The European Economic Community has set itself the target of completing the internal market by 1992. This entails removing all hindrances to the free circulation of goods, factors of production and services within and between member countries. One visible manifestation of progress towards this goal will be the removal of frontier posts on internal boundaries. Such removal clearly has implications for international trade policy because, although a common commercial policy is a central feature of the Treaty of Rome, it is still the case that intermember trade is subject to a number of border restrictions.
This paper explores two sets of implications of completing the internal market for trade policy. First, the consequences of prohibiting members from taxing or controlling inter-member trade, and second, the potential dangers of members resorting to subsidy-based protection in the enforced absence of border measures.
Part I considers the consequences of abolishing taxes or controls levied at internal borders. Ethier and Horn have argued that in certain circumstances an imperfect customs union may be preferable to a perfect one, in which there is a common external tariff for each good and completely unfettered trade between members. If for example, starting from a perfect customs union, a small tariff is introduced on inter-member trade, both trade diversion and trade creation are reduced. Given the initial position, the marginal benefit of a unit of creation is infinitesimal because free trade has equalized the real resource cost of the marginal unit of output between any two member states. The real cost of a unit of trade diversion, on the other hand, is finite, namely the difference in supply price between the partner and the (efficient) rest of the world. Thus, taking the existence of the external tariff as given, the optimum policy will involve a reduction in both trade creation and diversion through the imposition of some impediments to internal free trade.
I argue that, interesting though Ethier and Horn's proposition is, it is not particularly relevant to the practical assessment of the effects of completing the European internal market. First, it does not quantify the optimal internal tariff, although in principle this could be done. Second, there are rather few tariff or similar fiscal barriers to intra-EC trade. Some restrictions are quantitative - for example, on the trans- shipment of third- country goods between members - while most others take the form of cost-increasing, rather than revenue-raising barriers, such as excessive customs procedures. Ethier and Horn's analysis of the welfare effects of a change in trade, measures only the difference between the utility of and the costs of a marginal unit of trade. With cost-increasing barriers, however, losses are experienced on non-marginal units of trade, which undermines the Ethier-Horn result.
Despite arguments in favour of some restrictions on internal trade, the abolition of such cost-increasing barriers is almost certain to be beneficial. It is essentially like an improvement in technology which reduces real costs.
Part I also considers the loss of two existing barriers to internal trade. First, Article 115 of the Treaty of Rome is currently used to support national trade restrictions which prevent trade deflection (whereby imports excluded from one member country enter the Community via another and then flow to the first under the provisions for free internal circulation). The most vigorous use of Article 115 is in defence of the Multi- Fibre Arrangement: the basic quantitative restrictions on imports of textiles and clothing are negotiated by the Commission, but the quotas are defined for and administered by individual nations. By allowing national governments to restrict imports from third countries, it results in identical goods being sold at very different prices in different member states. For the EC as a whole, abolishing such measures would be beneficial, just as it would be for countries which were obliged to liberalize their import regimes. However, if abolition involved increased restriction in any country, that country could lose from the process.
Most quotas covered by Article 115 are bilateral, so that if the exporting firms act in concert they can appropriate the scarcity rents arising from quotas for themselves. This changes the analysis above, for the prices paid abroad by the importers - their terms of trade - are affected by the substitution of Community measures for national ones. This, of course, is also the case with a voluntary export restraint (VER). Moreover, for a VER, Article 115 may not be necessary for this to happen, because the exporter may wish and be able to keep markets isolated voluntarily in order to practice discriminatory pricing. Such is probably the case with Japanese car exports to the major European markets.
In a simple case it is straightforward to show that the welfare gain from shifting from national to Community quotas is approximately where a and b are the slopes of the two inverse demand curves and
is the initial difference in prices between members. It is generally very difficult to estimate the extent to which national quotas induce price differences between member states. For the MFA, however, Hamilton (1987) has estimated the quota rents on Hong Kong's exports of certain types of clothing to certain EC countries. Although averaged over time and commodities the major markets appear to be roughly equally restrictive (i.e. the rents are roughly equal), the same is not true of the detailed data. By way of illustration we consider imports of jeans during the first half of 1982. Ignoring the possibility (for which there is some evidence) that French, German and UK imports from Hong Kong are not identical, I estimate that perfect mobility between the three countries involved would have raised consumer prices by about 3% and 12% in France and Germany respectively and reduced them by 19% in the UK.
The second external barrier considered in Part I is Monetary Compensatory Amounts (MCAs), which are border taxes and subsidies on agricultural trade which vary between members and over time. They too allow prices to vary between states and so involve waste. Provided their abolition is accompanied by no rise in EC agricultural prices overall, it would be generally beneficial. However, for low price countries - especially the UK - there is some danger that the beneficial effects of uniform European agricultural prices on resource allocation would be offset by increased import prices.
Part II of the paper examines the consequences of abolishing border controls on trade, but at the same time failing to control the national subsidies that may replace them. Subsidies are quite widespread at present, and at least one influential commentator - Padoa-Schioppa (1987) - has speculated that they should be subject to fewer controls in a completed internal market in order to compensate national governments for the loss of other instruments of policy. Such a view is fundamentally misguided.
The crucial dimension of the argument about subsidies in the internal market is the effect of factor mobility - especially that of highly skilled labour. Section 4 shows that for a small country, the national costs of subsidizing a sector are increased in the presence of factor mobility. The costs of subsidies arise because domestic factors of production are diverted into the subsidized industry (where they can be profitably used only with the help of subsidies), and out of other industries where they were productively employed previously. If one factor can be drawn in from abroad, the subsidized sector's ability to absorb other factors of production is enhanced, and the consequent production distortion enlarged.
Sections 5 and 6 consider the case where subsidies may be thought to be beneficial if applied at an EC level. This is the so-called rent-snatching argument in which a country may be able to earn a larger share of monopoly rents on the world market by promoting the existence of its own companies over those of companies located elsewhere. The paper makes no judgement as to whether such opportunities actually exist (the author rather doubts it), but it shows that if EC members try to snatch rents individually, they could end up in expensive subsidy wars. The paper assumes, following previous analyses, that the rents which countries wish to snatch arise from the application of the special skills embodied in scientists. In the completed internal market, there will be a single European market for scientists. If one member seeks to increase its share of world rent by promoting its own industry, this will be at the expense of industries elsewhere in the EC, which lose scientists. If the latter countries retaliate by subsidizing their own industry - as would appear rational - a subsidy war will result. This will almost inevitably lead to oversubsidization of science-based industries throughout the Community.