REPORT TONATIONAL COUNCIL FOR SOVIET AND EAST EUROPEAN RESEARCHTITLE: AN ESTIMATE OF THE DYNAMIC EFFECTSOF REGIONAL ECONOMIC INTEGRATIONHOW EFFECITVE IS THE CMEA?AN INTERNATIONAL COMPARISONAUTHORS: Josef C. Brada and Jose A. MendezCONTRACTOR: Yale UniversityPRINCIPAL INVESTIGATOR: J. Michael MontiasCOUNCIL CONTRACT NUMBER: 800-9DATE: February 1988The work leading to this report was supported by funds provided bythe National Council for Soviet and East European Research. Theanalysis and interpretations contained in the report are those ofthe author .NOTEThis report consists of two related papers. In the first paper,the authors identify the dynamic effects of integration andpresent estimates of the effect of integration on the rate ofcapital formation and on technological progress in 6 regionaleconomic integrations schemes; the EEC, EFTA, CMEA, CACA, LAFTA,and EACM, on the basis of an econometric model. The second paperconstitutes part of a much broader study of the Hungarian economy.In that context the paper examines the static gains fromintegration and CMEA's ability to generate dynamic gains fromintegrat ion.This report is an incidental product of Council Contract No. 800-9,"Industrial Policy in Eastern Europe," Josef C. Brada and J.Michael Montias, Principal Investigators; the Final Report fromwhich has been submitted to the U.S. Government separately.AN ESTIMATE OF THE DYNAMIC EFFECTSOF REGIONAL ECONOMIC INTEGRATIONI. IntroductionThe rapid rates of growth of the member countries of the EEC and EFTA inthe 1960s created a presumption that economic integration has an importanteffect on the level and growth of economic activity. At first the beneficialconsequences of economic integration were attributed the so-called staticeffects. Chief among these is the increase in production arising from the morerational allocation of resources brought about by the elimination of tradebarriers among member countries. The belief that the static effects ofintegration were responsible for the "European miracle" was buttressed bystudies showing that, in these two integration schemes, trade creation was much2greater than trade diversion.Unfortunately attempts to quantify the static gains from integrationproduced a series of estimates notable for their general agreement that sucheffects were miniscule. The most optimistic estimate placed them at aonce-and-for—all increase in GNP of no more than 1 percent; the remainder of theestimates places the gain in GNP at much less. Because the static effects ofintegration were so small relative to overall growth rates in Western Europe,proponents of integration turned to the so-called dynamic effects to explain theevident success of the EEC and EFTA and to serve as the basis for the promotionto economic integration among other, mainly developing, countries. Unlike thestatic effects, which produce a once-and-for-all increase in output and thushave a short-lived impact on the growth rate of output, the dynamic effects ofintegration act to increase the rate of growth of output over a long period.Thus, even if the impact on the rate of growth is relatively small, compoundedover a number of years it can represent significant gains in output and welfare.Although the importance of the dynamic benefits of integration is now amatter of textbook orthodoxy, the hypothesis that integration leads to morerapid rates of growth of output remains a theoretical plausibility whoseexistence,not to mention significance, remains to be measured. In this paperwe identify the dynamic effects of integration and present estimates of theeffect of integration on the rate of capital formation and on technologicalprogress in six regional economic integration schemes. Among them are threeschemes made up of developed countries, the European Economic Community (EEC),the European Free Trade Area (EFTA) and the Council for Mutual EconomicAssistance (CMEA). The three developing country schemes are the CentralAmerican Common Market (CACM), the Latin American Free Trade Area (LAFTA) andthe East African Common Market (EACM). These estimates are then employedto calculate the effect of integration on the growth of output ineach integration scheme.II. The Dynamic Effects of IntegrationEconomic integration increases the rate of growth of the integratingcountries in two conceptually different ways. First, the rate of growth offactor inputs may be increased leading to more rapid rates of growth of output.Second, the rate of technological progress within the economic union may beincreased so that even if inputs do not increase more rapidly, outputnevertheless will grow more rapidly than in the pre-integration period.Integration is assumed to increase the rate of growth of capital by raisingthe return to capital and by reducing the risk to investors. The creation of alarge multinational market reduces the risk attributed to individual investmentproject in a national market in two ways. First, the greater heterogeneity ofthe multinational market should be more likely to provide a sufficiently largegroup of consumers with particular needs to make the investment successful whilea similar investment constrained to a national market might fail due to the lackof sufficient demand. Second, to the extent that the member countries haveasynchronous business cycles or seasonal buying patterns the opportunity tooperate plants at rates closer to capacity or to reduce the inventory-to-salesratio exists. Firms within the union should also be able the realize greaterprofits from lower production costs caused by economies of scale and themobility of capital and labor, and, even if factors are not free to move withinthe integration scheme, free trade will permit firms to relocate productionfacilities so as to take advantage of factor-price differentials among members.The risk of intra-member trade will also fall relative to other foreign tradebecause the risk of changes in tariff and nontariff barriers among members ismuch less than in trade with non-members. Finally, the risk to investors may bereduced through the establishment of a regional capital market that, because ofits size and international scope, would be less subject to the imperfectionsthat characterize small, national capital markets.Of course, in the process of integration there will be both losers andwinners. Some firms will be successful and capture a large share of theexpanded market and subsequently increase their volume of investment. At thesame time