral trade deficits into a sin relating to the European Union. deficits or surpluses with every other EP to the EPU as a whole. Most members ha.- --,m:11.-------------------------------' wartime damage (which made exporting diffi advantage of this approach was that the need t all that mattered was the nation's overall trade Figure 1.6 Eurozone long-run interest rates, 199~ the web of bilateral trade restrictions that had EPU can be thought of as the real start of pos 35 liberalized trade flows inside Europe. Germany

30 25

Spain Greece Ireland


Figures and tables Figures and tables feature throughout the text to help illustrate important statistics and data about the European Union and its Member States.

- - Italy - - Portugal

Guided Tour

5.6 Summary This chapter introduced the verbal logi liberalization in an NICNIR setting. Afte and welfare effects of the formation of a

Chapt er su mmaries Recaps of the key ideas and discussions are featured at the end of each chapter.

• Formation of a preferential trade ar• ...__'"'I'!!"'___ _ _ _ _ _ _-:--_____________________.,, area, tends to lower domestic prices and r liberalizations also produce supply switch member-based suppliers. • The welfare effects of any trade libera · standard public-finance concepts, which price) effects.

Self-assessment questions The NICNIR was the backbone of 'customs W' and provisos were put forth in the NICNIR se exercises illustrate the basic points.

Self-assessment questions Self-assessment q,uestions are included to allow students to test themselves on the economic concepts and facts featured in each chapter.

Kemp-Wan theorem, 1976) Starting from hree nations are symmetric in everything, nd Partner form a customs union and low he new, post-liberalization border price f 'beralization, i.e. P' - T. Show that this 'K ain while Ro W does not lose from this CU Cooper-Massell, 1965, extended) We can



1 -

Essay questions

1 Could immigration be a solution to Essay q,uestions feature at the end 2 Can you imagine other regions in th 3 You are given the task of designing students to write full answers to Eurozone. Consider both how to coll practice for exams. 4 'Admission of more countries into shocks.' Comment. 5 Are business cycles and economic struc comfortably with euro interest rates on a p 6 If problems emerge, is there sufficient fle ·

of some chapters and encourage explore ideas in more detail as

Further reading: the aficionado's cor

Acharya, R., J.-C. Crawford, M. Maliszewski and _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ ___.....__--.,, s) Preferential Trade Agreement Policies for D

, Chapter 2. , P. and C.F. Fole-y (2011) 'Poultry in motion: ers 17091. in, R. (2006) In or Out: Does it Matter? An Evi nomic Policy Research, London. For students who want to explore key concepts, each chapter in, R. (2014) 'The in1pact of mega-regionals: th contains a list of extra sources to help further research. .me-changers or Costly Distraction for the Wo ' - - - - - - - - - - - - - - - - - - - - : - - - - - - - : - - - - - - - - - 1 1 - - i :m1fstrand, J. (2008) 'How much has European econ, 6 September, http:/ big-was-boost.

Further reading, useful websites and references

Annex: Discriminat cou Annex This Annex presents the classic analysis of Where appropriate, Annex sections offer further economic country' case. Here 'small country' means n explanations, data or background information. The annexes enable Partner and Ro W alike. In particular, sim is flat so the world price never changes. In further study to complement the chapter, covering more advance Figure A5.l, which allows for two pot the reasoning. To set the stage, suppose th concepts and providing greater detail. (Goods produced in the countries A, B and face a flat import supply curve from both coun

Online Learning Centre Online Learning Centre

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~h~~~-W~p~Onllne Leaming C•ntr1 for Tht £conomlcs of EuroPNn Jnt~n,th,n 6th edition, by Rkh1rd Baktwln 1nct

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_ _ , , , KeyFut1.1resandUod1t!s: • Wld, ran;re of lurntno ,uturu lnducllna;i bo,o:1d u11mplu and !Ru,tr11tlonJ, lil'ld of cha Pl• summ1riu, sdf-Hsessm111 t Q1Jts0on1 Mid unyQil-,:tloru. • Fully Updete.d to lndudt new dlsaiulons 1nd er.amplu ,udl n dlt Stlblt,t-1 and Growth Pict, lhe tontll'IVll'l\l lmPUt ilnd trutmfl'lt r,/ mloniUoll. and tht atttmDls 10 molvt the Wrozone Ctl!Js • The taint d1 velo9mtT1U In EU poOcifi !ndudlno the Common Aoriai.ltu~t Polley {CAP) ,nd lh1 Qian, for the M>ot Multl•AnnWil Finand~F~mtwork. • Tht ~ c t of Brvcll end how tN1 retnu ID olhtr EV tnde de.ii~ . • An Onllr,e I..Umlf19 Cen111 with reaure ourlinn, PowerPoll'lt presenaUons and •nfflen; to Hlf•UHfl.lfletll and esuv qutsUon&. TIICSTUDENlC~TR£



Learning Centre

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2.3 12.2

CHAPTER 3 Decision making

Notice that the 2004 enlargement greatly reduces the passage probability. T~s i~ ~rue even with the Nice Treaty voting reforms (which were supposed to maintain the enlarged EU s ability _to act). In fact, the Nice Treaty's complex rules made matters slightly worse than they would hav~ been Wlth no re_f~rm at all. The results show that accepting 12 newcomers without reform would dramatically reduce efficiency, cutting the current passage probability by something like a third, from 7.8 to 3.6 per cent. This point, which became widely accepted after 2001, was why EU leaders asked the European Convention to reconsider the EU's decision-making rules - the req,uest that eventually led to the Lisbon Treaty's new double-majority rule for the Council. Note that the decision-making rules in the Parliament and Commission were not viewed as problematic and thus were not reformed in the Constitution or the Lisbon Treaty.

The role of the Commission and Parliament In the mainstay legislative process, the ordinary legislative procedure (i.e. the old codecision procedure), both th e Commission and the Parliament play critical roles. But they do not really affect decision-making efficiency. The Commission proposes legislation and drafts the first version. This gives it a good deal of power, as will be discussed in more depth below. But it has always had this power, so the increasing difficulty of passing EU legislation is not related to the Commission's role. A more plausible link would be with the enlargement of the European Parliament. After all, if enlarging the Council makes it harder to pass laws, doesn't enlarging the Parliament do the same thing? To address this, it is necessary to realize a special feature of the 50 per cent majority rule that the Parliament uses. When the winning coalition needs only half the votes, the passage probability is unrelated to the number of voters. Upon reflection, this is obvious. There is an almost unfathomable number of possible yes/no coalitions in the 785-member Parliament (2 raised to the power of 785 is something like 2 with 236 zeroes after it), but when you only need half to win, it is clear that half of all coalitions will be winners. Thus the passage probability is always 50 per cent regardless of the number of voters. 2 This is wh1:1 we can ignore the Parliament when considering the passage probability. Of course, in the real world things are much more complex than the passage probability, but this concept provides a good point of departure for judging how various things like enlargement and voting reform can affect the EU's capacity to act.

3.4 The distribution of power among EU members The next aspect of EU de~ision making that we address is the distribution of power among EU member . As with efficienqJ, there 1s no perfect measure of power. The tactic we adopt relies on the law of large

numbers. That is, we look to see ho_w likely it is that each member's vote is crucial on a randomly drawn issue. Before turning to the calculat10ns, however, we lay out our specific definition of power. For our purposes, power means influence, or, more precisely, the ability to influence EU decisions by being in a position to make or break a winning coalition in the Council. Of course, no one has absolute power in the EU, so we focus on the likelihood that a Member State will be influential. On some things Germany's vote will be crucial, on others it will be irrelevant, and the same goes for all other members. What determines how likely it is that a particular nation will be influential? The most direct and intuitive measure of political power is national voting shar s in the Cmmcil, but as Figure 3.3 showed, there are actually two sets of weights, so it is not obvious how to combine them. In any case, simple voting shares can be a misleading indicator of pow r.

a.4.1 Voting shares as a power measure: the shortcomings




Whil voting shares are a natural measure of power, they have problems. To illustrate the potential pitf

th et· g weights as a power measure consider a 'toy model' of the Council. Suppose there are only - ree o f vo m ' pect1vely. • m· this to11 model-imaginatively called A, Band C- and they have 40, 40 and 20 votes, res countnes t1 _ 2

This 1s n

ot exactln true with an odd number of voters but the difference is negligible. 1:1

The distribution of power among EU members


Decisions are based on a simple major"t ul wer we would say th t . i Y r e C+50 per cent to win). If we used voting weights as a measure of p O , a countnes A and B h ·th h · · · its 2ovotes. This is wrong. , eac wi t err 40 votes, were twice as powerful as C with With a bit of reflection you can co · . t. th nvmce yourself that all three nations are eq,ually powerful in this toy Council . Th e porn is at any winnin li · . . f . g coa t10n req,urres two nations but any two nations will do. Likewise any pair o nat10ns can block an thi As ' · ' h . Y ng. a conseq,uence, all three nations are eq,ually powerful m the t t th sense a ey are eq,ua11y likely to make or break · · lit· Th 1 1 Of th . . a wmnmg coa wn. e eve e maJonty threshold can also be important in terms of power. For example continuing with our toy model · ·tY r ule from 50 to 75 per cent would stnp · nat10n · C of all' power. The . . . ~ raising the m aJon th only ~ g co~litwn at C would belong to is the grand coalition A&B&C, but here C would not be able to turn it mto a losmg one by leaving the coalition. Therefore C's vote can have no influence on the outcome. Again ' voting shares in this examp1e wo uld give · a very mcorrect · · of power. view More ?eneral~y, power - that is, the ability to make or break a winning coalition - depends upon a complex mteractwn of the majority threshold and exact distribution of votes. Indeed, the useless-vote situation in which nation C found itself in our second example actually occurred in the early days of the EU. See Box 3.4 for details.

Luxembourg's useless vote, 1958-73

Box 3.4

The 1957 Treaty of Rome laid down the rules for q,ualified majority voting in the EEC6. The big three - Germany, France and Italy - got four votes each, Belgium and the Netherlands got two each, and Luxembourg got one. The minimum threshold for a q,ualified majority was set at 12 of the 17 total votes. A little bit of thought shows that the Treaty writers did not think hard enough about this. As you can easily confirm, Luxembourg's one vote never matters. Any coalition (group of 'yes' voters) that has enough votes to win can always win with or without Luxembourg. According to formal power measures, this means that Luxembourg had little power over issues decided on a QMV basis. As Felsenthal and Machover (2001) write: 'This didn't matter all that much, because the Treaty of Rome stipulated that QMV would not be used until 1966; and even in 1966-72 it was only used on rare occasions. Still, it seems a bit of a blunder.' It all changed post-1973, when the weights were altered to allow for the accession of Britain Denmark and Ireland. Indeed, since then Luxembourg's votes have turned out to be crucial in a surprisingly large number of co~litions. M_a ybe that is why Luxembourg has the highest · t per capi·ta m· the EU despite being the nchest nation by far. receip .




Source: This box IS base on e1se

nthal and Machover's excellent eBook (2001), which provides a much more in-depth look at

voting theory.

. ch as these led to the development of several more sophi ticated power Simple counter-examp1es su h fI d , · mdices. We shall focus on t h e 'N ormalized Banz a n ex ·

Index 3.4.2 Power t o brea k a w1·nning coalition: the Normalized Banzhaf 1·1 1 ·t . th

. f.m d s 1·ts elf m . . . . dB haf Index (NBI) gauges how 1< y 1 1s at a nation In plam English, the Norma_hze ~-:~ on a randomly sele t d issu . By way of criticism, note that the 10 a position ~o 'break' a winru~g co~ : shallow depiction of a r al-world voting process. For instance, 0 set-up behind the NBI provides . Y da how coalitions are formed and how intensively each country the q,uestions of who sets the votmg ag~: In a sense the eq_ual probability of each coalition occurring holds its various positions are not c?nsi er; t~ deal with ~his shallowness. The idea is that all of these things and each country switching its vote is meanf tes on a broad range of issues. Thus, this measure of power number o vo . Would average out over a 1arge h y of looking at it is as a measure of power m the abstract. .18 pt Anot er wa . . really a very long-term conce · b on a randomly chosen issue. Of course, on particular issues, Itt ll t y is likely to e e s us how powerful a coun r uch less powerful. Various countries may be much more or m ~----~--~--------------------


CHAPTER 3 Decision making


The easiest way to understand this concept more deeply is to calculate it for our simple examplP in Table 3.2. To make it interesting, we take the uneven vote allocation case (#2) and assume a 70 per c nt majority threshold, so winning takes 21 votes. As before, we line up all eight possible coalitions and decide which are the winning ones (Table 3.3). These are the first three. Then we ask who the critical players are in these winning coalitions - critical in the sense that they would tum the winning coalition into a losing coalition if they changed their vote. In the first coalition, only A is critical since the defection of either B or C would not change the outcome; nation A and the remaining other nation would have enough votes to win. In_the second and third coalitions, where the majority is narrower, both nations are critical, namely , A and C rn the second and A and B in the third. Table 3.3

Critical players with a 70 per cent majority threshold

Yes votes

70% majority?

Critical player(s)









































·tuThus · there are five situations in which a nat·1011 would f d ·

s1. at10n three of the five times, while Band C . . . m itself critical. Nation Ar d . . A IS more powerful than B and C. The NB! for : : cntical m only one of the five times m s. itself m this The calculation of NB! for all EU memb . three-fifths, while it is one-fifth f . Thus, m this sense, essential to our study of EU deci . k ers is a topic that may fascin t or B and C. s10n ma mg, so we relegate its discussion ta eBsome readers, but it is not 0 ox 3.5.

Box 3.5

Calculating the Normalized Banzhaf Index (NBI)

The . easy to describe a and mechanical a PC with 1 calculatio n of the NBI is


(i.e. all cone . ots of horsepower. To work it out one as nd req_mres nothing more


:~/i:~ble _:::i:~:::u::s~f ;~el~ io~d i~=n~;:t::,~;;o~~\f'~:s~~::~:!~:~: coalitions a group of 3 there are 8. However numbers of vot rs; in a< '. on . ote that listing 1 th ~:~::::.i~!{am~P;Piu~t~e-~ ;;,~issoo~li~id1:n1·aevgge:t~~b;'~ fo:r ..~~b~b: t . rs next ta J · o e h .. uu,ers y h d . urned mto a loser by the def .· s ' is to work out all ti . k d. In the EU28 an q_mckly trmes each nation could be a ,:ction of a single nation ~e ways that each wmn· , the number is over 0




:~::e~~=:~~:::~ry b:!~:!~



t!:ccti~n o;:~•



ca1:\1a~::~~ :i:ie~


a particula . ouncil de ·d .u.ues that an _ _ _ _ _ _ _ _ ____:__:_::~r~n:a~ti:o:n~WI~ -n~~~e 1cnt1cal • • c1 es on a vast Y country on a random! array of iSSues, so thecould NBI y selected issue.

The distribution of power among EU members


3.4.3 Power shifts from Brexit When the UK leaves, the power shares of all remaining nations will change since both the population-shares and the member-shares will change for everyone. One very useful application of our q,uantitative power measure concerns the impact of Brexit on the distribution of power of the remaining 27 members. We start with the distribution of power in the EU28 under the Lisbon Treaty's double majority rule for QMV, using the NBI to measure the shares of power held by each member. Figure 3.5 shows the NBI and compares it to the population shares of members. What the figure shows is that, as mentioned above, the power share of members is something like a blend of the population share and the member share, which is the same for all members. This makes a lot of sense intuitively. For share members whose population shares are negligible, the double majority system is basically a single majority system where only the member share vote matters. The power shares for all the small countries are thus q,uite similar and range between 2 and 3 per cent. That is, below the membership sh~re (3.6 per cent for everyone). For the big nations, the main determinant of their power is _t~e populatio~ share, so the NBI power share rises steeply along with their population share, but of course it 1s below therr population share since the number-of-members threshold also matters.

Figure 3.5 Power shares of EU28 and changes from Brexit. Power index versus population shares 20% ■

NBI power share ■ Brexit impact






UJ _j N :::> I- UJ I- I_j Q _Jz ro UJ U IO.. Vl ~ oo O VlI-_J_j a.. 0::: . . b Treaty are identical to those in the rejected onsUtution. Note: The Council voting rules m th e Lis on Source: Based on data from E urostat , and Kirsch (2016).





~ I- Vl

u.. ::, -



t!:: >- :::>


th uestion- How will Brexit affect the power distribution in the Figure 3.5 also shows the ans~er to el Cl; and ;ery simple. The UK's power share, which was about er is very c ear G Council of Ministers? The answ less evenly among all the large members, namely ermany, . di t 'buted more or . . . . ·t· . 8 per cent in the EU28 will be s n . t the other members is negligible. It 1s slightly pos1 1ve m 11 . d The impac on a . France, Italy, Spam and Polan · . . the tiny and minuscule nat10ns . . htl negative m the small nations, and sllg Y

CHAPTER 3 Decision making


. EU decision making

so much national sovereignty been in . . Nowhere else in the world has . death and destruction from • organization. . d t the massive . . The EU 1s a truly uruq,ue . al bod . As Chapter 1 pomte ou .' sfer but the continual wilhngness of transferred to a_ supranat10:e EU'syfounders to contemplate this tran m;re practical considerations. One two world wars is wt_hat 1;~~opeans to accept it depends upon_ mucrthant consideration is the democratic the current genera ion ults but another 1mpo . 1s . the EU's a b'lity , 1 to deliver res considerat10n legitimacy of the EU's decision-making process.

3.5 Leg1t1macy .



3.5.1 Thinking about democratic legitimacy

. . . . ult estion so it helps to start with an ·t· t ? This is a diffic q,u . . . t Alm What makes a decision-making system 1egi ima e · . b t why it seems illegitrma e. ost thin nd extreme and obviously illegitimate voting scheme a to k a ;{u landowning males the right to vote. 0 every European would view as illegitimate a system that allo_wed 1Jd wru·ng men were forward looking, • d· · t And if the 1an o Why? Because those without votes would fm it u~JUS · . . ht one da!J lose their land. In short, they would also find it illegitimate since they or their male offspring mi~ h , rule A system is legitimate a good way to think about legitimacy is to apply the 'in the other pe~son s s o~s · which if !JOU think if all individuals would be happy with any other individual's allocation of voting powe~, . ' .. • hus a very natural legitimac9 prmc1p1e. . about it req,uires eq,uality. Eq,ual power per c1t1zen 1st . ' But what constitutes a citizen? In the EU there are two answers.. nati' ons an d people · The EU. 1s a uruon of states so each state is a citizen and should thus have eq,ual voting power. The EU is also a urnon of people, so pe~ple are citizens and so each person should have eq,ual voting power. This makes it impo~sible to ap?ly the eq,uality principle in a simple manner. Note that there is a more classical way to phrase this same po~t. Democracy, it has been said, is the tyranny of the majority. To avoid this tyrannical aspect, democracies must have mechanisms that protect the rights and wishes of minorities. Indeed, many nations provide mechanisms for giving disadvantaged groups larger than proportional shares of power, but the starting point for such departures is one vote per person. In the EU, the over-weighting of small nations' votes was one such mechanism. For example, eq,uality of power per person would grant Germany 2,000 per cent more power than Ireland; eq,uality per member would grant Luxembourgers 160 times more power per person than Germans. Given the dual-union nature of the EU, neither extreme is legitimate. Using the NBI described above, we have a very precise (albeit crude) measure of 'power per person' and 'power per nation'. The 'fair' power distribution for the union-of-states view is trivial; in the EU28, each member should get 1128th of the power. For the union-of-people view, power should be distributed such that each EU citizen has eq,ual power regardless of nationality. As it turns out the Lisbon Treaty's double majority voting rules achieve a very _nic_e b~lance between the union of states ~nd union of peoples perspective. As noted above, the po':er distnbut10n as measured by the NBI is in between members' population shares and their membership shares. This does not let us concl~de that EU ~ecision ma~ing is legitimate, but at least it shows that it seems reasonable from the perspective of the EU s goal of bemg a union of people and nations.

3.6 Summary Just to continue to _o?erate, the EU mu~t make a steady stream of decisions to adjust to the ever-changing economic and pohtical landscape. This chapter looked at the EU d cision-making process from two perspectives. First, it considered the EU's current allotment of 'compet nc s' between the EU and national government levels. In terms of actual practices and principl s, th k y points were: • Polic9 making is categorized into areas in which th EU has ' xclusive competence', that is, where the decision is made only at the EU level; areas in which competence is shared· areas in which the EU can undertake supporting, coordinating or complementary actions; and area; in which the EU has no competence, that is, where decisions are made only at the national or subnational level. • The allocation of policy areas to these categories is determined by the Treaties and, when necessary, by decision of the European Court. This allocation, however, is blurred since the Treaties do not always refer to specific fields. Sometimes they refer only to areas by fw1ctional description, f_o_r_ _ __

Self-assessment questions


exa~pl_e the inten:ial market, which themselves are only vaguely defined ( or at least vague from a legalisti_c pe~spective). To clarify the allocation, the EU operates on the principle of subsidiarity and proportwnality, which says that unless there is a good reason for allocating a task to the EU level, all tasks shoul~ ~e allocated to national or subnational governments, and even then the EU should take o~y the nummum necessary action. The old three-pillar structure of the EU helped to clarify the allocat~on; ~am~ly, first-pillar (Community pillar) issues were under EU competences while secondand ~hird-pillar_ issues were not. The Lisbon Treaty removed the pillars, but essentially merged the old frr st a nd third pillar into one supranational area while keeping the old second pillar (foreign and defence policy) as intergovernmental. The chapter also presented a framework for thinking about how tasks should be allocated between various levels of government (theory of fiscal federalism). This framework stresses four trade-offs that suggest whether or not a particular decision should be centralized:

1 Diversity and information costs favour decentralized decision making 2 Scale economies favour centralization

3 Democracy-as-a-control-device favours decentralization 4 Jurisdictional competition favours decentralization. The second part of the chapter considered the EU decision-making process in more detail, focusing on efficiency (i.e. the EU's ability to act), national power shares and democratic legitimacy. These three concepts are inherently vague, but the chapter assumes a series of simplifications that enable us to present precise measures of all three. Of course, the necessary simplifications mean that the resulting measures provide only shallow indications of efficiency, power and legitimacy; however, they do at least provide a concrete departure point for further discussion. These measures were:

• Efficiency. We measured efficiency using 'passage probability', that is, the likelihood that a randomly selected issue would win a 'yes' vote in the Council. We showed that enlargement has continually lowered the EU's passage probability, but that the 2004 enlargement lowered it by a large and unprecedented amount. We also saw that the voting reforms established in the Lisbon Treaty help restore efficiency. • National power distributions. This section presents a ~?phisticate~ measure of power called the Normalized Banzhaf Index, which measures the probability that a given nation will find itself in a . . w h ere b y 1·t can break a winning coalition. pos1t10n . . This is by far the vaguest of the three concepts. The approach we adopt is to check • L egitimacy. U' c ·11· · · cation of votes in the E s ounc1 mes up agamst two notions of legitimacy. If the w h et. h er. th e da llo uru·on-of-people a natural yar ds t·1ck 1s · eq,ua1 power per citizen. ·· If the EU is viewed , Eu 1s v1ewe as a . f t t the natural metric is eq,ual power per Member State. Under the principl of eq,ual as a urnon-o -s a es, . . . ., ·t· the mathematics of votmg tells us that this req,urres that the Cmmc1l votes per power per Eu c1 1zen, , . . . h th nuare root of the country s populat10n. The benchmark of eq,ual power per EU country nse wit e s'-1, . . enual number of votes per nat10n. Member State req,urres an '-1,

Self-assessment questions d by the theory of fiscal federalism. Discuss how the tension st List the main trade-?ffs ress; diversity can explain the fact that the EU has adopted only very between negative spillovers an . . . . . f of social policies. hm1ted harmornza ion d for the past couple of decades has been to decentralize tren 1 . 2 In many European n ations ' the . el to the provincial or regional level. How could you exp am . . . f the nat10na11ev dec1s1on makmg rom f fiscal federalism? this trend in terms of the th eory 0

CHAPTER 3 Decision making

. . coalitions that you might ·1 otes in the Lisbon Treaty, list five blocking 3 Using the actual Counci v h voter has an eq,ual 'lik 1 ' s that eac think of as e Y. di cussed in the chapter assume t of the various voters 4 The formal power meas~re ' so' on a random issue, and that the vorti~s ular issue is unrelated bilit of saying 'yes or n A 'nes' on a pa c will proba Y . th likelihood that voter says ~ f a group of voters . are uncorrelated. That is,, e, However in many situations, the votes o ·milar views on issues to whether voter B says yes . ' bers are all likely to have si . . .on of be correlated. For example, po~r EU; e ; t how this correlation changes the di~~nb)utiT be concerning spending in poor regions. or ~u can break a winning coaliti~n ·. o power ( defined as the likelihood that a particular vote~ E) each has 20 votes, the maJonty rule concrete assume that there are five voters (A, B, C, D an ' is 51 per ~ent and A and B always vote the same way. person) try to determine . th text ( eq,ual power per ' d 5 Using the definition of legitimacy propose d m e h two houses: the Senate an


whether the US Congress is 'legitimate'. Note that the US Congr~ss the House of Representatives. In the Senate, each of the 50 states .as of Representatives per state is proportional to the state's population.

Senators while the number '

References and further reading References . . . . i hts Baldwin R. and M. Widgren (2007) 'Pandora's (ballot) box', CEPR Policy Insight No.4, g · Bolkest~in, F. (2004) 'UK in dock after booze-cruise blitz', Borchardt, K.-D. (2010) The ABC of European Union Law. Download from legislation/pd£/oa8 l 0714 7_en. pdf. Felsenthal, D. and M. Machover (2001) Enlargement of the EU and Weighted Voting in the Council. LSE eBook on uk. House of Commons (2002) 'Crossborder shopping and smuggling'. House of Commons Library, Research Paper 02/40, London. Kirsch,

w. (2016) 'Brexit and the distribution of power in the Council of Ministers', CEPS Commentary, 25 November.

Further reading: the aficionado's corner Baldwin, R. (2007) 'Stranger than fiction: The voting rules in the Reform Treaty are a victory for Poland',, 24 June 2007.

u. and C. Hantke (1997) 'The power distribution in decision making among EU Member States', European Journal of Political Economy, 13, 171-85.


Kauppi, H. and M. Widgren (2004) 'What determines EU decision making? Needs, power or both?', Economic Policy, 19(39), 221-26.

More wide-ranging introductions to fiscal federalism applied to the European Union can be found in: Berglof, E., B. Eichengreen, G. Roland et al. (2003) Built to Last: A Political Architecture for Europe, CEPR Monitoring European Integration 12, CEPR, London. Dewatripont, M., F. Giavazzi, J. von Hagen et al. (1995) Flexible Integration: Towards a More Effective and Democratic Europe, CEPR Monitoring European Integration 6, CEPR, London. The latter includes a general discussion that applies the theory to the Constitutional Treaty.

For an opinionated view on what decisions should be allocated to the EU, see: Alesina, A. and R. Wacziarg (1999) Is Europe Going too Far?, Carnegie-Rochester Conference on Public Policy. Although this contains several factual errors concerning EU law and policies, it provides a highly cogent application of the theory of fiscal federalism to decision making in the EU.

References and further reading

To learn more about formal measures of power and lemt ·m . t,A 1 acy, see. th nd Felsen al, D. a M. Machover (2001) Enlargement of the EU and Weighted Voting in the Council, For historical power distributions, see: nd Laruelle, A. a M. Widgren (1998) 'Is the allocation of voting power among EU Member States fair?' Public Choice 94, 317-39. ' ' See also:

Baldwin, R. (1994) Towards an Integrated Europe, CEPR, London. Baldwn_i, R_-, E. Berglof, F. Giavazzi and M. Widgren (2001) Nice Try: Should the Treaty of Nice be Ratified?, CEPR Momtonng European Integration 11, CEPR, London. Begg, D., C. Wyplosz, A.J. Venables et al. (1993) Making Sense of Subsidiarity: How Much Centralization for Europe? CEPR Monitoring European Integration 4, CEPR, London. Peet, J. and K. Ussher (1999) The EU Budget: An Agenda for Reform?, CEPR Working Paper, February.

Useful websites Extensive explanation and use of formal voting measures can be found on the 'European Voting Games' website: http:// ~mbilbao/eugames.htm. You can find software for calculating voting power indices at:


The Microeconomics of European Integration Chapter 04 Chapter 05 Chapter 06 Chapter 07 Chapter 08

Essential microeconomic tools and tariff analysis The essential economics of prefer ntial liberalization Market size and scale eft t Growth effects and fa tor mark t integration Economi int grati n hbour markets and migration

97 119 143 159 177


4 Essential microeconomic tools and tariff analysis Chapter Contents 4 .1 4.2 4.3 4.4 4.5 4.6 4.7

Preliminaries I: supply and demand diagrams Preliminaries II: introduction to open-economy supply and demand analysis MFN tariff analysis GVC analysis Types of protection: an economic classification Sources of competitiveness differences Summary

98 101 105 109 110 113 116

. 1

CHAPTER 4 Essential microeconom1c too s a

nd tariff analysis

Introduction . tudy of European economic integration This chapter presents the tools that we shall nee d w hen we begin ours ·es of assumptions that greatlY re duce the in the next chapter. The tools are simple b ecaus e we make a sen complexity of economic interactions. h b haviour of firms. In particular, all firms are The primary sin1plification in this chapter concerns t eh e f' s take as given the prices they observe · · ', tha t is, · we assume t at rrm assumed to be 'perfectly competitive . pact on prices and t h at th ey could sell th th in the market. Firms, in other words, believe at ey have _nok_IID bout this assumption is to view each · A g ood way of thin. mg aton market prices. This • is · o b v10uslu · as much as they want at the market pnce. a firm as so small that it believes that its choice of outp~t has no imDpa~ h producer of Lego toys or the Dutch . d frrms - the ams very rough approximation since even me dium-size ll i·s related to the price they charge. . th brewer of Heineken, for example - reahze that e am ount. they can . ulse scale economies. Scale economies The second key simplification concerns technology, m partic ar e uru·ts Almost every industrn f m produces mor · . ~ 11 11 refer to the way that per unit cost (average cost) fa s a~ a em (in Chapter 6) will be important, but a is subject to some sort of falling average cost, so considermg ~h . lif' t' on in turn allows us to master great deal of simplification can be gained by ignoring them. This simp ica i ' ' the essentials before adding in more complexity in subseq,uent chapters.


4.1 Preliminaries I: supply and demand diagrams


· · is · ma d e c1ear er with the help of a srrnple uet Assessing many economic aspects of European mtegrat10n . flexible diagram with which to determine the price and volume of imports, as_well as the level ?f dom~~c consumption and production. The diagram we use - the 'import supply and rrnp_ort_ demand ~agram ~ 18 based on straightforward supply and demand analysis. But to begin from the begmrnng, we q,mckly review where demand and supply curves come from. Note that this section assumes that readers have had some exposure to supply and demand analysis; our treatment is intended as a review rather than an introduction. Readers who find it too brief should consult an introductory economics textbook. Well-prepared readers may want to skip this section, moving straight on to Section 4.2.

4.1.1 Demand curves and marginal utility A demand curve shows how much consumers would buy of a particular good at anu particular price. Generally speaking, consumers strive to spend their money in a way that makes them better off. Their demand curve is thus based on some sort of economic calculation. To see this, the left-hand panel of Figure 4.1 plots the 'marginal utilitu' curve for a typical consumer. But what do 'utility' and 'marginal' mean in this context? Utility means nothing more and nothing less than 'happiness', and we measured the happiness in euros. Money sounds like a shallow measure of happiness, but we are talking about the happiness people get from consuming goods, like a cappuccino or a bottle of fresh-sq,ueezed orange juice. For such things, we are weighing the cost of buuing the thing versus the money we have to give up to get it, so the money is a natural - if not perfect - measure of the happiness the good gives us. The word 'marginal' is here used to mean nothing more and nothing less than 'one more'. Putting together, 'marginal utility' means the money-value of consuming one mor cappuccino. For example, if we are considering the demand for cups of coffee, the marginal utility curve shows how much extra joy a consumer gets from having one more cup starting from any given number of cups already consumed. Typically the extra joy from an extra cup falls with th number of cups bought per day . For example, if the consumer buys very few cups of coffee today, say c' in the diagram, the gain from buying an extra one is likely to be pretty high, for example mu' in the diagram. If, however, the consumer has already bought lots of cups already, then the gain from one more is likely to be much lower. This is shown by the pair, c" and mu". This marginal utility curve allows us to work out how much the consumer would buy at any given price. Suppose the consumer could buy as many cups as she likes at the price p*. How many would she buy? If the consumer is wise, and we assume she is, she will buy cups of coffee up to the point where the last one bought is just barely worth the price.

Preliminaries I: supply and demand diagrams

Figure 4.1 Optimization and demand and supply curves Price

Price Marginal cost

Marginal utility

c' c*c"


q' q* q"


In the diagram, this level of purchase is given by c* since the extra benefit (marginal utility) from buying an extra cup exceeds the cost of doing so (the price) for all levels of purchase up to c*. At this point, the consumer finds that additional cups would not be worth the price. For example, the marginal utility from buying c* plus one cups of coffee would be below p *. This is the demand curve for one indiv~~ua!. ~en we ~ant to_~now how many cups will be bought in a particular market, we add all consumers mdiv1dual margmal utihty curves horizontally . This is obvious once you think about it. If the price is p* and there are 100 identical consumers, market demand will be 100 times c*. And a similar calculation holds for all prices. In particular, at pm, no one will buy coffee so individual and group demand is zero. ' A key point to retain from this is that the price that consumers face reflects the marginal utility of consuming a little more.

4.1.2 Supply curves and marginal costs


Derivation of the supply curve follows a similar logic, but h~re the optimization is done by firms. The righthand panel of Figure 4.1 shows the 'marginal co st ' curve facmg a typical firm ( assume they are all identical for the sake of simplicity). As before, marginal m~ans 'one more' and 'cost' means co t. Thus marginal cost is the extra cost involved in making one more umt of the good. While the marginal cost of production in the real wo~ld often declii~es with th scale of production, allowing for this inv olves consideration of scale econonues_ and t~ s , m turn, introduce a whole range of complicating factors that would merely clutter th~ analysis. at tlus stage. T_o keep it simple, we assume that firms are operating at a point where the margm~l cosl 1s up~ard slopmg; tl1at is, that the cost of producing an extra unit rises as the total number of u~11ts produced nses._The curve in the diagram shows, for exa 1 th t •t t m e' to produce one more umt when the product10n level ( e.g. the number of cups mp e, a 1 cos s ,, f d · · · · · of coffee per day) is q,'. This is less than the cost, m e , o pro ucmg an extra urut when the firm 1s producmg r,11 . 't. uruts per year. . . . · t h"1s curve we can determine the firm's supply behav10ur. Presummg that the firm to. make Usmg . . . wants . the m t "bl f m selling coffee ( or as econormsts put 1t, they want to max1m1ze profit), the os money poss1 e t roth point where the margma . 1 cost JUS . t eq,ua1s th e pnce. . w·1th a Iitt1e refl ect10n, . fi-rn-. •n WI supply goods up o e -