The Creation and Development of the European Union

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Comparative Advantages

In the early 19th century David Ricardo (1817) developed the theory of absolute and comparative advantages. A country that can produce something more efficiently than another has an absolute advantage. The comparative advantage is not as intuitive and is therefore demonstrated with an example involving England and Portugal:
Ricardo (1817) assumes that in England 100 men would be needed for a year to be able to produce a certain amount of cloth. To instead produce wine would require 120 men for a year. In Portugal the labour requirements for production of the same quantities of cloth and wine are 90 and 80 respectively. Hence, Portugal has absolute advantages for the production of both goods. Nevertheless, trade can still be beneficial since Portugal can, by focusing its production on wine, use the labour of 80 men and trade their wine output for the amount of cloth it would take 90 men’s labour to produce. England can devote the labour of a 100 men and trade their cloth output for a quantity of wine that requires 120 men’s labour. The conclusion Ricardo (1817) draws is that this trade is mutually beneficial although at a first glance Portugal would appear the best producer of both goods.
The optimal rule of specialisation is thus to specialise in the good for which the country in question is the least bad at producing; has a comparative advantage in. In an area with no tariffs or other obstacles to trade these comparative advantages can be fully utilised which would lead to a higher efficiency in production and a larger union output. According to Balassa (1962), this more efficient production would lead to a higher welfare in the union.

Welfare Effects of Economic Integration

Whether the net effect of creating a large economic unit, such as the EU, is positive or negative depends on whether the utilisation of economies of scale and comparative advantages, in the absence of tariffs, give rise to trade creation or trade diversion. Trade creation refers to the new trade that is initiated when countries become members of the same FTA or customs union. Trade diversion is referring to a case where a good that was previously imported from a certain country is, after the creation of the union, replaced with a good from another member country even though the initial good was cheaper and more efficiently produced (Viner, 1950).
Which one of these two effects that is the largest has to be calculated on a case-by-case basis. However, Balassa (1962) mentions that successive increases of the size of a customs union should at least reduce the risk of trade diversion. In addition, he summarises a few characteristics that increase the likelihood of a customs union having a positive effect on the world’s welfare. Some of the mentioned ones are; the competitive structure in the member countries, high levels of tariffs prior to the establishment of the customs union, large differences in production costs between the member countries, a large size of the union and short distances between the member countries.
Without making a thorough examination of the EU it is quite clear that at least some of these characteristics are present. For example the EU presently consists of 27 member countries (European Union, 2010d) out of the total 49 countries in Europe7 (Encyclopædia Britannica, 2010). In terms of population size the EU incorporates 495 million of the continents total 732 million inhabitants (European Union, 2010d; Nationalecyklopedin, 2010). The EU also has developed polices to enhance free competition which has resulted in bans of cartels and other uncompetitive behaviour (Molle, 2006).

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1 Introduction
1.1 Previous Research .
1.2 Disposition
2 The World Trade & the EU .
2.1 Changing Patterns in the World Trade
2.2 The Creation and Development of the European Union
2.3 Trade Agreements of the EU
3 Trade Analysis based on Economic Integration
3.1 The Levels of Economic Integration
3.2 The Positive Effects of Integration
3.3 Welfare Effects of Economic Integration
4 Trade Analysis Using the Gravity Approach
4.1 Tinbergen .
4.2 Pöyhönen
4.3 Linneman
4.4 Recent Development
4.4.1 Theoretical Foundations .
4.4.2 Econometric Specifications
5 Empirical Section
5.1 Presentation of Model and Variables
5.2 Other Assumptions and Information
5.3 Econometric model .
5.4 Descriptive Statistics .
5.5 Regression Results .
6 Analysis.
7 Conclusion
List of References