EAP MBA50 Vol.3 PDF

Economics for Managers
G.M. AGIOMIRGIANAKIS VOLUME 3
European Business
To
Myrona, Yanni and Manoli

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ECONOMICS FOR MANAGERS
European Business
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European Business
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SCHOOL OF SOCIAL SCIENCES
PROGRAM OF STUDIES
Masters in Business Administration
(MBA)
MODULE
Economics for Managers
VOLUME 3
EUROPEAN BUSINESS
PATRAS 2005
CONTENTS
Preface 14
Introduction 15
CHAPTER 1
The European business environment and the steps toward
European integration 19
The Scope of the Chapter...................................................................................................19
Learning Objectives............................................................................................................19
Key Words ...........................................................................................................................19
Introductory Comments.....................................................................................................19
1.1 The European business environment ........................................................................20
1.1.1 Definition of European business and the business environment .....................20
1.1.2 Political .................................................................................................................21
1.1.3 Economic ..............................................................................................................21
1.1.4 Social .....................................................................................................................22
1.1.5 Technological .......................................................................................................22
1.1.6 Legal ......................................................................................................................23
1.2 Setting the scene for European Integration..............................................................24
1.2.1 The integration process........................................................................................24
1.2.2 The stability of the divided Europe in the aftermath of World War II ............24
1.2.3 Changing the scene...............................................................................................25
1.2.4 Economic integration...........................................................................................25
1.2.5 Global institutions................................................................................................25
1.2.6 A brief history of the European Union...............................................................29
7
Synopsis – Conclusions .....................................................................................................32
Appendix .............................................................................................................................33
Bibliography ........................................................................................................................35
Recommended Reading.....................................................................................................35
CHAPTER 2
A new Europe – the way toward the European Union 37
Key Words ...........................................................................................................................37
2.1 Toward an integrated Europe.....................................................................................39
2.1.1 A historical review................................................................................................39
2.1.2 Benelux..................................................................................................................39
2.1.3 The Council of Europe ........................................................................................39
2.1.4 The Western European Union............................................................................39
2.1.5 The European Coal and Steel Community ........................................................39
2.1.6 The Treaty of Rome .............................................................................................40
2.1.7 The Merger Treaty ...............................................................................................41
2.1.8 “Eurosclerosis” from the 1970s to mid 1980s.....................................................41
2.1.9 The Single European Act of 1987 .......................................................................41
2.1.10 The Treaty of Maastricht –The Treaty on European Union (TEU)..............41
2.1.11 The Treaty of Amsterdam .................................................................................42
2.2 The main institutional bodies in the EU ...................................................................44
2.2.1 The Council of Ministers .....................................................................................44
2.2.2 The European Council.........................................................................................44
2.2.3 The European Commission.................................................................................44
2.2.4 The Court of Justice .............................................................................................45
2.2.5 The Court of Auditors..........................................................................................45
2.2.6 ECOFIN................................................................................................................45
2.2.7 The Economic and Social Committee (ECOSOC) ...........................................45
2.2.8 The Committee of the Regions ...........................................................................46
8
2.2.9 The European Central Bank ...............................................................................46
2.2.10 The European Investment Bank .......................................................................46
2.3 EU enlargement - A historic opportunity..................................................................48
2.3.1 European enlargement – ∆he way to the future ................................................48
Appendix .............................................................................................................................51
Bibliography ........................................................................................................................53
CHAPTER 3
EU competition policy 55
Key Words ...........................................................................................................................55
3.1 Competition policy.......................................................................................................56
3.1.1 What is competition policy in the EU?...............................................................56
3.1.2 What is competition? ...........................................................................................56
3.1.3 Market structure...................................................................................................56
3.1.4 Perfect competition..............................................................................................57
3.1.5 Monopoly..............................................................................................................58
3.1.6 Oligopoly...............................................................................................................58
3.1.7 Monopolistic competition ...................................................................................58
3.2 Laws and regulations...................................................................................................60
3.2.1 The legislation ......................................................................................................60
3.2.2 The Single European Act ....................................................................................60
3.2.3 Article 85 (81): Restrictive practices...................................................................60
3.2.4 Article 86 (82): Dominant positions ...................................................................61
3.2.5 Articles 90, 92, 93: State aids ...............................................................................61
3.2.6 The new merger legislation: Regulation EC - 4064/89 ......................................62
3.2.7 Public procurement..............................................................................................63
9
Appendix .............................................................................................................................64
Bibliography ........................................................................................................................66
CHAPTER 4
EU Social Policy 67
Key Words ...........................................................................................................................67
4.1 What is EU Social Policy? ...........................................................................................68
4.1.1 The aims of EU Social Policy ..............................................................................68
4.1.2 History and development of European Union Social Policy ............................69
4.1.3 The Social Charter ...............................................................................................70
4.2 The changing nature of work ......................................................................................73
4.2.1 Declining number of workers ..............................................................................73
4.2.2 The flexible firm ...................................................................................................74
4.2.3 The Japanization of production methods...........................................................76
4.2.4 Other developments in the EU labor markets ...................................................77
4.2.5 The issue of minimum wage ................................................................................78
4.2.6 How the EU is responding to the changing nature of work ..............................80
Appendix .............................................................................................................................83
Bibliography ........................................................................................................................86
CHAPTER 5
The Single Market and the European Single Currency 87
Key Words ...........................................................................................................................87
10
5.1 The need for a Single European Market ...................................................................88
5.1.1 Inflation in Europe...............................................................................................88
5.1.2 Economic Integration in the EU.........................................................................88
5.1.3 A Single European Market (SEM): What was the need for SEM?..................89
5.1.4 The Single European Act (1987).........................................................................89
5.1.5 The Cecchini Report (1989)................................................................................90
5.2 The Economic and Monetary Union..........................................................................92
5.2.1 The European Monetary System (EMS)............................................................92
5.2.2 The Delors Report (1989) ...................................................................................92
5.2.3 The convergence criteria....................................................................................93
5.2.4 The Treaty of Maastricht (1991-1993)................................................................93
5.3 The Single European Currency (SEC) ......................................................................96
5.3.1 What is the SEC to the EU? ................................................................................96
5.3.2 Life in a single currency .......................................................................................96
5.3.3 A single currency for Europe – The case of Euroland.......................................96
5.3.4 The benefits of the euro .......................................................................................97
5.3.5 The advantages and disadvantages of the EMU operating in a single
currency ................................................................................................................97
Appendix/Answers to Activities ......................................................................................100
Appendix of macroeconomic concepts ...........................................................................102
Bibliography ......................................................................................................................112
Recommended Reading...................................................................................................112
CHAPTER 6
Foreign Direct Investment in the EU 113
The Scope of the Chapter.................................................................................................113
Learning Objectives..........................................................................................................113
Key Words .........................................................................................................................113
Introductory Comments...................................................................................................113
6.1 Multinational companies and Foreign Direct Investment ...................................114
11
6.1.1 Motives for undertaking FDI ............................................................................114
6.1.2 Alternatives to FDI ............................................................................................115
6.1.3 The growth of FDI in the EU ............................................................................116
6.2 Theories explaining FDI ...........................................................................................119
6.3 Determinants of FDI in the EU ................................................................................121
6.3.1 Labor market conditions....................................................................................121
6.3.2 Real exchange rate and its variability ...............................................................121
6.3.3 Output in the origin and the host country .......................................................122
6.3.4 Distance between the origin and the host country...........................................123
6.3.5 Cultural and language differences ....................................................................123
6.3.6 European Integration ........................................................................................123
6.3.7 Government policies ..........................................................................................123
6.3.8 The size of the parent firm.................................................................................125
6.4 The importance of FDI for the EU ...........................................................................126
6.4.1 Capital accumulation .........................................................................................126
6.4.2 Diffusion of knowledge and Research & Development (R&D) ....................126
6.4.3 Economic growth................................................................................................127
6.4.4 Unemployment...................................................................................................127
Synopsis – Conclusions ...................................................................................................129
Appendix ...........................................................................................................................130
Bibliography ......................................................................................................................134
CHAPTER 7
The case of the Central and Eastern European Countries
toward the EU and the effects of the enlargement
on the Union’s policies 135
The Scope of the Chapter.................................................................................................135
Learning Objectives..........................................................................................................135
Key Words .........................................................................................................................135
Introductory Comments...................................................................................................135
7.1 The applicant countries and their own state of reform .........................................136
12
7.1.1 A brief history of the candidate countries toward EU membership...............136
7.1.2 Central and Eastern European Countries in the 21st century........................136
7.1.3 The accession requirements ..............................................................................137
7.1.4 Smoothing the integration process ...................................................................137
7.1.5 What do the EU’s current members fear from enlargement? ........................138
7.1.6 Reforming the EU’s institutions to prepare for enlargement.........................138
7.2 The effects of the enlargement on the Unions’s policies........................................140
7.2.1 The economic impact of the enlargement ........................................................140
7.2.2 Agriculture..........................................................................................................140
7.2.3 Economic and Monetary Union........................................................................141
7.2.4 Horizontal policies .............................................................................................141
7.2.5 Sectoral policies..................................................................................................143
7.2.6 Justice and home affairs.....................................................................................144
Synopsis – Conclusions ...................................................................................................145
Appendix ...........................................................................................................................146
Bibliography ......................................................................................................................148
13
PREFACE
This Volume of HOU on European Business has been designed to provide you
with an overview of the main issues, concepts, principles and tools of analysis, of the
European Business module. As such, this Volume should be used as your main point
of reference as you begin to study the educational material of the module.
The Volume of HOU on European Business follows loosely the structure of the
Reader (Neil Harris, European Business, Macmillan, 1999). The Volume of HOU
focuses on seven main topics/chapters analyzed in more detail in the Reader, which is
organized around eleven chapters.
Quoting the definition for European business given by N. Harris (1999, p. 1),
“European business is a generic term which describes a very wide variety of
agricultural, industrial and service activities undertaken by a large number of different
organisations across the continent of Europe”. European businesses can be any small-
or medium-sized enterprise (SME) up to 250 employees, or any large one (higher than
250 employees), that operates within the European continent. This enterprise does not
have to be owned by Europeans in order to be considered as a European business. The
European business environment is affected by many interactive factors and forces such
as political, economic, social, technological, and legal ones. Of course, the foremost
factor affecting the European business environment is the process of European
Integration and thus a considerable extent of this volume will cover several aspects of it.
The present volume of HOU is intended to be an integral part of your effort to
master the principles of European business environment and the principles of the
economics of the EU. The purpose of this textbook is to help students:
ñ Effectively and systematically study the issues analyzed in more detail in the
chapters of the reader.
ñ Assess their degree of understanding of each chapter by providing self-assessment
activities at the end of each section.
ñ By equipping them with the means to analyze the European business environment
and take business decisions.
ñ Deepen their knowledge by providing recommended reading.
We hope that MBA students will find this textbook useful in follow-up case courses
as well as after graduation, when they will be called upon to apply this material in real-
life situations.
We welcome recommendations or comments about this textbook. We would like to
thank the Hellenic Open University for giving us the opportunity to produce this work.
We would like to thank Nic Potts for his help in designing and developing the
Appendix on Macroeconomic concepts in chapter 5. We would also like to thank the
reviewers, Panagiotis Liargovas, Nicholas Konidaris, Athanassios Mihiotis and Alexia
Tzortzaki, for providing helpful comments and suggestions that have significantly
improved the quality of the content.
George M. Agiomirgianakis
December 2004
14
INTRODUCTION
∆his textbook provides a solid, easy-to-read review of “European Business.” It
is intended to provide students with methods and tools used in modern European
Economics and it aims to further develop the ability of students to think critically
on issues relating to the European economic environment. The book is organized
into ten chapters.
Chapter 1 analyzes the economic environment after World War II, in which
several European countries decided to join forces to pursue economic stability,
foster economic development and increase the living standards of their citizens. It
was the continuously emerging political and economic power of the US and the
former Soviet Union that implied the need for an integrated European market to
stand up for the European countries and their economies. The need for an
integrated European Economic Environment was vital. This chapter also presents
the main global institutions and a brief history of the European Union.
In Chapter 2 we present the process of European Integration by presenting

the treaties of EU. We also present the main institutional bodies in the EU,
which are responsible for the decision-making policy and management upon an
equal basis for all parties in the EU. Finally, in Chapter 2 the enlargement of the
EU is presented on a historical basis, showing that Europe integrates the individual
power of its member states over time so as to form a competitive organization to
external markets and forces from which all parties benefit.
Chapter 3 analyses the competition policy of EU that ensures fair competition

and prevents undesirable business practices among its member states or European
firms to the benefit of European consumers.
In Chapter 4 we examine the rationale, the provisions and the history of the
European social policy that aims to develop social cohesion among European
citizens and improve European convergence. We also present the changing nature
of work and how this affects European labor markets. We then examine the efforts
of the EU to address these changing conditions in order to develop social cohesion
and form a social policy.
In Chapter 5 we present the need for a Single European Market and the
establishment of the single currency. In each case we present the relative benefits
and costs.
In Chapter 6 we examine MNCs and the FDI emanating from their activities in
establishing subsidiaries abroad. MNCs expand their activities abroad for a variety
of reasons, including the exploitation of economies of scale/scope, the use of
specific advantages, the life-cycle pattern of their products, or simply because their
competitors are engaged in similar activities. Other reasons, such as the avoidance
of tariffs and non-tariff barriers to trade; relative labor cost; real exchange volatility;
15
culture and language factors; as well as human capital; the density of infrastructure
and the agglomeration factor could also induce FDI flows into and out of a country.
In the EU the intra-FDI flows, as well as the FDI inflows from US and Japan, have
been greatly motivated by the European Integration process. The EU encourages
FDI inflows since they are considered welfare improving for the host countries.
Indeed, FDI flows are associated with a number of positive effects, such as the
diffusion of knowledge among countries by creating positive productivity spillovers
to domestic firms, as well as with a positive contribution to the economic growth of
a country, thus resulting in a reduction in the domestic unemployment of the host
country.
In Chapter 7 we present the case of the Central and Eastern European countries
and their application to join the European Union. We identify the major changes
in their traditional political and economic environments and present the concept of
their reform effort toward integration with the European Union. We also present
the effects of the enlargement on the Union’s policies and identify the need for
well-structured communication among member states to fully understand the
meaning and the importance of each and every enlargement.
At the beginning of each chapter, there is an introductory text presenting the

main issues in the chapter. Each chapter has the following structure:
ñ Chapter (Title)
ñ The Scope of the Chapter
ñ Learning Objectives
ñ Key Words
ñ Introductory Comments
ñ Self-Assessment Activities in each section of a chapter
ñ Synopsis – Conclusions
ñ Bibliography and Recommended Reading
At the end of each chapter there is an Appendix with the suggested answers to
the activities in each section.
Students may study the material in this textbook more efficiently by following
the steps below:
1. Read the introductory material at the beginning of each chapter, thus you will
have an overview of the issues to be discussed in the chapter.
2. Do the self-assessment activities at the end of each section and try to answer
them; then check the recommended answers in the appendix.
3. To gain even more understanding and deepen your knowledge of the issues
presented, read the material proposed in the recommended reading section of
each chapter.
16
4. Remember that effective and efficient reading means that you keep in close
touch with the issues studied, devoting a relatively little amount of reading time
each day rather than a huge amount of time in a relatively few days.
17
CHAPTER 1
THE EUROPEAN BUSINESS
ENVIRONMENT AND THE STEPS
TOWARD EUROPEAN
INTEGRATION
The scope of Chapter 1 is to present the European Business Environment and the The Scope
international institutions that shape it. We also present a brief history of the European of the Chapter
Union.
Having completed the study of Chapter 1, the reader will be: Learning
ñ familiar with the European environment after World Wars I and II Objectives
ñ familiar with the driving forces of European Economic Integration
ñ able to understand the role of international institutions in shaping the international
economic arena.
ñ European integration Key Words

ñ Member states
ñ Global institutions
The post-war period was characterized by the strong desire of all Europeans to Introductory
restructure the continent from the ashes of World War II. Within the post-war Comments
period, European businesses were developed in a multi-dimensional environment
characterized by political, economic, social and technological factors. This diversity
of factors has influenced the business environment and, consequently, the creation
and development of European businesses. The most prominent influence among all
other influences was and still is today the European Integration process. The
European Union (EU) is not, nor has it ever been, a static organization. Its history
has been one of change and development, apart from a brief period of the so-called
Eurosclerosis in the 1980s, as we will see in the next chapter. The pressure for the
most recent changes, which occurred in the mid and late 1990s, had its origin in the
collapse of the Soviet Empire in the late 1980s. The scale and nature of the impact of
that collapse was tÔ a great extent unexpected by the governments of the ∂U states. πt
carried with it the potential for unprecedented change. As a result, both the practice
and the theory of political and economic integration within the European Union
have changed over time.
19
1.1 THE EUROPEAN BUSINESS
ENVIRONMENT
In Section 1.1 we define the European business environment and present the factors
that may affect it, as well as their level of importance regarding the implementation of
businesses’ strategic plans.
1.1.1 Definition of European business

and the business environment
Quoting the definition for European business given by Harris (1999, p. 1),
“European business is a generic term which describes a very wide variety of
agricultural, industrial and service activities undertaken by a large number of
different organizations across the continent of Europe”. European businesses can be
any small- or medium-sized enterprise (SME) up to 250 employees or any large one
(more than 250 employees) that operates within the European continent. This
enterprise does not have to be owned by Europeans in order to be considered as a
European business. In the EU there are about 19 million SMEs representing 99.8%
of all enterprises; they have been the major job generator by providing jobs to more
than 70 million people that is about two-thirds of all EU employment, 55% of
turnover and 65-85% of the total value added.1 Moreover, SMEs contribute to regional
development, social cohesion and innovative creation. On the other hand, European
large firms are clearly necessary in order to achieve economies of scale in production,
research and marketing. The strength of these advantages has been increasing as
improved communications, deregulated capital and increasing globalization have
favored multi-national corporations. Furthermore, large-sized enterprises (LSEs), by
investing in R&D, can innovate directly and thus lead to an increase in general
economic progress. When referring to the European business environment that
surrounds European SMEs and LSEs, we mean “the conditions within which
European Business operates”.2 The European business environment is affected by
many interactive factors and forces. We may briefly distinguish them into political,
economic, social, technological, and legal ones.
1
See e.g. OECD 2000, EUROSTAT, 1999.
2
N. Harris (1999, p. 2).
20
CHAPTER 1
1.1.2 Political
The political beliefs of governments are vital for businesses to decide on whether
they should enter a particular market or not; consequently, political beliefs are
important for promoting or deterring investments. For example, the election of
Mrs. Thatcher in power in the 1980s created an environment that favored a large
inflow of foreign direct investment from Japanese multinationals such as Nissan and
Toyota. On the other hand, political instability, caused say by a civil war deters
business from investing in a politically unstable country as was the case in the former
Yugoslavia during its civil war period. Businesses tend to avoid entering into
national markets that are characterized by uncertainty or political instability since
both imply a higher business risk. Indeed, an investor undertaking an investment
project will incur a cost, mainly at the beginning of the investment, while the stream
of the project returns will be in the future. As any investment needs time in order to
give returns, the existence of political instability will expose an investment project to
uncalculated risks and uncertainties. In the European Union we have experienced
these effects of uncertainty with several Eastern European Countries that joined the
Europe Union only when their political stability was enforced.
1.1.3 Economic
Inflation and unemployment rates, exchange rates and monetary policy, are to be
considered by businesses operating in the European and global environment. All the
above affect both the producers of goods and services, as well as the potential
consumers of these goods and services. Moreover, investors consider in depth the
economic situation to be certain that the return on their investment in a particular
environment is profitable. For Europe it was very important that inflation and
exchange rates for the individual member states be at a similar level. The establishment
of the single currency and the existence of common economic policies could
guarantee an environment of stability needed for the smooth functioning of modern
businesses. However, the imposition of the euro as the single European currency,3
the exercise of monetary policy by the European Central Bank by setting interest
rates for the whole EU, as well as the common economic policies, set rules and
restrictions to European businesses that should now compete in global markets by
being more competitive on a micro level as well as making macro level adjustments,
3
The euro is the currency of twelve European Union countries: Belgium, Germany, Greece, Spain, France,
Ireland, Italy, Luxembourg, the Netherlands, Austria, Portugal and Finland. It was established on 1
January 1999 when eleven European Union countries (Greece joined the euro from January 2001, to
become the twelfth country) irrevocably established the conversion rates between their respective national
currencies and the euro and created a monetary union with a single currency, giving birth to the euro (see,
e.g., http://europa.eu.int/comm/economy_finance/euro/origins/origins_main_en.htm ).
21
such as an exchange rate devaluation and/or changing the interest rates, is not
optional for Euroland.4 Indeed, European producers should adjust their businesses
internally and externally in order to be able to compete internationally. This adjustment
for example not only requires the implementation of more advanced technology and a
better marketing strategy worldwide, but an internal adjustment that requires flexible
national European labor markets (e.g. increasing labor mobility, re-training and
increasing part time work).
1.1.4 Social
Culture, values, attitudes, morals, religious beliefs and language are social
elements that may cause problems or provide a positive impetus for European
businesses. All the social domestic features can create barriers and obstacles for
businesses to operate in domestic markets if those special characteristics are not
identified and taken into serious consideration. A product or service preference is a
matter of social culture too. Some countries are of similar social culture and some are
completely different. Indeed, it is easier for foreign businesses to enter domestic
markets with the same or similar social features as they save money and time to prepare
the domestic market and consumers. In the case of different social backgrounds,
business managers should be cautious not to insult or to mislead consumers with
regard to their religious beliefs, as that could damage their business image. Language,
religion, and traditions should be seriously considered. By 2000 there were some 13
EU official languages and some 35 territorial minority languages.5 Clearly, multilingual
persons are better equipped and more required by European businesses. Domestic
features in the EU are to be perceived and respected but a European identity for all is
promoted.
1.1.5 Technological
The entire world has gone through dramatic technological changes over the last
three decades. Those changes made information available almost to everyone in any part
of the world. Nowadays, communication is a simple matter of pressing a computer button
and the Internet is probably the biggest host environment for businesses. We consider the
fact that all businesses follow technological progress, investing large amounts in acquiring
advanced technological assets to enhance production, administration, and improve
4
Euroland refers to the twelve countries taken together that participate in the euro. It is worthwhile to note
that on 1 January 2002, around 7.8 billion euro notes and 40.4 billion euro coins, together worth _144
billion, were put into general circulation by the central banks of the twelve participating countries of the
euro area. Euro notes were distributed by bank machines and shops started to give customers change in
euro cash.
5
See N. Harris (1999, p. 10).
22
CHAPTER 1
quality of products and services. In the European business environment the majority of
businesses is of a high technological level and follows innovative practices and
techniques to remain competitive.
1.1.6 Legal
Clearly, the diversity of countries, people, religions and values in the EU would
necessarily result in a diversity in the legal systems adopted in each individual
member state. The implication of this is that the same issue could be considered
differently in different member states. However, gradually and after the Maastricht
treaty, member states have come to agree that the Union’s legislation dominates over
the legislation of a member state. So far, the EU laws are an overarching framework
that could guarantee the smooth functioning of the common policies such as the
social, competition and environmental policies. A common adjustment of all
countries entering into the EU is the adjustment they often have to make in their
legislation concerning the bureaucracy surrounding the establishment of new
businesses or the extension of an existing one. For example, in Greece a small
enterprise is required to get more than fifty certifications from several ministries and
public organizations in order to get the permission to go ahead. The so-called
problem of excessive bureaucracy (red-tape) discourages businesses from investing.
In sum, in Section 1.1 we present the European business environment and its
dimensions, i.e. political, economic, social, technological and legal.
Activity 1/Chapter 1
Explain the factors and forces shaping the European business environment.
The answer can be found in the Appendix at the end of this chapter.
23
1.2 SETTING THE SCENE FOR EUROPEAN
INTEGRATION
1.2.1 The integration process

The fall of the Berlin Wall in November 1989 signified a period of dramatic
changes for the EU. Indeed, the EU had to fulfill its commitment (made by the
original six member states) that it would support the unification of Germany, if this
ever became a possibility. German unification was vital for the progress toward
European economic and monetary union. It forced the German government’s
economic policy tÔ focus Ôn national events, because of the massive transfer of
resources needed tÔ support the economic development of the new Eastern Lander.
However, in political terms, Germany was released from many of the constraints
imposed Ôn it by the peace settlement at the end of World War II.
The process of integration within the ∂U is taking place against a background of
pressure for enlargement. This will have created a European Union of at least 25
states by the early part of the twenty-first century. The ∂U has member states whose
combined borders reach from the Arctic Circle to the Northern shores of the
Mediterranean. Following the unification of Germany and the accession of Austria,
Poland, Slovakia, Slovenia, and the Czech Republic, the ∂U today embraces areas of
Central and Eastern Europe. Much of the political controversy and lack of clarity
about the future of the European Union is the result of the fact that the EU had to
react tÔ a rapidly changing geopolitical environment, which led tÔ the Treaty on
European Union (TEU) in 1993.
1.2.2 The stability of the divided Europe

in the aftermath of World War II
By the mid 1950s, European countries had become firmly divided into two
groups. One group included the Federal Republic of Germany, the UK, France, and
Italy under the umbrella of the North Atlantic Treaty Organization (NATO). NATO
had emerged after World War II from the joining forces of the USA, Canada and
several other European countries as an organization providing security from the
Soviet Union and its allies. Another group was formed by those countries in Europe
that followed the former Soviet Union, including the former German Democratic
Republic, Bulgaria, Romania, Hungary, Poland, and Czechoslovakia under the
COMECON (the Council for Mutual Economic Assistance). The domination of
24
CHAPTER 1
these states by the Soviet Union led to strict military control to maintain the
relationship between the countries.
1.2.3 Changing the scene

The collapse of the Berlin wall and the unification of Germany, followed by the
collapse of the Soviet empire and the ending of COMECON in 1991, created new
elements in the European political and economic environment. Germany joined the
EU stronger than ever while the rest of the countries formerly under the influence of
the Soviet Union were formulating their procedures to join the EU.
1.2.4 Economic integration

The traditional view of economic integration is based Ôn the differentiation of a
number of different levels of cooperation between member states. The loosest form
is that which exists among a group of states in a free trade area. Tariffs and quotas are
eliminated Ôn trade amongst the members of the Free Trade Area, but maintained
Ôn trade with third countries. In a customs union, the barriers to trade are removed
and a common external tariff is imposed on third-country trade. The introduction of
a Common Market not only requires the unrestricted trade of goods and services, but
it also guarantees the free movement of the factors of production, i.e., labor and
capital. The next step toward economic integration is the economic and monetary
union of the member states, which requires the harmonization of national economic
policies. In the final stage of full economic integration, there is integration of
member states’ economic policies and the imposition of a single currency.
Economic integration at all levels requires a level of political integration. The
process of political integration is therefore inseparable from the process of economic
integration and still remains a major topic for the member states of the EU.
The European Union is a group of independent member states that have agreed to
a considerable pooling of their national sovereignty in order for the economic
integration to succeed. It is in the interests of the member states of the European
Union to cooperate in this way. They are a group of small- and medium-sized states
and, by becoming member states of the European Union, they have been able to
maintain a global position. European member states have benefited from the
increased levels of economic integration, and as a group are among the world’s richest
countries.
1.2.5 Global institutions

In the aftermath of World War II, the international community established several
world organizations in order to facilitate the process of economic development and
cooperation among countries. These organizations were the GATT, IMF, WB,
25
OECD; their operation affects European businesses as these organizations shape the
rules of international trade and finance economic growth internationally and thus in
Europe.
The General Agreement on Tariffs and Trade

The General Agreement on Tariffs and Trade (GATT), which is now the World
Trade Organization, emerged soon after World War II to promote international
economic cooperation on free trade – together with the so-called “Bretton Woods”
institutions now known as the World Bank and the International Monetary Fund. The
aim of GATT was to liberalize international trade by reducing governmental
interventions and restrictions on it. For this reason, GATT held rounds of talks
among countries in order to negotiate multilateral reductions in the barriers to free
trade. As a result of these negotiations, a set of rules and regulations was agreed
upon among countries, relating to employment, commodity agreements and
restrictive business practices. The result of the first round of negotiations was some
45,000 tariff concessions affecting $10 billion - or about one-fifth - of world trade.
Those tariff concessions, together with common rules and regulations, became
known as the General Agreement on Tariffs and Trade. They were put into force in
January 1948. GATT remained the only multilateral instrument governing
international trade from 1948 until the establishment of the World Trade Organization
(WTO) in April 1994. The WTO is not a simple extension of GATT; on the contrary,
it completely replaces its predecessor and has a very different character. Among the
principal differences are the following:
ñ GATT was a set of rules and regulations, an agreement, with no institutional
foundation. It functioned in the form of a small associated secretariat that was
born by the attempt to establish an International Trade Organization. On the
other hand, the WTO is a permanent institution with its own secretariat.
ñ GATT was never considered to fully apply permanent commitments. The WTO
commitments are full and permanent.
ñ GATT rules were imposed only on goods whereas the WTO applies to services as
well.
ñ The old GATT system suffered from bureaucracy in presenting and implementing
its findings. The implementation of WTO dispute findings will also be more easily
assured.
A brief history of The General Agreement on Tariffs and Trade is illustrated in
Table 1.
Table 1: GATT Rounds and their Objectives

Name Dates Objective
Geneva 1947 ñ adoption of GATT
Annecy, France 1949 ñ tariff reduction
26
CHAPTER 1
Torquay, England 1951 ñ tariff reduction

Geneva 1956 ñ tariff reduction
Geneva (“Dillon”) 1960-62 ñ tariff reduction
Geneva 1962-67 ñ tariff reduction
(“Kennedy”) ñ GATT negotiation rules
Tokyo 1973-79 ñ overall reduction of tariffs to an average level
of 35% and 5-8% among developed nations
ñ non-tariff barrier codes
ñ government procurement
ñ customs valuation
ñ subsidies and countervailing measures
ñ antidumping
ñ standards
ñ import licensing
Uruguay 1986-94 ñ broadening of GATT
ñ limit agricultural subsidies
ñ include services trade
ñ include intellectual property
ñ establishment of the WTO
The International Monetary Fund

The International Monetary Fund (IMF), located in Washington, D.C., was
created in 1945 to help promote stability in the world economy. It is governed by and
accountable to the governments of the 184 countries that make up its near-global
membership. The International Monetary Fund promoted a framework for
economic cooperation in order to avoid, in times to come, economic crises similar to
those of the Great Depression in the 1930s. The IMF’s main purpose is to ensure and
maintain economic stability regarding the international monetary and financial
system, i.e. the system of international payments and exchange rates among national
currencies that enables trade to take place between countries. The IMF provides the
means to resolve crises when they do occur and seeks ways to be always ahead of
crises. It is accountable to the governments of its member countries. At the top-level
of its organizational structure is its Board of Governors, which consists of one
Governor from each of the IMF’s 184 member countries. All Governors meet once
each year at the IMF-World Bank Annual Meetings; 24 of the Governors sit on the
International Monetary and Finance Committee (IMFC) and meet twice each year.
The IMF’s resources are provided by its member countries, primarily through
payment of quotas, which broadly reflect each country’s economic size and the total
amount of quotas determines the IMF’s lending capacity. In the 1970s the IMF was
primarily focused on large budget deficits and on establishing stable exchange rates,
27
especially after 1973 with the break-down of the fixed exchange rate system. In the
1980s the main theme of its interventions was on the debt problem of third world
countries, short-run imbalances in the balance of payments and structural reforms of
economies worldwide. In the 1990s the focus of the IMF was on the transition
economies of Central and Eastern Europe and their transformation from a command
economy (central planning) to a market economy. IMF was criticized both for its
failure to predict crises as well as for the prescriptions and guidelines used in advising
countries. Indeed, the IMF failed to predict the Asian crisis of 1997-98 that also had
negative implications on the EU. The criticism of IMF practices is that it always gives
the same prescriptions/guidelines to all countries, consisting of a combination of
deflation, devaluation, tight monetary and fiscal policy, regardless of whether the
countries are in Latin America or in Asia or in Central and Eastern Europe. Milton
Friedman, Nobel Laureate in economics, has argued that the IMF should cease its
existence as it has completed its mission.
The World Bank

The International Bank for Reconstruction and Development (IBRD) better known
as the World Bank (WB), is an international organization created to fight poverty by
means of financing international economic development. It was established on
December 27, 1945 following international ratification of the agreements reached at
the Bretton Woods Conference of 1-22 July 1944. The World Bank raises financial
capital directly from the international capital markets and uses it to finance selected
projects of the public sector in many countries worldwide. It lends funds for relatively
long periods and at lower interest rates than the ones a small country could obtain in
the international capital markets.
The World Bank’s activities are currently focused on developing countries, (since
2000, the preferred term is Less Developed Country (LDC)), in fields such as education,
agriculture and industry. More specifically, the World Bank provides long term
loans, grants, and technical assistance, to help developing countries implement their
poverty reduction strategies. As such, World Bank financing is used in many different
areas, from reform of the health and education sectors, to environmental and
infrastructure projects, including dams, roads and national parks. The World Bank
provides loans to governments and public enterprises, always with a government (or
“sovereign”) guarantee. The funds for this lending come from a combination of the
repayment of past loans and the issuing of bonds on the global capital markets. The
World Bank is one of the highest-rated borrowers on the international markets, and
is thus able to borrow at relatively low interest rates. It lends to countries at interest
rates that are usually still quite attractive to them, by adding a small margin (about
1%) to its borrowing costs to cover administrative overheads. Funds of the World
Bank to individual countries are often conditional not only on economic but also on
political measures that should be taken domestically such as limiting corruption or
fostering democracy. In addition to financing, the World Bank provides advice and
assistance to developing countries on almost every aspect of economic development.
28
CHAPTER 1
The World Bank commenced operations on 25 June 1946; it approved its first
loan on 9 May 1947 ($250m to France for postwar reconstruction, in real terms the
largest loan issued by the Bank to date). It was established mainly as a vehicle for the
reconstruction of Europe and Japan after World War II, with an additional mandate
to foster economic growth in developing countries in Africa, Asia and Latin
America. Originally the bank focused mainly on large scale infrastructure projects,
building highways, airports, and power plants. As Japan and its European client
countries “graduated” (achieved certain levels of income per capita), the IBRD
became focused entirely on developing countries. Since the early 1990s, the IBRD
has also provided financing to the post-Socialist states of Eastern Europe and the
Former Soviet Union.
In recent years the World Bank Group has been moving from targeting economic
growth in aggregate, to aiming specifically at poverty reduction. It has also become
more focused on support for small-scale local enterprises. It has embraced the idea
that clean water, education, and sustainable development are essential to economic
growth and has begun investing heavily in such projects. In response to external critics,
the World Bank Group’s institutions have adopted a wide range of environmental and
social safeguard policies, designed to ensure that their projects do not harm
individuals or groups in client countries. Despite these policies, the World Bank
projects are frequently criticized by non-governmental organizations (NGOs) for
causing environmental and social damage and for not achieving their intended goal
of poverty reduction. Finally, the World Bank is criticized for its bureaucracy that
reduces the effective use of its funding.
The Organization for Economic Co-operation and

Development (OECD)
The origins of OECD lie in the Organization for European Economic Cooperation
(OEEC) that was established in 1948 in order to administrate and allocate the funds
of the Marshall Plan aimed at reconstructing postwar Europe.
With the joining of the US and Canada in 1961, OEEC became the Organization
for Economic Co-operation and Development, based in Paris. The role of the OECD is
to conduct economic forecasts for its members and to provide advice on global issues
such as unemployment. Members of the OECD are the EU 15 members, the US,
Canada, Japan, Australia and New Zealand. The total number of its members is 24
and therefore OECD is also known as the Group of the 24 (G24).
1.2.6 A brief history of the European Union

The origins of the present European Union lie in the period after the end of
World War ¶. πt was formed as a result of the desire for stability in Western Europe.
∞ similar search for stability was taking place at the same time in the states of Central
and Eastern Europe, but the outcome was very different from the attempts in
29
Western Europe. The ∂U was not the first attempt at economic integration, nor was
it the only attempt during the first 15 years after Wor1d War ¶.
Within Europe, the European Union was only one group of small- and medium-
sized countries that emerged in the quest for stability in Europe. Others included the
Western European Union (WEU), an alliance of countries with a defense objective.
Many of the states of the EU belong tÔ this organization and, following the TEU, it
has been seen as the European replacement for NA∆O.
The Nordic Council (NC) was another organization established by an agreement
of the Parliaments of the Scandinavian States. The greater part of the cooperation
within this organization has been in the areas of social and welfare policies. Another
group of European countries formed the European Free Trade Association (EFTA)
that was established in 1960 with the objective of facilitating trade in industrial
products between its members.
Some of the above organizations were based Ôn political integration; however, the
most successful and enduring of them were based Ôn forms of economic cooperation.
As we have already mentioned, the underlying pressure for these independent
states tÔ agree tÔ cooperate was the need to create stability in Europe so that the
process of reconstruction following World War II could begin. Therefore, this
cooperation among European countries was different depending upon which group
these countries were participating in.
We turn our analysis next to the case of the European Coal and Steel Community
(ECSC), which was the forerunner of the European Economic Community, and was
established in 1952 with an avowedly federalist framework. πt was “...a first step in the
federation of Europe...” The institutions that were established were designed tÔ
impose limits Ôn the governments of all participating countries. It was not the intention
of either Jean Monnet or Robert Schuman, when they put forward the plan for the
ECSC, that the member states should preserve their own national interests over the
Community interest. The European Coal and Steel Community was therefore a group
of states that had agreed to a pooling of sovereignty over a relatively limited area of
economic activity (West German and French coal and steel production). Supranational
institutions were established tÔ ensure that the ECSC functioned. Thus, the main
purpose of the ECSC was tÔ bring Germany and France into close cooperation so that
the benefits from this cooperation would outweigh any other motivations.
The institutional framework established tÔ run the ECSC formed the basis of the
institutional framework of the European Union when the ECSC was incorporated
into the Treaties of Rome in 1957. Two other Communities were formed in 1958 by
the Treaties signed in Rome: the European Economic Community and EURATOM.
The purpose of EURATOM was to enable the peaceful use of nuclear power. µy
1967 the three communities had come together with a single administration and with
the commonly-used title of European Communities, which before the TEU, had been
commonly known as the European Community (EC).
According to the Treaty of Rome, the decision-making process for major decisions
was based on unanimous voting. Minor matters, Ôn the other hand, could be decided by
majority voting in the Council of Ministers, which represented the national interests.
30
CHAPTER 1
However, it was envisaged that by 1966 all decisions would be taken by the weighted
majority voting. This would have signified a massive transfer of sovereignty from
the member states to the supranational organization of the European Economic
Community.
The French government led by de Gaulle objected in 1965 tÔ the increased use of
majority voting, seeing it as a move toward the creation of a more federal Europe,
and as undermining the role of the nation states of the EU. The months following in
1965 were the ‘empty chair’ period of the European Union, when the French
Ministers were not allowed by their own government to take part in the deliberations
of the Council of Ministers. As a result, the decision-making process was halted. An
agreement was reached in Luxembourg in early 1966, known as the Luxembourg
Compromise. If an issue was considered tÔ be of vital national interest for one of the
members of the EU, the decisions would be based Ôn unanimous agreement.
Following the death of de Gaulle, the French adopted a different approach, but the use
of majority voting remained a rare occurrence within the ∂U until 1987. Under de
Gaulle, the French government had undermined the transfer of power from the nation
states tÔ the supranational authority of the European Union. The member states of the
∂U were reminded of national interests which it was felt had tÔ be preserved in order
tÔ protect a nation’s sovereignty. It was not until the Single European Act was signed
and came into effect in 1987 that greater use was made of the majority voting system in
the Council of Ministers. This was in order to achieve the legislative program
necessary for the operation of the Single Market. The use of the majority vote has
been extended to a number of areas since the TEU in 1993.
∞ further French-led initiative, which has emphasized the intergovernmental
aspects of the European Union, was the launch of the meetings of the European
Council in 1974. This was the beginning of the series of regular meetings of the heads
of state of the members of the EU. It has taken Ôn a policy agenda setting and
guidance role for the member states, which is contrary tÔ the original intention of the
institutional framework of the EU. In the Single European Act of 1987, the informal
status of the European Council was altered and it became included in the institutions
of the European Union. ∞ number of important events in the history of the ∂U have
been the achievements of the European Council. For example the preparations for
the intergovernmental Conferences (IGCs) in Maastricht in 1991 and the acceptance
of the German Democratic Republic into the ∂U were a result of the work of the
European Council.
The early draft Treaty Ôn European Union presented for discussion in preparation
for the 1991 intergovernmental Conferences included the phrase ‘Union with a federal
goal’. This phrase was altered in the ∆∂U to read “...ever closer union among the
peoples of Europe, in which decisions are taken as closely as possible tÔ the citizen”
(TEU, 1993, Article ∞).
In sum, in Section 1.2 we briefly present the European integration process as a
path toward stability in the continent. We also present the international environment
as it was shaped after World War II with the establishment and operation of global
organizations such as GATT, IMF, WB and OECD.
31
Explain the negative implications that the Asian Crisis of 1997-98 had on the EU
economies.
Synopsis – Conclusions
In Chapter 1 we saw that after World War II several European countries had
to join forces to create an environment of economic stability that could foster
economic development and increase the living standards of their citizens. It was
the continuously emerging political and economic power of the US and the
former Soviet Union that implied the need for an integrated European market to
stand up for the European countries and their economies. The need for an
integrated European environment was vital.
32
CHAPTER 1
APPENDIX
Answers to Activities
Activity 1
The European business environment is affected by many interactive factors and forces. We
may briefly distinguish them into political, economic, social, technological, legal and
environmental factors.
Political
The political beliefs of governments are vital for businesses to decide on whether they
should enter a particular market or not, consequently political beliefs are important for
promoting or deterring investments. Several examples from different countries can be
analyzed here.
Economic
The imposition of the euro as the single European currency, the exercise of monetary policy
by the European Central Bank by setting interest rates for the whole EU as well as the
common economic policies, set rules and restrictions to European businesses that should
now compete in global markets by being more competitive on a micro level as well as
making macro level adjustments, such an exchange rate devaluation and/or changing the
interest rates, is not optional for the Euroland.
Social
Culture, values, attitudes, morals, religious beliefs and language are social elements that
may cause problems or provide a positive impetus on European businesses. All the social
domestic features can create barriers and obstacles for businesses to operate in domestic
markets if those special characteristics are not identified and taken into serious consideration.
Multilingual persons are better equipped and more required by European businesses.
Domestic features in the EU are to be perceived and respected but a European identity for
all is promoted.
Technological
All businesses follow technological progress investing large amounts in acquiring

advanced technological assets to enhance production, administration, and improve quality
of products and services. In the European business environment, the majority of businesses is
at a high technological level and follows innovative practices and techniques to remain
competitive.
Legal
The implication of different legislation in different countries is that the same issue could be
considered differently in different member states. However, gradually and after Maastricht
treaty member states have come to agree that the Union’s legislation dominates over the
33
legislation of a member state. So far, the EU laws are an overarching framework that could
guarantee the efficient functioning of the common policies such as the social, competition
and environmental policies. The so-called problem of excessive bureaucracy (red-tape)
discourages businesses from investing.
Activity 2
In an era of increasing globalization, economic events in one part of the world are transmitted
quickly to the whole world, as international capital markets are integrated and shocks in
one market are transmitted instantaneously worldwide. European or American pension
funds that had invested heavily in South East Asia, felt a sharp reduction in the value of their
portfolios and thus in their activities. As Asian stock markets fell heavily, the wealth of
people (shares is part of wealth) dropped sharply and Asian consumers reduced their
consumption of domestic and foreign goods. As South East Asia absorbs 15% of EU
exports (Harris, 1999, p. 39), European exports were lower and thus contributed to a
reduction in European employment, as less production implies less employment of labor.
Foreign direct Investment from these countries into the EU either had to be delayed or
cancelled. The volume of tourism and students from Asian countries had to be lower due to
the financial crisis that reduced the wealth of these countries and their citizens.
34
CHAPTER 1
BIBLIOGRAPHY
Harris N., European Business, Second Edition, Palgrave 1999, pp. 1-41.
RECOMMENDED READING
Jones R., The Politics & Economics of the EU, Second Edition, Edward Elgar 2001.
McDonald F., Dearden S., European Economic Integration, Second Edition, Longman
1994.
Mercado S., Welford R., Prescott K., European Business, Fourth Edition, Prentice
Hall 2001.
35
CHAPTER 2
A NEW EUROPE –
THE WAY TOWARD THE
EUROPEAN UNION
The scope of Chapter 2 is to introduce and analyze the origins of the European The Scope
Union (EU) and how it has developed since the early 1950s when it was founded, and of the Chapter
onwards to its present position as one of the most important organizations worldwide.
We focus in this chapter on the evolution of the EU by examining its treaties and
institutional bodies.
ñ familiar with the historical background of the EU Objectives
ñ able to understand the main issues of the EU
ñ familiar with the main institutional bodies of the EU.
ñ World War II Key Words

ñ NATO
ñ Cold War
ñ Inflation
ñ Free movement of goods, services, labor, capital
ñ European institutional bodies
Having presented a brief history of European Integration and described the Introductory
European business environment in Chapter 1, we will now focus on an analysis into Comments
the evolution of the EU through its treaties. By the end of the Second World War in
Europe in May 1945, the US and the Soviet Union had clearly emerged as the world’s
two superpowers and it was obvious to the individual European countries that they
could not hope to follow their pace. To that extent, Western European countries
chose to follow the US’s lead in foreign and security policy. As a result, the North
Atlantic Treaty Organization (NATO) was formed in 1949 by the US, Canada and
several European countries to provide security guarantees to the Western world
against the former Soviet Union and its Eastern and Central European allies. This
was the starting point of the so-called Cold War.
In the same period the economic situation in Europe was getting even worse.
There was very little left of the infrastructure; high unemployment and shortages in
food supply resulted in very low standards of living for the people. It was not until the
1950s that European politicians, particularly from France and Germany, began to
realize that Europe should:
37
ñ Compete with America’s growing economic power over the world markets.
ñ Stand up to America’s intervention in world affairs, which would require that
European countries be able to speak and act with one voice.
The above could only be a result of a united Europe, in the form of competitive
organization with common interests.
38
CHAPTER 2
2.1 TOWARD AN INTEGRATED EUROPE
2.1.1 A historical review

Europe’s post war developments followed two directions. The first one
mentioned above was the cooperation with the Atlantic superpower for security
reasons, through NATO and the Organization for Economic Cooperation and
Development (OECD), formed in 1948 to get reconstruction aid through the famous
Marshall Plan. The second direction was the necessity for Europe to understand the
potential of its very own environment.
2.1.2 Benelux
In 1947 Belgium, the Netherlands and Luxembourg formed a free trade economic
group known as the Benelux customs union. A common tariff was imposed on non-
member countries.
2.1.3 The Council of Europe

The Council of Europe, which is not part of the European Union, was formed in
1949 to promote democracy, and economic and social progress together with the
support for human rights. Currently it consists of 39 members, including the former
EU15. Most recently Russia, Bosnia-Herzegovina and Belarus joined in.
2.1.4 The Western European Union

Within NATO, there was a need for representation of Europe and in 1954 the
Western European Union (WEU) was formed, aiming at strengthening security
relations between the UK, France and the Benelux thus becoming the European
body in NATO debates. These countries joined military forces hoping that Germany
and Italy would also join in. WEU can be considered as the cornerstone of the united
European military forces.
2.1.5 The European Coal and Steel Community

In the early 1950s the coal and steel industry was in deep crisis because of
overproduction, creating the risk of cartels and price-fixing. West German coal and
39
steel industries provided inputs for its domestic armament producers such as Krupps,
and France felt the need to influence those industries on the basis of common
prosperity and the future of a European Community. The above was part of the plan
by the French Foreign Minister, Robert Schuman, and Jean Monnet, who was
responsible for the French industrial evolvement. Indeed the aim of the plan was to
encourage West Germany to become active in the Cold War, defending Western
Europe against the former Soviet Union. The plan was formulated in 1950 and
became known as the Schuman Plan.
The Schuman Plan followed the Treaty of Paris in 1951 and the formation in 1952
of the European Coal and Steel Community (ECSC). The Treaty of Paris was signed
by the Benelux, West Germany, France and Italy. In the ECSC the Council of
Ministers provided the national governments with the means to be heard.
2.1.6 The Treaty of Rome

The Treaty of Rome refers to the treaty that established the European Economic
Community (EEC) and was signed by France, Germany, Italy, Belgium, the
Netherlands and Luxembourg on 25 March 1957 and became operative in 1958; it is
now generally called as the EC Treaty. In 1957 the Treaty of Euratom was also signed
to promote nuclear potential industries in the existing six member states.
The member states shared the vision of a single or common market, emphasizing
the development of all industries and agricultural opportunities, as well as political
integration.
The Treaty of Rome led to the creation of a customs union. Therefore, the EEC
became known as the Common Market. All member countries agreed to a 12-year
transitory period for an utter tariff and at the same time, a common tariff was
established for all the products coming from third countries.
The basic element of the common market is without doubt the free circulation of
goods, whereas free movement of people, capital and services continued to suffer from
important limitations. The other essential agreement included in the treaty of Rome
was the adoption of a Common Agricultural Policy (CAP). Essentially, the CAP
enacted a free market of agricultural products within the EEC and established
protectionist policies that guaranteed to European farmers sufficient revenues, avoiding
competition from third countries’ products by means of granting agricultural prices.
The Treaty of Rome also established the prohibition of monopolies, some
transport common policies, and the granting of some commercial privileges to the
colonial territories of the member states.
To sum up, a process was started in which progressive economic integration was
paving the way to the final objective, the political union, considered as a long-term
goal. The Treaty that instituted the EURATOM tried to create the conditions for
developing a strong nuclear industry. It was much less important and, in fact, when
people spoke about the Treaties of Rome, they referred, incorrectly, only to the one
that established the EEC. The UK still saw itself as a superpower in the 1950s, trying
40
CHAPTER 2
to match the US economically and militarily, and did not apply for membership in the
EEC. This view, however, changed drastically in the early 1960s as the UK realized a
decline in its economic and military power and thus it applied to join the EEC.
2.1.7 The Merger Treaty

The Merger Treaty, which was signed in Brussels on 8 April 1965 and went into effect
on 1 July 1967, is of great importance because it first unified the existing three
European Communities (European Coal and Steel Community, European Economic
Community and EURATOM). Essentially, this treaty allowed the three communities
to have common governing institutions. The Merger Treaty with its implementation
introduced and established the term European Communities or EC from 1967 onward.
2.1.8 “Eurosclerosis” from the 1970s to mid 1980s

All member states that signed the Treaty of Rome were in favor of a fast developing
EEC on an integrated basis, which was indeed materialized in the late 1950s and 1960s.
However, by the mid 1970s to early 1980s, economic problems due to the two major oil
crises in 1973 and 1979, and high inflation rates that affected all European economies,
had forced member states to look into their domestic problems and give no effort to the
idea of the EEC. On the other hand, the United States of America was still leading the
so-called Cold War against the former USSR and Europe was trying to emerge in a
very unstable political environment until the collapse of the Soviet Union in 1991.
Nevertheless the EEC did, significantly, admit new members. The UK, Ireland and
Denmark joined in 1973, as the EEC changed its name to the European Community
(EC). Greece joined in 1981, Spain and Portugal joined in 1986.
It was in 1979 that the European Parliament was first elected, but it had no
significant power or influence in the European integration process.
2.1.9 The Single European Act of 1987

The Single European Act that came into force in 1987 was based on the report of
Lord Cockfield and presented the first axis to implement a truly integrated European
Market free of internal barriers, including physical, technical and fiscal restrictions
on trade. Thus, the Single European Act moved the EC to the Single European
Market (SEM).
2.1.10 The Treaty of Maastricht –

The Treaty on European Union (TEU)
With the Maastricht Treaty member states hoped to take European integration a
step further in strengthening the SEM, creating a common European foreign and
41
security policy and establishing the Single European Currency. The treaty identified
three pillars of European integration:
ñ The existing European Community institutional structure and responsibilities.
ñ Intergovernmental co-operation over justice and home affairs (but agreement on
common policies to require the unanimous approval of all member states).
ñ Intergovernmental co-operation to form a common European foreign and
security policy (but agreement on common policies to require the unanimous
approval of all member states).
The Treaty of Maastricht promoted economic and monetary union, a common
foreign and security policy, cooperation on home affairs and justice, and most
importantly, brought up EU citizenship.
On 2 November 1993 the Treaty of Maastricht came into force after a number of
very difficult ratifications across Europe, which were the result of a hard and dark
economic and political period (high inflation rates, the war in former Yugoslavia). In
spite of the difficulties that the EU had to contend with, there were new entry
applications submitted to Brussels: Austria in 1989, Malta and Cyprus in 1991, Finland,
Norway and Switzerland in 1992. This last country retired its candidature a few months
later after a referendum. Negotiations with Austria, Sweden, Finland and Norway
began in 1993 and were quite easy due to the high economic development of those
countries. The ratification of the Treaties was accomplished in 1994. However, the
Norwegian people rejected the accession to the EU. The “No” vote to the European
Union won in a referendum with 52.2% of the votes. It was the second time that
Norway had refused to join the community.
On 1 January 1995, the fourth enlargement of the EU took place with the
accession of Austria, Finland and Sweden. The Europe of the Fifteen was born. In early
1996, in the European Council of Turin, an Intergovernmental Conference (IGC)
commenced with the purpose of elaborating a new treaty to reform the Treaty of
Maastricht. The objectives were focused on developing the Europe of citizens,
strengthening the EU role in international politics, reforming the institutions and
tackling a new enlargement involving the applicant countries of Central and Eastern
Europe. After a long and intricate negotiation, the member states’ governments
reached an agreement in the European Council held in Amsterdam on 16-17 June
1997. The Treaty of Amsterdam was born.
2.1.11 The Treaty of Amsterdam

The Foreign Ministers of the fifteen member countries of the European Union
signed the Treaty of Amsterdam on 2 October 1997 and it came into force on 1 May
1999. Although the Treaty was expected to boost an integrated European way of
policy making, it instead received harsh criticism.
The Treaty of Amsterdam did not manage to provide the right perspective for a
number of member states of the EU when appealing to certain institutions. As a result
the European institutional bodies were not efficiently prepared for the forthcoming
42
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European enlargement considering the participation of the Eastern European

countries. In other words, it did not solve one of the greatest pending problems of the
Union: the adaptation of the institutions to an increasingly wider Community. Despite
the need for political union and cooperation and the tactic to make decisions based on
a majority voting, the veto right, known as the Luxemburg compromise, remained in
favor of each individual country that wanted to block a decision because of matters of
national interest. The idea of a multi-speed Europe was limited.
On the other hand the Treaty of Amsterdam meant advancement along the road
toward European Union. The Union committed itself to establishing a common area
of freedom, security and justice. All affairs related to free movement of persons;
controls on external borders; asylum, immigration including safeguarding the rights of
third-country nationals; and judicial cooperation in civil matters were “communitized”
by the Treaty of Amsterdam, that is to say, they were brought under the legal
framework of the first pillar. To this effect, the Schengen Agreement and Convention
was included in the Treaty to guarantee that all travelers could move across Europe
without the need of passports. The United Kingdom, Ireland and Denmark
voluntarily stayed out and, therefore, kept the right to exercise controls on people at
their frontiers. Denmark joined Schengen in 1996. As the free movement of persons
makes it necessary to create information systems on a European scale, the guarantees
of protection of personal data were reinforced as well.
On 28 July 2000, four important EU countries – Spain, Italy, Germany and France
–agreed to eliminate the obligation of obtaining a residence permission to the rest of
the EU citizens.
In sum Section 2.1 presents the economic and political environment in Europe
after the Second World War, and outlines through the European Treaties the
process of European integration to what is today known as the EU. It shows that the
EU is the result of continuous efforts in creating a common mentality and promoting
the common interest within its member states.
Europe went through hard times to develop an integrated approach. What were the main
reasons that led Europe to form a common interest organization? Highlight the basic steps
of European Integration by referring to each and every treaty.
43
2.2 THE MAIN INSTITUTIONAL BODIES
IN THE EU
The main bodies in the EU are The Council (The Council of Ministers and the
European Council), The European Commission, The European Parliament, The
Court of Justice and The Court of Auditors, together with a number of other institutions
such as the ECOFIN, The Economic And Social Committee (ESC), The Committee of
the Regions, The Central Bank and The European Investment Bank. These bodies
are responsible for the decision-making process within the EU.
2.2.1 The Council of Ministers

The ministers of the member states form the Council of the European Union
which is the organization that truly makes policy in Europe. Its membership varies
depending on the issue that is to be discussed. Each country will be represented by
the minister responsible for that subject (e.g., foreign affairs, finance, social affairs,
transport, agriculture). The role of the Council of Ministers is to:
ñ Provide broad guidelines of policy.
ñ Represent the interests of all member states.
ñ Adopt or reject decisions about the legislation.
2.2.2 The European Council

The European Council was not included in the founding Treaties of 1958. It
became part of the institutional framework in the Single European Act in 1987. The
European Council is the main decision-making body of the European Union with
power exciding that of the Council of Ministers as it consists of the heads of the EU
member states. The European Council meets twice a year under the authority of the
President of the council and voting procedures are governed by the requirement for
unanimous decisions. The Presidency is held for six months by each member state on
a strict alphabetical rotational basis.
2.2.3 The European Commission

The Commission is the politically independent institution set up in the 1950s
under the EU’s founding treaties that represents and upholds the interests of the EU
as a whole, rather than the self-interests of each member state. This institution plays
a key and vital role within the EU’s institutional system as it is responsible for:
44
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ñ Proposing legislation, policies and programs of action.

ñ Implementing the decisions of the Parliament and the Council.
2.2.4 The Court of Justice

The Treaty of Paris in 1952 established the Court of Justice of the European
Communities. The Court’s main responsibility is to ensure that all decisions and
legislation passed on the EU environment are compatible with the EU treaties. In
addition, its task is to ensure that EU legislation does not favor an individual member
state, and that all parties are equal under the EU rules and regulations in all
circumstances without anyone making any misinterpretations. All member states,
EU institutions, businesses and individuals may apply to the Court to settle all their
legal matters. All parties participate in the Court with one representative, but for the
sake of efficiency the Court is able to sit as a “Cabinet” of a majority of judges (11),
instead of always having to meet in full in a plenary session attended by all the judges.
To help the Court of Justice cope with the thousands of cases brought before it, and to
offer citizens better legal protection, a “Court of First Instance” was created in 1989
under the Single European Act. This Court (which is attached to the Court of Justice)
is responsible for giving rulings on certain kinds of cases; particularly actions brought
by individuals and cases related to unfair competition between businesses. Its
judgments may be submitted to the Court of Justice for appeal procedures. The
Court of Justice and the Court of First Instance each have a president, chosen by
their fellow-judges to serve for a term of three years.
2.2.5 The Court of Auditors

The Court was set up in 1977. It has the very specific role of checking on the
financial matters of the EU and has authority over all revenue and expenditure issues
and the so-called EU budget. All member states appoint one member whose
independence of action is guaranteed. In their countries of origin, the members of the
Court have all worked for an auditing institution or are specifically qualified for that
work. They are chosen for their competence and independence, and they work full-
time for the Court under the President of the Court who is elected every three years.
2.2.6 ECOFIN
The Council of Ministers of Economics & Finance is responsible for all economic
matters within the EU.
2.2.7 The Economic and Social Committee (ECOSOC)

The ECOSOC was established jointly in the EEC and EURATOM Treaties in
1958; it is a consultative committee that brings together different economic social
45
interest groups. It presents their views and defends their interests in policy discussions
in front of the Commission, the Council and the European Parliament. Thus the
ECOSOC provides a forum for the various interests to put forward their concerns. The
members are nominated by the EU governments, but they work in complete political
independence. They are appointed for a period of four years, and they may be re-
appointed. The European Economic and Social Committee has three main roles:
ñ To advise the Council, Commission and European Parliament, either at their
request or on the Committee’s own initiative.
ñ To encourage civil society to become more involved in EU policymaking.
ñ To bolster the role of civil society in non-EU countries and to help set up advisory
structures.
2.2.8 The Committee of the Regions

The Committee of the Regions was set up in 1994 under the Treaty on European
Union (Maastricht), and is a 220-member institution with a consultative role, able to
make comments on the proposals put forward by the European Commission and to
secure that regional and local identity and prerogatives are respected. The Committee
has to be consulted on matters that concern local and regional decision making policy,
such as regional policy, the environment, education and transport. The members of the
Committee are elected municipal or regional politicians, representing the entire range
of local and regional government activities in the European Union. They may be
regional presidents, regional parliamentarians, town councilors, mayors of large cities,
and so on.
The EU governments nominate Committee members, but members work in
complete political independence. The Council of the European Union appoints them
for four years, and they may be reappointed. The Committee of the Regions appoints a
President from among its members, for a term of two years.
The Commission and the Council must consult the Committee of the Regions on
topics of direct relevance to local and regional authorities, but they can also consult the
Committee whenever they wish. For its part, the Committee can adopt opinions on its
own initiative and present them to the Commission, Council and Parliament.
2.2.9 The European Central Bank

The European Central Bank (ECB) was set up in 1998, under the Treaty on
European Union, to introduce and manage the new currency (euro) - conducting foreign
exchange operations and ensuring the smooth operation of payment systems. The ECB is
also responsible for framing and implementing the EU’s economic and monetary policy.
2.2.10 The European Investment Bank

The European Investment Bank (EIB) was set up in 1958 by the Treaty of Rome.
46
CHAPTER 2
It is based in Luxemburg and its primary role is to finance capital investment schemes
that the EU has defined as important for economic growth.
The schemes and projects selected by the EIB are in the less favored regions of
the European Union and they are mainly associated with improving the infrastructure
of those regions. It is non-profit-making and gets no money from savings or current
accounts. Nor does it use any funds from the EU budget. Instead, the EIB is financed
through borrowing on the financial markets and by the bank’s shareholders - the
member states of the European Union. They subscribe jointly to its capital, each
country’s contribution reflecting its economic weight within the Union. This backing
by the member states gives the EIB the highest possible credit rating on the money
markets, where it can therefore raise very large amounts of capital on very competitive
terms. This in turn enables the bank to invest in projects of public interest that would
otherwise not get the money - or would have to borrow it at higher rates.
The projects the bank invests in are carefully selected according to the following
criteria:
ñ They must help achieve EU objectives such as making European industries and
small businesses more competitive; creating trans-European networks (transport,
telecommunications and energy); boosting the information technology sector;
protecting the natural and urban environments; or improving health and education
services.
ñ They must chiefly benefit the most disadvantaged regions.
ñ They must help attract other sources of funding.
These criteria apply to activities both within and outside the European Union.
Nearly 90% of the EIB’s activities take place within the European Union, but a
significant proportion of the funding goes to the future member states. The EIB also
supports sustainable development in the Mediterranean countries, Africa, the
Caribbean and the Pacific, as well as projects in Latin America and Asia.
Finally, the EIB is the majority shareholder in the European Investment Fund.
This fund was set up in 1994, to finance investment in small- and medium-sized
enterprises (SMEs).
In sum Section 2.2 analyzes the institutional structure of the EU, presents the main
institutional bodies so as to clarify how decision-making policy is made, and the
elements it depends on. Decision-making policy is the most important matter in the
EU and the European institutions guarantee equal treatment for all parties in the EU.
The European institutional bodies are required to act upon an equal basis for all member
states. What are the main characteristics of the main institutional bodies that guarantee the
above?
47
2.3 EU ENLARGEMENT – A HISTORIC
OPPORTUNITY
2.3.1 European enlargement - The way to the future

Enlargement is one of the most important opportunities for the European Union at
the beginning of the 21st century. It is a unique, historic task to further the integration
of the continent by peaceful means, extending a zone of stability and prosperity to
new members. In just over 30 years, the EU had grown from a six-member entity with
a population of 185 million into a 15-member entity with 375 million people, before
becoming a 25-member entity with 455 million citizens on 1 May 2004 – and the
process is not over yet. Meanwhile, “widening” the club’s membership has gone hand
in hand with “deepening” integration too. In the late 1980s the EU launched its
Single Market program and adopted policies for the environment, economic and
social cohesion, research and technology, and social affairs. The Treaty of Maastricht
of 1992 laid the foundations for economic and monetary union, which was followed
by the introduction of the common European currency, the euro. The Copenhagen
Council of June 1993 laid down the foundations for the EU’s fifth enlargement
process. The Council declared the so-called “Copenhagen criteria”, under which a
candidate country must meet:
ñ Political criteria - “stability of institutions guaranteeing democracy, the rule of
law, human rights and the respect for and protection of minorities”.
ñ Economic criteria - “the existence of a functioning market economy as well as the
capacity to cope with competitive pressure and market forces within the Union”.
ñ Acquis criterion - “ability to take on the obligations of membership, including
adherence to the aims of political, economic and monetary union”.
Third countries will significantly benefit from an enlarged Union. A single set of
trade rules, a single tariff, and a single set of administrative procedures will apply not
just across the existing member states but across the Single Market of the enlarged
Union. This will simplify dealings for third-country operators within Europe and
improve conditions for investment and trade. In Table 1 we summarize the applications/
memberships of the existing member countries and we include the countries that will
follow in the next enlargement.
48
CHAPTER 2
Table 1: European Countries and their Applications for Membership in the EU

Country Application Membership
Founding members
Belgium 1957
France 1957
Germany 1957
Italy 1957
Luxembourg 1957
Netherlands 1957
First enlargement
Denmark August 1961 January 1973
Ireland July 1961 January 1973
United Kingdom August 1961 January 1973
Second enlargement
Greece June 1975 January 1981
Third enlargement
Portugal March 1977 January 1986
Spain July 1977 January 1986
East Germany German reunification October 1990
Fourth enlargement
Austria July 1989 January 1995
Finland March 1992 January 1995
Sweden July 1991 January 1995
Fifth enlargement
Cyprus July 1990 1 May 2004
Czech Republic January 1996 1 May 2004
Estonia December 1995 1 May 2004
Hungary March 1994 1 May 2004
Latvia October 1995 1 May 2004
Lithuania December 1995 1 May 2004
Malta July 1990 1 May 2004
Poland April 1994 1 May 2004
Slovakia June 1995 1 May 2004
Slovenia June 1996 1 May 2004
Next enlargements (planned)
Bulgaria December 1995 1 January 2007 [scheduled]
Romania June 1995 1 January 2007 [scheduled]
Croatia 20 February 2003 1 January 2007 [scheduled but less certain]
Turkey 1963 ?
49
In Section 2.3 we presented the Copenhagen criteria for joining the EU and we
stressed that the European enlargement is a unique, historic task to further the
integration of the continent by peaceful means, extending a zone of stability and
prosperity to new members.
What is the level of importance of the European enlargement for European economic
prosperity? In what ways will the enlargement make the EU a more competitive organization?
In Chapter 2 we extend our analysis in Chapter 1 on the economic and
political environment in Europe in the late 1940s when Europe had just come out
of the Second World War. The economic situation in most European countries
was very unpleasant as they were dealing with high inflation rates, low
infrastructure and high unemployment. As a result they were not able to compete
with the world’s emerging superpowers (USA and USSR). It became more than
obvious that it was vital for European countries to overcome their nationalism
and form an integrated European organization for the common interest that
emerged through the European Treaties described in this chapter.
We also presented the main institutional bodies in the EU, responsible for the
decision-making policy and management upon an equal basis for all parties in
the EU.
Finally, in Chapter 2 the enlargement of the EU was presented on a historical
basis, showing that Europe has developed the right mentality to integrate the
individual power of the member states over time so as to form a competitive
organization to external markets and forces from which all parties are to benefit.
50
CHAPTER 2
APPENDIX
Activity 1
After World War II, in May 1945, the US and the Soviet Union had clearly emerged as the
world’s two superpowers and it was obvious to the individual European countries that they
could not hope to follow their pace. In the same period the economic situation in Europe
was getting even worse. There was very little left of infrastructure; high unemployment and
shortages in food supply resulted in very low standards of living for the people. It was not
until the 1950s that European politicians, particularly from France and Germany, began to
realize that Europe should:
ñ Compete with America’s growing economic power over the world markets.
ñ Stand up to America’s intervention in world affairs, which would require that European
countries speak and act with one voice.
The above could only be a result of a united Europe in the form of competitive organization
with common interests. The starting point toward that common European effort was the
Benelux Treaty in 1947 when Belgium, the Netherlands, and Luxemburg formed a free trade
economic group known as the Benelux Customs Union imposing a common tariff on non
member countries. The Treaty of Rome made the next very important step toward
integration in 1957 that led to the creation of a customs union. As a result the concept
emerged of the common market and the free movement of goods, services, capital and
people. The Single European Act that came into force in 1987 removed physical, technical
and fiscal barriers on trade, moving the EC to the Single European Market. On 2 November
1993 The Treaty of Maastricht came into force, promoting economic and monetary union, a
common foreign and security policy, cooperation on home affairs and justice, and most
importantly brought up EU citizenship. The Treaty of Maastricht is known as the Treaty of the
EU and led to the Europe of the Fifteen.
Activity 2
The main bodies in the EU are The Council (The Council of Ministers and the European
Council), The European Commission, The European Parliament, The Court of Justice and
the Court of Auditors. The role of the Council of Ministers is to provide broad guidelines of
policy, to represent the interests of all member states and adopt or reject decisions
about legislation. The European Council is the main decision-making body of the
European Union with power exciding that of the Council of Ministers as it consists of the
heads of the EU member states overlooking the acts of the council. The European
Commission is the politically independent institution that represents and upholds the
interests of the EU as a whole rather than the self-interests of each member state. The
Court of Justice has as its main responsibility to ensure that all decisions and legislation
51
passed on the EU environment are compatible with the EU treaties. In addition, its task is to
ensure that EU legislation is not in favor of an individual member state and that all parties
are equal under the EU rules and regulations in all circumstances without anyone making
any misinterpretations. The Court of Auditors has the very specific role of checking on the
financial matters of the EU and has authority over all revenue and expenditure issues and
the so-called EU budget.
Activity 3
The 2004 enlargement of the European Union finally filled in the gaps from the East-West
confrontation and the Cold War. The newcomers from Central and Eastern Europe,
together with Malta and Cyprus, are legitimate members whose peoples share the same
goals of democracy, liberty and prosperity as other EU citizens. They have met the strict
criteria for joining the Union. Enlargement will stimulate economic growth in EU countries
both new and old – for the benefit of all.
The integration process is already well under way. Even before formal accession, the EU
opened its markets to exports from the newcomers, who also benefited from the Union’s
assistance programs. Enlargement has raised concerns among citizens from existing and
new member states, but there are adequate responses to meet them. The EU of the 25 will
create new relationships with its neighbors and the wider world. Deepening European
integration and widening EU membership have gone hand-in-hand since the foundation of
the Union. Each successive enlargement – this is the fifth since 1973 – has brought benefits
to Europe’s citizens and new opportunities for its businesses. In between times, the EU has
created a customs union, a single market and a single currency. As a result, people, goods,
services and money move around within the EU as freely as within one country. These
freedoms are being extended to the ten newcomers. The inclusion of 25 countries in the
EU’s zone of peace, prosperity and stability will enhance the security of all its citizens.
In addition the third countries will significantly benefit from an enlarged Union. A single set
of trade rules, a single tariff, and a single set of administrative procedures will apply not just
across the existing member states but also across the Single Market of the enlarged Union.
This will simplify dealings for third-country operators within Europe and improve conditions
for investment and trade for all.
52
CHAPTER 2
BIBLIOGRAPHY
RECOMMENDED READING
Jones R., The Politics & Economics of the EU, Second Edition, Edward Elgar 2001,
pp. 3-33.
1994, pp. 1-20.
Hall 2001, pp. 38-82.
The EU General Report Website, http://europa.eu.int/abc/doc/off/index-en.htm
53
CHAPTER 3
EU COMPETITION POLICY
The scope of this chapter is to analyze the EU competition policy and to examine The Scope
its importance to the integrated Europe. of the Chapter
Having completed the study of Chapter 3, the reader will be familiar with: Learning
ñ the nature, scope and purpose of EU competition policy Objectives
ñ the EU competition legislation.
ñ Competition policy Key Words

ñ European legislation
ñ Market forces
As was analyzed in the previous chapter, the establishment of the single European Introductory
market and consequently the free movement of goods, services, labor and capital, has Comments
led to increased competition between European businesses. The Cecchini report
predicted substantial economic benefits for member states, as European businesses
would be able to operate in an integrated environment with greater potential of
further development. However, to ensure fair competition and to avoid undesirable
business practices, the Union needed to develop an efficient competition policy.
55
3.1 COMPETITION POLICY
3.1.1 What is competition policy in the EU?

The completion of the single market in the EU offered the prospect of a more
competitive environment within the EU. Competition policy within the EU involves
the monitoring of and intervention into markets to ensure that there is an efficient
level of competition. The responsibility for competition policy within the EU is
shared among member states. Competition policy has become increasingly
important as businesses operate on a Europe-wide basis rather than being restricted
to an individual member state, in order to become able to gain a competitive
advantage that will lead to greater efficiency and innovation. In the words of Peter
Sutherland, who was in charge of EC Competition policy between 1985 and 1988,
competition policy aims to develop “a level playing field where individual talent,
effort and comparative advantage lead to victory, rather than an inclined pitch with
moving goal posts, a biased referee and an opposing team full of steroids” (Welford
and Prescott, 1994, p. 83).
3.1.2 What is competition?

In markets, companies trade their goods and services so as to achieve maximum
profit and obtain a greater market share. Competition can be said to exist when
businesses operating in the same market are free to exploit their different production
costs, prices, and quality. This requires that firms be free to advertise their goods and
services without excessive intervention from government. In addition companies
should not be involved in tying clauses (where companies make special agreements
with customers or distributors) and should be able to enter or exit the market relatively
easily. Also there must be no special arrangements between two or more firms in an
industry.
3.1.3 Market structure

A market is a mechanism which allows people to trade, normally governed by the
forces of demand and supply. The number of firms that operate in each market will
affect the level and type of competition in that industry and thus one has to know the
market structure in order to be able to understand the objectives of EU Competition
policy. Markets may foster or hinder efficiency which can by defined as technical,
allocative or dynamic efficiency.
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CHAPTER 3
Technical Efficiency
When firms have decided to produce a given good or service, they are then
interested in producing it in the most efficient way. Technical efficiency, the most
commonly used term, refers to that level of output with the lowest possible
production costs per unit. In economic theory this is denoted by the lowest point on
the average cost curve. Also, in the long run, it is possible for companies to achieve
economies of scale, through merging or increasing the scale of production, and this
means lower average costs. This is also considered to be more technically efficient.
Allocative Efficiency
The study of economics is primarily concerned with the scarcity of resources and
the ways in which these resources are allocated toward different tasks. Allocative
efficiency refers to the direction of resources toward alternative productive uses in
order to maximize total utility (or satisfaction) in society as a whole.
3.1.4 Perfect competition

Under conditions of perfect competition there are many companies producing
more or less the same good or service in the market. Thus, customers are indifferent
when choosing their suppliers. Furthermore the firms have equal ability to enter and
exit the industry and have equal access to perfect information. In the short run it may
be possible for a single firm to achieve abnormal profits, that is the case when a firm
has profits after it has paid all factors of production including entrepreneurship.
However, if there are abnormal profits in the short run, and given that access to the
market is possible to other producers attracted by the abnormal short-run profits,
there will be no long-run abnormal profits.
In perfect competition a single producer or consumer has no power to influence
prices in the market. This leads to an outcome which is efficient, according to the
economic definition of Pareto efficiency. The analysis of perfectly competitive
markets provides the foundation of the theory of supply and demand. One example
of perfect competition in the real world is the agricultural industry, where a large
amount of suppliers, a relatively inelastic demand, and almost identical product
make a good example of the perfect competition model.
In general a market is said to be one with perfect competition if:
ñ There are a large number of individual producers and consumers.
ñ None of the producers or consumers can influence the price on their own - they
are price takers.
ñ Goods and services produced are perfect substitutes, i.e. they are homogeneous.
ñ All resources (including information) are perfectly mobile.
ñ Transaction costs are zero.
ñ The price is determined at the level that equates supply and demand, and moves
instantaneously to equilibrium.
57
3.1.5 Monopoly
In economics, a monopoly (from the Greek monos, one + polein that means “to
sell”) is defined as a market situation in which there is only one provider of a product
or service. Monopolies are characterized by a lack of economic competition for
the good or service they provide (and a lack of viable substitute goods), as well
as high barriers to entry for potential competitors in the market. Any firm that
has a complete or substantial share of a particular market is considered to be in
a monopoly situation.
3.1.6 Oligopoly
An oligopoly is a market form in which a market is dominated by a small number
of sellers (oligopolists). The word is derived from the Greek word “oligopoleion” for
few sellers. Because there are few participants in this type of market, each oligopolist
is well aware of the actions of the others. Oligopolistic markets are characterized by
interactivity. The decisions of one firm influence, and are influenced by, the decisions
of other firms. Strategic planning by oligopolists always involves taking into account
the likely responses of the other market participants. Oligopolistic competition can
give rise to a wide range of different outcomes. In some situations, the firms may
collude to raise prices and restrict production in the same way as a monopoly. Where
there is a formal agreement for such collusion, this is known as a cartel. There are
legal restrictions on such collusion in most countries. There does not have to be a
formal agreement for collusion to take place (although for the act to be illegal there
must be a real communication between companies) - for example, in some industries,
there may be an acknowledged market leader which informally sets prices to which
other producers respond, which is known as price leadership.
3.1.7 Monopolistic competition

This is likely to be a more realistic description of many markets since the conditions
of perfect competition rarely exist in practice. Here several firms compete with
differentiated products and in the long run technical efficiency is established.
Dynamic Efficiency
In general, competition policy seeks to approximate conditions of perfect
competition or monopolistic competition, since these market structures lead to
better technical efficiency. The consumer enjoys more choice, and lower prices, and
the economy benefits from the improved competitiveness. However, it may be
possible to achieve these objectives through a monopoly or oligopolistic market
structure if ‘dynamic efficiency’ is established. If the firm achieves economies of
scale, as a result of the size of the company, and technological advances which
58
CHAPTER 3
improve costs, as a result of previous abnormal profits, then it may be possible to

achieve even lower prices and increased output than under conditions of perfect
competition. Sometimes it may be appropriate to break up a monopoly market
structure in order to create allocative and technical efficiency and on other occasions
it is more appropriate to leave the companies untouched.
In Section 3.1 we presented the definitions of competition policy and competition
and provided a short analysis of the economic forms of possible market structures. This
is necessary to understand how firms and organizations may act to take advantage of
their natural efficiency and the possible result of unfair competition. Restricting
competition, or even more having the case of unfair competition, would be a major
threat to the founding treaties of the European Union and that could challenge the
common interest policy for member parties.
How does the EU react to the situation of cartels? Are there any exceptions?
59
3.2 LAWS AND REGULATIONS
3.2.1 The legislation

The Commission has had to reconcile two seemingly contradictory objectives: on
the one hand, to allow firms to restructure and merge in order to compete more
effectively with the United States and the Far East and, on the other hand, to ensure
that the newly restructured firms do not employ practices that harm the consumer or
inhibit some of the benefits that competition should bring. The main ways in which
competition is restricted in Europe are through restrictive practices, market
domination, state aids, and through public procurement restrictions. All of these
issues are dealt with in the legislation. The Treaty of Rome and the Single European
Act contain much of the legislation that relates to competition and the major aspects
of these EU laws will be examined in turn, in conjunction with a new merger policy
adopted in 1990.
3.2.2 The Single European Act

The SEA has, in itself, contributed to a fair competitive environment for European
businesses since the elimination of non-tariff barriers means that firms are competing
on a more equal footing. The physical, technical, and fiscal barriers that have almost
disappeared in the single market have served to give some firms an advantage.
Subsequently, the single market program has helped to level the playing field.
3.2.3 Article 85 (81): Restrictive practices

This article prohibits activities that are incompatible with the operation of the
market, influence trade between the individual parties, and have an impact on
restricting, preventing or distorting competition. The article does not come into force
unless the activities have an impact or potential impact, on the usual trade pattern
between the individual parties. To be more specific the article prohibits arrangements
that:
1. Fix prices or trading conditions.
2. Control or limit production, markets, technical development or investment.
3. Share markets or sources of supply.
4. Make the conclusion of contracts subject to the acceptance by other parties of
supplementary obligations which by their or according to their commercial usage,
have no connection with the subject of such contracts.
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There are a few cases in which an agreement may be allowed under the article, if
that is to present “benefits”. The benefits are in cases when an agreement will make
the industry more efficient productionwise and distributionwise and finally will
restructure the industry under socially-acceptable conditions. The buyers are to
benefit from a more competitive industry.
3.2.4 Article 86 (82): Dominant positions

This article concerns the activities of firms that take advantage of their dominant
position in the market. The Treaty of Rome states that:
“Any abuse by one or more undertakings of a dominant position within the
common market or in substantial part of it shall be prohibited as (being)
incompatible with the common market in so far as it may affect trade between
member states”.
The existence of large firms that dominate markets is not always something to be
criticized. Dominance may be the result of a company’s superior efficiency in being a
better producer or a better seller providing products to the consumers with more
beneficial attributes. Article 86 prohibits the abuse of a dominant position, when it
affects trade between member states. The fact is that it has proved to be rather
difficult to imply a definition for a dominant organization. Dominant firms should
not impose unfair prices or trading conditions on their trading partners. If they use
their market power to develop or hold on to their dominance, they can be held back
by the Commission. Prosecutions depend on either the Commission’s search, or
complaints about firms’ activities.
3.2.5 Articles 90, 92, 93: State aids

Article 92 states that: “save as otherwise provided in this treaty, any aid granted by a
member state...in any form…which distorts or threatens to distort competition by favoring
certain undertakings or the production of certain goods shall, insofar as it affects trade
between member states, be incompatible with the common market”.
In a more simple way, the abolishing of national aids to industry will appear to be
a key element of the Single Market. State aids are subsidies given by the government
sector to organizations, which are designed to affect the expected outcomes of the
market. State aids may include any of the following measures:
ñ Direct cash loans
ñ Tax concessions
ñ Direct investment fund by the government
ñ Permission to use land or facilities at preferential rates
ñ Buying of shares in companies
However, there may be cases where state aids are justified, where the market fails
to come up with a positive result. This happens for example where there is the need
for help so as to save jobs and stop a decrease in the living standards.
61
The granting of state aids can give a substantial competitive advantage to domestic
producers and as a result many are regarded as being incompatible with the Single
Market. Under Article 92(1) of the EEC Treaty, state aids are not permitted if they
affect the EU in any way. However, article 92(2) exempts certain state aids such as
those given for social purposes or in the case of a national disaster.
State aid can be given for several reasons in support of the national industry
including:
ñ The complete failure of the market, which may cause unpleasant activity.
ñ Public goods and strategic industry, for example, the defense industry.
ñ To maintain rates of employment.
ñ To encourage exports.
ñ To develop underdeveloped regions.
ñ To promote projects of European interest.
Member states should inform the Commission of any aids being given to industry,
and these aids must conform to the requirements of the Treaty. If they do not conform,
the Commission can issue a decision requiring the member either to amend or
abolish the scheme.
3.2.6 The new merger legislation:

Regulation EC - 4064/89
The completion of the Single Market changed the nature of competition within
the EU. Firms faced many more challenges in their home markets as the barriers to
trade were removed. This was the great opportunity of the enlarged market for firms
to grow in size as well to develop their research and development plans. One of the
quickest methods to grow was to expand geographically by merging with other firms
in other states. The sale of assets also generated opportunities for other firms to
acquire further assets. The introduction of merger legislation in 1989 at the EU level
presented the fact that merger control was an important issue for the member states.
This was particularly important toward the completion of the Single Market and to
overcome the problem that there were no strong guarantees to avoid potential pan-
European monopolies. It took 17 years to negotiate an EU Merger Regulation and to
decide what powers the commission would have. Its main features were that mergers
should be notified to the European Commission (EC) if the mergers involved:
ñ Turnover of two or more firms in excess of 5bn ECU.
ñ Each firm having turnover of more than 250m ECU.
ñ Less than 2/3 of business in one EU country.
ñ 20% stake in another firm could qualify as a merger.
Furthermore, the EC Merger Regulation specified that:
ñ The Commission must be notified of bid within one week of bid.
ñ The EC has one month for preliminary enquiry.
ñ The EC has four months to complete investigation.
ñ Member states can ask for small mergers to be investigated under EU law.
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The EU’s merger legislation has become well regarded by European business that
tried to create competitive deals everywhere in the environment of the Single Market.
3.2.7 Public procurement

The case of Public Procurement occurs when the EU’s national governments or
other individual public bodies offer contracts for public works by tender, in order to
boost the economy by creating extra jobs in particular industries promoting R&D
and investment in that regional or national economy. The process on behalf of the
firms to obtain the work is through closed bids.
In Section 3.2 we presented the legislation with regard to the European business
environment that provides the guarantees that fair competition will be the case in the
Single Market so as to benefit the consumers through consumption of better
products and the firms through better allocation of resources and progress in the
research and development field.
How does the EU control mergers and state aids?
“The EU Commission is torn between the pursuit of perfectly competitive markets and the
establishment of ‘Eurochampions’.” Discuss this statement.
The current competition policy works well but many may argue that all
member states should enjoy its benefits. The main issue is to keep competition
policy efficient and open to changes and new proposals to plan for an environment
of greater certainty protected by respected authorities.
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APPENDIX
Activity 1
It is illegal for businesses, including the professions, to collude with each other to fix prices
or carve up markets between them. If a single company has a dominant position in a
particular market, it may not abuse its market power to drive out competitors, nor may a
large company exploit the weaker negotiating position of its smaller customers and
suppliers. This makes it illegal for a big firm to impose conditions on its suppliers that make
it difficult for them to do business with other companies. The Commission can (and does)
fine companies for these practices. Some exceptions are allowed. The Commission can
allow companies to cooperate in developing technical standards if the end-result is an
agreed upon single standard for the market as a whole. It can allow smaller companies to
cooperate if this strengthens their ability to compete with larger ones. Some types of
cooperation need specific Commission approval, but others are covered by rules on
blanket exemptions. The overriding consideration is whether consumers will benefit.
Activity 2
Merger control
The Commission can ban mergers between two large companies or takeovers of one firm
by another if the enlarged company would dominate the market and therefore too easily be
able to squeeze out its competitors. The Commission generally only scrutinizes large
cross-border mergers. Unless more than two-thirds of their combined sales are in a single
EU country, companies must clear their mergers and takeovers with the Commission if they
have a combined EU turnover of more than _250 million and a worldwide turnover of more
than _5 billion. It makes no difference where they are headquartered. Mergers between
major US-based corporations or other multinationals are a matter for the Commission if the
companies concerned exceed the EU turnover threshold.
The merger and anti-trust rules changed on 1 May 2004. The changes clarify some rules
and make some procedures more flexible. They facilitate cooperation with national
competition authorities. They also allow firms to use the Commission as a one-stop shop
for clearance of mergers which would not normally come to the Commission’s attention, if
these involve more than three member states.
State aids
The Commission monitors closely how much aid member state governments make
available to business. It looks not just at obvious forms of aid, such as loans and grants, but
at tax breaks, goods and services made available at preferential rates, and loan guarantees
which make the borrower a better credit risk. The Commission does not allow governments
to provide aid to businesses which have no chance of ever standing on their own feet, but
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will agree to temporary assistance if there is a real chance that a business in difficulty can
eventually become more competitive as a result.
Activity 3
The student needs to describe the key objective of competition policy, which is the
elimination of undesirable business practices, and outline the economic benefits of
competition. The concept of ‘dynamic efficiency’ needs to be evaluated, whereby the large
firm (theoretically) gains economies of scale, which then proves to be more allocatively and
technically efficient than a competitive market. Conversely, the student should demonstrate
how introducing competition can bring increased efficiency in another scenario.
65
BIBLIOGRAPHY
RECOMMENDED READING
1994, pp. 90-109, 136-156.
Hall 2001.
Welford R. and Prescott K., European Business: an issue based approach, Second
Edition, Pitman Publishing, London UK 1994.
66
CHAPTER 4
EU SOCIAL POLICY
The scope of this chapter is to analyze the EU social policies and to examine their The Scope
importance to the integrated Europe. of the Chapter
Having completed the study of Chapter 4, the reader will be familiar with: Learning
ñ the nature, scope and purpose of EU social policy Objectives
ñ the rationale for EU social policy and its development
ñ how social policy may address the changing conditions of European labor markets.
ñ Social Charter Key Words

ñ Minimum wage
ñ Economies of scope
ñ Flexible firm
ñ Team working
ñ Lifelong learning
ñ Knowledge driven economy
As resources and wealth within the EU are distributed unevenly, there is an income Introductory
differential between countries as well among the citizens of the EU. Social Policy is Comments
aimed at bridging this gap in income differentials and developing social cohesion and
real convergence of living standards for all its citizens. Just as competition policy is
aimed at producers and consumers, the social policy is aimed at the people of the EU.
67
4.1 WHAT IS EU SOCIAL POLICY?
In the early days of the European Union, economic integration was the primary
objective. The Treaty of Rome, Art. 130a states, “the community shall develop and
pursue its actions leading to the strengthening of this economic and social cohesion”.
The term “social cohesion” as used in the Treaty of Rome includes:
ñ The harmonization of some social measures to enable the movement of workers
within the European Union.
ñ A rather broader objective to protect workers from the potential negative effects
of the Single Market.
ñ The concern for those who find it difficult to get employment in the Single Market
(i.e. disabled, young mothers and elderly people that are no longer active).
EU social policy is an ongoing program by the European Union to raise economic
and employment standards for all EU citizens to a minimum acceptable level. By its
nature, social policy is related to economic regional and industrial policies. The main
provisions of social policy are along the following lines:
ñ The right to education
ñ Equal work opportunities for all
ñ Consultation of workers on management decisions of the business they work for
ñ The notion of fair wage, i.e. establishing a minimum wage
Clearly, harmonization of social policies among member states entails the notion
of upward harmonization. This has been particularly important for Mediterranean
countries such as Greece, Spain, Portugal and southern Italy, which have relatively
lower economic prosperity and, consequently, they have different expenditures on
social policy compared to the other northern European states.
4.1.1 The aims of EU Social Policy

Within the EU, resources and wealth are distributed unevenly. Some areas are
very prosperous while others are relatively poor. One aim of European social policy
is to improve the standards of living of the lower income/wealth areas and to achieve
a real convergence toward the higher prosperity areas. This of course will be a real
challenge especially for the upcoming years, with the accession of more Central and
Eastern European countries. Social policy also aims to eradicate distortions arising
from competition and resource allocation or due to differences in investment and the
marginal cost of labor in different member states. Thus, what competition policy is
for European producers is similar to what the European social policy is for the
citizens of the EU, who should also enjoy the benefits of a Single European Market.
In the absence of a European social policy there would be a risk of social dumping.
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That would be the case when either European businesses moved to locations within
the union that have lower social provisions, i.e. lower cost of labor, and/or employees
moved to those areas of the union offering higher social provisions.
4.1.2 History and development of European Union

Social Policy
First phase: 1957 to mid 1970s

The period between the Treaty of Rome and the mid 1970s was characterized by
some activity in the social provisions area. The origins of Social Policy were
established in the European Coal and Steel Community (ECSC) and the concerns of
the EURATOM Treaty, as well as in the European Community. The main economic
objective of the ECSC Treaty was to achieve integration in the areas of coal and steel,
so as to provide the economies of France, Germany, Italy and the Benelux States
with natural resources. From the social area point of view, the Treaty promoted
improvement in the working conditions of the employees of the industry and
presented plans to resettle and retrain those who intended to leave the industry. The
EURATOM Treaty’s concerns were about basic health and safety matters at work.
Moreover, the Treaty of Rome emphasized working conditions such as social
security and collective bargaining, but its most important outcome was the creation
of the European Social Fund (ESF). The Fund was established in order to encourage
an increase in the mobility of the workforce geographically and occupationally. By
encouraging mobility, it was expected that employability would increase and thus
prosperity could improve for the workforce. Consequently, the ESF emphasized and
financed job-creation schemes and retraining/resettlement of unemployed workers.
Second phase: early 1970s to mid 1980s

In the first chapter we described the economic environment in Europe during this
time period. The social matters were in all the agendas but the oil crisis in 1973 and
its effects on the level of employment limited the activity on Social Policy. The
economic pressures that Europe had to cope with in the mid 1970s caused the
member states to fall back on national responses to economic difficulties rather than
to advance the possibility of the EU action.
Third phase: Single Market – Single European Act

The period from the mid to the late 1980s was characterized by Europe’s effort to
regenerate an integrated mentality, think on a common basis and fight against social
dumping. As we have already seen, social dumping meant that the EU would have to
overcome the fears that the opening of the borders could enable either workers to
69
move to member states with greater social welfare provisions and/or firms could built
plants in those member states having relatively lower social welfare provisions. The
single European Act addressed social issues on health and safety provisions for the
workers and modified the Treaty of Rome regarding social policy with the
introduction of qualified majority voting (QMV), making it possible to bypass
countries such as the UK, which sought to block the legislation.
4.1.3 The Social Charter

The fear and the concern on behalf of the European institutions that there was
going to be a cutoff in the social rights led to the adoption of the Community Charter
of the Fundamental Social Rights of Workers (Social Charter) in 1989. The Social
Charter was a response to the potential danger of some groups being disadvantaged.
The Social Charter was built upon twelve areas of action:
1. Protection of the rights of workers who move within the EU
2. Fair remuneration for employment
3. The improvement of conditions of employment
4. Social security
5. Freedom of association and collective bargaining
6. Vocational training
7. Equal treatment for men and women
8. Information, consultation and participation arrangements
9. Health and safety at work
10. Young people
11. Retired people
12. Disabled people
More analytically the provisions of the Social Charter and the associated programs
are illustrated in Table 1.1
1
For more details see http://europa.eu.int/pol/socio/index_en.htm
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Table 1: Main Provisions of the Social Charter

Fundamental social rights Social Action Program
Freedom of movement
The right of an individual to freedom of Rights of workers to remain in a country;
movement and to work anywhere in the EU on coordinated and equal treatment for social
the same terms as nationals benefits, e.g. subcontracted workers
Employment and remuneration
Freedom of choice to engage in an occupation; Directives covering atypical workers; equivalent
all employees to be fairly remunerated; holiday, pension rights etc. to full-time workers
equivalent treatment for part-time workers
Improvements in living and working conditions
The approximation of working conditions, e.g. Duration and organization of work time, standard
maximum duration, annual paid leave, daily employment contract, union consultation.
and weekly rests contracts Directives on 48 hour week, nights shifts and
written contracts
Social protection
Adequate social benefits for all workers, including Objective: the convergence of social protection
those not in the labor force schemes, e.g. common criteria for benefits
Freedom of association and collective
bargaining Communication on the role of social partners in
Freedom to join, or not to join, a union; the collective bargaining. Unqualified right of the
right to strike; procedures for consultation, original Charter draft amended: existing
mediation and arbitration national legislation takes precedence
Vocational training
Access to vocational training throughout a A permanent vocational training system with
person’s lifetime in a system run by the public leave provided; a common vocational training
authorities policy with comparability of qualifications
Equal treatment
Equal opportunities for men and women; Pregnant workers directive; 19 weeks maternity
amenities to reconcile occupation and family leave; protection of pregnant women at work
obligations and childcare
Rights to information, consultation and
participation Trans-European Works Councils directive;
Especially regarding changes in working supranational works councils to be established
conditions, restructuring and collective in firms operating in two or more EC countries
redundancies with consultation and information rights
Health and safety
Harmonizing and improving standards 12 initiatives and 10 directives. New safety,
hygiene and health agency proposed
Protection of children and adolescents
Minimum employment age not less than the Proposal to ban children younger than 15 from
minimum school leaving age; maximum hours; working and limit 15-17 year olds to a maximum
provision of vocational training; equitable of 40 hours per week (15 for those in education)
remuneration
Elderly persons
Retired people must be able to afford a decent
standard of living
Disabled persons
Additional measures to improve the standard Increasing the rights of disabled people, using
of living of the disabled directives in work, vocational training,
transport and housing
71
None of these provisions were new or radical. The Charter did not contain just a
list of legislation. It drew on other declarations, not just pronouncements from within
the EU, but also the Universal Declaration of Human Rights, the International
Conventions on Civil and Political Rights and on Economic and Social Rights, the
European Convention on Human Rights and others. Much of what is presented in
the Social Charter was already accepted by the member states, except for the UK that
did not sign.
In sum, in Section 4.1 we examined the rationale, the provisions and the history of
European social policy that aims to develop the social cohesion among European
citizens and improve European convergence.
What is the rationale for Social Policy?
What are the main stages of development for the social policy?
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4.2 THE CHANGING NATURE OF WORK

Increased globalization and thus increased competition, along with advances in
technology, communication and telecommunications, have resulted in a number of
structural changes in business organizations that inevitably affected European labor
markets. These structural changes are due to: (1) decline of traditional sectors; (2)
increased competition within the EU, as well as from third countries; (3) the
replacement of labor by technology; (4) the replacement of full-time staff with part-
time staff; (5) outsourcing functions that previously were within the firm; (6) the
flexibility of modern businesses; (7) the Japanization of production; (8) the growth of
small- and medium-sized enterprises (SMEs); (9) the role of women; (10) lifelong
learning, career breaks, e-universities; and (11) Teleworking.
In the last two decades there has been a significant decline in the full-time
permanent jobs in most western economies including the EU. Thus, EU citizens can
no longer consider that they have a job for life. Fifty years ago, an employee with a
permanent job could easily assume that she/he would stay with her/his employer for
as long as she/he was able to work. This certainty of a permanent job would not allow
much motivation, on the part of an employee, to improve his/her skills and abilities
via further education and/or training. Nowadays, however, the average length of stay
with an employer is much shorter than it was in the past. For example, in the UK the
average length of staying at a job is eight years, while in the USA it is much lower. The
idea of ‘a job for life’ is gone and the same applies to the assumption that no further
training is required. Forecasts for 1996-2006 by the UK’s Department of Education and
Employment estimates that there will be 770,000 new jobs created in the UK and
725,000 (94%) will be part-time while 2/3 of these jobs will be taken by women (note
that women’s earnings are about 70% those of men in the UK).
4.2.1 Declining number of workers

In examining the reasons for the declining number of workers, we may distinguish
between manual and non-manual workers. The declining numbers of manual
workers in the EU are often attributed to: (1) automation of assembly lines; (2) a loss
of international markets for traditional industries (steel, coal, shipbuilding, textiles
and so on) in favor of American, Japanese and especially Chinese industries; (3) a
loss of trade union power, inhibiting the unions’ ability to fight for the employment of
their members; (4) privatizations of state-owned companies leading to substantial
labor reductions in order to achieve maximization of profits for shareholders. On the
other hand, the declining numbers of non-manual workers are often attributed to
management restructuring and more specifically to either outsourcing or downsizing.
73
Outsourcing is the case when, in order to save costs, a firm cuts its labor force and sub-
contracts work to outside specialist organizations (e.g. office cleaning, catering,
human resources service, payroll services and information technology). Costs of
employing labor are thus reduced or saved (e.g. pensions, national insurance
contributions, sickness pay, paid leave, office space and costs, rents, council tax,
heating and lighting). Also when work for business diminishes the outsourced
suppliers bear the lower income, not the business. Delayering/Downsizing is when
entire levels (layers) of usually middle management (managers) are eliminated from
business organizations in order to cut costs. As a result, those remaining employed
have to work harder with low morale (“Am I going to be the next to leave?”) and
stress from overwork (often that means a tendency to stay at work longer). Neil Harris
(1999), in summarizing Charles Handy,2 defines the strategy for downsizing as:
Competitiveness = ó á 2 á 3 = P
where
ó = half the people are employed in an organization
2= they are paid twice as much as previously
3= they are expected to produce three times as much as before
P = Profit
4.2.2 The flexible firm

According to the approach developed by J. Atkinson3 in the mid 1980s, the higher
level of competition from Japan (the Japanization of the business organization) has
forced firms to adopt flexibility. In a flexible firm, employees of a firm are
distinguished into two categories: they are either core employees or peripheral
employees. Core employees are full-time, permanent career workers such as
managers, designers, or technicians, who in return for job security, i.e. having a
permanent job and enhanced terms and employment conditions such as a higher
salary or the possibility for training and education, may accept both short-term and
long-term functional flexibility. They may perform a wide range of often unrelated
jobs (working one month in one area and another month in another area, if business
so requires), work as members of multi-disciplinary teams, or may be expected to
retrain, abandon existing careers/start new ones. On the other hand, peripheral
employees are those with jobs less significant to the business. Their jobs are less
specific to the business and hence their skills are more generalized. Peripheral
employees can fall into one of the following categories: short-term contracts, job
sharing, part-time work, and trainees that are subsidized by the government. They
2
Charles Handy (1994), The Empty Raincoat: Making Sense of Modern Business, London, Arrow Books.
3
Jon Atkinson (1984), “Manpower Strategies for Flexible Organizations” Personnel Management, Vol. 16,
no. 8.
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also have fewer opportunities for firm-based benefits such as staff development.
Clearly, when a firm needs to make adjustments through cost pressures (as a firm may
face changes in the demand for its products due to higher international competition),
some of the peripherals will lose their jobs, e.g. short-term contracts are not renewed.
A third group of people is the self-employed workers that undertake the
outsourced work. This group will be exposed to any changes in conditions and will
incur the risk of business downturns.
Cost saving policies on behalf of the firms aim to shift the average and marginal
cost curves to the right and so exploit economies of scale by expanding firms output.
This is illustrated in Figure 1.
H Long-run average cost curve (LAC)
Output
Figure 1: Economies of Scale
A movement along the long-run average cost curve from point A to point B will
increase output and lower the average cost, thus leaving higher profits for the firm.
That is the case of economies of scale often occurred due to specialization of labor
and capital in the production of a good or service. Clearly, a shift in the LAC to the
right and downwards by adopting downsizing, outsourcing or distinguishing between
core and peripheral workers, will reduce cost and will increase profits, provided that
other things remain equal. Modern firms, however, may not try to exploit economies
of scale as they may instead prefer to exploit economies of scope. Economies of scope
occur when a reduction in average cost is due to the production of two or more
products by a single firm. An example is the case of a transport industry that uses the
same fixed capital for passengers and freight transport. In this case of economies of
scope the overheads such as information technology, marketing, premises and so on
can be spread over a number of products.
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4.2.3 The Japanization of production methods
Due to the Single European Market, many multinational companies (MNCs)
established subsidiaries in the EU in order to avoid the common tariff wall they had
to face by producing outside the EU. This has led to higher competition and thus
European firms have gradually adopted Japanese production methods such as Just in
Time, Total Quality Management, team-working and quality circles.
Just in Time (JIT)

According to this production method, component parts and intermediate goods
are ordered and delivered just before the production (this method is called Just in
Time, although in the EU it is mainly Just in Case). Component suppliers are
located close to the plant, servicing its stock needs by making up to 16 deliveries a
day. The suppliers have full responsibility for the quality of the components they
deliver, while the final producer does not need to have large volumes of stock, or
waste time in checking the quality and delivery of the components to be used.
Consequently, the JIT method essentially minimizes inventory costs.
Total Quality Management (TQM)

TQM states that all staff, at all stages of the productive process, should constantly
re-evaluate methods in order to improve quality. Rather than solving problems once
they have occurred, TQM seeks to prevent them from occurring in the first place;4
prevention rather than cure minimizes costs. Thus all members of the business are
responsible for the quality of the work they undertake and hence for the quality of
the final goods/services delivered. Essentially this method aims at having zero defects
in all work undertaken within the firm.
Team-working
This method of production is based on the Japanese culture which is different
from the European and the American cultures. Indeed, European and American
cultures are more individualistic, while the Japanese culture is more family or group
oriented. In Japanese businesses, therefore, more emphasis is given to teamwork.
Quoting Harris (1999, p. 271), “If one member of the team is not performing as well
as he/she should, then the rest of the team has an obligation to help until the person
can catch up or otherwise rectify the problems”. This method essentially raises
collective responsibility for high quality products. An example of team-working is the
quality circles, in which workers meet on a regular basis per week in order to discuss
4
N. Harris (1999, p. 269).
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ways of improving the quality of their work. Their suggestions for improvement are
then forwarded to the management of the firm.
4.2.4 Other developments in the EU labor markets
The Growth of Small- and Medium-Sized Enterprises (SMEs)

SMEs are companies with less than 250 employees and are often family operated
and owned. An SME does not have to be owned by Europeans in order to be
considered as a European business. In the EU there are about 19 million SMEs,
representing 99.8% of all enterprises, which have been the major job generator by
providing jobs to more than 70 million people. That is about two-thirds of all EU
employment, 55% of turnover and 65-85% of the total value added (see e.g. OECD
2000, EUROSTAT, 1999). Moreover, SMEs contribute to regional development,
social cohesion and innovative creation.
The Role of Women

Women can get a job more ezsily than men can, as they are more flexible in terms
of the daily hours they can work. Many want to work only during school hours or in
the evenings when the husband/partner is looking after the children. They are more
adaptable than men. Women are also paid less than men. On average women are
paid 76.3 percent of what males earn, as illustrated in Table 2.
Table 2: Percentage of Female Earnings to Male Earnings on 31 January 2000
Countries Female wage/ Male wage

Denmark 88.1%
Sweden 87%
Luxemburg 83.9%
Belgium 83.2%
Greece 68%
Netherlands 70%
Portugal 71.7%
EU 76.3%
This wage discrimination against women makes them more economically attractive
to employers.
77
Lifelong Learning, Career Breaks, e-universities
Wages for skilled labor are not only higher than the wages for unskilled labor but
they are also increasing more, resulting in an increasing wage differential over time
between these two categories of workers. This also suggests a positive role for education,
training and in general investment in human capital. Moreover, it is becoming more
and more fashionable for workers to take career breaks or even complete changes of
occupation, because these are seen to increase motivation levels. This has contributed to
the idea of lifelong learning, rather than having an investment once in a person’s life.
This requires that people go back into further/higher education a number of times during
their lives, either for short courses or for longer-term qualifications such as an MBA.
e-trade or e-commerce and Teleworking

The advances in technology and the use of the Internet allow businesses to trade
their products in new markets, e.g. 24 hour shopping or home shopping, thus
resulting in a higher level of competition with lower transaction costs for buyers/sellers
(cutting out the middleman). These advantages will boost new businesses and
employment, especially the SMEs run by families. Another development associated
with the use of the Internet is the possibility of working from home (Teleworking).
4.2.5 The issue of minimum wage

Workers in most Western countries favor the establishment of a minimum wage.
We turn our analysis to the economic definition of a minimum wage, with the help of
Figure 2, where W/P is the real wage and L stands for the work time.
W/P LD
LS
(W/P)Min
(W/P)*
L* L
Figure 2: The Imposition of a Minimum Wage
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CHAPTER 4
In Figure 2, Equilibrium occurs at (W/P) * where the demand curve (L D )

intersects the supply curve (LS) of labor and full employment occurs. For real wages
over and above the equilibrium, there is involuntary unemployment. That is, for
(W/P)Min > (W/P)* the labor market results in involuntary unemployment. The size
of this involuntary unemployment depends on how high the wage rate is set.
Arguments for Introducing a Minimum Wage

1) Social justice
Due to the possibility that market forces may drive the equilibrium wage to levels too
low to subsist, there is a need for government intervention on equity grounds to protect
weak or poorly qualified workers, such as immigrants, women and part-time workers.
2) Keynesian multiplier argument
People, by having more income due to the establishment of a minimum wage, will
spend more, resulting in increased consumption and thus an increased aggregate
demand which will lead to a higher GDP (as more is produced to meet the higher
demand). This, in turn, will increase economic growth and welfare, e.g. the German
model of high earning and high spending (assuming spending is on domestic goods
and not on imports). This idea is based on the empirical evidence that lower income
consumers have a higher propensity to consume than wealthier consumers who save
more.
3) Income redistribution alternative
Income inequalities have increased since 1979 and minimum wage may help in
reducing inequalities.
Arguments against Introducing a Minimum Wage

1) Efficiency
Regulated markets work less efficiently as in a flexible labor market introduced in
the 1980s in the USA and UK (the Anglo-Saxon model), resources are allocated
more efficiently.
2) Origins of unemployment and low pay
Unemployment and low earnings (two sides of the same problem) are due to
skills gaps between well qualified (and hence well paid) workers on the one hand,
and low skilled on the other. A better policy could be to improve education and
training. Also, a minimum wage will not help the unemployed 5-10% of the
population since they do not work anyway.
3) Competitiveness of the country
Adoption of a minimum wage may harm the competitiveness of the country (higher
labor cost will pass to the prices of final products), creating inflationary pressures and
in the end the government should adopt an exchange rate depreciation to offset
inflationary pressures.
4) What is the correct level of the minimum wage? There is not a clear answer.
79
Empirical Evidence on Minimum Wage
The empirical evidence on whether a minimum wage (MW) creates
unemployment is inconclusive. In particular studies are categorized into prior and
post 1990s studies.
Prior to 1990s: Most USA studies suggested that the adoption of MW would have
a small negative effect on employment (elasticity of employment wrt MW between
–0.2 and –0.1).
Post 1990s: Card and Krueger (1994) found that increasing minimum wage in
New Jersey from $4.25 to $5.05 led to 13% increase in employment.
French studies find a small negative effect of a MW of between –0.12 and –0.15.
UK: From April 1999 the adult MW is í3.60 per hour and í3.00 per hour for the
18-21 year olds (rising to í3.20 in June 2000). It is estimated that 1.9 million workers
will be directly affected by having a real wage increase, of which 66% will be women.
The MW is likely to raise the overall wage bill by around 0.5%, resulting in an
increase in inflation of around 0.5% The Bank of England’s Monetary committee
argues that the likely overall effect of the MW on unemployment is uncertain.
Stephen Machin and Alan Manning5 (who examined nursing homes on the south
coast of England) suggest that wage increases of 15% will not create job losses.
4.2.6 How the EU is responding to the changing

nature of work
With regards to SMEs, the EU places considerable emphasis on them as a vehicle
for wealth creation and especially for generating employment. The EU promotes
SMEs, especially high-tech SMEs, by providing tax incentives, better access to
finance, training courses for entrepreneurs, and providing mentors to new
companies to help them develop. One million new businesses start each year in the
EU and most of them are SMEs. Half of them have failed within five years and the
other half grow and provide jobs.
Regarding the Japanization of production, the EU has moved to the adoption of
the Japanese methods such as JIT or TQ. This is also due to the FDIs (Foreign
Direct Investment). These methods are expected to improve the cost conditions and
the quality of the EU products (competitiveness is not only in terms of prices).
The EU response to downsizing/delayering is by promoting education at the
primary, secondary and tertiary levels up to the age of 24. It offers programs for training
and retraining for new careers, as existing sources of employment decline. It promotes
the links between employers and employees as well as industry links and cooperation.
5
Machin, Stephen and Allan Manning (1994) “The Effects of Minimum Wages on Dispersion and
Employment: Evidence from the UK Wage Councils,” Industrial and Labor Relations Review, 47(2), pp.
319-329.
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The year 1996 was designated as the “year of lifelong learning” in the EU. The
ideas of a Knowledge-Driven Economy and Society or a Learning Society are based
on the acquisition of new knowledge and involving teaching and lifelong learning.
Some Knowledge-based policies adopted by the EU are the encouragement of
innovation, research, education and training. Also, the establishment of e-
universities and the adoption of distance learning in the whole EU are encouraged.
Universities are becoming more responsible to learner and employer needs. As stated
by the Council of the European Union in January 2000, “Innovation and knowledge
are increasingly becoming the decisive source of wealth and also the main source of
difference between nations, businesses and people. Fresh opportunities for redefining
European competitiveness and creating new jobs are thus arising, but also new risks
of social exclusion”.
The European Council meeting in Lisbon in April 2000 set the following targets:
ñ Medium-run target of 4% unemployment.
ñ Investment in human capital should increase by 25% by 2005 and 50% by 2010.
ñ In 2000 the percentage of the population below poverty was 18%. This should be
reduced to 15% by 2005 and to 10% by 2010.
ñ Incorporation of information technology into economy, education and
dissemination of knowledge in the EU countries.
ñ The EU could follow a model similar to the USA model of the last 10 years: High
growth, low inflation, low unemployment, businesses/consumers embrace new
technologies. The above can be achieved by adopting better coordination of
economic and technological policies of the EU states; a knowledge-driven society
based on innovation, efforts toward the improvement of competitiveness of the
EU economies through innovation, the adoption of macroeconomic policies that
will sustain economic growth (3% in 1999).
Regarding the minimum wage one can say that it underpins the Social Charter.
Minimum wage is common throughout Western Europe and reinforces the Social
Charter of Maastricht. Low wages force workers into the black market, or encourage
them to resort to unlawful employment practices.
In Section 4.2 we presented the changing nature of work and how this affects
European labor markets. We then examined the efforts of the EU to address these
changing conditions in order to develop social cohesion and form a social policy.
What are the labor market policies and outcomes in the UK that has adopted the Anglo-
Saxon model of labor market as opposed to the German-French model of labor market?
81
In this chapter we examined the rationale, the provisions and the history of
European social policy that aims to develop social cohesion among European
citizens and improve European convergence. We also presented the changing
nature of work and how this affects European labor markets. We then examined
the efforts of the EU to address these changing conditions in order to develop
social cohesion and form a social policy.
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APPENDIX
Activity 1
The moral obligation to the electorate of any democratically-elected government is to provide

the best facilities and opportunities it can for its workforce. The economic rationale is that a
better housed, educated and rested workforce, with a ‘satisfactory’ standard of living will work
better, be more flexible in its attitudes and so on. This should contribute to improved labor
productivity, GDP, quality of output. These are important dimensions in the era of
globalization and increased competition, when the EU countries cannot compete on cost
grounds to cheap labor costs of NICs, and hence needs to compete in terms of quality which,
of course, depends on skills and education. A flexible workforce is adaptable to the changing
nature of modern labor markets (we will see more later on about the changing character of the
labor markets and also e-trade, Internet and so forth). The EU (since the mid 1980s) has tried
to demonstrate to the population of the EC/EU that the benefits from the SEM and a wider/
deeper economic integration extend to all, not just to businesses via scale economies. There
is a human/social dimension to economic and political progress. Otherwise there is the risk of
social dumping by firms and labor: businesses seeking new locations for investment where
social provisions are lower and hence the cost of employing labor is less or labor moving to
areas where social provisions are greatest, e.g. Portuguese workers moving to Germany.
Social policy promotes the idea of convergence among EU states and EU areas.
Activity 2
The Treaty of Paris 1952: Creation of ECSC (European Coal and Steel Community).
The Treaty of Rome 1957: Creation of EEC (European Economic Community) and
EURATOM (European Atomic Community). Articles 117-122 emphasize EC promoting
improved and harmonized working and living standards.
Article 119 emphasizes equal work for men and women. The 1970s saw stagnation in the
EU Social Policy known as Eurosclerosis due to oil price hikes: 400% oil price hike in 1973
and 100% in 1979.
The Single European Act
1. Greater freedom of movement for labor
2. Addresses social dumping, created by workers and firms, by upward harmonization
3. Promotes social dialogue to improve industrial relations (co-determination), the right of

workers to be consulted, express their views and have input into management decisions.
The Social Charter 1993
1. Fear that the single market would lead to reduction of social rights through business’
desire for cost efficiency.
83
2. Need to demonstrate that citizens benefit from the single market.
Establishes twelve minimum conditions for all countries, to be implemented in order to

achieve upward harmonization.
Activity 3
ñ Early post-war view: Government should intervene in the economy to achieve full
employment. Keynesian view of demand management. White Paper on employment
1945. Use of fiscal policies to counteract recessions or inflationary pressures during
booms.
ñ 1970s and 1980s: Doubts about the above approach. Trade unions were strong, two
supply shocks and the collapse of Bretton-Woods led to high inflation and high
unemployment. Monetarism and the new classical economics. An increased scepticism
about the ability of the government to influence macro-outcomes. 1980s reduction in
trade union power.
ñ 1990s: “Selective Employment Measures” rather than general reflation or deflation.

Targeted labor market programs with three objectives:
1. To reduce the overall level of unemployment.
2. To overcome imperfections in the labor markets, especially training,
3. A fair distribution of employment and training opportunities across the population.
Wage and employment subsidi\es
a) General subsidies: Applied to all employees, so employers get “windfall gains” but
spread thinly so not that successful in reducing unemployment.
b) Recruitment subsidies: These apply to the wages of newly hired workers.

Shortcoming: There is an incentive for firms to increase their labor turnover rather than
to create extra employment.
c) Marginal subsidies: Payments are based upon changes in the stock of employed
persons and apply to the cost of those hired above a given base level of employment.
This in theory should be the best form of subsidy. However, this method is criticized
because of the “displacement” effect: subsidized firms gain a competitive advantage
over the non-subsidized, which leads to lay-offs (or reductions in new hires) in the non-
subsidized firms. In open economies these subsidies are at the expense of foreign
workers abroad and have the effect of export subsidies. The empirical evidence
suggests small employment gains. That was the TES (Temporary Employment
Scheme) subsidies to firms to keep workers on to produce more output.
d) A different approach is the Temporary Short Time Working Scheme (TSTWS). This
approach reduces labor supply by subsidizing leisure rather than work. “Worksharing”,
early retirement, increased annual leave and sabbaticals.
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e) Public sector job creation: This is a 100% employment subsidy. Most EU countries try
to avoid it, since since it is a relatively expensive policy compared with subsidies, jobs
are temporary rather than permanent, workers are not integrated into the labor markets,
and the public sector does not produce in an efficient way.
Policies to reduce wage pressure
Keynes’ idea of wage-price relation: An increase in wage leads to an increase in price.

Phillips curve and the augmented Phillips curve. An alternative to a demand management
appeared to be income policies. That is by controlling wage fixing in the labor market, the
rate of increase in the product market could be reduced. Wage freeze, or increase in wages
in line with the rise in productivity. Income policies can be an instrument to reduce union
power and thus NAIRU. Adoption of income policies such as a tax on wage increases.
Shortcomings: the distributional aspects of income policies. Wage differentials increase
between rich and poor. Advantages: Productivity gains. UK the Thatcher Government of
1979 reduced union power and removed the wages councils.
Labor market regulation, institutions and flexibility
Culture, politics and institutions are important in determining the way in which labor
markets work in different countries. So models working in one country cannot easily be
transplanted to another country. For example, the Japanization of manufacturing
production is difficult in the UK. The key issue in the UK and USA (Anglo-Saxon model) is
flexibilization:
1. Pay the greatest flexibility of wages, more decentralized and individual bargaining. So
more diversified pay rates, which are more performance related.
2. Employment contracts: Decrease in traditional full-time and increase in part-time

contracts. Sub-contracting, self-employment.
3. Working time: The movement away from the standard 40 hour work week toward less.
4. Work organization: The movement away from single-skilled jobs toward multi-skilling,
team working, quality chains, continuous or lifelong learning.
85
BIBLIOGRAPHY
RECOMMENDED READING
Card D. and Krueger A.B. (1994), «Minimum Wages and Employment: A Case
Study of the Fast-Food Industry in New Jersey and Pennsylvania», American
Economic Review, vol. 84, pp. 772-93.
1994, pp. 90-109, 136-156.
Hall 2001.
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CHAPTER 5
THE SINGLE MARKET AND THE

EUROPEAN SINGLE CURRENCY
The scope of Chapter 5 is to present the reasons that created the need for the Single The Scope
European Market (SEM) and the use of a Single European Currency (SEC). of the Chapter
ñ able to understand the history of the SEM Objectives
ñ familiar with the structure of the SEM
ñ able to understand the history and development of the SEC.
ñ Single European Market (SEM) Key Words

ñ Single European Currency (SEC)
ñ Convergence criteria
ñ Euro
The Single Market (alternatively called the internal market) is an economic space Introductory
without internal frontiers and barriers, where goods, services, capital and people can Comments
move without any restrictions. From a European business point of view, this is the
result of integrating business laws and regulations among individual member states
that trade freely. The EU committed to establishing a common market by the Treaty
of Rome in 1958. However, for the next two or three decades, there was very little
progress toward establishing the Single Market. The main problem was the difficulty
in reaching agreement about eliminating the non-tariff barriers (NTBs) which
hindered free movement of goods, services, capital and people.
87
5.1 THE NEED FOR A SINGLE EUROPEAN
MARKET
5.1.1 Inflation in Europe

In the 1970s, a high inflation rate was the main macroeconomic problem for
almost every country in Europe. This was an ongoing unpleasant economic situation
and in the 1980s European countries accepted that controlling inflation should be
the top macroeconomic priority, regardless of the high rates of unemployment that
could arise, leading their economies into a recession. West Germany’s economy with
the lowest inflation rate was the model to be followed, thus EC countries started
converging inflation to that of West Germany’s. As EC economies began to
converge, hopes of greater European economic co-operation rose.
5.1.2 Economic Integration in the EU

Member states within the context of the EU joined their forces in creating a much
larger European economy, aiming to improve the economic welfare of their citizens,
and at the same time, to enhance the process of European political integration. It is a
fact that when there are no guarantees of free trade between countries, markets favor
agreements to satisfy business interests and needs of particular member states. Some
of the possible types of agreements are described briefly below, in order of the
required commitment on the part of the participants.
1. Trade Agreements
Certain countries are preferred in international trade compared to other countries.
This is often the result of political motivation that serves the political strategy of a
nation.
2. Free Trade Areas (FTA)
These are agreements between participating countries on removing tariffs,
quotas, or other barriers to trade that hinder the flow of goods and services between
member states. However, member states are still free to impose their own tariffs
against third countries.
3. Customs Unions
Customs unions have been used in the past to promote political as well as
economic integration. The main features of a customs union are as follows:
ñ Tariff barriers are eliminated between member states.
ñ A common external tariff (CET) is imposed on third countries. This implies that
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import duties are charged at the same rate regardless of the point of entry.
ñ Customs revenues obtained by the imposition of the CET are distributed among
the member states.
4. Common Markets
A common market is the next step toward economic integration, as this extends
the customs union by incorporating free movement of capital, goods and labor, as
well as adopting common policies to deal with areas such as transport, energy,
industry and taxation.
5. Economic Union
Economic union promotes the idea that all economies are managed collectively in
an integrated environment without the negative effects of national sovereignty. That
requires the existence of common economic policies and the establishment of a
single European currency.
5.1.3 A Single European Market (SEM):

What was the need for SEM?
The great expectation for the EC was, from the very beginning, to emerge as a
true common market rather than a simple customs union, relieved from all sorts of
barriers holding back free trade of goods and services, as well as having the free
mobility of capital and labor. In the early 1980s most trade tariffs and quotas had
been removed, but significant non-tariff barriers to intra EC trade remained in the
form of different national legislation on environmental, health and safety policies as
well as subsidies, exchange controls and other product technical standards.
In order to compete with the US and other large economies, e.g. Japan or Korea,
Europe needed a true SEM where all non tariff-barriers to intra EC trade should be
removed in order to enhance competition and specialization, increase output per
worker and thus allow living standards to rise. That should be followed by the use of a
single currency and political integration.
5.1.4 The Single European Act (1987)

The Single European Act, which was signed in Luxembourg and The Hague in
1986 and came into force on 1 July 1987, was the first modification of the foundational
treaties of the European Communities, that is to say, the Treaty of Paris in 1951 and
the Treaties of Rome in 1957.
The plan of the SEA was to create a Single Market in Europe by 1992. The legislation
arose as a result of the influence of Jacques Delors and the findings of the European
Commission’s white paper, “Completing the Internal Market,” under Lord
Cockfield. This white paper, commonly known as the 1985 Cockfield report, presented
300 measures that needed to be considered so that a single market could emerge, and
identified three broad types of barrier to the completion of the Single Market: physical
89
barriers, technical barriers and fiscal barriers. These barriers were in place for a variety
of reasons, such as the protection of domestic producers, and had been in existence
for a long period of time. As mentioned above, the Cockfield report advocated the
elimination of non-tariff barriers and the free movement of goods, services, labor,
and capital.
NTBs take three forms:
Physical Barriers: Until their removal in 1993, significant physical barriers to
trade existed at the customs posts throughout the EU. These include such things as
border controls, administrative procedures, and barriers to transport. Britain,
Denmark, and Ireland kept minimal border controls in place after 1992, for a variety
of national reasons, including fighting terrorism and helping the fight against drugs.
Fiscal barriers: These include different forms of direct and indirect taxation,
which serve to distort intra European trade. The EU needs to move toward a
harmonized system of taxation that does not distort market conditions. This implies
that there must be a harmonization of tax rates, the tax base and the enforcement of
taxes.
Technical Barriers: This is the problem of meeting the divergent national
standards and regulations regarding the different legislative frameworks on the
technical standards of European products.
It was hoped that the completion of the Single Market would:
ñ Allow the full exploitation of an enlarged market.
ñ Encourage firms to become more efficient as they faced increased competition
and had greater opportunities.
ñ Benefit the consumer by offering a wider choice of goods and services at lower
prices.
ñ Speed up the process of political integration.
5.1.5 The Cecchini Report (1989)

The Cecchini report in 1989 projected that the “single market” would add 4.5
percent to the GDP of the 12-nation EU, adding somewhere between 1.8 to 5 million
jobs, subject to the macroeconomic policies being followed. Also, it projected a
reduction in consumer prices of about 6 percent in the medium term and an increase
in the intra-EU trade of about 1 percent. All these gains would arise due to a number
of contributing factors, such as: (a) economies of scale; (b) higher efficiency arising
due to competition; (c) improved innovation; and (d) reallocation of resources. On
30 October 1996, the EU released a report on the first four years of the single market
and it estimated that the GDP of the by-then 15-nation EU was 1.1 to 1.5 percent
higher than it would have been without the removal of market barriers and that a net
300,000 to 900,000 new jobs had been created.
In sum, in Section 5.1 we presented the environment that led Europe to develop
an integrated approach through a rather hard process to overcome member states’
national interests and to accomplish truly free trade. The gains obtained with the
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establishment of the single European market showed the way toward the deepening
of the union into a Monetary and Economic Union.
What is the importance of the Single European Market to individual member states and how
does it work?
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5.2 THE ECONOMIC AND MONETARY
UNION
5.2.1 The European Monetary System (EMS)

In the late 1970s, because of the two oil shocks, there was an attempt at monetary
stability between one currency and another, so as to stop the fluctuation of exchange
rates. As a result, the European Monetary System came into existence that became
part of the treaties via the Single European Act in 1987. Its further development
came to be considered as the basic axis for the completion of the Single Market,
because exchange rate instability was seen as a significant barrier to trade. There are
three main features of the EMS: the European Currency Unit (ECU), the Exchange
Rate Mechanism (ERM) and the European Monetary Institution (EMI).
The ECU was a composite of the EMS currencies, weighted according to their
importance in trade, with the following functions:
ñ It served as the central rate of the Exchange Rate Mechanism.
ñ It was the nominal currency that the EU used to conduct its transactions, i.e. on
products related to the Common Agricultural Policy (CAP).
ñ It was used as a means of settlement between monetary authorities in the EU.
The Exchange Rate Mechanism was the most important element for the European
Monetary System that allowed currencies in times of fluctuation to move by a +/-
2.25% margin against their central rates. In 1995 the last ERM crisis occurred, due to
the strengthening of the deutschemark against the weakness of other currencies.
The European Monetary Institute was established on 1 January 1994 and its
main functions were to:
ñ Strengthen cooperation between national central banks.
ñ Monitor the operation of the EMS.
ñ Facilitate the use of the ECU and overlook its development.
Despite the success of the EMS in the 1980s, it received harsh criticisms in the
early 1990s when there was a severe exchange rate crisis. It was made clear that there
was no real commitment that the members of the ERM would have unlimited
support for their currencies if they were placed under pressure, and furthermore that
it was wrong to move to the EMU from the base of the EMS.
5.2.2 The Delors Report (1989)

At a meeting in Hanover on 27-28 June 1988, the European Council set up a team
under the leadership of Jacques Delors, president of the European Commission, to
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develop proposals for the progressive completion of the EMU. The report that was
produced is generally known as the Delors Report. It came up with a series of proposals
for moving toward EMU, leaving behind the EMS. Thus, in April 1989 the report of the
Delors’ Committee anticipated the accomplishment of the EMU in three stages:
ñ Stage 1: 1990-1994
The first stage involved the completion of the Single Market with freedom of
movement for goods and capital.
ñ Stage 2: 1994-1999
This stage was designed to prepare the foundations for the establishment of the
Single Currency, considering convergence criteria that would not cause a monetary
shock to the participating currencies. The European Monetary Institute was created
and the idea of the European Central Bank was adopted to replace it.
ñ Stage 3: 1999-2003
This stage included the adoption of a single currency and the implementation of
the European Central Bank.
The Maastricht Treaty in 1991, as we will present in more detail in Section 5.2.4,
was designed to ensure that progress was made, and that no individual member state
could delay the process for its own political purposes. The requirement that states
meet the convergence criteria before adopting the Single Currency was in favor of
the states that wished to see that the quality of the new currency met the highest
standards regarding economic stability.
5.2.3 The convergence criteria

The adoption of a set of convergence criteria was indeed undertaken in order to
guarantee that national economies would adopt the single currency without having to
suffer extreme consequences. The move to the third stage of the EMU depended on
the progress of the member states toward achieving a number of strict convergence
criteria, which were placed in the Maastricht Treaty and are in the form of temporary
arrangements. The convergence criteria are the following:
1. For one year, inflation rates must be within 1.5 percent of the three best performing
economies.
2. For one year, long-term interest rates must be within 2 percent of the three best
performing economies.
3. The exchange rate should follow the ERM standards of +/-2.25 percent for two
years without devaluing.
4. The country’s budget deficit should not exceed 3 percent of its GDP.
5. The ratio of the national debt should not exceed 60 percent of GDP at market prices.
5.2.4 The Treaty of Maastricht (1991-1993)

In December 1991, in the town of Maastricht in the Netherlands, the European
Union established the Maastricht Treaty, which offered the EU an opportunity to
93
become a political and economic world power. The treaty provided the basis for a
single European currency, common citizenship, common foreign and security policy,
a more effective European Parliament, and a common labor policy. Each of these
goals presents some challenges for the countries involved, such as setting a new
monetary policy.
The original goal of the EU was to establish a bloc of countries within which
goods could be traded tariff-free and without quotas. The Maastricht Treaty would
establish a single EU currency; provide the EU with more power to deal with such
matters as the environment, education, public health, and communications among
members; establish a common foreign and defense policy; and create greater
cooperation among the members’ police and justice systems. The concept of a
monetary and an economic union was raised for the first time in the Treaty of
Maastricht in December 1991. This was the most significant difference between this
treaty and the Treaty of Rome that was drafted in 1957, and put into action in 1958.
The success of the economic and monetary integration of the European Union
would be critical for the future of the union. In the Treaty of Maastricht, it was
decided that there are five economic and monetary conditions/requirements, known
as the convergence criteria mentioned above, that have to be fulfilled before a
member state is allowed to join the European Monetary Union. The requirements
were extremely strict, as the key to success of the European Union lay in convergence
of the economies of the individual nation states. All nations would need to maintain a
similar economic standard. The five criteria of standards developed in the Maastricht
Treaty would insure that there is economic compatibility between the member
nations. Below is an analysis of each requirement that a member state should meet.
ñ The first of the five economic criteria concerns price stability in the member
states. To measure price stability is to analyze the inflation rate for each one of the
national economies. An average is taken of the three nations with the lowest
inflation rates of all the nation states in the European Union so as to create a fair
determinant of the level of inflation that is accepted. The inflation rate of a
candidate member state should be within 1.5 percent of the three best performing
economies.
ñ The second criterion that was considered to be important is the long-term
interest rates of the nations. These interest rates are directly related to the
economic activity in the nations. It can be controlled to a certain extent by the
individual governments, as they can adjust the long-term interest rate to fit the
country’s long-term economic needs. Long-term interest rates of a candidate
member state should be within 2 percent of the three best performing economies.
ñ The third criterion that has to be met regards the stability of currencies. Before a
fully functioning European Currency Unit could become a reality in 1999, the
member states would have to ensure that there was economic compatibility within
the states. The European Currency Unit was used as the control unit, against
which the nation’s individual currencies were compared. According to the treaty,
currencies were not allowed to fluctuate more than 2.5 percent from an upper and
lower boundary of the European Currency Unit without devaluation.
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ñ The fourth economic criterion that the nation states have to satisfy deals with is
the national average budget deficit. The budget deficit demonstrates the relative
strength of an economy. In addition, it gives us a fair idea of government policies
and political aspects of the individual nation’s monetary systems. The treaty states
that the national average budget deficit (budget balance) may not exceed three
percent of the member state’s gross domestic product.
ñ Perhaps the most difficult criterion that individual member states have to meet is
the fifth condition. The criterion for this condition is the following; the public
cumulative debt may not exceed sixty percent of the national Gross Domestic
Product. The key word in this condition that makes it so difficult to fulfill is
“cumulative”. It takes a long time to lower the cumulative debt as it is generally
increasing, as interest on debt may be paid by buying new debt. The cumulative
debt criterion gives us the best determinant for analyzing the strength of an
economy. In several cases, the cumulative debt of several countries, e.g. Greece,
exceeded the GDP.
The ultimate goal of the Maastricht Treaty was to facilitate a monetary and
economic union with a single currency by 1999. The whole purpose of an economic
union is to tie the economies in the EU together, and foster economic cooperation-
operation and strength.
In sum, in Section 5.2 we presented the European situation from the early 1970s to
the early 1990s and all the intermediate stages to reach the Monetary Union in the
Treaty of Maastricht. A monetary union is indeed needed to support a single European
market and a single currency. Without a monetary union, the EU will not be able to
create a central bank. Without a central bank, it will be impossible to create a European
Currency Unit that would support the three functions of money.
What is the importance of the Treaty of Maastricht?
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5.3 THE SINGLE EUROPEAN CURRENCY
(SEC)
5.3.1 What is the SEC to the EU?

The EU requires all its members to share a Single European Currency to complete
the SEM, and guarantee EU-wide economic convergence. Sharing a SEC has
profound economic implications; removal of transaction costs when exchanging EU
currencies is a visible but minor issue.
5.3.2 Life in a single currency

The adoption of the euro as the SEC shared by all EU members means that each
of the 15 member states in Euroland ceased to have its own interest rate. All SEC
members face the same set of SEC interest rates. Indeed, the European Central
Bank sets short-run SEC interest rates. A single set of SEC interest rates does not
encourage inflation to converge across the SEC area, and as a result, high inflation
SEC members face lower real interest rates than the low inflation SEC members.
Powerful microeconomic forces converge inflation across the SEC area, since firms
directly compete with each other across the SEC area. As result of this competition,
if one SEC member’s inflation rate is above the inflation rate in the rest of the SEC
area, that member’s industry would directly lose competitiveness to the rest of the
SEC area. The high inflation SEC member’s level of unemployment would inevitably
rise, until that member’s inflation rate fell to the SEC area’s converged inflation rate.
Inflation automatically converges across the SEC area through unemployment
adjusting locally to force such convergence.
5.3.3 A single currency for Europe – The case

of Euroland
The euro is the name of the single currency that from 1 January 2002
circulated in the twelve countries that, at that time, formed part of the euro area or
euro zone. With the introduction of the euro, all the economic agents of the
member states had to face new challenges. In the case of public administrations,
their role in relationship to the change to the new currency was essential since they
should not only adapt to the euro as it happens in all areas of activity, but they also
had to take the initiative and make the transition to the euro simple, attempting to
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achieve it in the most neutral way possible. With this purpose, each and every one
of the governments undertook different communication activities in connection
with the implementation of the single currency and its effects, paying special
attention to consumer protection in an attempt to do all that was possible to avoid
irregular behavior during the period of substitution of national currencies by the
euro. The eleven countries that on 1 January 1999 passed to the third stage of the
EMU (Greece joined the euro area on 1 January 2001), prepared a plan for the
transition to the euro and they all implemented policies to make the transition to
the euro easier for companies as well as for their own public administrations and
citizens.
5.3.4 The benefits of the euro

The euro became the legal currency of the countries that participated in the third
phase of the EMU. The denomination euro was adopted in the European Council of
Madrid in December 1995 from a German proposal, since they were considering the
convenient substitution of the ECU expression (European Currency Unit) with
another word easily pronounced in the different languages of the EU. The 15
member countries of the EU established in the summit of Madrid that the word
“euro” constitutes a valid interpretation of the ECU that had appeared in the Treaty
of Maastricht.
The existence of the euro as the single currency favors the single market by
providing advantages such as:
ñ Greater safety in trade and in international relations as risks that provoke
fluctuations in the exchange rates between the different currencies are reduced.
ñ Reduction of the costs of transactions within the EMU.
ñ Greater transparency in the market, that motivates competition between
companies.
ñ Greater macroeconomic stability through the harmonization of the monetary
policy and of inflation rates.
ñ Disappearance of the speculative pressures as compared to other currencies due to
the importance of the euro with respect to the currencies for which it substitutes.
5.3.5 The advantages and disadvantages

of the EMU operating in a single currency
In a general sense we can assert that the EMU provides net benefits for the euro
area as a whole, though the allocation of those benefits depends on how the different
countries and their agents adapt to the new situation.
As advantages of the EMU we can mention, among others:
ñ The decrease in transactions costs with the countries in the euro zone.
ñ Reduction in the degree of uncertainty among the currencies of each nation with
97
respect to the exchange rate, as it should improve the quality of the information
with which consumers as well as companies can take decisions.
ñ Greater prices transparency when all goods are labeled in euros, that will
provoke an increase in the level of competition in the single market.
ñ Promotion of economic integration resulting in some European finances
becoming more efficient.
ñ Greater price stability.
ñ The single currency will be an international reserve currency.
ñ If the ECB maintains inflation under control, this will contribute to greater
economic efficiency.
ñ Advantages in foreign policy and common security as well as with co-operation in
areas such as justice and home affairs.
As a rule, we can say that the principal objective of the EMU is to obtain price
stability. It can have large benefits for companies that are able to control their
production costs, for the public administrations (since with the control of the
deficit, fiscal pressure will decrease), and for consumers, who will see an increase in
the number of products and services with lower prices due to greater competition,
and for whom it will be more inexpensive to request credit and to travel to the
countries of the euro zone as they will not have to face the cost of changing their
currencies.
But together with the advantages, disadvantages are also observed in the EMU,
such as:
ñ Impossibility of carrying out monetary policy at a domestic level, as each state on
an individual basis will be not be able to alter the exchange rates to respond to
temporary economic crises, nor modify unilaterally the national interest rates.
ñ Requirement to substantially limit the use of expansive fiscal policies at a
domestic level.
ñ Probability of the existence of unemployment problems in some zones that will be
difficult to combat due to the loss of sovereignty in monetary policy, requiring
some form of transfer between the richest zones and the most disadvantaged
areas of the EMU, in an attempt to achieve a sense of convergence among the
members states, basically through the Cohesion Funds.
In sum, in Section 5.3 we presented the European Single Currency and the case of
the euro. The euro is perceived as the means to economic stability and the guarantee
for a complete European Monetary Union. The importance of the euro as a single
currency is based on its scope; it affects all the economic agents of the countries that
accede to the third stage of the EMU and it is a currency with influence on other
countries, including those which do not form part of the EU.
What are the general considerations about the euro as a European single currency?
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As the Maastricht Treaty is often blamed for restricting national sovereignty of member
states, define national sovereignty in economic terms.
It was obvious to Europe that the way to future economic prosperity was
through a single market and the use of a single currency. The way has not been
easy, as the individual members had to overcome national interests and try hard
to meet high economic performance criteria. The future of the EMU is to be
tested over time on the basis of the everyday experience for the people of the
participating countries and their transactions with the euro. Political
integration and integration on a wide range of policy areas is the next major step
to be made for the completion of a truly integrated European environment.
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APPENDIX
Activity 1
It was clear to all parties that in order to compete with the US and other developing
economies (i.e. Japan), Europe needed a true SEM where all non-tariff barriers to intra EC
trade were removed in order to enhance competition and specialization and increase
output per worker allowing living standards to rise. The single market is the core of today’s
European Union. To make it happen, the EU institutions and the member countries strove
determinedly for seven years from 1985 to draft and adopt the hundreds of directives
needed to sweep away the technical, regulatory, legal, bureaucratic, cultural and
protectionist barriers that stifled free trade and free movement within the Union. The Single
Market has, according to the Commission, created 2.5 million new jobs since 1993 and
generated more than _800 billion in extra wealth. Helped by new technology, the opening
of national EU markets has brought down the price of national telephone calls by 50% since
1998. Under pressure of competition, the prices of promotional airfares in Europe have
fallen significantly. The removal of national restrictions has enabled more than 15 million
Europeans to go to another EU country to work or spend their retirement. This means lower
prices for the consumer – with the added bonus of a greater choice of goods and services.
Firms selling in the single market know they have unrestricted access to more than 450
million consumers in the enlarged European Union - enabling them to achieve economies
and efficiencies of scale, which translate in turn into lower prices. The Single Market also
provided a useful springboard for European firms to expand into today’s globalized
markets. The four freedoms of movement – for goods, services, people and capital – are
underpinned by a range of supporting policies. Firms are prevented from fixing prices or
carving up markets among them by the EU’s robust anti-trust policy. People can move
around more freely for work because member states recognize many of each other’s
academic and professional qualifications. Governments have agreed to take decisions
affecting the single market by a system of majority voting rather than by unanimous
agreement – which is much harder to achieve. The creation of the single market gave
European Union countries a stronger incentive to liberalize previously protected monopoly
markets for utilities such as telecommunications, electricity, gas and water. The
independent national regulators who supervise the now-liberalized markets for telecoms
and energy coordinate their activity at the EU level. Not just big industries, but also
households and small businesses across Europe are increasingly able to choose their
supplier.
Activity 2
The treaty provided the basis for a single European currency, common citizenship,
common foreign and security policy, a more effective European Parliament, and a common
labor policy. Each of these goals presents some challenges for the countries involved, such
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as setting a new monetary policy. As all 12 EU countries have approved and/or ratified the
treaty, its monetary policies have been set in action. The Treaty of Maastricht also known as
the Treaty on European Union (TEU), constitutes a turning point in the European
integration process. By modifying the previous treaties, i.e. Paris, Rome and the Single
European Act, the initial economic objective of the Community, building a common market,
was outstripped and, for the first time, a distinctive vocation of political union was claimed.
The Treaty of Maastricht changed the official denomination of the EEC. Henceforth, it will be
known as the European Union.
Activity 3
The introduction of a single currency within the EU cannot be separated from the process
of the enlargement of the EU and the opportunity this provides for a subsequent potential
expansion of the euro. In this case, one has to view this new phenomenon as part of the
European project. On the other hand, the single currency is a major development in its own
right, leading to very significant changes in financial and economic terms, not only in the
near future but also in the medium and long term. In particular, the launching of the single
currency in 2002 together with the potential for its adoption by the new member states in
the coming years implied that the European Union is on its way toward an ever more
important presence on the international financial and economic scene, enhancing its
competitiveness with other leading world economies like the US and the Far East.
Activity 4
National economic sovereignty is a country’s ability to:
1 Set its domestic macroeconomic policy and deliver its own choice of average inflation
over the economic cycle.
2 Set its domestic macroeconomic policy to determine the timing of the domestic
economic cycle (when the domestic economy booms and slumps).
3 Set domestic macroeconomic policy so as to efficiently adjust to asymmetric demand

or supply shocks where asymmetric shocks simply mean different shocks, i.e. shocks
that effect economies differently. A positive shock would cause an economy to grow
faster (potentially creating the need to tighten macroeconomic policy to hold back the
growth surge), while a negative shock would reduce growth (potentially creating the
need to loosen macroeconomic policy to stimulate growth).
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Appendix of
MACROECONOMIC CONCEPTS*
Introduction
Macroeconomics considers the behavior of the economy as a whole.
Macroeconomics is considered a complex science; pure macroeconomics tends to be
both mathematical and abstract from the real world. Such a technical approach is
inappropriate to our study of the European economy, for which we require a clear
overall picture. The aim of this revision appendix is to create in the reader’s mind a
simple macroeconomic framework, from which the reader will understand the
consequences of, say, increasing interest rates or reducing public spending.
Nominal and Real

To understand macroeconomics, students must appreciate the importance of
clearly defining what is real and what is nominal. Nominal means in cash/money
terms. Say I was paid í200 a week, this is my nominal wage. My real wage is my
nominal wage adjusted for inflation (w/p conventionally on labor market diagrams).
An example should make clear what is real or nominal. Say I was paid í200 a week
last year and this year’s inflation is 10%. That is, this year the prices of the goods and
services I consume increases by 10%. If I still get paid í200, the real quantity of goods
and services I can buy will fall by 10%, so my real wage falls by 10%. If I get paid í220,
10% more, it will allow me to buy the same quantity of goods and services as last year,
so my real wage is constant. If I get paid í240 this year, a 20% nominal wage increase,
then with 10% inflation, my real wage increases by 10%.
Usually both real and nominal statistics for economic variables are provided in
statistical sources, but you must remember that the first fact to establish when looking
at any sequence of statistics on an economic variable is whether that variable is in real
or nominal terms. As we consider the main macroeconomic variables, I will explain
how each is conventionally converted from nominal to real terms. Before we can
consider anything, we must be clear about the difference between nominal and real.
Key Macroeconomic Variables

GDP. International convention has decided upon GDP (Gross Domestic Product)
as the standard measure of output. GDP measures the total money value of goods and
services produced in the economy in a year. As prices rise each year, the money value of
output rises, so in money terms nominal GDP appears to grow strongly through the
years. We need to adjust changes in nominal GDP by the rate of inflation to identify
how output in physical terms, i.e. real GDP, is changing. If nominal GDP rose in a
* We would like to thank Nic Potts for his help in designing and developing this Appendix.
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given year by 10%, while prices rose by 5%, we would subtract the 5% inflation rate
from the change in nominal GDP to discover that real GDP had grown by 5%.
Inflation. To be able to manage the economy we must know how the prices of goods
and services are actually changing. We measure the percentage increase in prices over a
year to determine the rate of inflation (weighting goods and services by their share of
total spending). Various measures of inflation are conventionally calculated. Consumer
price inflation considers the movement of the final prices which face consumers
(sometimes including the cost of housing, i.e. mortgage interest rates). Producer price
inflation considers the prices firms charge each other for goods and services.
Unemployment. National measures of unemployment vary, between countries,
and over time. To be consistent we use (unless otherwise stated) the standard
definition of unemployment that the European Commission calculates and presents
in its own publication, European Economy (available in the library). Unemployment
is measured as a percentage of the total labor force.
Aggregate Demand. Aggregate demand is the total level of demand in the
economy. It is made up of four broad categories. 1) Private households’ level of
consumption - Consumption depends on earnings, taxes, interest rates (through
mortgage payments) and the level of saving and borrowing (consumer confidence).
2) Government spending - It depends on government policy and the position of the
economic cycle. Modern economies have the automatic stabilizer of a social security
net. In a recession, as unemployment grows social security spending rises. In a
recovery, unemployment falls reducing social security spending. 3) Investment - It
depends on the cost of borrowing (the interest rate), expectations of the level of
future aggregate demand (required capacity) and the expectation of potential
profitability. 4) Exports - Exports depend on the price of exports in the home
currency, income, and inflation abroad and the exchange rate.
Government Finances
Governments usually spend more each year, G, than they tax, T, so have a budget
deficit, BD, for that year (if the government in a year taxes more than it spends it
would have a budget surplus). Governments could fund budget deficits by simply
printing money, but such action, particularly if taken to extreme, is likely to cause
rapid inflation. Consequently governments conventionally borrow, by issuing
government bonds, to cover budget deficits. A country’s national debt is the sum of all
of its past budget deficits and surpluses put together. Say at the start of a particular
year the national debt stood at í1000, so í1000 of government bonds are held by
investors. Note that each year some bonds will reach their maturity and will need to be
rolled over by new bond issues, but this is a complexity we need not go in to. Interest
must be paid to bond holders, so interest counts as part of this year’s government
spending. Say the government pays 5% interest, so í50 interest is paid. Assume í700
tax is collected this year, and the government wishes to spend í750, excluding interest
on the national debt.
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Budget deficit = í750 + í50 - í700 = í100
Primary balance = í750 + í700 = í50
To service the national debt, and cover this year’s current expenditure, the
government must borrow í100 more this year (issue í100 more bonds). The national
debt at the start of next year will rise to í1100. Note, to calculate how the governments
fiscal stance, i.e. budget deficit, is likely to affect aggregate demand, it is conventional
to calculate the government’s primary budget balance which excludes interest on the
national debt. To adjust for inflation, and to facilitate cross-country comparison, the
budget deficit and national debt are conventionally measured each year in relation to
that year’s GDP. Assume, for the year we consider above, that GDP stands at í2000,
then the budget deficit would equal 5% of GDP and the national debt would stand at
50% of GDP.
Interest Rates and Money

To avoid the extensive debate between economists that surrounds the questions
of money supply, inflation and interest rates, we present a simplified version of the
monetary system (based on what we observe in the real world). At the base of each
country’s financial system (or, more precisely currency, as we shall see for the Single
European Currency), that county’s Central Bank controls the release of money into
the financial system. The Central Bank can be seen to provide the raw material of
money/loanable funds to that country’s banking sector. The interest rate charged for
these funds, which are lent on a short-term basis (i.e. are subject to rapid repayment
if the Central Bank requires it), can be seen as the system’s base rate of interest, base
short-run interest rate. If the base rate is increased by the Central Bank, interest rates
in general would rise to reflect the increased ‘raw-material’ cost of money
(consequently fewer loans are likely to be taken out, thus reducing the growth of the
money supply). Conversely a reduction in the base rate would cause interest rates in
general to fall (increasing loans and the growth rate of the money supply). The
interest rate any individual or firm will be charged will reflect the perceived risk of
default associated with that individual or firm.
To calculate the real cost of borrowing, we need to subtract the rate of inflation
from the nominal interest rate. Say the base nominal interest rate was 5% and the
rate of inflation was 3%, then the real base interest rate would equal 2%. Conversely
if the base rate were 10% and inflation 15%, the real base interest rate would equal
–5%, a negative real cost of borrowing.1
Loans can be agreed upon at fixed rates for any given time span. Such long-term
1
Negative real interest rates are very uncommon in advanced industrial countries. To ration money to its
most efficient use, positive real interest rates are usually (outside crisis) maintained. If we have a negative
real interest rate it’s profitable to borrow purely to buy goods for storage. By the time the loan is due the
goods’ price has sufficiently risen (if inflation is higher than the interest rate) to repay the loan and make a
positive profit from simply hoarding goods.
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loans have a fixed long-run interest rate. Long-run interest rates are affected by the
current level of short-run interest rates and the lender’s expectation of future inflation.
For example in an economy, which has had on average in the past ten years 10%
inflation, the long-run interest rate would probably stand at say 12%. Another
economy with 5% average inflation over the previous 10 years would say have 7% long-
run interest rates. As long-run interest rates depend on banks’ expectations of future
inflation, they are subject to the current mood of the financial sector (crucially on the
financial sector’s evaluation of the government’s future target average inflation rate).
Finally a country’s Central Bank can either operate independently of that
country’s government (i.e. an independent Central Bank), or simply follow the
government’s direction. In the UK the Central Bank (Bank of England) simply
followed the direction of the UK government up to 1997. The UK’s Chancellor of
Exchequer (Finance Minister) simply told the Bank of England what base interest
rate to set (thus determining UK monetary policy). Since 1997 the UK government
provides the Bank of England with a target inflation rate to aim for, leaving the Bank
of England to independently decide when to change the base rate (monetary policy)
to fulfill the inflation target. Germany had, up to the introduction of the euro in 1999,
an independent Central Bank, the Bundesbank, which was completely free of
government influence. The Bundesbank’s constitution permanently committed it to
preserving price stability; in practice around 2% inflation. The Bundesbank thus
entirely independently controlled German monetary policy.
The Balance of Payments

The balance of payments records transfers of domestic to foreign currency, and
transfers from foreign currency to domestic currency. The rate of exchange of
domestic to foreign currency is the exchange rate. A depreciation of the exchange
rate is when a unit of domestic currency buys less foreign currency, e.g. the pound
depreciating from í1=$2 to í1=$1.5. An appreciation of the exchange rate is when a
unit of domestic currency buys more foreign currency e.g. the pound appreciating
from í1=$1.5 to í1=$2.
To balance the overall balance of payments, the numerous demands for foreign
currency must match the numerous supplies of foreign currency. We shall consider
the exchange rate’s role in balancing the balance of payments in detail when we look
at the EMS (European Monetary System) later in the unit. For statistical purposes
the balance of payments is split into several components, the two main components
being the current account and the capital account.
Current = Trade Balance, exports-imports (goods)
Account + services balance (services exports-imports)
+ net investment income from abroad
Capital = Net Foreign direct investment
Account + Net long term investment
+ Net inflow/outflow of short term capital
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To adjust for inflation, and to facilitate cross-country comparison, the current
account balance is conventionally measured each year in relation to that year’s GDP.
Assume, for a particular year, that GDP stands at í2000 and the current account
stands at a í50 surplus, so we have a 2.5% of GDP current account surplus. If the
Current Account were say í100 in the red, we would have a 5% of GDP current
account deficit.
Technological Change/Productivity Growth

Over time technological change allows the total quantity of goods and services
produced, for the same labor input, to increase, thus laying the foundation for
average long-term growth. Real GDP has, on average, consistently grown over the
long run in all EU economies. We shall consider the dynamics of technological
change further when considering the topic of European Economic Experience. For
now let us point out that the faster technological change occurs, the higher real GDP
will rise for a fixed labor input. The size of the national cake, to distribute in wages to
workers and profit to business, thus depends on the rate of technological progress.
Explaining the Economic Cycle

Boom/Slump - all market economies grow at a fluctuating rate around their
(varying through time) long-term growth trend. In booms, GDP rapidly increases,
causing unemployment to fall and inflation to rise. In slump/recession, low real GDP
growth, or even real GDP decline, causes unemployment to rise and inflation to fall.
Note that in practice changes in real GDP growth usually take a year to be reflected
in changes in unemployment. Changes in inflation also usually lag behind real GDP
changes. Such an economic cycle has been a permanent feature of the behavior of all
market economies. The severity of boom and slump may vary through time and
between countries, but a continuing economic cycle is evident for all countries at all
times (outside of exceptional ‘planned’ war conditions).
So why might inflation and unemployment be related in such a way through the
economic cycle? We must consider the process of production. Firms employ workers
to produce goods for sale in the market. Business seeks to make a profit. Workers
seek to maximize their standard of living, i.e. their real wages. If goods and services
were sold at a given fixed price, an increase in nominal wages would mean a
reduction in profits. If nominal wages rise faster than firms’ increase prices, labor
costs would grow, consuming a growing share of total revenue, and thus reducing
firms’ real level of profit.
In times of low unemployment and high real GDP growth, i.e. boom, skilled
workers are likely to be in increasingly short supply. Workers will feel in a strong
position to successfully demand real wage increases, while firms will bid up wage
rates against each other to attract skilled labor. Say last years inflation was 3%, and
this year’s wage increase was 5%, reflecting workers aspirations for higher real
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wages. Firms must decide whether to increase prices. For simplicity, assume all costs
are labor costs, so a 5% price increase would cover the wage rise and keep profits
intact. To maintain profits, firms thus increase prices by 5%, but 5% inflation
undermines the real wage increase the workers bargained for. So next year workers
demand a 10% nominal wage increase to ensure an increase in real wages, however
firms increase their prices by 10% producing 10% inflation. Inflation is growing
because low unemployment is provoking a move for higher real wages. European
experience suggests that when inflation rises, wages tend to rise faster, reducing
profitability.2 Clearly firms are likely to be unable to pass on their entire increased
wage bill to higher prices. With low unemployment a wage push for higher real wages
is likely to damage business profitability. Rising inflation is thus reflecting a real
change in the economy. To tackle the rising level of inflation, the government must
take action to contract the economy.
The government (or, of course, an independent Central Bank) could tighten
monetary policy, i.e. increase the base interest rate, or/and tighten fiscal policy, i.e.
reduce the budget deficit (even have a surplus) through reduced government spending
and increased taxation. The economy is thus managed into recession. Unemployment
rises, undermining workers’ bargaining position. Increases in real wages are
abandoned: to maintain employment reduction in real wages may be accepted. As a
result nominal wage rises moderate and inflation falls. Profitability is likely to recover
as inflation falls, as wage moderation exceeds price moderation. Once inflation is
under control, employment is encouraged to grow; we are back to mild boom. The
cycle continues.
Cycles may be influenced by a number of factors. Changes in tax or exchange rate
or key import prices such as oil can alter the size of the national cake available to
distribute to workers, thus influencing the central business/labor conflict. Small open
economies (with a high proportion of trade) are likely to follow the cycle of their
main trading partners. As their trading partners boom high export demand is likely to
make the associated small economy boom, while when trading partners are in
recession low export demand is likely to spread recession. Recessions may also be
provoked through financial crisis if banks collapse and the stock market crashes, as
happened in America in 1929. Japan suffered such a crisis in the 1990s; consumers
were reluctant to spend and investors were reluctant to invest, causing a decade of
slow growth.
2
To statistically observe this phenomenon compare a EU country’s inflation rate and its unemployment
rate to its adjusted wage share (AWS), the total value of wages as a percentage of total output. Total GDP
represents a cake to share between labor and business. Labor earns wages, while business earns profit.
When labor’s share of total output rises, businesses’ profit share must fall. Inflation, unemployment and
AWS tend to move together. As unemployment falls and inflation rises, AWS tends to rise (reducing the
profit share), while if unemployment rises and inflation falls, AWS tends to fall (increasing the profit
share). Note that in most EU countries AWS tends to fall, through boom and slump, over time, reflecting a
long-run increase in their capital labor ratios.
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The Natural Rate of Unemployment
Given the inevitable continuation of the economic cycle, we need to develop a
notion of a long-run/natural rate of unemployment. In the short run unemployment
will fluctuate around the natural rate through booms and slumps. Long-run changes
in the labor market will cause the natural rate to change over time. Let us define
three groups of unemployed.
Voluntary unemployed. These are people who are unwilling to accept
employment at the level of real wages on offer in the labor market. Here we are in
practice primarily concerned with the unskilled. As unskilled wages are low,
unskilled workers may find benefits offer similar income to unskilled employment
and may thus choose voluntary unemployment.
Structurally unemployed. These are people who are made unemployed by
industries in structural decline. The dynamic nature of the market economy ensures
that as some industries expand others will decline. Such decline is termed structural
decline. Those made structurally unemployed may be willing to work at their old job
for the same or even a lower real wage. However their skills may now be redundant
(only appropriate to the industry in structural decline) or their location on becoming
unemployed (the location of the industry in structural decline) may be too far away
from available job opportunities, so they remain unemployed, as casualties of
technological change.
Involuntary unemployed/inflation fighters. As the voluntary unemployed
choose not to work they can have little effect on the wage demands of those actually
in work and thus little influence on inflation, e.g. an unemployed economics lecturer
not willing to work for less than í50,000 would not affect my own personal wage
demands. As the structurally unemployed are unable to take up available job
opportunities, they are unable to influence the wage demands of those in work and
thus the rate of inflation. For example an unemployed lecturer in medieval cooking
who was willing to work for a lower real wage than I would accept, would not affect
my wage demands, as he does not represent an alternative to the skills I can offer. In
contrast, the involuntary unemployed, those willing and qualified to take up available
job opportunities, influence the wage demands of those in work and thus the level of
inflation. For example, the number of unemployed equally qualified economics
lecturers willing to work at or below my current wage will influence my personal wage
demands. If we think of replies to a job advertisement, some applicants will rule
themselves out by seeking too high a wage, some will be insufficiently qualified, the
remaining number of suitable applicants will influence the wage the firm will actually
agree on.
If involuntary unemployment were very low, those in work, feeling very secure in
their employment, would bargain for higher wage increases. Firms in response would
raise their prices, with the result being inflation. If involuntary unemployment were
very high, those in work, feeling very insecure about their employment prospects,
would accept low wage increases (or even constant or falling wages). Firms would
have to raise prices less (or even not at all), with the result being falling inflation.
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Logically at some point involuntary unemployment is just sufficient to keep the

wage demands of those in work constant, and thus keep inflation constant.
Constant inflation marks our imaginary point of long-run equilibrium. The level of
involuntary unemployment required to keep inflation constant plus the levels of
purely wasteful (in the sense of not contributing to the fight against inflation)
voluntary and structural unemployment represent our definition of the natural rate
of unemployment. Here is our notional long-run equilibrium level of unemployment.
In practice economies continually cycle around their natural rates, inflation rising in
boom when unemployment is below the natural rate or, more precisely, involuntary
unemployment is too low to prevent rising wage demands. In slump involuntary
unemployment grows sufficiently high to ensure that wage restraint causes inflation
to drop. If the natural rate were to fall, unemployment at all points of the cycle would
fall; if the natural rate rose, unemployment at all points of the cycle would rise.
The Free Market versus the Social Democratic Approach

In natural sciences most scientists accept in their specialist subject areas the same
broad common body of accepted knowledge/“facts”. Such scientists research the
boundaries of knowledge. Occasionally a breakthrough occurs, and once confirmed
by repeated experiment, such new knowledge is soon incorporated and redefines that
subject area’s common body of accepted knowledge. Science progresses, just as
Emanuel Kant, the inventor of the scientific method, suggested it should.
Macroeconomics is a strange science. New and old ideas coexist, in fact it might be
better to say that different ideas come into fashion and go out of fashion. Developed
economies have fluctuated between a belief in free-market economic solutions (from
classical, to monetarist, to new-classical economics) and a belief in state-
interventionist economic solutions (from Keynesian to post-Keynesian economics).
Economics lacks a broad common body of universally accepted knowledge. The
“best” or “most efficient” way to run the economy is thus a matter of opinion rather
than scientific fact, no matter how convinced each economic approach might be of its
own supremacy.
The Free-Market Approach. This approach is traditionally supported by right of
center political parties, such as Conservatives in the UK, Gaullists in France and
Christian-Democrats in most of the rest of Europe (and often center, usually termed
liberal, parties). In the extreme they believe the market is always right and the
government, and trade unions, are only prone to cause economic problems through
interference in the market. If unemployment is high, trade unions must be responsible
for demanding too high real wages. Income inequalities are seen to reflect and
encourage entrepreneurial activity and career self-development. High tax rates
(particularly progressively high tax rates for high earners) are seen to discourage work
and wealth creation. The government should seek to limit the size of the state (the
proportion of total spending and tax in total output) to encourage private business
activity. High government borrowing is seen to push up interest rates, crowding out
private business activity. Nationalized industries are seen as inefficient, so must be
109
privatized, as only private business knows how best to run an efficient business. To
create a stable business environment the free-market approach recommends that
inflation should be kept at a low average rate over the economic cycle (at ‘price
stability’, which in practice is average low inflation around 2%, rather than 0%
average inflation as the term implies). Governments are not trusted to deliver price
stability, short-term political pressures or social democratic approach following
governments may allow average inflation to drift upwards. Such behavior may push
long-run interest rates up and increase the cost in terms of unemployment of
reducing inflation in short-run recessions (as workers and trade unions may hold out
against wage restraint believing the government, under political pressure, may
reverse its policy, i.e. the government’s policy is not credible). To prevent such
political interference Central Bank independence is advocated. Such independent
Central Bankers (universally followers of free-market economics), free of political
influence, can ‘efficiently’ apply a ‘credible’ monetary policy aimed at delivering, as a
first priority, price stability.
The Social Democratic Approach. Traditionally left of center political parties,
such as the Labour Party in the UK, Socialists and Communists in France and Social
Democrats throughout Europe, support the state-interventionist approach. Business
is still seen as the heart of the system but the government is perceived as having a
central role in coordinating the economy to deliver social welfare for all (to enhance
the stability of that society). Progressive taxation is encouraged to facilitate
distribution of income from rich to poor (without, according to the social democratic
approach, discouraging entrepreneurial activity or work effort). The government
believes it has a role to bring together business and trade unions to collectively decide
wages and working conditions. Co-operation rather than conflict is best thought to
deliver appropriate wage levels and high average levels of employment.
Nationalization is seen as an important tool to revitalize declining industries or bring
co-ordination to strategically important industries (such as railways for example).
High government spending and tax is encouraged to build up the physical and social
infrastructure of the country, e.g. high expenditure on education is seen to enhance
the productive capacity of the workforce. The government is thus seen as a crucial
facilitator of growth in the private sector. Temporary high government borrowing, in
order to facilitate fiscal expansion led recovery from recession, is not seen to increase
interest rates, but is seen to help business through increasing demand for their
products. The government is committed to maintaining as high as possible aggregate
demand, in-order to keep average unemployment as low as possible. Inflationary
spirals must still be met by wage restraint, but business and trade union co-operation,
rather than sharp recession, is advocated to deliver such wage restraint. This does not
imply that social democratic governments could infinitely expand the economy;
recession/slow downs would still be required to keep inflation under control, but not
such tight control. We may summarize by saying that the social democratic approach
is likely to tolerate higher average inflation over the economic cycle than the free-
market approach, in the hope of lower average unemployment over the economic
cycle.
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CHAPTER 5
If such a view of an unemployment inflation trade off were a reality (see the
following European Economic Experience section for further detail), we would have to
modify our concept of the natural rate of unemployment. We defined the natural rate of
unemployment independently of what the long-run average inflation rate might be
(following the economic mainstream’s assumption of the long-run neutrality of money).
If on average over the economic cycle higher growth, and lower unemployment, were
associated with higher average inflation than price stability, the natural rate of
unemployment would depend on what average rate of inflation the government set its
policy to achieve on average over the economic cycle. Logically as voluntary and
structural unemployment act purely as an economic waste, the association would be
between the level of long-run average involuntary unemployment and the level of long-
run average inflation.
Clearly many economists’ and politicians’ views lie between these two, extremely
presented, approaches. Individual economists and politicians may favor free-market
solutions in some areas and social democratic solution in other areas. We identify
these stylized approaches to provide a broad framework of reference from which to
analyze European economic affairs.
111
BIBLIOGRAPHY
RECOMMENDED READING
1994, pp. 15-42.
Hall 2001, pp. 69-87.
112
CHAPTER 6
FOREIGN DIRECT
INVESTMENT IN ∆∏∂ EU
The scope of Chapter 6 is to present the growth, the determinants and the effects The Scope
of foreign direct investment (FDI) in the EU. of the Chapter
ñ familiar with the multinational companies and their resulting capital flows Objectives
ñ familiar with the importance of foreign direct investment to economic growth in
the EU
ñ able to understand the factors that may affect foreign direct investment and the
role of governments in attracting them.
ñ Foreign direct investment Key Words

ñ Portfolio investment
ñ The specific advantage
Foreign direct investment is the capital flows resulting from the behavior of Introductory
multinational companies (MNCs). Thus, factors that affect the behavior of MNCs Comments
will also affect the magnitude and direction of FDI flows. FDI facilitates the diffusion
of knowledge among countries and contributes to the general welfare of a country.
This is the reason why governments in the developing and developed countries alike,
try to attract FDI flows, by incorporating FDI-encouraging strategies into their
industrial and competition policies. More specifically, in the EU there has been an
active promotion of FDI in the last two decades, not only for intra-EU FDI flows, but
also for US and Japanese FDI inflows into member states.
113
6.1 MULTINATIONAL COMPANIES
AND FOREIGN DIRECT INVESTMENT
A multinational is a company operating its businesses in more than one country.
MNCs have a home base in one country and the whole or partial control of subsidiaries
abroad. There are a number of reasons why a company may become a multinational
one and there are several theories to explain the expansion of MNCs, as we will see in
the following sections. However, a company that expands into foreign markets by
setting up subsidiaries, can exploit either economies of scale or scope arising due to
vertical or horizontal integration. Hence, by this expansion, the MNC could expect to
gain monopolistic or oligopolistic gains. Examples of multinationals are IBM and Ford
(both from the USA); Glaxo and Shell (UK); Michelin (France); Mercedes-Benz and
Volkswagen (Germany); Nestle (Switzerland); and Toyota and Sony (Japan).
MNCs, in order to achieve their goal, which is. to expand abroad by setting up
subsidiaries, need to undertake investment that we call foreign direct investment and
which is directed at the control of physical rather than financial assets. Thus, as a
definition, we could say that FDI is the purchase of physical assets abroad over which
the parent company retains control. These physical assets can be real estate, factories
or businesses run by other firms or individuals.
6.1.1 Motives for undertaking FDI

There are several motives for MNCs in undertaking FDI:
ñ The parent company might decide to establish a new, greenfield, subsidiary abroad,
i.e. the company constructs new plants and equipment in another country.
ñ The parent company could try, either by a take-over of or a merger with a foreign
firm, to acquire direct control over the assets of the foreign company.
ñ The parent firm might want to establish a joint venture with a foreign firm.
ñ The parent company might transfer capital abroad in order to finance an expansion
of its subsidiary.
ñ Profits of overseas subsidiaries are reinvested abroad.
FDI can be either inward, when foreigners purchase assets into the home economy,
or outward, when home citizens purchase assets abroad. In the first case, there are
capital inflows into the home economy while in the second there are capital outflows.
FDI should be distinguished from portfolio investment, with the latter being the
acquisition of financial assets such as bonds, shares, treasury bills, bank accounts and
other securities. Investment in financial assets is usually for a shorter-term period than
investment in physical assets. Moreover, an acquisition of bonds and shares in some
company does not lead to direct control of this company, which is the case with FDI.
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CHAPTER 6
6.1.2 Alternatives to FDI

Firms can internationalize, i.e. expand their activities into foreign markets, not only
by following an FDI path, but also by adopting other strategies such as exporting,
licensing and franchising.
Exporting
If the foreign market is not heavily protected by tariffs, a home firm can expand into
the foreign market by exporting its products. However, before the firm embarks on this
sort of activity, it should know the characteristics of the foreign market: size,
preferences, perspectives and the quality of other competing products. Although this
information is costly, exporting is a lower risk activity relative to FDI, allowing the firm
to exploit economies of scale and/or scope. However, as we have already mentioned,
exporting could be prohibitive if there are high tariffs and transportation costs that
effectively act as a protective wall in the foreign market. Moreover, non-tariff barriers
to trade and exchange rate volatility could also be very costly or prohibitive for
exporting. It should be noted, however, that the choice by the home firm, between
exporting and FDI, is not always possible. For example, it has been better for Boeing to
centralize its operations in Seattle in the US and export airplanes abroad, rather than
establishing a foreign subsidiary that would require a huge investment relative to the
size of the foreign market.
Licensing
Licensing is when a home firm authorizes a foreign firm to manufacture and market
its goods for the foreign market under the same or a different brand name. For
example, Coca-Cola is manufactured in different countries with the same brand name.
Under licensing the home firm will gain either by royalties on sales or by a lump sum
fee. The advantage of this method is that the home firm does not need to know the
characteristics of the foreign market, as in the case of exporting, since it uses the local
market knowledge of foreign firms (the licensee); also this method does not require
any capital expenditure. It is also less risky than FDI or exporting, especially in the case
of political uncertainty and social unrest in the foreign country. However, the home
firm has to incur the cost of monitoring the quality of the product produced by the
foreign form.
Franchising
This is like licensing, but for a longer period of time and with the home firm having
control of the whole design of the product and the standardization of its quality.
Examples of franchising are Benetton, Pizza Hut, Kentucky Fried Chicken, The Body
Shop and so on. The advantages and disadvantages of franchising are the same as in
the case of licensing.
115
Advantages and disadvantages of FDI compared
to its alternative forms
ñ FDI allows MNCs to overcome difficulties arising from high tariffs and non-tariff
barriers to trade.
ñ MNCs, by undertaking FDI, can have tighter control over the production and
marketing of their product abroad.
ñ MNCs can exploit economies of scale or scope by diversifying either horizontally
or vertically.
ñ MNCs, by undertaking FDI, can spread their risk through market diversification,
especially if there is exchange rate volatility.
ñ FDI is the highest risk internationalization activity, mainly due to the lack of
information about the foreign country with respect to different culture, language,
consumer preferences and cost conditions in the host country.
6.1.3 The growth of FDI in the EU

International capital flows have increased dramatically in the last 20 years. Indeed,
the outward FDI stocks increased from 4.9% of world output in 1980 to about 10% by
1995. OECD countries carried out, on average, about 95% of the total outward FDI
while the EU-15 had a share of about 44% in this period. On the other hand, about
75%, on the average, of the world FDI was directed into OECD countries and about
37% into the EU-15. Clearly, not only is there a rapid increase in FDI worldwide, but
the main bulk of FDI is among the developed countries.
The examination of FDI inflows rather than FDI stocks exhibits a similar pattern
for the period 1989-1997, as can be seen in Graph 1 for three groups of countries: the
developed, the developing, and the Central and Eastern Europe Countries (CEEC).
250
200
150
(S bn)
100
50
0
1989 1990 1991 1992 1993 1994 1995 1996 1997
Years
Developed Countries Developing Countries Central and Eastern European Countries
Graph 1: Inflows of Foreign Direct Investment

Source: The United Nations Conference on Trade and Development (UNCTAD) (1998).
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CHAPTER 6
Developed countries are by far the main recipients of FDI inflows with developing
countries continuously increasing their share. To a much less degree the same is true
for the CEEC. It is interesting, however, to note the cyclical behavior of FDI inflows in
developed countries during the recession of 1990-92 (Griffiths et al. 1999).
The geographical distribution of the cumulative FDI flows in the EU during the
1990s is shown in Table 1.
Table 1: Cumulative Foreign Direct Investment Flows in the EU, 1990-1999

(in million US dollars)
INFLOWS OUTFLOWS NET OUTFLOWS (+)
UNITED 319 726 UNITED 566 400 GERMANY 305 988

KINGDOM KINGDOM
FRANCE 215 804 GERMANY 422 455 UNITED 246 674
KINGDOM
NETHERLANDS 159 523 FRANCE 347 839 FRANCE 132 035
SWEDEN 127 633 NETHERLANDS 250 860 NETHERLANDS 91 337

BELGIUM-LUX 123 206 BELGIUM-LUX 109 350 ITALY 33 451
GERMANY 116 467 SWEDEN 102 114 FINLAND 17 919
SPAIN 97 780 SPAIN 93 236 IRELAND 9 444
ITALY 37 697 ITALY 71 148 DENMARK 782
DENMARK 32 176 FINLAND 40 760 AUSTRIA -2 929
GREECE 26 942 DENMARK 32 958 SPAIN -4 544
FINLAND 22 841 IRELAND 26 895 PORTUGAL -7 038
AUSTRIA 21 084 AUSTRIA 18 155 BELGIUM-LUX -13 856

PORTUGAL 17 501 PORTUGAL 10 463 SWEDEN -25 519
IRELAND 17 451 GREECE 573 GREECE -26 369
TOTAL EU 1 335 831 2 093 206 757 375

TOTAL OECD 2 709 512 3 552 013 842 501
% EU/OECD 49.30 58.93 89.90
Source: Organization for Economic Co-operation and Development (OECD), Financial

Market Trends No. 76, June 2000 and author’s calculations.
The three main recipients of FDI are the UK, France and Netherlands while the
three main countries undertaking FDI are the UK, Germany and France. Moreover,
the three first countries account for more than 50% of the cumulative inflows and
outflows of EU FDI. The EU, in turn, also accounted for about half of the OECD
117
FDI inflows in the 1990s. The UK holds a dominant position in the EU FDI flows by
having a share of about 24% of FDI inflows and 27% of outflows. This is the result of
an “open door” policy toward FDI. It should be noted at this point that, in the 1960s,
the focus of the UK outward FDI shifted from Commonwealth countries toward the
EU and the US, while as a host country the UK is receiving FDI inflows from USA,
Japan and EU. Indeed the UK is the preferable location of USA FDI outflows as
about 17% of the total US direct investment was directed to the UK in 1995. Also,
about 40% of the whole Japanese investment in the EU for the period 1951-1994 was
located in the UK.
In this section we explain the links between MNCs and FDI; we distinguish
between inward and outward FDI, as well as between FDI and portfolio investment; we
explain when FDI occurs and what the alternatives to FDI are, as well as the advantages
and disadvantages of FDI compared to its alternatives. Moreover, with the use of graphs
and tables, we illustrate the growth of FDI worldwide and particularly in the EU.
Explain the motives of MNCs in undertaking FDI and discuss the advantages and disadvantages
of FDI compared to its alternatives.
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CHAPTER 6
6.2 THEORIES EXPLAINING FDI

All theories of MNCs in explaining their behavior make the assumption that
markets are imperfect. If markets were perfect, then all firms and their products would
be homogeneous and everybody would have perfect information. However, what we
observe in examining the behavior of MNCs is that MNCs are very heterogeneous.
Most of them are large companies, although there are also medium-size MNCs.
Moreover, MNCS have considerable market power on well-differentiated products,
allowing them to be price setters. Finally, it is exactly their oligopolistic nature that
allows them to exploit economies of scale and/or scope. Here we explain briefly the
main theories of why companies may become multinational and we refer the reader to
several more detailed books (e.g. Griffiths et al. 1999; Harris 1999; Sodersten et al.
1994).
The Specific Advantage

This theory says that an MNC should possess a specific advantage over competing
local firms. This specific advantage could be technical knowledge, product innovations
and managerial or financial expertise that the firm can better exploit and protect by
setting-up foreign subsidiaries. Examples of this case are pharmaceutical products,
intellectual property and production processes. This specific advantage should give the
firm the advantage over local firms that have better knowledge of their market than the
MNC. So, the firm could be engaged into establishing a subsidiary abroad and
consequently undertaking FDI, if this advantage would give the MNC benefits well
above the costs associated with this investment.
The Eclectic Approach

This theory encompasses several approaches. It is also know as the OLI approach.
The initials stand for Owner specific, Location specific and Internalization factors.
ñ Ownership specific factors are those that give a specific advantage to a firm, such
as innovation, ability to diversify and organizational or management skills.
ñ Location specific factors are associated with lower transport costs or proximity to
markets and resources.
ñ Internalization is the process by which the MNC draws activities under a centralized
control rather than outsourcing them. Internalization allows the exploitation of
economies of scale and/or scope, the minimization of risk and the maintenance of
quality control (Harris 1999).
119
Follow the Leader
The basic assumption of this theory is an oligopolistic structure of the market with
barriers to entry. In oligopolistic competition all firms are interdependent, i.e. they are
engaged in a “game” of actions and counteractions depending upon their competitors’
positions and actions. So if one MNC undertakes FDI (the leader) then other MNCs
should also follow them in order to maintain their competitive edge. A characteristic
example of this is the case of Japanese car manufacturers establishing subsidiaries in
Europe in the 1980s and 1990s. Although this theory explains well the behavior of the
follower, it does not explain the behavior of the leader.
The Level of Development Theory

According to this theory, a large and well-developed market will have all the
resources, the technical infrastructure, human skills and a well-developed financial
system that could support the undertaken FDI. Thus, this theory suggests that net
outward investment is a positive function of the level of development in the foreign
country, which in empirical studies is proxied by the level of output in the foreign
country.
The Product Life-Cycle Theory

This theory suggests that all products follow a life-cycle pattern: initially a firm
introduces its product into the home market and exports it overseas. At some point
later on, this product reaches a stage of maturity, i.e. fewer domestic buyers, the
product is standardized and there is higher competition. During that phase of maturity,
a firm’s profitability is lower than in the beginning of the life cycle and the firm will
try either to expand into new markets or to adopt a cost reducing relocation. This
implies that the home firm could establish a foreign subsidiary in either one or
several developed countries, where the demand for the product could still be high
and competition relatively low. Alternatively, the home firm could relocate its
production in a less developed country where the unit labor cost might be lower.
In sum in this section we present several theories explaining the behavior of
MNCs and their choices in the process to internationalization.
Discuss the theories that attempt to explain the growth of FDI in the EU.
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CHAPTER 6
6.3 DETERMINANTS OF FDI IN THE EU
6.3.1 Labor market conditions
Labor Cost
Labor cost is considered to be a major determinant of FDI since a lower labor
cost abroad may induce MNCs to relocate some of their activities to a foreign
country. Moreover, in an era of increasing globalization, the barriers to FDI are
falling continuously (FDI liberalization) and hence reinforcing higher FDI flows
worldwide. Indeed, empirical evidence in the UK and Germany suggests that a high
relative unit-labor-cost (ULC) in a country is associated with net FDI outflows from
this country. The UK has net inflows from Denmark and Sweden, both having a
higher relative unit-labor-cost; while in the case of Germany, there is an even
stronger association between net FDI outflows and high relative unit-labor-cost.
Strikes
Strikes could reduce the attractiveness of a country in hosting FDI inflows.
Strikes, to the extent that they occur often, reduce the flexibility of the labor market
in a country. This reduction in the labor market flexibility could be seen by MNCs as
a cost increasing signal that would, potentially, threaten the expected (actual)
profitability of their planned (existing) investment. This, of course, would deter
MNCs from undertaking further risks by establishing or expanding the scale of a
subsidiary abroad, resulting in a redirection of new subsidiary or the relocation of an
existing one. Thus, strikes are expected to reduce FDI inflows into a country.
Empirical studies, indeed, suggest that strikes are negatively related to FDI flows.
6.3.2 Real exchange rate and its variability
The Real Exchange Rate and FDI

The real exchange rate (RER) expresses the value of a currency in terms of its real
purchasing power. Since RER can express the real value of goods and investment plans
it is a measure of the real competitiveness of a country. Therefore, changes in RER will
result in changes in the competitiveness of this country, which in turn could either
121
increase or decrease the level of FDI flows. Consider, for example, the case of
exchange rate depreciation in the host country. The positive effects on FDI are:
ñ It will encourage import substitution in the host country by increasing the value of
imports.
ñ It will improve the international competitiveness of the host country hence the
profitability of FDI.
ñ Facilities in the host country will become less expensive, as the value of foreign
financial flows increases.
The negative effects on FDI flows are:
ñ The expected profit repatriation will be less if profits are nominated in the
currency of the host country.
ñ The exchange rate depreciation may cause inflation in the host country thus
reducing the international competitiveness in the longer run.
ñ The exchange rate depreciation by reducing the value of the subsidiary in the host
country will eventually reduce the total value of the parent MNE.
Empirical evidence suggests that the negative effects dominate and thus exchange
rate depreciation in the host country will lead to lower inward FDI.
Real Exchange Rate Variability

MNCs have the power to reduce the effects of exchange rate changes on their
profits. Large and unpredictable exchange rate fluctuations as in the 1980s would
induce MNCs to shift production and sales abroad for two main reasons: first, by
having a foreign subsidiary, a MNC can take advantage of unexpected declines in the
variable costs abroad; and second, as real exchange rate variability increases, the
transaction costs involved in international trade will also rise, inducing MNCs to
undertake more FDI. As a result of this shift of production abroad, FDI flows should
increase. Therefore, one should expect that greater exchange rate volatility would
increase FDI.
6.3.3 Output in the origin and the host country

As we have already seen, FDI volumes are affected by the volume of output in both
the host and the origin country. The reason for this is because the absorption capacity
in each country depends on the size of its market, which in many empirical studies is
approximated by the level of output (GDP) in each country. The size of the market in
the host country is an important determinant of FDI since a large market will allow the
MNC to capture the host market demand by exploiting economies of scale.
Furthermore, in a well-developed market, an existing infrastructure will support the
FDI. Agiomirgianakis et al. (2004), using data from for the period (1975-1997) found
that certain variables associated with the level of development in the host country, such
as human capital, the density of infrastructure, and the agglomeration factor, are
significant determinants of FDI inflows in OECD countries.
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6.3.4 Distance between the origin and host country

Many empirical studies on the determinants of FDI use the distance between host
and origin country as a variable to capture the cost of coordination, communication
and transportation between the subsidiary and the MNC. One should expect that the
higher the distance is between the two countries, the higher would be the above costs,
implying a negative relationship between distance and FDI.
6.3.5 Cultural and language differences

Cultural bonds and language similarities (CLS) between the two countries are
important for the establishment of an efficient business network since they can
facilitate a smooth flow of information from the MNC to the subsidiary and the
reverse. Empirical studies on OECD countries, examining the relationship between
FDI flows and CLS for three distinct language groupings, English, German and
Latin, show that a) an English language effect raises FDI stock by a factor of three; b)
a Germanic language effect raises FDI stocks by a factor of four; and c) there is no
significant Latin language effect.
6.3.6 European Integration

The European integration process, and especially the Single Market Program
(SMP), has positively affected intra-EU FDI, either directly by the removal of capital
controls, or indirectly by increasing the level and the growth of overall economic
activity. However, other aspects of the SMP, such as the removal of non-tariff
barriers to trade, have encouraged more intra EU trade flows rather than FDI flows.
Several empirical studies support the positive effect on FDI of the establishment of
the Internal Market after 1987. It is estimated that the European Internal Market has
increased intra-EU FDI stocks for the UK and Germany by 8%-14%, or around
0.5% of EU GDP at constant 1990 prices. Moreover, the USA FDI flows into the EU
have also been higher due to the European integration process. In addition to the
above, the launch of the euro in 2002 has been another incentive in attracting more
FDI as it allows lower transaction costs for the MNCs. The Japanese MNC Toyota,
for example, asked its suppliers in Britain (a country that is not in the Euroland) to
use the euro to settle accounts, in order to avoid currency exposure risks (Financial
Times, 11 August 2000).
6.3.7 Government policies

Many governments worldwide, including in the EU states, try to incorporate
policy measures to attract FDI as a part of their strategy for economic growth in their
countries. There are several measures that a government can take in order to attract
FDI, such as tariffs, taxes, subsidies, regulatory regime and privatization policy.
123
Tariffs
The imposition of a high tariff on imported goods may effectively motivate
foreign producers to establish a subsidiary in this country in order to avoid the tariff
wall. An example of this is the FDI flows in the EU in order to capture the gains from
the internal market. Indeed, after 1987 the Internal Market resulted in a common
external tariff to non-EU products and the elimination of barriers to trade among
EU states. Thus, a foreign firm, say, from the USA or Japan, that wanted to expand
into the large EU market could only avoid this tariff wall by establishing a subsidiary
in some EU state. An example of a Japanese MNC is the carmaker Nissan with
subsidiaries in England and Spain. Other examples are Toyota and Honda with
subsidiaries in the UK. An example of an American MNC is General Motors with
subsidiaries in the EU, under the name Vauxhall in the UK and Opel in several other
places in Europe.
Corporate Taxes
Higher corporate taxes in the host country, by increasing the cost of investment
and thus its profitability, will deter the MNC from undertaking an investment in this
country and possibly motivate the MNC to invest in another country. In OECD
countries the average corporate tax rate had fallen from nearly 50% in the early
1980s to under 35% by 2001.
Subsidies
Most EU countries have used subsidies as part of their regional and industrial
policies. Indeed, FDI has been seen as a key element in regional economic development
and one of the areas of policy competition among EU countries. An example of this
is the competitive offer by both the UK and the French governments of a í5 million
subsidy to Hoover in 1994 for establishing a subsidiary in their countries. Another
example is a $80 million subsidy by the British Government, in 1995, to MNC Ford in
order to attract it into an investment of í400 million for a new Jaguar car model.
Subsidies, however, distort competition and thus are constrained by article 92 of the
Treaty of Rome.
Regulatory Regime and Privatization Policy

Although the above factors are very significant in attracting FDI, the successful
experience of some EU countries shows the importance of other factors such as the
regulatory regime concerning FDI, or the privatization policy of a government. The
experience of the UK, the most successful country in attracting FDI inflows, shows
three key factors: a) the liberalization of foreign ownership regulation in the early
1980s; b) the privatization program of Mrs. Thatcher in traditionally state-controlled
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CHAPTER 6
activities (telecommunication, railways, electricity water); and c) the financial

deregulation, the “Big Bang” in 1986. Japanese firms have responded positively to
these UK policies; for example, about 80 Japanese MNC established affiliates in the
UK in the period 1988-1990.
6.3.8 The size of the parent firm

The size of the parent firm is a crucial factor in determining the internationalization
path that a firm will embark on and consequently, the size of the FDI flows. Large
MNCs are involved primarily with wholly owned subsidiaries. On the other hand,
SMEs, in their path to internationalization, face much tighter managerial and
financial constraints than do their competitors, the large firms. These constraints
impose an adverse asymmetry in terms of information cost against the SMEs, forcing
them to adopt other risk minimization strategies, such as the joint ventures rather
than a wholly owned subsidiary. Consequently, the magnitude of the FDI will depend
on the size of the parent firms involved. Indeed, empirical evidence suggests that the
size of the parent firm and the propensity of establishing a joint venture are inversely
related (Mutinelli 1998). This may explain why governments mainly target large
firms in their effort to attract FDI.
In sum in this section we examine the determinants of FDI. In our analysis we
combine both the predictions of economic theory, as well as findings of empirical
studies in identifying a number of factors that may affect the direction and size of
FDI flows.
Briefly discuss the factors affecting FDI.
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6.4 THE IMPORTANCE OF FDI FOR THE EU
6.4.1 Capital accumulation

Capital accumulation is the increase in the capital stock of a firm, which is
created by investing over and above the depreciated capital of the firm. The
accumulation of capital expands the productive potential of a firm and, consequently,
the productive potential of a country. FDI inflows contribute to the capital
accumulation in the recipient country. In this capacity, FDI inflows are growth
enhancing. In the period 1984-89, intra-EU FDI flows were on average 2% of the
gross domestic fixed capital formation in the EU while in the period 1989-94 this
was raised to 4,5%.
6.4.2 Diffusion of knowledge and Research &

Development (R&D)
FDI is different from other forms of investment because it not only transfers the
production know-how, but it also facilitates a diffusion of knowledge from one
country to another and an assimilation of technologies or ideas across countries.
FDI, by facilitating this diffusion of knowledge, effectively motivates research and
development (R&D), that is, the research for and the adoption of new products,
processes, and techniques, as well as the introduction of new technical, managerial
and marketing skills. This distinct characteristic of FDI has the potential to
transform the host economy. Empirical studies support the fact that FDI flows
have, indeed, provided a channel for the diffusion of knowledge from other
countries such as the USA and Japan into the EU, as well as for the intra EU FDI
flows. Empirical evidence suggests that positive spillovers from MNCs occur to
domestic firms in the same sector and region as the foreign affiliates. Moreover,
domestic firms may gain more from these spillovers if the technology gap they have
from foreign firms is low.
MNCs are fostering R&D not only at home but also in their subsidiaries
abroad. Indeed, the shares of R&D undertaken by foreign affiliates worldwide and
particularly in Europe are large. Moreover, as will be evident shortly, R&D
propensities of foreign affiliates are higher than those of domestic firms (see
economic growth data below).
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6.4.3 Economic growth

Within the endogenous growth theory, FDI flows may contribute directly or
indirectly to the economic growth of a country. Many of the empirical studies seem to
focus on the less developed countries where FDI is considered to be the major source
of economic growth. One, however, would ask whether economic growth in the
developed world and more specifically in the EU, has also been affected by FDI.
According to Barrell et al. (1997), FDI inflows in EU countries have, indeed,
contributed to the EU economic growth for a number of reasons:
ñ USA affiliates have a greater propensity to undertake R&D expenditures in all
EU countries than the domestic firms.
ñ The labor productivity of US manufacturing affiliates in the UK is higher by one-
third than that of the domestic manufacturing productivity.
ñ The level of inward investment in many smaller EU states has been very
significant. For example, in Belgium and Ireland 59% of manufacturing output in
1989 was produced by foreign affiliates. In the UK, FDI has transformed the
production side of the economy.
6.4.4 Unemployment
The large FDI flows, however, create some concerns among the general public in
several European countries regarding whether they aggravate unemployment
problems and thus lead to wage moderation.
Public perceptions and attitudes regarding FDI liberalization differ from one
country to another, depending on the characteristics of the labor market in each
country. In continental European labor markets characterized by labor market
inflexibility, such as the labor markets in Germany and France, the public perception
of FDI liberalization is that it may either lead domestic companies abroad (exporting
jobs) or it may reduce domestic wages. On the other hand, with a flexible labor market
such as the British one, the public perception is that FDI liberalization will attract
MNCs seeking access to the EU market. However, as is evident from Graphs 2 and 3:
ñ A significant percentage of EU production is carried out by foreign affiliates. For
example, about 28% of the French manufacturing production in 1996 was
produced by foreign-owned firms. In Germany about 12% of the manufacturing
output in 1996 was produced by foreign affiliates.
ñ A significant percentage of employees in less flexible EU labor markets, such as
France and Germany, is employed by foreign affiliates, e.g. 25% of employees in
French manufacturing worked in foreign affiliates in 1996 and about 8% of
German employees in the manufacturing sector worked in foreign owned firms.
These shares are also high for other countries such as the UK, Netherlands and
Sweden.
127
Hungary
Ireland (1996)
Canada (1996)
United Kingdom (1996)
Czech Republic
Netherlands (1996)
France (1996)
Sweden (1996)
Norway (1996)
United States (1996)
Finland
Germany (1996)
Turkey (1996)
Italy (1995)
Japan (1996)
0 10 20 30 40 50 60 70
%
Graph 2: Share of foreign affiliates in manufacturing production (or turnover)
1997 or latest year available
Source: OECD, Activities of Foreign Affiliates database, 1999
Ireland (1996)
Hungary
France (1996)
Sweden (1996)
United Kingdom (1996)
Netherlands (1996)
Czech Republic
Norway (1996)
Finland
United States (1996)
Italy (1995)
Germany (1996)
Turkey (1996)
Japan (1996)
0 10 20 30 40 50
%
Graph 3: Share of foreign affiliates in manufacturing employment
1997 or latest year available
Source: OECD, Activities of Foreign Affiliates database, 1999
In addition:
ñ Many EU citizens are employed in MNCs outside their country of origin. For
example, 30% of employees in French manufacturing worked in companies
outside France.
ñ High-wages EU states have been preferable locations for US affiliates. For
example, Germany is the preferable production location for US manufacturing
affiliates, although German wages are well above the EU average wage.
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ñ In the UK about 500,000 jobs were created by foreign affiliates in the period 1979-
1998. Also 67% of the intermediate inputs of Japanese-owned firms are from the
UK (Griffiths et al. 1999).
ñ FDI outflows from the EU to the rest of the world either lead to an increase or no
change in the domestic employment in EU.
ñ Empirical evidence in the UK and Germany in the last twenty years, shows that
FDI has flattened the long-run labor demand curve which, in turn, could lead to
wage moderation and lower aggregate unemployment in the EU.
The above empirical evidence suggests that FDI inflows have resulted in a net
output and job creation effect in the EU.
In sum in this section we examine the significance of FDI in the diffusion of
knowledge, R&D, economic growth and unemployment for the EU.
Discuss the contribution of FDI in fighting European unemployment.
In Chapter 6 we examined MNCs and the FDI emanating from their activities
in establishing subsidiaries abroad. MNCs expand their activities abroad for a
variety of reasons, including the exploitation of economies of scale/scope, the use
of specific advantages, due to a life-cycle pattern of their products, or simply
because their competitors are engaged in similar activities. Other reasons, such
as the avoidance of tariffs and non-tariff barriers to trade; relative labor cost;
real exchange volatility; culture and language factors; as well as human capital;
the density of infrastructure and the agglomeration factor, could also induce
FDI flows in and out of a country. In the EU the intra-FDI flows, as well as, the
FDI inflows from US and Japan have been greatly motivated by the European
Integration process. The EU encourages FDI inflows since they are considered
welfare improving for the host countries. Indeed, FDI flows are associated with a
number of positive effects, such as the diffusion of knowledge among countries by
creating positive productivity spillovers to domestic firms, as well as with a
positive contribution to the economic growth of a country resulting in a reduction
in the domestic unemployment of the host country.
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APPENDIX
Activity 1
There are several motives for MNCs in undertaking FDI:
ñ The parent company might decide to establish a new, greenfield, subsidiary abroad, i.e.
the company constructs new plants and equipment in another country.
ñ the parent company could try, either by a take-over of or a merger with a foreign firm, to
acquire direct control over the assets of the foreign company;
ñ the parent firm might want to establish a joint venture with a foreign firm.
ñ the parent company might transfer capital abroad in order to finance an expansion of its
subsidiary;
ñ Profits of overseas subsidiaries are reinvested abroad.
Advantages and disadvantages of FDI compared to its alternative forms
ñ FDI allows MNCs to overcome difficulties arising from high tariffs and non-tariff barriers
to trade.
ñ MNCs, by undertaking FDI, can have tighter control over the production and marketing
of their product abroad.
ñ MNCs can exploit economies of scale or scope by diversifying either horizontally or

vertically.
ñ MNCs, by undertaking FDI, can spread their risk through market diversification
especially if there is exchange rate volatility.
ñ FDI is the highest risk internationalization activity, mainly due to the lack of information
about the foreign country regarding different culture, language, consumer preferences
and cost conditions in the host country.
In discussing the advantages and disadvantages one should take into account the different
degree of exposure in the business risk.
Activity 2
The Specific Advantage Theory
This theory says that an MNC should possess a specific advantage over competing local
firms. This specific advantage could be technical knowledge, product innovations and
managerial or financial expertise that the firm can better exploit and protect by setting-up
foreign subsidiaries. Examples of this case are pharmaceutical products, intellectual
property and production processes.
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The Eclectic Approach

This theory encompasses several approaches. It is also know as the OLI approach. The
initials stand for Owner specific, Location specific and Internalization factors. Ownership
specific factors give a specific advantage to a firm, such as innovation, ability to diversify
and organizational or management skills. Location specific factors are associated with
lower transport costs or proximity to markets and resources. Internalization is the process
by which the MNC draws activities under centralized control rather than outsourcing them.
Internalization allows the exploitation of economies of scale and/or scope, the minimization
of risk and the maintenance of quality control.
Follow the Leader

The basic assumption of this theory is an oligopolistic structure of the market with barriers
to entry. In oligopolistic competition all firms are interdependent, i.e. they are engaged in a
“game” of actions and counteractions depending upon their competitors’ positions and
actions.
The Level of Development Theory

According to this theory a large and well-developed market will have all the resources, the
technical infrastructure, human skills and a well-developed financial system that could
support the undertaken FDI.
The Product Life-Cycle Theory

This theory suggests that all products follow a life-cycle pattern: initially a firm introduces its
product into the home market and exports it overseas. During that phase of maturity, a
firm’s profitability is lower than in the beginning of the life cycle. This implies that the home
firm could establish a foreign subsidiary in one or several developed/less developed
countries, where either the demand for the product could still be high and competition
relatively low, or where the unit labor cost might be lower.
In evaluating the relative merit of each theory, one should take into account that these
theories are complements in explaining FDIs. In the EU the main motivation in attracting FDI
was the establishment of the common market. Indeed, MNCs – in order to avoid the common
tariff wall – had to establish subsidiaries within the EU. As MNCs are oligopolies, the actions of
one MNC is swiftly followed by its competitors, resulting in the phenomenon of large FDI
inflows in the EU (see e.g., the Japanese car MNCs such as Toyota, Nissan, or Honda).
Activity 3
Labor Cost
Labor cost is considered to be a major determinant of FDI since a lower labor cost abroad
may induce MNCs to relocate some of their activities in a foreign country.
Strikes
Strikes could reduce the attractiveness of a country in hosting FDI inflows. Strikes, to the
extent that they occur often, reduce the flexibility of the labor market in a country.
131
The Real Exchange Rate and FDI
The real exchange rate (RER) expresses the value of a currency in terms of its real
purchasing power. Changes in RER will result in changes in the competitiveness of this
country, which in turn could either increase or decrease the level of FDI flows.
Empirical evidence suggests that the negative effects dominate and thus exchange rate
depreciation in the host country will lead to lower inward FDI.
Real Exchange Rate Variability
As real exchange rate variability increases, the transaction costs involved in international
trade will also rise, inducing MNCs to undertake more FDI.
Output in the Origin and the Host Country
As we have already seen, FDI volumes are affected by the volume of output in both the host
and origin country. The reason for this is because the absorption capacity in each country
depends on the size of its market, which in many empirical studies is approximated by the
level of output (GDP) in each country.
Distance between the Origin and Host Country
Many empirical studies on the determinants of FDI use the distance between host and origin
country as a variable to capture the cost of coordination, communication and transportation
between the subsidiary and the MNC.
Cultural and Language Differences
Cultural bonds and language similarities (CLS) between the two countries are important for
the establishment of an efficient business network since they can facilitate a smooth flow of
information from the MNC to the subsidiary and the reverse.
European Integration
The European integration process and especially the Single Market Program (SMP) has
positively affected intra-EU FDI, either directly by the removal of capital controls, or
indirectly by increasing the level and the growth of the overall economic activity.
Government Policies
There are several measures that a government can take in order to attract FDI, such as
tariffs, taxes, subsidies, regulatory regime and privatization policy.
The Size of the Parent Firm
The size of the parent firm is a crucial factor in determining the internationalization path that
a firm will embark and consequently, the size of the FDI flows.
Once again in evaluating the relative merit of each factor, one should note that there is no
one single factor for explaining FDI.
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Activity 4
Public perceptions and attitudes regarding FDI liberalization differ from one country to
another, depending on the characteristics of the labor market in each country. In
continental European labor markets characterized by labor market inflexibility, such as the
labor markets in Germany and France, the public perception of FDI liberalization is that it
may either lead domestic companies abroad (exporting jobs) or it may reduce domestic
wages. On the other hand, with a flexible labor market such as the British one, the public
perception is that FDI liberalization will attract MNCs seeking access to the EU market.
133
BIBLIOGRAPHY
Barrell R. and Pain N. (1997), “Foreign Direct Investment, Technological change
and Economic growth within Europe”, The Economic Journal 107, pp. 1770-1776.
Harris N., European Business, Second Edition, Palgrave 1999, pp. 31-32, 280, 291,
300-310, 313-17.
Multinelli M. and Piscitello L. (1998), “The influence of Firm’s size and International
Experience on the Ownership Structure of Italian FDI in manufacturing”, Small
Business Economics II, pp. 43-56.
RECOMMENDED READING
Agiomirgianakis G. M., Asteriou D., Papathoma K., “The Determinants of FDI: A
Panel Data Study for the OECD”: in Tsoukis C., Agiomirgianakis G. and Biswas T.
(eds.), Aspects of Globalization, Kluwer 2004.
Zervogianni A., Argiros G. and Agiomirgianakis G.M., “Foreign Direct Investment
and European Integration” in European Integration, Chapter 9, Palgrave Macmillan
Publishing, London UK, Forthcoming 2005.
This chapter provides more detailed information on the subject of foreign direct
investment in case the reader wishes to expand on this issue.
Griffiths A., Wall S., Applied Economics, Eighth Edition, Longman, London 1999.
Sodersten B., Reed G., International Economics, Third Edition, Macmillan Press
1994.
134
CHAPTER 7
THE CASE OF THE CENTRAL AND
EASTERN EUROPEAN COUNTRIES
TOWARD THE EU AND THE EFFECTS
OF THE ENLARGEMENT
ON THE UNION’S POLICIES
The scope of Chapter 7 is to present the background of the Central and Eastern The Scope
European countries and their way toward the European Union. We also present the of the Chapter
effects of the enlargement on the EU’s policies.
ñ familiar with the Central and Eastern European countries’ environment Objectives
ñ familiar with the driving forces that led to the enlargement
ñ able to understand the effects of the enlargement on the Union’s policies.
ñ Central and Eastern European countries Key Words

ñ Reform
ñ The enlargement effects on European Union policies
Over the period from the EU’s first steps up to the present day, the number of Introductory
participant member states in the EU has continuously increased. It is now becoming Comments
more than obvious that one cannot think of the European Union without considering
the accession of the Central and Eastern European countries. A few decades ago this
statement would have been unthinkable, but times are certainly changing. The latest
enlargement, from 15 to 25, is the biggest in Union history. Its origins are in the
collapse of communism, the fall of the Berlin Wall in 1989, which provided the
opportunity to enlarge Europe with the accession of the Central and Eastern European
countries.
135
7.1 THE APPLICANT COUNTRIES
AND THEIR OWN STATE OF REFORM
7.1.1 A brief history of the candidate countries

toward EU membership
In 1989 Europe experienced a dramatic transformation. First the fall of
communism, then the break-up of the USSR followed by other major events, reshaped
the continent. It was obvious to the Central and Eastern European countries that
accession to the EU would be the only way to establish democratic systems based on
respect for human rights, and at the same time change their strict communist
economic system to a fully operating market economy. It was also a matter of finding
security in an uncertain context (break up of the USSR, Yugoslavia and so forth).
NATO seemed the best guarantee for their security and – despite the discontent
of Russia, the USSR’s successor – Hungary, Poland and the Czech Republic joined
the Atlantic Alliance in 1999. The former communist countries expressed their
interest in joining Western institutions, and especially the European Union.
7.1.2 Central and Eastern European countries

in the 21st century
Nowadays the ten Central and Eastern European countries enjoy political
stability, democracy and substantial economic growth without fearing ethnic conflicts
or cases of war. Indeed, the above situation is the result of the winds of change that
favored the liberal democracy for which people in Central and Eastern Europe have
waited patiently for so many years.
The rounds of accession negotiations for Hungary, Poland, Slovenia, the Czech
Republic, and Estonia (along with Cyprus) began in 1998 following the Luxembourg
European Council summit of 1997. These five countries have made a very successful
effort toward rebuilding and reforming their political and economic systems to meet
the requirements for membership in the EU.
The rounds of accession negotiations for the remaining five countries – Slovakia,
Bulgaria, Lithuania, Latvia, and Romania (along with Malta) – began later in the
year of 2000 following the Helsinki European Council summit of 1999, because of
the fact that their political leaders were still exploiting fear – fear of economic reform
and fear of the changing structure and administration of the nations. However, by the
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late 1990s, progressive political powers took over in all the remaining candidate
countries and put comprehensive economic reforms on the agenda.
7.1.3 The accession requirements

The accession requirements that the candidate countries had to meet in order to
qualify for the EU are divided into two groups:
ñ The Copenhagen political and economic requirements
ñ The acquis communautaire.
It is a fact that the Copenhagen requirements, issued in 1993, are of a rather
general nature. Their main purpose of existence is to guarantee stability in the
administration, to protect democracy, promote equality in law, protect human rights
and care for minorities; they enhance a fully active market economy considering all
market forces.
The acquis communautaire is much more specific. The entire body of European
laws is known as the acquis communautaire. This includes all the treaties, regulations
and directives passed by the European institutions as well as judgments laid down by
the Court of Justice. The term is most often used in connection with preparations by
the candidate countries to join the Union. The candidate countries are obliged to fully
adopt, implement and enforce all the acquis to qualify for membership in the EU. As a
result, they need to change or reform national laws and set up or change the necessary
administrative or judicial bodies that oversee the legislation. The negotiations between
the EU and the candidate countries are structured around the acquis – 80,000 pages of
text divided into 31 chapters. The candidate countries had to close with the EU all the
chapters in order to fully accede to the EU. By the end of 2002 – less than 13 years after
the break-up of the Soviet empire and the end of the Cold War – eight Central and
Eastern European countries had completed their negotiations and joined formally on 1
May 2004, together with the two Mediterranean islands. Two other candidate
countries, Bulgaria and Romania, were unable to conclude their negotiations on time,
and their membership has been rescheduled for 2007.
7.1.4 Smoothing the integration process

The EU’s previous enlargements guarantee the high level of efficiency of the
integration process. In the case of the eastern enlargement, the task is much greater
for the EU. The number of candidates is quite impressive, their political background
is completely different, and economically they were left behind. The large size of the
enlargement seems to worry citizens in the existing member states regarding its
impact on their lives and jobs. There have been fears in the existing member states
about a rise in immigration, the consequences of cheap labor and the impact of lower
environmental standards. On the other hand, citizens of the new members are
worried about whether their economies can be competitive with those in the rest of
the EU or whether their farmers can stand up to those who have benefited in the past
137
years from the EU subsidies. To that extent, most Central and East European political
leaders have explained to their publics that the long-term benefits of EU accession
will outweigh the short-term costs of economic adjustment. But West European
political leaders have failed to make the case for an enlarged EU, or to outline the
benefits to their people, or to calm their fears. They have mostly remained silent on
the subject of enlargement. Consequently, only the voices of populists and extremists
have been heard—voices that raise the issues of rising immigration, unemployment,
and international crime, all flowing from enlargement.
Each of these issues was addressed and, in fact, answered in the entry negotiations.
As with earlier enlargements, the EU provides safeguard mechanisms which are
designed to overcome any unforeseen consequences.
7.1.5 What do the EU’s current members

fear from enlargement?
Spain, Portugal, and Greece fear the redistribution of the cohesion funds they
now receive from the EU. New members will have to be supported under the
cohesion funds and the amount of money will be distributed among more countries.
On the other hand, the UK, Germany and France fear that because of the
enlargement they will have to contribute substantially more to the EU budget. In
addition, the agricultural members are deeply concerned with the implementation of
the Common Agricultural Policy (CAP). It is a fact that agricultural subsidies will be
drastically reduced. Germany and Austria fear that a possible movement of low-
skilled workers from the Central and Eastern European countries will threaten
wages and increase unemployment of the domestic workforce. They also fear that
they will suffer an increase in crime and illegal immigration. It seems though that
these fears have been greatly exaggerated by politicians and the press; previous
enlargements to include Greece, Portugal, and Spain, have proved that only small
numbers of people leave their homes to seek work abroad, even if the wages differ
substantial.
7.1.6 Reforming the EU’s institutions to prepare

for enlargement
The first challenge for the enlarged European Union was to reform the EU
institutions to make them more efficient for the accession of the newcomers. This
reform required some serious consideration among member states. Matters like the
composition of the Commission, the weight of each country’s vote, the powers of
Parliament and so on, all gave rise to arguments among domestic governments. To
give a solution to those questions an Intergovernmental Conference (IGC) was
called in February 2000. It led to the European Council in Nice, France, in 2001. The
IGC was called for a broader and deeper discussion on the future of the European
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Union soon after having given the green light to the fifth enlargement. To this end,
the result of the IGC – the Treaty of Nice – called for the initiation of a broad
discussion among all interested parties: the representatives of the national
parliaments as well common people, in both the already existing member states and
the candidate countries.
The Treaty of Nice was signed on 26 February 2001, and concluded the IGC,
preparing the European institutions to reform for the arrival of new member states
from Central and Eastern Europe. The Treaty of Nice has been ratified by all the
Member States, in accordance with their respective constitutional rules, and came
into force on 1 February 2003. The main changes it brings are related to limiting the
size and composition of the Commission, extending qualified majority voting,
implying a new weighting of votes within the Council and making the processes more
flexible. Following the 2000 IGC and the Nice Treaty, the number of votes allocated
to each member state has been revised, in particular for those states with larger
populations, so that the legitimacy of the Council’s decisions can be safeguarded in
terms of their demographic representativeness. The Nice Treaty also promoted the
qualified majority decision-making system. A qualified majority is reached if: the
decision receives a set number of votes (which will change as new countries join) and
is agreed upon by a majority of member states. Moreover, a member state may
request that it be verified that the qualified majority represents at least 62% of the
total population of the Union. If this is not the case, the decision is not adopted.
In Section 7.1 we presented the situation of the Central and Eastern European
countries and their effort toward political and economic reform. We tried to identify
the major changes and the key role of the existing body.
What are the benefits of enlargement for existing EU members?
139
7.2 THE EFFECTS OF THE ENLARGEMENT
√N THE UNION’S POLICIES
7.2.1 The economic impact of the enlargement

The enlargement, from an economic point of view, will be of major importance
because of the fact that a more integrated market will boost economic growth for
both the new and the existing individual member states. The newcomers will benefit
from potential investments from enterprises based in Western Europe and from
access to the EU funds. Enlargement to the countries of Central and Eastern Europe
will increase the economic and human potential of the Union, thus enhancing its
level of influence for the rest of the world markets.
The expansion of the Single Market, from the overall integration process, as well as
its enriched human potential, will strengthen the Union’s position in global markets.
Central and Eastern European countries have significant natural resources and their
geographic position will be an asset regarding transport, energy and communications.
Major investments on behalf of the Western-based enterprises, related to the
moderniztion of the acceding countries’ economies and their catching up with ∂U
living standards, will boost demand across the Union and strengthen competitiveness.
7.2.2 Agriculture
The Common Agricultural Policy (CAP) had to face the impacts of enlargement in
May 2004, when the 15 member states became 25 and the number of farmers in the EU
increased by nearly 70%. It was vital to prepare farmers in the new member states for
the new reality in the EU by providing funds available to modernize farms, food
processing and marketing structures, and encourage environmentally friendly farming.
After the EU enlargement, a special three-year funding package was announced
specifically to meet the needs of these farmers. It provides _5.8 billion to encourage
early retirement, to boost less favored areas, enhance environmental protection, and
promote compliance with EU food, hygiene and animal welfare standards.
Enlargement will greatly increase the agricultural potential of the Union, while the
market for European primary products and processed food will increase by more
than 100 million consumers. The existing and acceding members will trade products
freely with no restrictions or barriers. Indeed, these developments should improve
economic welfare for each individual member and the Union as a whole. At the same
time, adjustment strains from exposure of the candidate countries to competition
could be considerable, and the adjustment time is very important.
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7.2.3 Economic and Monetary Union
Economic and Monetary Union

It is very important for the new members to meet the EU requirements and
reform their economic systems to stabilize their economies, aligning properly with
the existing member countries. The Central and Eastern European countries that
joined the EU in May 2004 will adopt the euro within the next few years, though
there is no fixed timetable. In the meantime they have to prepare their economies
and they might have to wait if they think that their economies are not yet ready. They
have to weigh the disadvantages (less control over their inflation, interest and
exchange rates) against the likely benefits – which include having the same currency
as major trading partners, greater credibility in international financial markets and,
consequently, greater flows of investment. Most candidate countries have adopted a
positive approach toward EMU.
7.2.4 Horizontal policies
Social Policy
Social policy in an enlarged Union will have to address the tough social problems
of acceding countries, including unemployment and public health issues, as well as
problems resulting from the adjustment process in both old and new member states.
Important investment in human resources will be necessary and Community social
policy and its funding will be burdened accordingly. Adaptation of acceding countries
to the Community social provisions and the European social model could be adversely
affected by the large number of citizens having a standard of living far below the ∂U
average, by insufficiently developed vocational training networks, by systems of
industrial relations still in transition and in need of improvement, and by inefficient
public administrations. πn some areas, for instance in health and safety at work,
adaptation of acceding countries to the Community provisions, while benefiting the
well-being of workers and enhancing productivity, will require serious and sometimes
costly efforts. However, too slow or inadequate adaptation could have adverse effects
on competition and could complicate further development of Community policies.
On the other hand, enlargement will highlight the importance of social cohesion in the
objectives of the Treaties and should thus enhance the role of social policy.
Environment
The new members have to meet the challenge to overcome their major
environmental problems, so as to be able to follow the Community policy. There is a
quite a big gap between the newcomers and the existing members that will have to be
141
bridged. Thus, the Union should invest and fund the effort of the new members to
develop in the field of environmental protection and mainly in the public utility
sectors for water, energy and waste. ∞ major investment and effort is also necessary
for the Central and Eastern European countries to built the appropriate infrastructure
and develop and modernize the administration to enforce the EU legislation.
Consumers
Enlargement will favor ∂U consumers overall by providing a bigger variety of
products and services. It is very important to underline the consumer policy strategy
for 2002-2006 that states that all member states should:
ñ Guarantee essential health and safety standards, so that buyers are sure the
products they purchase are safe and that they are protected against illegal and
abusive practices by sellers.
ñ Empower individuals to understand policies that affect them and have an input
when these policies are made.
ñ Establish a coherent and common environment across the Union so that shoppers
are confident about making cross-border purchases.
ñ Ensure that consumer concerns are integrated into the whole range of relevant EU
policy areas from environment and transport to financial services and agriculture.
The implementation and strengthening of quality controls can guarantee the
above. It is a fact that the new members will need some time to adjust.
Science, Research & Development

Benefits can be obtained for ∂U Research and Development from the participation
of countries with an important scientific potential matching the needs of the existing
members with the needs of the newcomers.
Information Society
The newcomers’ interest in Information and Communication Technologies
(ICTs) has proved to be particularly high. These countries seem to offer very
promising opportunities for related industries and might emerge to become very
competitive. The year 2005, when the economies of the ten new members will be fully
integrated with the rest of the EU, is very important as the newcomers have already
prepared themselves by setting a series of e-Europe targets of their own.
Culture and the Importance of Different Tongues

With the enlargement in 2004, the number of official Union languages has risen
from 11 to 20. The EU’s legislation is available in all languages and therefore
accessible to all citizens. It also guarantees that any EU citizens have the right to
142
CHAPTER 7
correspond and communicate with an EU institution or body and receive a reply in

their own language. To that extent a member of the European Parliament has the right
to represent his or her voters in the European Parliament in his/her own language. The
enlargement will develop and enhance the multi-European profile of the Union.
7.2.5 Sectoral policies
Transport
In the transport sector the Central and Eastern European countries are currently
implementing programs to meet the EU transport acquis. The transport issues which
need to be addressed as a matter of priority are as follows:
ñ In road transport, issues relating to the technology, safety and environmental
legislation, as well as market access, fiscal matters and social legislation.
ñ In inland waterway transport, issues concerning fleet capacity.
ñ In rail transport, the integration of services between EU and CEEC railway
companies, as well as improving the latter’s organization and financial situation to
operate in market conditions.
ñ In air transport, issues relating to market access and safety and infrastructure
organization.
ñ In maritime transport, the enforcement of the maritime safety acquis.
The enlargement should benefit the transport sector provided that important
financial resources, partly from ∂U funds, will be available for the development of
transport networks, for adaptation of acceding countries and their transport fleets to
Community social, safety and other technical and educational requirements.
Energy
The key issues in the energy sector for the newcomers are: the need to develop a
strategic energy policy with clear timetables for restructuring and alignment with the
Unions’ energy requirements; and the effort to reorganize all the oil, gas, electricity
and nuclear infrastructure to meet the required safety standards. Enlargement would
seem to assist the Unions’ policies in the energy sector, while it will provide stability of
energy supplies, research, and energy efficiency on a bigger scale. πn some countries,
nuclear safety is a problem because of a different approach and politics, causing
serious concern throughout the rest of Europe. The solution of this problem is to align
fully with the Community requirements and to promote a “nuclear safety culture”
through educational programs.
Industry
The expected increase in economic activity and the improvements of the resource
allocation will, overall, boost the European Union’s industry. However, significant
143
adjustment strains can be expected in both acceding and present members. In the
meantime the newcomers will have a comparative advantage because of the low-cost
production. The concept is that there will be an industrial co-operation to the benefit
of all.
Telecommunications
With the enlargement, the market of telecommunications will expand and demand
for Community funding will increase. Firms will certainly expand to remain
competitive but there will be no major changes for the Union’s policy.
Small- and Medium-Sized Enterprises (SMEs)

SMEs in acceding countries will at first suffer from considerable competitive
pressure because of the different economic measurements and standards. ∂U
policies will have to provide support so that they will have the time to adjust.
7.2.6 Justice and home affairs

∆he enlargement of the Union will certainly be a challenge and an opportunity to
identify common problems relating to migration and political asylum, police and
customs co-operation between current ∂U countries and the newcomers. It is in the
common interest to ensure that justice and home affairs measures are applied to all
individual member states and that all countries fully meet the EU requirements to
avoid crime and fraud within the Union.
In Section 7.2 we presented the effects of the Union’s policies of enlargement on
the applicant countries of Central and Eastern Europe. It seems that it is all a matter
of well-structured politics regarding the governments of the participant member
states. There is a true need on their behalf to guide their people, presenting the
advantages of the enlargement and taking away the fear of the move for the Central
and Eastern European countries.
On what do you think the economic gains from the Enlargement will depend?
Explain the functions of an economic system and distinguish between a free market
economy and a planned economy. Explain why the centrally-planned economies of
Eastern Europe failed.
144
CHAPTER 7
In Chapter 7 we presented the case of the Central and Eastern European
countries and their application to join the European Union. We tried to identify
the major changes in their traditional political and economic environments and
present the concept of their reform effort toward integration with the European
Union. We also presented the effects of the Union’s policies of enlargement on
the applicant countries of Central and Eastern Europe and identified the need
for well-structured communication among member states to fully understand
the meaning and the importance of each and every enlargement.
145
APPENDIX
Activity 1
They are long-term benefits, which resonate little with Western European voters. Internally,
after enlargement, the EU as a whole will enjoy an increase in economic activity and
prosperity. Regionally, the EU will gain from the stabilization and economic revitalization of
its borderlands, especially the Balkans. This will open new markets for EU products and
investments while saving the money and effort that would be expended in the event of
further economic upheaval and war. Internationally, the EU will enjoy greater influence as a
geopolitical player. Reflecting on this list of benefits, some Europeans would add still
another: the historical opportunity for the EU to build an undivided, peaceful, and
democratic Europe.
Activity 2
∆he economic gains from enlargement will depend primarily on the prevailing conditions
before and after accesion as well as on the adaptability of new member states in aligning
their laws and practices with those of the EU. Economic gains will also depend on the
adequacy of transport, telecommunication and energy infrastructures and networks in
acceding countries, which are necessary to support the increased trade and economic
activity resulting from integration.
Activity 3
The functions of an economic system are:

1. To allocate scarce resources to their best uses and so achieve maximum efficiency.
2. To ensure that the demands of consumers are met by producers rapidly and optimally.
3. To ensure that if there are external changes the economy will adjust rapidly.
4. To ensure that resources will be transferred to future generations through savings
achieved by postponed consumption
Types of Economic Systems
The Free Market Economy

In a free market system all the economic decisions are taken through the market forces of
demand and supply. Businesses are owned privately and profit maximization is the driving
force of their operation.
The Planned Economy

In a planned economy (or command economy), economic decisions are made by the state
– or, more specifically, the state bureaucracy – rather than the market. Administrators
appointed by the government take the key decisions on:
146
CHAPTER 7
ñ What to produce
ñ How to produce it
ñ For whom to produce it
ñ How to distribute it
The Mixed Economy
A mixed economy comprises:
A Public Sector (nationalized industry + national government + local government)
A private sector (households + non-state owned businesses)
Why Did The Centrally-Planned Economies of Central and Eastern Europe Fail?
ñ Lack of flexible production plans
ñ Emphasis on heavy industry rather than popular consumer goods
ñ Decreasing political legitimacy through corruption, secret police, control of information
and so forth
ñ Slow economic growth in the 1980s
ñ A demand/supply imbalance – especially consumer goods
ñ Poor quality of goods
ñ Black markets
ñ Large bureaucracies – often with unfair privileges
ñ Inferior technology at times
ñ Lack of international trade
ñ Lack of financial infrastructure and inability to use western capital markets.
147
BIBLIOGRAPHY
RECOMMENDED READING
1994.
Hall 2001.
148
George Agiomirgianakis is Associate Professor at the Business School of the Hellenic
Open University and holds a Senior Research Fellowship at City University of London. He
is also the Secretary General of the European Economics and Finance Society (EEFS).
He has 20 years teaching experience in higher education, both in Greece and in Britain.
From 1997 to 2001 he taught at City University of London. His research interests lie in the
areas of International Economics, Macroeconomic Policy Games, Labour Economics,
Human Capital, Economic Growth, SMEs and Foreign Direct Investment. He has served
as guest editor for the following journals: Policy Modelling, Applied Economics,
International Journal of Economic Research, International Journal of Financial
Management Services, International Review of Economics and Finance, International
Journal of Finance and Economics and the Journal of Economic Integration. He has
published three books: a) The Macroeconomics of Open Economies under Labour
Mobility (1999), Ashgate Publishing UK, b) European Integration (December 2004), with
A. Zervoyianni and G. Argyros, Macmillan (Palgrave),UK and c) Aspects of Globalisation:
Macroeconomic and Capital Market Linkages in the Integrated World Economy
(December 2003), with C. Tsoukis and T. Biswas, Kluwer, USA.
Panagiotis Liargovas is Associate Professor at the Department of Economics of the

University of Peloponnese and member of the Board of Directors of the Hellenic Open
University. He is also a member of the Programme Committee of the Sixth and Seventh EU
Framework Programmes regarding research in Social Sciences and Humanities. He has
taught for more than 15 years in many Universities including Clark University, the
Universities of: Bologna, Athens, Thessaly, Patras, Crete and the Athens University of
Economics and Business. His research interests are focused in the areas of International
Economics, Economics of Transition, Regional Economics and European Economics.
He is the author of four books (in Greek) and the editor of three books (two of them in
English). His articles appear in the following journals: Journal of Developing Areas, Acta
Oeconomica, Ekonomia, Economic Analysis and Policy, Annals of Regional Science,
Open Economies Review, The European Union Review, Journal of the Asia Pacific
Economy, Journal of Economic Integration, Journal of Southern Europe and the Balkans,
Post-Communist Economies, Regional Studies, Small Business Economics, European
Environment, Economia Internazionale, and Greek Economic Review. He has served as a
reviewer for many Journals including Regional Studies, Small Business Economics,
Journal of Economic Integration, Open Economies Review, Review of International
Economics, Portuguese Economic Review, Journal of Southeast European and Black Sea
Studies.
149
ISBN 960-538-578-3

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Economics for Managers

G.M. AGIOMIRGIANAKIS VOLUME 3

Myrona, Yanni and Manoli

PREPARATION OF THE TEACHING MATERIAL

Coordination of the development of the educational material

In accordance with Law 2121/1993,

Economics for Managers

In Chapter 2 we present the process of European Integration by presenting

Chapter 3 analyses the competition policy of EU that ensures fair competition

At the beginning of each chapter, there is an introductory text presenting the

ñ European integration Key Words

1.1.1 Definition of European business

1.2.1 The integration process

1.2.2 The stability of the divided Europe

1.2.3 Changing the scene

1.2.4 Economic integration

1.2.5 Global institutions

The General Agreement on Tariffs and Trade

Table 1: GATT Rounds and their Objectives

Torquay, England 1951 ñ tariff reduction

The International Monetary Fund

The World Bank

The Organization for Economic Co-operation and

1.2.6 A brief history of the European Union

All businesses follow technological progress investing large amounts in acquiring

ñ World War II Key Words

2.1 TOWARD AN INTEGRATED EUROPE

2.1.1 A historical review

2.1.3 The Council of Europe

2.1.4 The Western European Union

2.1.5 The European Coal and Steel Community

2.1.6 The Treaty of Rome

2.1.7 The Merger Treaty

2.1.8 “Eurosclerosis” from the 1970s to mid 1980s

2.1.9 The Single European Act of 1987

2.1.10 The Treaty of Maastricht –

2.1.11 The Treaty of Amsterdam

European enlargement considering the participation of the Eastern European

2.2.1 The Council of Ministers

2.2.2 The European Council

2.2.3 The European Commission

ñ Proposing legislation, policies and programs of action.

2.2.4 The Court of Justice

2.2.5 The Court of Auditors

2.2.7 The Economic and Social Committee (ECOSOC)

2.2.8 The Committee of the Regions

2.2.9 The European Central Bank

2.2.10 The European Investment Bank

2.3.1 European enlargement - The way to the future

Table 1: European Countries and their Applications for Membership in the EU

ñ Competition policy Key Words

3.1.1 What is competition policy in the EU?

3.1.2 What is competition?

3.1.3 Market structure

3.1.4 Perfect competition

3.1.7 Monopolistic competition

improve costs, as a result of previous abnormal profits, then it may be possible to

3.2.1 The legislation

3.2.2 The Single European Act

3.2.3 Article 85 (81): Restrictive practices

3.2.4 Article 86 (82): Dominant positions

3.2.5 Articles 90, 92, 93: State aids

3.2.6 The new merger legislation: