The role of economic integration within the frame-

model of the competitiveness of an industry

When a country participates in economic agreements and trade blocks with other countries this is a special case of a government policy affecting an in-dustry’s competitiveness. These can include the formation of free trade agree-ments, customs unions and common markets.³⁰

The emergence of regional trade blocks, and especially the creation of the European Economic Community in 1958 and its subsequent deepening and enlargement have motivated a large amount of theoretical as well as empirical studies dealing with the economic effects of regional economic integration for participant countries as well as for the rest of the world.³¹ The creation of the Single European Market (SEM) has significantly contributed to our under-standing of the impact of economic integration on the competitiveness of econo-mic sectors. The aim of the SEM was to create a large market where firms could take advantage of economies-of-scale, grow in efficiency and gain competiti-veness vis-à-vis competitors outside the single market (Traill 1996: 63).

There is a large number of studies dealing with the potential and actual economic effects of the removal of the remaining trade barriers on trade between EU member countries (e.g. Baldwin et al. 1997; Corado, de Melo 1985 and 1986; Hine 1989; Sapir 1992; European Commission 1996).³² In the

30 A free trade agreement refers to a situation where the partners dismantle all visible barriers on trade between them, but countries continue to apply individual trade policies vis-à-vis third countries outside the free trade agreement. A customs union includes, in addition to the abolition of trade barriers between member countries, the imple-mentation of a common trade policy towards third countries. A common (single) market can be considered the highest form of trade integration, also including the abolition of

“invisible” trade barriers between member countries, which go beyond the traditional trade barriers such as tariffs and quantitative restrictions.

31 The theory of regional economic integration can be considered as developed in three separate phases. The first phase in the 1950s and 60s was based on traditional customs theory, assuming perfect competition and homogeneous goods (the main contributors:

Viner, Meade, Johnson). The second phase in the late 1970s and early 80s introduced imperfect competition, economies-of-scale and heterogeneous products into the analysis (Krugman, Dixit and Norman, Lancaster)(see e.g., Krugman 1979). The third phase (in the late 1980s) focused on the dynamics of the effects of integration on investment and growth (Romer, Lucas).

32 Trade barriers can be grouped into five categories: 1) tariffs, 2) quantitative restrictions (quotas), 3) cost-increasing barriers, 4) entry restrictions, 5) market-distorting subsidies and practices (Emerson et al. 1988: 21). Tariffs and quotas are

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following, the impact of economic integration on the competitiveness of an industry is analysed from the point of view of a small country (respectively to the situation in Estonia), which is joining a common market with, on the one hand, countries of a higher level of development (EU-15), and, on the other hand, with large countries of the same level of development (the Central and Eastern European countries, CEECs).³³

The impact of regional economic integration on the competitiveness of an industry within a country can be considered from two different aspects of integration: the abolition of trade barriers as a result of economic integration, and the implementation of common rules and policies that apply to everyone within the territory of the regional integration agreement (e.g. an industrial policy, a common trade policy towards third countries, etc.).³⁴ The former effect results in an opening up of markets in partner countries belonging to the regional agreement, but also in an opening up of the domestic market to com-petitors from partner countries. The latter, on the other hand, potentially in-cludes changes in policies directly applicable to the industry, and/or in policies that regulate the overall economy. The impact of introducing new common policies can be directly considered as a change in government policies affecting competitiveness (see sub-section 1.2.1), while the aspect of market opening via the abolition of trade barriers is a subject of the theory of regional economic integration.³⁵

Within the framework of the “filter” model of competitiveness, dismantling trade barriers implies direct changes to the “filter” while the aspect of intro-ducing new policies may result in both changes to policies that distort trade – and hence, belong under the “filter” – as well as policies that do not distort trade and impact the industry’s competitiveness via “real” determinants of compe-titiveness (see Figure 1.6).

Both of these aspects influence the environment the industry operates within directly by enhancing or impeding its costs and prices and, hence, its ability to

traditional trade barriers; while the latter three groups of barriers usually stem from government regulations and are considered invisible barriers since they do not directly restrict trade, however, hinder it with excessive and obscure requirements. Together with quotas, they constitute non-tariff barriers (NTBs).

33 Even though EU enlargement in 2004 also included Latvia, Lithuania and Slovenia, which are countries of a relatively similar size to Estonia, and Cyprus and Malta, which are relatively smaller countries, the aspect of forming an economic union with countries of similar size and level of development is not considered here. As regards Latvia and Lithuania, the accession to the EU did not result in significant changes in the trade regime vis-à-vis these countries due to the existence of the Baltic Free Trade Agreement prior to accession to the EU.

34 Hansen and Nielsen (1997) call these aspects of integration negative and positive integration, respectively.

35 Some of the most prominent works in the area of regional economic integration stem from Viner (1950), Meade (1955), Lipsey (1957), Johnson (1965), Winters (1987), Baldwin and Venables (1995), and many others.

earn, and can be considered the determinants of competitiveness external to the industry. However, the opening up of markets and changes in government policies can also influence the incentives of firms within the industry (e.g. to lower costs, to raise productivity, to innovate), and so contributing to the competitiveness of the industry. Hence, regional integration can also affect the determinants of competitiveness internal to the industry, although this effect might not occur immediately, as opposed to integration-led changes in the external determinants of competitiveness.

Figure 1.6. The main channels of the impact of regional integration on the competitive-ness of an industry within the framework of the “filter” model of competitivecompetitive-ness (author’s figure)

Note: Dashed arrows refer to an indirect effect as opposed to a direct effect.

COMPETITIVENESS

Dismantling of trade

barriers Common/new

government policies

Opening-up of markets (domestic and export markets)

Sector-specific

measures Non-specific measures

The industry’s ability to sell products on domestic

and export markets

Incentives of firms within the industry

The industry’s ability to earn

Theory of economic integration

CHANGES IN THE “FILTER”

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To summarize, accession to a regional trade block influences an industry there-fore via two channels: the direct change in the competitive environment, and the change in the incentives of firms belonging to the industry. In terms of the above-introduced “filter” model of competitiveness, this means that regional economic integration directly affects the “filter” (i.e. government policies that influence the relative price of trade) through which competitive potential will be transformed into competitiveness (performance), while it also indirectly influen-ces the competitiveness through its impact on the “real” determinants of compe-titiveness potential (see Figure 1.7). These two processes are discussed more thoroughly in the following sub-section.

Figure 1.7. Regional economic integration within the framework of the “filter” model of competitiveness (author’s figure)

COMPETITIVENESS PERFORMANCE

 Ability to earn / profitability

 Ability to sell on domestic and export markets

COMPETITIVENESS POTENTIAL

 Productivity

 Price competitiveness

 Cost competitiveness

 Technology & innovations

“REAL” FACTORS OF COMPETITIVENESS

 Firm-specific factors

 Industry factors beyond the firm level

 Factors controlled by governments (non-distorting policies)

 Quasi-controllable factors

 Uncontrollable factors

Trade-distorting

public policies

REGIONAL ECONOMIC INTEGRATION

Direct effect via price changes

Indirect effect via larger market and increased competition

1.2.2.2. The mechanism of economic integration