European Union

This chapter will focus upon the European Union (EU).  The UK joined the EU in 1973 and since then it has seen the level of integration between member states grow.



In 1950, Robert Schuman, the French foreign minister, proposed integrating the coal and steel industries of Western Europe. And in 1951, the European Coal and Steel Community (ECSC) was formed. Originally this consisted of six members: Belgium, West Germany, Luxembourg, France, Italy and the Netherlands.

In 1957 the ECSC had been so successful the member countries wanted to join together other aspects of their economy.  In 1957 they signed the Treaties of Rome; this created the European Economic Community (EEC).  The six member states set about removing trade barriers to create a common market between them.  This involved the setting up of joint external tariffs and a common trade policy.


The term European Union was not introduced until November 1993, it came into being with the signing of the Maastricht Treaty.  The Treaty established new areas of European co-operation in foreign and security policy, and justice and home affairs.  It also set out a timetable for the economic and monetary union and the introduction of a single currency.


Further changes were introduced by the Treaty of Amsterdam in 1999.  This increased the powers of the European Parliament and increased cooperation in foreign policy and home affairs.


Structure of the EU

The European Council

The European Council is the most important political body of the European Union; its meetings are often referred to as a European Summit.  It is made up from the head of government from each of the Union’s member states plus the President of the European Commission.  The summit meetings are chaired by the member state which has the Presidency of the Council of the European Union (this is rotated every six months).


The Council has no formal powers, but it deals with major issues and any decisions made will define future agendas and debate.


The European Council of Ministers

The European Council of Ministers, otherwise known as the Council of the European Union, is made up from one minister from each member state.  The country holding the Presidency of the EU has the responsibility to set the agenda.  It is the more powerful of the two legislative chambers, the other one is the European Parliament.


The government minister attending the council will depend upon the topic being discussed, for example, finance ministers (the Chancellor of the Exchequer in the UK) would attend a discussion about the role of the European Central Bank and the credit crunch and agriculture ministers would attend a meeting about the Common Agricultural Policy.


The European Parliament

The European Parliament is composed of 785 MEPs who are directly elected by the 342 million voters in the member states every five years.  The number of seats that each country has is based upon the size of its population.

The European Commission

The European Commission is responsible for proposing legislation, implementing decisions, upholding the EU’s treaties and the general day-to-day running.  All new legislation starts life as a proposal by the Commission before being passed onto the other bodies to be passed into law.


The Commission is made up from 27 Commissioners; there is one per state although they do not represent their country in the Commission.  The President of the Commission delegates positions to the Commissioners once they have been nominated.


The European Central Bank

The European Central Bank (ECB) is the central bank responsible for monetary policy in the 16 member States of the Eurozone.  It was established in 1998, but it did not become fully operational until the euro came into existence on 1st January 1999.  It is based in Frankfurt, Germany.


The Governing Council of the ECB set maintaining price stability within the Eurozone as the primary objective of the ECB.  They defined price stability as inflation, using the Harmonised Index of Consumer Prices, of below, but close to, 2%.  There are no other economic objectives of the ECB.

What are the secondary objectives of the Bank of England?




The main functions of the ECB, in addition to maintaining price stability, are:

  • To define and implement monetary policy for the Eurozone through the setting of interest rates.
  • Support the economic policies of the Eurozone members.
  • Conduct foreign exchange operations in euro.
  • Issuing euro bank notes.
  • Ensure smooth operation of the banking system.


The ECB is modelled upon the German Bundesbank, which had an excellent record on combating inflation.  It has independence from member countries and EU institutions.  It is given a separate budget from the member countries’ central banks.


The Governing Council is the main decision-making body of the ECB.  It is made up of the six members of the Executive Board and the governors of the national central banks of the 16 euro area countries.  It is responsible for formulating monetary policy for the euro area.  This includes decisions relating to monetary objectives, key interest rates, the supply of reserves in the Eurosystem and the establishment of guidelines for the implementation of those decisions.


The Governing Council usually meets twice a month in Frankfurt.  At the first meeting each month, the Governing Council assesses economic and monetary developments and makes its monthly monetary policy decision.  At its second meeting, the Council discusses issues related to other tasks and responsibilities of the ECB.  The minutes of these meetings are not published, but the monetary policy decision is explained in detail at a press conference held shortly after the first meeting each month.


The Executive Board of the European Central Bank is responsible for implementing the decisions of the Governing Council.  It also prepares for the twice monthly meetings of the Governing Council.  Members of the Executive Board are nominated by agreement between the heads of government of the Eurozone countries for a non-renewable eight-year term.  The ECB’s board members do not represent a particular country, nor are they responsible for keeping track of economic conditions in one country. Instead, all board members are jointly responsible for monetary policy for the entire Euro area.  The board consists of a President, Vice-President and four members.


The Court of Justice of the European Communities

European Court of Justice (ECJ) is the highest court of the EU.  It has the final say on matters of EU law in order to ensure its equal application across all member states.


Free Trade Area to Economic Union

There are various stages of economic integration that range from a free trade area to an economic union.



Countries belonging to the free trade area are able to sell goods and services between them without restrictions.  They do not have to agree on a common set of trade policies with countries outside the free trade area.


The European Free Trade Association (EFTA) was established in 1960 as an alternative for European countries who were either unable to, or chose not to, join the then European Economic Community (EEC) (now the European Union).  The UK was a member of the EFTA, but left to join the EEC in 1973.  Today only Iceland, Norway, Switzerland, and Liechtenstein remain members of EFTA.


Other examples include North American Free Trade Area (NAFTA) between the USA, Canada and Mexico; Asia Pacific Economic Cooperation (APEC) and COMESA (Common Market for Eastern and Southern Europe).



A customs union is essentially a free trade area with a common external tariff.  The member countries set common external trade policy.  Common competition policy is a desirable, but not an essential feature of a customs union.  Countries will want to move to a customs union from a free trade area if they share a desire to establish closer political and cultural ties.


The European Economic Area is an example of a customs union; it is an agreement between member states of European Free Trade Association and the member states of the European Union.  It allows the EFTA countries to participate in the Single European Market without joining the EU.



A common market is a customs union that also has the free movement of factors of production within it.

What are the four factors of production?



This means that workers are just as able to get a job in their own country as another member of the common market.  Mercosur is an example of a common market made up from a number of South American nations.



This is a common market where the level of integration is more developed.  The member states may adopt common economic policies, for example, the Economic and Monetary Union and Common Agricultural Policy of the European Union.  Greater political ties will signify further integration between nations in the economic union.  The European Union is an example of an economic union.


Single European Market (SEM)

The single market was introduced with Maastricht Treaty in 1992; it removed the barriers to the movement of people, goods, capital and services.


There are a number of benefits of the single European market:

  • Firms are able to achieve greater economies of scale.

What will happen to a firm’s average costs if it is able to achieve greater economies of scale?



What is a possible impact upon consumers?



  • It is made cross border mergers and takeovers easier.
  • Firms will be forced to become more competitive as they are exposed to more competition.

How should this impact consumers?



  • An increase in foreign direct investment should take place by firms wanting to produce within the single European market.
  • Individuals have the right to work, study or retire in any of the member countries.
  • A decrease in red tape for businesses that wish to export to other countries in the single market.
  • It should reduce price differentials.


There are also a number of disadvantages of the single European market:

  • The increased competition may lead to some firms not being able to compete and there will be job losses.
  • Some markets have not been completely opened up, for example, gas and electricity supply.
  • Differences in taxation laws can still make trade with and working abroad somewhat complicated.
  • There are still significant differences in prices between countries in the single market.



Trade Creation and Trade Diversion

These are concepts that explain the economic effects of moving into a customs union where trade barriers are removed.



This occurs when consumption shifts from a high cost producer to a low cost producer.  In the example below, we assume that France is the most efficient producer of wine.  France is willing to supply all of its wine at SFrance.  The UK imposes a tariff on all imports of wine from France.


What quantity is supplied by UK suppliers when the tariff is in place?



What quantity is supplied by French suppliers when the tariff is in place?



After joining the EU it is now possible to import wine from France without paying the tariff.

What has happened to the price of wine after the tariff is removed?



What quantity is supplied by UK suppliers after the tariff has been removed?



What quantity is supplied by French suppliers after the tariff has been removed?



What has happened to the quantity sold by the high cost UK supplier after the tariff is removed?



What has happened to the quantity sold by the low cost French supplier after the tariff is removed?



This movement from the high cost supplier to the low cost supplier is trade creation, it can be highlighted on the diagram below.


There has been an increase in consumer surplus of areas 1 + 2 + 3 + 4.  On the other hand there has been a reduction in the producer surplus for UK wine producers of area 1 and a loss in government tariff revenues of area 3.  This means there will always be a net gain of 2 + 4 when trade creation occurs as a result of a country joining a trading bloc.



This occurs when consumption shifts from a lower cost producer outside the trading bloc a higher cost one within it.


Assume the most efficient producer of lamb in the world is New Zealand.  Before joining a customs union the UK will place an identical tariff on lamb imported from any country, this is shown on the diagram below.


At an equilibrium price of PNZ+t UK producers would supply up to Q3 and New Zealand would supply Q3 to Q4.


After joining the EU the tariff on French lamb will be removed.  This reduces the price from PNZ+t to PFrance.  Trade diversion now takes place as consumption switches from the low cost New Zealand farmers to the higher cost French farmers.

Why is the price of French lamb cheaper than New Zealand’s if the French are a higher cost producer?



UK producers would supply up to Q1 and France would supply Q1 to Q2.


This will lead to a reduction in worldwide efficiency.  As far as the UK is concerned there will be gains and losses in welfare.


There will be a gain in consumer surplus, however the will be a fall in producer surplus and government revenue from the tariff.


On the diagram below it is possible to highlight the gains and losses in welfare:

  • There has been an increase in consumer surplus of areas 1 + 2 + 3 + 4.
  • There has been a reduction in the producer surplus of UK lamb producers of area 1.
  • There will be a loss of government tariff revenue of 3 + 5.


The will be a net loss in UK welfare if 2 + 4 < 5.  It is possible that trade diversion will lead to an increase in UK welfare if 2 + 4 > 5, this is shown below.  Whether there is a net loss or net gain will depend upon how the elasticity of domestic demand and the size of the initial tariff.


EU enlargement

The table below shows a timeline for countries applying and then joining the EU.  There are presently 27 nations who make up the EU.



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