Subsidiarity and the economic Basis for integration

The roll of the Government

• Market regulation

• Macroeconomic stabilization

• Equity- redistribution

Market regulation

– The problems, which subsidiarity can solve• Provision of public goods• Reduction of negative externalities

(environment)• Contract (treaty) enforcement• Reduction of negotiation costs• Coordination problem• Insurance against asymmetric macro shocks• Economy of scale in government sector may

reduce the costs and increase efficiency• Anti monopoly regulation• Correction for the incompleteness of financial

and insurance market

– Loss from subsidiarity• Policy should be differentiated to reflect

differences in preferences• Central government may not have information

about local preferences• Central government may not have incentive to

take account of regional differences

Externalities and Coase theorem

• Coase theorem: if there are no transaction costs (including legal, strategic or informational barriers) and if property right are clearly defined, then people can always negotiate to an efficient outcome

The roll of the Government:• To allocate the property rights

– the principle of inviolability of frontiers

• To enforce contracts– International arbitrage practice– European Court of Justice (ECJ)

• To reduce negotiation and other transaction costs

A Public good is a good that can be consumed by one person without diminishing the amount the other people consume of it and from which no individual can be barred from consumption.

Nonrivalous consumption - without diminishing.

Nonexcludability- impossibility to exclude others.

Examples: Firework, legal system, defense, environment, TV programs

Free-rider problem-the ability to consume for free provides no incentives for investment

Government: collect taxes and invest

An example: International Environmental Externalities

•  Cost of high pollution –2 in each countryBenefit = profit+3 if pollution is low and +6 if high

In this matrix the dominant strategy for both countries is to have a policy of High pollution i.e. low environmental protection (Nash equilibrium). Though (Low, Low) pollution is the Pareto Optimal outcome, without co-ordination the (High, High) pollution outcome will occur. This is because the “best response” is always to choose High Pollution.

 Evaluations of this type, concerning the effects of policy competition v.s.

policy co-operation, are relevant to our analysis of microeconomic policy-making not only in relation to environmental policy but also: competition, tax and social policy.

Low pollution in B

High pollution in B

Low pollution in A

3bn

3bn

6-2=4bn

3-2=1bn

High pollution in A

3-2=1bn

6-2=4bn

6-2-2=2bn

6-2-2=2bn

Price versus quantity regulation

How to reduce waste?

• Quantity approach: to set obligation to destroy fixed amount of waste

• Price: to impose charge per unit of waste

West utilization,Water purification,Environment protection

Mon

ey

MC1MC2

Price regulation create additional incentives to invest in environment protective technologies

t

• Communication costs– time costs

• Assessing the benefits of the transaction– How much does country benefit from particular

policy implementation?

– How to share benefits?

• Enforcement costs – How to control the possible opportunistic

behavior of a partner?

Negotiation costs

Central authorities

Monopoly

A

B

C

MC

DMR

Monopolist maximizes the profit by setting MC=MR, which causes higher prices and lover quantity

• Monopolist set the lower quantity than it is in Market equilibrium The sum of consumer and producer surpluses

is smaller • Monopolist has lower incentives to

reduce the costs under-investment in research and

development

Why does monopoly exist?

Barriers to entryExogenous or non-related to activities of the firm

populated in the market• Entry costs

– it may happened that the operation of two is firm unprofitable

• Lack of skills and knowledge – which can be acquired only with experience

(learning curve effects)– Lack of Reputation

• Decreasing return to scale– natural monopoly

Endogenous • Control over the key resources or assets ( precommitment contracts)• Possible punishment through price war• Collusion weak or strong• Licenses and patents (may relate to technology)

Weak collusionCartel is unstable:

– the deviation (price reduction) may be extremely profitable

– Anti-trust regulation prohibits cartels

The forms of week collusion:– Exclusive territories

• Example: coca-cola bottlers in USA

– Exclusive dealing• Mc Donald’s

Costs: – Higher deadweight loss– Higher pricesBenefits:– Higher Investment in region specific or business

specific capital• better accounting on the particular consumer’s

tests– Lower costs related to support the cartel’s agreement

Competition policy  Strict

competition in B

Lax policy in B

 Strict competition in A

11

2-1

 Lax Policy in A.

-12

00

Structure of competition policy in the EU.

 Structure of competition policy in the EU. EU competition policy is based on articles 85 and 86 of the

Treaty of Rome (1958) and on the Merger Regulation added in 1989.

 Article 85 regulates firm conduct: It prohibits and declares

void agreements between firms which both: • affect trade between member states and • are intended to or have the effect of restricting competition

within the EC. Agreements which restrict competition but do not affect trade

between members remain the responsibility of individual member states’ competition policies.

  Article 86 regulates both firm conduct and industry

structure: It prohibits abuse of a dominant market position. 'Abuse' means any attempt to use market position to substantially reduce or eliminate competition. The idea is not to penalise firms which are dominant simply by having a better product, more efficient methods, etc.

  The Merger Regulation (1989) came into force in 1990 and

regulates industry structure. It applies to “all concentrations with a Community dimension”. Previously, the EC could only consider mergers under article 86 if one of the parties already had a dominant market position; this lead to inconsistencies. while an agreement between two firms might be prohibited under Article 85, the same result could be achieved by the two firms merging.

Provision of Public goods• Transport system

– The treaty of Parish (1951) prohibited the discrimination in transport rates.

– The treaty of Rome (1957) established common transport policy within EU.

• Anti-discrimination measures

• Liberalization measures: carriers were to be given additional opportunities to supply services across national frontiers within the EC

• Harmonization measures: weight and height of vehicles, work condition, taxation

• Coordination of transport investment

– 1975 The European Regional Development Fund was set up

– Maastricht treaty:• Introduction of majority voting

• The needs to include the measures to improve transport safety

• the integration of environmental objectives within CTP

Deregulation of transport system

Transport system were public at the beginning– Natural monopoly (decreasing return to scale)

– System was manageable

then– Technological progress created the opportunities for public

transport system

– System growth required decentralization on national level

70th-80th

National transport systems competed for international markets

– With private sector

• Established regulatory restrictions– Geographic

– Types of good

– Restriction on charge that might be levied

– Restriction on number of vehicles restriction on the transport of goods to or from other countries and on “cabotage”

– With other countries public and private sector sector

Transport: deregulationControl over haulage charges

– establishment of maximum and minimum rate of traffic between member states

– 1977 introduction of price recommendation– 1983 recommended price became the norm– 1990 All central price regulation should have ceased

Licensing , quotas and cabotage– 1968 Community Quotas System was introduced: specified number

of private vehicles– 1992 the number has been increased– 1993 CQL abolished, quality requirements were introduced– 1998 cabotage restriction should be abolished

Rail Transport– 1975 Council Decision: railway management should become more

independent of state government– 1990

• Separating the management of rail infrastructure from the management of rail service

• State has to pay for rail services• Separation of accounts and management• Free access to the use of rail system by international grouping

operating between Member states

Air transport– 1993

• Any carrier satisfying safety, financial fitness and EU nationality tests is entitled to an EU operator’s licence

• Cabotage rights established• Airlines are free to determinate passenger fares

Social Policy• The importance of social policy

– State education corrects for capital market failure (children borrow against future income)

– Health –care service corrects for adverse selection problem in the market for medical care

– Social insurance

• Social dumping– National government may weak social standard to

promote national producers• Social insurance• work-place safety • Maternity live

 

“Social Dumping Game”.

  Good social policy in B

weak social policy in B

 Good social policy in A

33

40

Weak social policy in A

04

22

Subsidiarity and tax policy

Cross border externalities in tax-setting• effects on economic behaviour in other

countries - eg giving advantages or disadvantages to production of various goods – Tax exemptions may be used to protect some

firms or industries– The emigration of educated or high–income

people from and immigration of low-income to Sweden.

• effects on the tax base in other countries - by inducing cross-border shopping or the relocation of capital– Off-sore zones – The decision of Ericsson to move head office to

London

• spill-over from the rigour or otherwise of tax enforcement

Equity redistributionDistribution effects - a force affecting efficient exchange

pertaining to who has, or gets, what recourses; can refer to a party’s ability to afford its portion of efficient allocation or to share the value created within the firm

(Ownership, profit distribution)

Examples:

• Ownership – and care on computer, car, common's land,

– press and café owners conflict over noise pollution

– co-specialized assets and takeover incentives

• Share of benefit– wage and investment in human capital

• children would get education

• worker would be healthier

• worker would have incentives to invest in firm specific capital

• lower turnover of employees would reduce transaction cost

Redistribution as Insurance implementation

Example of Adverse Selection in Health Insurance

Expected AnnualMedical

ExpenditureAngela Wilson $ 100Bruno Lopez $ 500Cindy Lo $ 900-------Average $ 500

Bruno Lopez $ 500Cindy Lo $ 900-------Average $ 700

Cindy Lo $ 900

Insurance against asymmetric shocks

How dangerous the shocks may be for the national economy ?– World became more uncertain

– Destroy financial markets

– Increase debt burden

– Loss of creditability

– Loss of competitiveness

The principle of risk sharingExample: negatively correlated risks (when one has high income the

other has low one)

1/2 1/2

0 100

100 0

after risk sharing

50 50

Application: Rural and Urban regions may pool the risks from the food price fluctuation.

Regional Policy

• Disparity is bad for growth.– poverty gap reduce the possibility of the

allocation of talent people to production resources

– Redistribution may play an insurance roll in case of asymmetric shocks.

• Redistribution of the gain of integration:– Political concern for progress in economic

integration may require measures to ensure all are gains.

• Convergence:– Economic integration may reduce disparity

because of free movement of factors and policies harmonization

• Empirical evidence confirms this

– But specialization and incomplete harmonization of the policies with free movement may increase disparity

Perfect information if every participant of the market becomes aware of every price, product specification, and buyer and seller location at no cost Imperfect information if at least on buyer or seller does

not know something

Information asymmetric if one party to the transaction has knowledge that other parties do not.

Examples :

• market for used car

– seller has more information

• market for life insurance

– insured has more information on the risks

Bounded rationality concept states that due to the cost to gathering and evaluating information, economic agents will always bear some kinds of uncertainty, since eliminating it would be prohibitively expensive

Measurement costs the cost to acquire and proceed information

Information and its cost

Decentralization

when the central authority delegates his decision rights to lower level in hierarchy– benefits:

• better information

• able to provide more effort to solve the problem

• specialization

– costs: • Coordination costs

• Incentives to deviate from efficient solution

Disadvantage of Subsidiarity

Differences between member states should be taken into account.

1. Social policy objectives.• choices about penalising smoking

2. Distributional goals.• Country may have different degree of inequality• Bolton and Roland suggests this explains the

break-up of Czechoslovakia 3. Public spending choices and therefore revenue

requirements.• Difference in climate

4. Demand conditions. • Different price and income elasticity mean the

same taxes have different efficiency and distributional properties in different countries.