Measures which reduce price disparities across national frontiers in the European Community are essential in order to realize the benefits of a completed internal market in Europe, Anthony Venables told a CEPR lunchtime meeting on 7 March. Venables presented the results of new research, done jointly with Alasdair Smith, which indicated that completing the internal market would bring only modest welfare gains if it meant no more than a reduction in the costs of intra-Community trade. If such reductions were combined with the creation of an integrated European internal market, however, within which prices were equalized, this would produce welfare gains about four times larger, of between 1% and 4% of the value of consumption before the policy change. Venables concluded that EC competition policy should aim to remove sources of price differences between national markets within the Community: this would increase economic welfare far more in the long run than policies aimed only at the more obvious barriers to trade.
Anthony Venables is Roll Professor of Economic Policy at Southampton University and a CEPR Research Fellow. In his talk, he drew on joint research with Alasdair Smith, conducted for the Commission of the European Communities and reported in CEPR Discussion Paper No. 233, `Completing the Internal Market in the European Community: Some Industry Simulations'. The lunchtime meeting at which Venables spoke was one of a series on Trade Policy and the New International Economics, funded by the Ford Foundation and arising out of a research programme on `Empirical Studies of Strategic Trade Policy'.
Venables noted that the European Commission's objective of removing all artificial barriers to trade in goods within the Community by 1992 would have two effects on economic welfare. It should bring an increased degree of competition, affecting prices as well as the range of products offered to consumers; in addition, changes in the sizes of firms could lead to fuller exploitation of economies of scale in production.
In order to analyse the impact of completing the internal market, Smith and Venables developed a model of international trade which captured the possibility that firms may have increasing returns to scale, that markets are not perfectly competitive, and that there are large volumes of intra-industry trade. The model treats the world market for a product as being divided into six `countries': France, the Federal Republic of Germany, Italy, the UK, the rest of the EC, and the rest of the world. Smith and Venables applied this model to ten European industries, and then used it to simulate the effects of two different characterizations of `completion of the internal market' in Europe.
Their first simulation assumed that `completion of the internal market' means simply that the costs associated with shipping goods within the EC are reduced. Smith and Venables assumed that these cost savings would equal 2.5% of the value of trade. The model simulations revealed that such cost reductions would generate a significant increase in the volume of intra-EC trade in the model, increasing market penetration by imports from other Community members and thereby raising the degree of competition in each country's market. Consumers benefit from such increased competition, although firms' profits are reduced. As prices are now set closer to marginal costs, overall welfare (the sum of profits and consumers' surplus) is increased, although in none of the industries under study does the gain exceed 1% of consumption.
In the longer run the reduction in firms' profits may lead to restructuring and exit of firms from the industry. Remaining firms are larger, and the fuller realization of economies of scale leads to long-run gains which are larger than the short-run gains, but are still less than 2% of consumption for all industries. Smith and Venables also found that these welfare gains were larger for industries in which returns to scale were more important.
The distinction between `segmented' and `integrated' markets plays a crucial role in Smith and Venables's analysis. When firms treat different national markets as segmented, they set different prices in each market; if they treat the national markets simply as different parts of a single market, then the same price (transport costs aside) is charged in each market. The behaviour of firms can shift significantly when segmented markets become integrated: the monopoly power conferred by a large share in a firm's home market is greatly diminished if the share of the integrated international market is much smaller.
The second simulation conducted by Smith and Venables therefore took a more radical view of completion of the internal market. They assumed not only that trade costs were reduced, as in the previous case, but also that firms treated the EC as a single integrated market and set one price for the Community as a whole. This fosters competition, as the dominant position of firms in their domestic markets becomes irrelevant; it is their position in the entire EC market which is now important in determining their market power. In the short run, the combination of lower trade costs and market integration brings greater gains for consumers and greater losses for firms than was the case in the first experiment. Net welfare gains range up to 4% of base consumption. In the long run, exit of firms is required to restore industry profits to their original levels, and this brings about significant increases in firm size.
The effect of the policy is felt most strongly in industries which are highly concentrated (office machinery, artificial fibres, household appliances and motor vehicles). In these industries, where firms had significant power in the segmented national markets, the impact on welfare of the reduction in trade costs combined with the shift to integrated markets is typically (with fixed numbers of firms) four times the size of the welfare gain from the reduction in trade costs alone. In most of these industries welfare increases by between 1% and 4% of the value of aggregate consumption before the policy change. The effect on national outputs is to reinforce existing differences in trade patterns. In pharmaceuticals, for example, the UK expands and Italy contracts, while in household electrical appliances Italy expands and the UK contracts. For the EC as a whole, however, the output changes in each industry reduce the costs of production and so benefit consumers.
Venables argued that the difference between the two simulations highlighted the importance of ensuring that completion of the internal market involves not merely the removal of frontier controls, but also a more fundamental move towards integration of national markets into a single European market. Policy must be directed at reducing the extent to which firms can segment the market and thereby exploit relatively `captive' domestic consumers.