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THE THEORY OF COMMON MARKET. Common Market Common Market = CU + integration of factor markets (capital and labor) Basic Concern: Additional benefits that.

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Presentation on theme: "THE THEORY OF COMMON MARKET. Common Market Common Market = CU + integration of factor markets (capital and labor) Basic Concern: Additional benefits that."— Presentation transcript:

1 THE THEORY OF COMMON MARKET

2 Common Market Common Market = CU + integration of factor markets (capital and labor) Basic Concern: Additional benefits that can be derived by going beyond a CU Trade and factor mobility are sometimes substitutes for each other. In such a case allowing free factor mobility will reduce the trade creation/diversion effects of integration.

3 Common Market Assume that foreign investment has occurred in H, from outside the area prior to the formation of the CU, but that no capital movement among countries occurs as a result of integration. Then, the gains to H from the CU may be greater or smaller depending on whether foreign capital is invested in Hs import-competing industries or in its export industries.

4 Common Market If the high cost firm in H is foreign-owned and following the formation of the CU, production is transferred to a locally-owned company in P, the fall in production in H will be a loss to the foreign company, not to domestic producers foreign profit diversion Gain from the formation of the CU will be greater than in the basic case

5 Common Market If H is an exporter of a product, and assume that foreign capital is invested in the export industry. After formation of the CU, the demand for the firms product will increase foreign profit creation A national loss for the CU

6 Reasons for the establishment of multinationals Three possible strategies open to firms: Produce at home and export Produce at home and sell licenses to allow the production of the good abroad by other companies Establish subsidiaries and produce abroad

7 Reasons for the establishment of multinationals The choice among these strategies depends on the balance among three types of advantages: Ownership-specific advantages: Anything which gives the firm a quasi-monopolistic position in foreign markets; a patent, technical know-how, marketing knowledge, economies of scale Internalization advantages: Gains from making use with the firm of the ownership-specific advantages. Firms will internalize these advantages if they believe that they can make more profit from doing so than from selling the knowledge, patents etc. to other firms. Locational advantages in the target market: The benefits from producing in a foreign market including savings on tariffs and transport costs and lower prices for some factors of production.

8 Reasons for the establishment of multinationals A firm with only ownership-specific advantages will sell licenses to produce abroad. A firm with both ownership-specific and internalization advantages is likely to produce at home and export. The additional possession of locational advantages may well cause firms to produce abroad.

9 The direction of FDI Reorganization of investment: Multinational enterprises already located within the new CU will have an incentive to reorganize their existing investments to take advantage of trade creation effects, leading to a concentration of their activities in fewer locations. Defensive import-substituting investment: Multinational companies not located within the new CU but exporting to it and thus facing losses through trade diversion or trade suppression will be tempted to invest directly within the CU to avoid the CET.

10 The direction of FDI Rationalized investment: Multinational companies not located within the new CU will invest directly within it, in order to avoid loss of markets as a result of the reduced costs of the domestic firms within the CU. Offensive import-substituting investment: Multinational corporations not previously exporting to the new customs union investing in order to take over new markets following on the market integration and the possible increased rate of economic growth within the CU.

11 Common Market: EU Experience Freedom of capital was a necessary condition for the achievement of totally integrated markets for all goods and services and also for promoting the free movement of labor across borders. It was a powerful incentive for governments to adopt macroeconomic policies conducive to price and exchange rate stability. Opening up the capital market would widen the freedom of choice for European investors and contribute to a more-efficient allocation of savings.

12 Common Market: EU Experience Mobility of Capital Treaty of Rome (1957): Article 67 Extensive liberalization took place in 1960s with direct investments, commercial credits and the acquisition of securities on the foreign stock exchanges being liberalized. 1979: UK removed all capital controls, in the following years Germany, Netherlands etc. followed. The Single European Act (1986) set the end of 1992 as the date for removal of all controls.

13 Common Market: EU Experience Mobility of Labor Treaty of Rome (1957): Objective of full mobility of labor Supplemented by rules which provide for migrants from within the EU to have the same social rights as the citizen of the host country. Labor mobility is slow ???


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