Switzerland and the European Economic Area: A General Equilibrium Assessment of Some Measures of Integration

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Article

Reference

Switzerland and the European Economic Area: A General Equilibrium Assessment of Some Measures of Integration

ANTILLE, Gérard, et al.

ANTILLE, Gérard, et al . Switzerland and the European Economic Area: A General Equilibrium Assessment of Some Measures of Integration. Swiss Journal of Economics and Statistics , 1993, vol. 129, no. 4, p. 643-672

Available at:

http://archive-ouverte.unige.ch/unige:35462

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G A B R I E L L E A N T I L L E * * , M A R C B A C C H E T T A * * , F A B R I Z I O C A R L E V A R O * * , T O B I A S

MÜLLER**, and NICOLAS SCHMITT***

1. INTRODUCTION

After the refusal of the Swiss voters to ratify the treaty establishing the European Economic Area (hereafter EEA), the necessity of adapting the Swiss economy to a changing Europe remains an important challenge. Paying particular attention to the industrial and manufacturing sector, the purpose of this paper is to investigate the aggregate and sectorial effects of some specific measures of integration that the Swiss government is likely to pursue¹.

Of course, unilateral measures cannot replace membership to the EEA. In particular Switzerland cannot expect that reciprocity will be granted to its efforts to promote domestic competition. We therefore also propose results about the effects on the Swiss economy of membership to the EEA.

The assessment is based on simulations using a general equilibrium model of the Swiss economy. Applied general equilibrium techniques are not new in the economic literature as they have already been used to assess the effects of numerous structural changes ranging from bilateral trade liberalization in Canada [see HARRIS (1984)] to a moratorium in the production of nuclear power in Switzerland [see CARLEVARO, MÜLLER

and ANTILLE (1988)]. This approach is particularly useful to take into account complex interactions between sectors and to uncover through simulations the relative importance of various adjustment mechanisms induced by a particular structural change. Member- ship of the EC or of the EEA, as well as unilateral measures of integration are ideal scenarios where such an approach can be helpful to identify the important economic adjustments faced by Switzerland.

* This article is partly based on the report written by the authors in collaboration with C. MARANON for Prof.

HEINZ HAUSER and for the Swiss Federal Office for Economic Policy entitled "Effets d'équilibre général de l'intégration de la Suisse à l'Europe" and on more recent work on this topic financed by the Swiss National Fund for Scientific Research (Grant: 12-28650.90).

** Université de Genève, CH-1211 Genève 4.

*** Simon Fraser University, Burnaby, B.C., Canada, V5A 1S6.

1. The outline of this research and some of its methodological aspects were summarized in this Journal

by ANTILLE, CARLEVARO and SCHMITT ( 1990). See also ANTILLE, BACCHETTA et al. ( 1991 ).

Swiss Journal of Economics and Statistics 1993, Vol. 129 (4), 643-672

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644 ANTILLE/BACCHETTA/CARLEVARO/MÜLLER/SCHMITT

Any model ultimately rests on a set of characteristics that are fundamental to capture the particular issues to be analyzed. The model presented below is no exception. It is designed to simulate the effects of a set of policies that Switzerland might adopt. More specifically, we assume that economic policy will take two directions. First, the Swiss government will introduce unilateral measures in order to stimulate domestic competition. Those measures include the reduction of non-tariff barriers (hereafter NTBs) on imports, a ban on cartels, and the opening of the borders to workers from EEA countries.

Secondly, we assume that Switzerland will eventually join the EEA and that the resulting changes in economic policy correspond to the three measures mentioned above. Addi- tional changes stem from the reciprocity of the agreement, specifically the opening of EEA countries to Swiss workers and products.

To analyze the impacts of these structural changes, one needs to represent the Swiss economy by a model that incorporates international trade flows, international flows of factors of production, as well as aspects of imperfect competition. Although several existing models include some aspects of these characteristics [e.g. HARRIS (1984), D E

MELO and TARR (1991), MERCENIER (1993)], the model presented below can be distinguished from other contributions by two crucial aspects. First, not only all the manufacturing sectors are modeled as imperfectly competitive, but the model also distinguishes two causes for deviations from perfect competition: a technological cause captured by the importance of economies of scale in each sector, and a structural cause captured by the nature of the product (homogeneous or differentiated) and by the nature of the interactions between firms within each manufacturing sector (Bertrand, Cournot or collusive behavior). Second, the consumer demand and the supply of labor are derived in a consistent and integrated fashion. In particular, the utility function includes leisure in a household production framework. This specification of the consumer's utility function is essential to derive the individual domestic supply of labor, and thus to incorporate international labor mobility in the model. Other aspects of the model are standard with respect to the existing literature [see HARRIS (1984), BROWN and STERN (1989), and DE MELO and TARR (1991) in particular].

The results show that, overall, the integration measures are beneficial to the Swiss economy. We show that per capita welfare gains resulting from trade liberalization and from a ban on cartels dominate the welfare losses resulting from freer international labor mobility.

However, the results are not without limitations. In particular, we ignore the lobbying and rent-seeking activities which hamper the adoption of unilateral measures of integration as compared to multilateral measures of integration. Perhaps more importantly, we ignore any increase in discrimination against Swiss products which could result from the non-participation of Switzerland to the EEA.

The remainder of the article is organized as follows. In the next Section, the main aspects of the model are reviewed. Issues related to the various integration measures are discussed in Section 3, and the results of the simulations are analyzed in detail in Section 4. Section 5 proposes an overall appreciation of the results and some concluding remarks.

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2. THE MODEL

This Section reviews the main aspects of the applied general equilibrium model used in the simulations. Starting with a description of consumers' and producers' behavior, it then briefly presents the modeling of the main links between the domestic economy and the rest of the world², and concludes with a discussion of some of the equilibrium conditions.

The model is static and represents an equilibrium of the real (non-financial) activities of the Swiss economy. Like in most general equilibrium models, consumers' and producers' behavior is assumed to comply to basic microeconomic principles. Besides these behavioral equations, the model includes equilibrium conditions on goods and factor markets, and the agents' budget constraints. These simultaneous equations describe the equilibrium of the economy. An equilibrium is given by a set of quantities, relative prices, and real income flows that are a solution to the model3.

Whereas most studies on European integration rely on multi-country models [e.g.

SMITH and VENABLES (1988), MERCENIER (1993)], we adopt here a one-country model of an "almost" small open economy where Switzerland is assumed to be a price taker for its imports and a price maker in its export markets. Hence, by taking as exogenous incomes and prices of the EEA countries and of the rest-of-the- world, it is assumed that the policies of integration in Switzerland have no economic impact on other countries.

Although we are concerned only with the consequences of integration policies by Switzerland, the formation of the EC single market or that of the EEA without Switzer- land will undoubtedly have an important impact on the Swiss economy. However, this matters only insofar as our results, measured as relative differences between the status quo and the integration scenarios, are affected. We checked numerically that our results change only marginally when the effect of the EC single market is taken into account in both the status quo and the integration scenarios4.

2.1 Household Behavior

As social welfare relies on the satisfaction of the households' needs, their behavior has been treated with special care. While in most models consumer's utility depends only on the volume of all the goods consumed, the utility function adopted in this study depends

2. A detailed description and the formal presentation of the model without its welfare implications can be found in ANTILLE, BACCHETTA et al. (1991).

3. All prices in the model are real, the numéraire being the consumer price index. Note that the aggregate price level and nominal variables cannot be determined by the model, since it does not include the financial and monetary sectors.

4. Technically speaking, we simulated the formation of the EC single market by lowering the import prices and the prices of competing products in export markets, and by increasing the GDP of the EC. The numbers are taken from CAWLEY and DAVENPORT (1988) and EMERSON et al. (1988).

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646 ANTILLE/BACCHETTA/CARLEVARO/MÜLLER/SCHMITT

on the functional breakdown of consumption by needs5, on leisure time, and on an aggregate stock of personal financial assets, representing future consumption.

Moreover, we did not adopt the common assumption of a CES utility function for the representative consumer, since it implies trivial price and income elasticities of consumer demand. As these elasticities play a crucial role especially in a model with imperfect competition, we chose to estimate them with Swiss data, which are only available in a breakdown by needs. For this reason, needs are introduced into the model in a way that reflects the structure of the available data. They are related to products through household production functions, which allow not only a given need to be satisfied by several products, but also a single product to satisfy several needs6. Furthermore, this model allows the consistent treatment not only of labor supply but also of welfare measurement (see Appendix A) because of the inclusion of leisure in the utility function.

All households are assumed to be identical. Consumption demand, saving, and labor supply are first derived for a representative household and then aggregated over the number of resident households, which depends on the immigration policy in each scenario (see below). The general formulation of the representative household's utility function is thus

u = u(b0,bh ...9bfi ... ,bF,a), (1)

where b0 designates the representative household's leisure time; bfis the volume of need f(f= 1,...,F)> and a is the stock of financial assets held by the representative household.

The functional form is of the Stone-Geary type. The household's budget constraint can be written as

F

[ pL • (T- b0)+ynw] (1 - td)+ynt = ]T bf-pf+p • (a - a0),

/=• (2) wherepL represents the wage rate; 7, the household's time endowment; ynWJ its non-wage

earnings; td, the tax rate on total income; ynfy the net transfers received from abroad; pfj

the price index of need/; p- 1, the consumer price index chosen as the numéraire, and a0i the initial stock of financial assets.

5. Needs are defined as categories of demand. A description of the breakdown is given in Table 7 (Appendix B).

6. The fact that the utility function has "needs" as arguments is close to the spirit of BECKER (1965) and LANCASTER (1971) who defines utility in terms of characteristics of products. It must not be interpreted as an assumption of separability of the utility function between groups of products.

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Maximizing utility (1) under the budget constraint (2) yields the representative household's labor supply, demand for real financial assets, and allocation of demand between consumption needs. To satisfy a particular consumption need, products are combined under fixed proportions. As already mentioned, a single product can be used to satisfy several needs. Thus, the private consumption demand for a given product follows from the demand for needs, by aggregating the demands for the product over the entire set of needs.

A resident household's labor supply is defined as the difference between its total time endowment and its demand for leisure7. It depends, among other variables, on the real wage rate and non-wage income. The household's saving, in real terms, is obtained as the difference between the demand for the end-of-period stock of financial assets and the initial stock.

In the model, immigration affects the Swiss economy because consumption, saving, and labor supply are aggregated over the number of resident households which includes immigrants.

2.2 Production, Technology and Market Structure

In each sector, firms are assumed to be of equal size, so that the behavior of one representative firm is sufficient to model each sector of the economy. The technology used in any sector requires capital, labor, and intermediate products. It is described by a cost function of the following form

c(wK, wL, wh x) = M -f(wK, wL) + v(wK, wh wj)-x9 (3)

where x is output8 and where unit variable cost (v) is a CES function homogeneous of degree one in its arguments: the price of capital (wK), of labor (wL\ and the price index of a composite input (u>7). M is the number of firms in the industry and/is the fixed cost of the firm which consists in capital and labor expenditures. For industries that exhibit increasing returns to scale,/is a linear function of the prices of both factors. Otherwise, fis equal to zero.

Making use of Shephard's lemma, all input demands are derived from the cost function assuming price-taking behavior on the input markets. The demand for capital (z^K) for example is thus given by

7. The labor supply of non-residents is described in Section 2.3.

8. In sectors supplying differentiated products, each firm is assumed to produce only one variety which is imperfectly substitutable to all others in the sector. In this case, x is defined as the sum of the outputs of all varieties.

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648 ANTILLE^ACCHETTA/CARLEVARO/MÜLLER/SCHMITT

de

ZK(WK> ">L> W7, X) = - — .

dwK (4) Domestic supply depends on the market structure prevailing in the industry. The

following general expression is used for the pricing rule

v(\VKi WL, Wj)

Px = l-IJt ' (5)

where p^x is the price of the output and u. designates the markup of the representative firm (p-v/p). The optimal markup depends on the particular market structure in which the representative firm operates. Four different market structures are considered: perfect competition, monopolistic competition, non-collusive oligopoly and cartels (collusive oligopoly).

In perfect competition, price equals marginal and unit cost. This implies that firms produce under constant returns to scale (f= 0) and that

H = 0 . (6) With monopolistic competition, each firm sells a product variety which is an imperfect

substitute to those of all other firms in the same industry. The representative firm is assumed to choose the price, and thus the markup which maximizes its profits, taking other firm's prices as given (Bertrand conjecture). In this case,

1 M- = "

e (7) describes the optimal markup and e denotes the absolute value of the elasticity of the

perceived demand for the representative variety.

In the presence of non-collusive oligopoly, the firms sell homogeneous products and maximize profits by choosing output given the production of the other firms (Cournot conjecture). Profit maximization leads to

1 _

** ~ Af-Ti ' (8) where M is the number of firms in the industry and T] is the elasticity of the perceived

demand for the homogeneous product.

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In the presence of cartels, firms also sell homogeneous products but they now maximize joint profits. In this case, the optimal markup is given by9

1

JLX = - .

^1 (9) The precise value of the elasticity of the perceived demand (r|) depends then in part on

whether products are homogeneous or differentiated [see ANTILLE, BACCHETTA et al.

(1991)]. It also depends on whether firms face one integrated market consisting of both their foreign and domestic markets, or whether they are able to segment these markets.

For this study, it has been assumed that markets are integrated, so that firms are unable to set specific market prices. Hence, since prices are the same across markets, the perceived elasticity is a weighted average of the market specific perceived elasticity, and is thus equal to

TI = scrf\CH + sEEAr\EEA + sRWT]RW , (10) where Sj is the share of total output sold in market / and r|t is the perceived elasticity of

demand on market /.

All market structures are constrained to their long-run, zero-profit equilibrium except under collusive oligopoly where profit rates are exogenously imposed.

2.3 Trade and International Flows of Factors of Production

Total supply of products comes from three sources: domestic production, imports from the EEA, and imports from the rest-of-the-world. Import supplies are assumed to be perfectly elastic at world prices. However, goods of different origins are assumed to be imperfect substitutes. Specifically, in each industry, the domestic product and the products imported from the EEA and from the rest-of-the-world are aggregated using the Armington assumption of a CES aggregation function which is homogeneous of degree one. Cost minimization of the aggregate gives the share of demand by origin and the price (p^c) of the composite good

Pc = Pei Px . PEEA > PRW) » (11)

9. Despite very different market structures, the similarities between equations (7) and (9) can be explained by the fact that one needs a cartel to have some monopoly power over a homogeneous good produced by several suppliers, whereas by definition, any differentiated product is unique and thus always confers some monopoly power.

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650 ANTILLE^ACCHETTA/CARLEVARO/MÜLLER/SCHMITT

where px is the price of the domestic good, pEEA represents the price of imports from the other EEA countries and pRW is the price of imports from the rest-of-the-world.

Product differentiation adds a level to the Armington aggregation function. All varieties of the same origin form a composite good which enters the Armington function with the composite goods from the other two origins. Assuming symmetry between domestic varieties10, the price of the composite good becomes

Pc = Pei Px> M> PEEA > ^EEA , pRW, MRW ) , (12)

where MEEA is the number of varieties imported from the EEA and MRW, the number of varieties imported from the rest of the world11.

Export demand is a constant elasticity function of the ratio of the price of competing foreign goods to the export price. Since markets are integrated by assumption, the export price is equal to the domestic price.

Like products, the factors of production are traded internationally. Even though capital and labor are both perfectly mobile across domestic sectors, only capital is assumed to be perfectly mobile across countries. Hence, the world price is unique and the supply is infinitely elastic at that price.

Two categories of foreign workers in the Swiss economy are distinguished: non-resident workers and foreign residents. The labor supply of non-residents is assumed to depend on the ratio of the domestic wage rate to the foreign wage rate, both expressed in the same currency. The number of foreign residents in Switzerland is fixed in the benchmark equilibrium because of present quotas. If these quotas are abolished under the EEA or by unilateral action, foreign labor is assumed to become imperfectly mobile between countries (see Section 3 for the formal description of this point). Since we admit that all foreign residents have the same preferences as Swiss residents, their labor supply and their consumption and saving decisions are modeled as described in Section 2.1.

2.4 General Equilibrium

The preceding Sections describe most of the behavioral equations of the model. Of course, the model also includes equations describing investment, the public sector, the balance of payments, the distribution of factor income, as well as equilibrium conditions for all the markets, various budget constraints and accounting identities. It would be tedious to review all these aspects of the model. Below, we simply provide a brief

10. More precisely, the function aggregating all varieties from the same origin is assumed to be symmetric.

11. Because of our assumption stating that each firm produces only one variety, the number of domestically produced varieties is equal to the number of firms. The symmetry assumption implies that all varieties of a product have the same price.

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summary of their main features in order to provide the reader with some sense of their role in the determination of the equilibrium [see ANTILLE, BACCHETTA et al. (1991) for technical details].

First, total investment (private and public) is simply determined by total saving. As the current account deficit and government saving are exogenous, investment depends primarily on the firms' retained earnings and, to a lesser extent, on household's saving.

Once determined, total investment is allocated in fixed proportions across industries producing capital goods. Second, spending decisions by the public sector, that is by all levels of government as well as social security, are modeled according to a simple budgetary rule. Public saving (surplus or deficit) is fixed, so that current public expenditures are constrained by the total revenue of the public sector, and thus by revenue from direct and indirect taxes, import duties and the social security contributions. This implies that the public sector has a passive role in the model and does not have much impact on the outcome of the simulations. Third, the balance of payments is composed of an exogenous current account deficit and an endogenous balance of trade. Its equilibrium determines the real exchange rate. Fourth, as the distribution of factor income determines to a large extent the structure of domestic final demand, it is worth noting that capital income is allocated in fixed proportions to firms (75% in 1985), to households and to the rest-of-the-world, whereas labor income is earned almost exclusively by residents (98%). In turn, households spend 94% of their disposable income and save the remainder.

Finally, since all prices are flexible, all markets clear.

3. POLICY EXPERIMENTS

As mentioned in the Introduction, the first three simulations are built on structural changes which capture the main aspects of a possible strategy of unilateral liberalization by Switzerland. They also can be thought of as being part of the EEA treaty that Switzerland would have to implement if it decided to join the EEA12. The first of these structural changes deals with barriers to trade, the second with market structure, and the third with the international mobility of labor. The fourth simulation takes into account the lower trade barriers that Swiss firms would enjoy in EEA countries if Switzerland ratified the EEA treaty. Explanations about all the simulations are provided below.

1) Swiss Barriers to Trade: If tariff barriers between Switzerland and the EC/EFTA countries are sufficiently low to be ignored, it is not the case of the so-called non-tariff barriers (hereafter NTBs). Government procurement regulations favoring domestic goods and industry-specific technical requirements and standards aimed at protecting domestic producers from foreign competition are notoriously important in all EC/EFTA

12. The content of the EEA agreement which was later rejected by the Swiss electorate is summarized in the press release published by the Integration Office of the Swiss Federal Government on October 22, 1991.

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countries, including Switzerland. Eliminating NTBs will facilitate the access by foreign firms to Swiss markets. We assume that the three levels of the Swiss government (federal, cantons, communes) will no longer be allowed to favor regional or national producers.

The five sectors which will be particularly affected are the following: Construction, Metal products, Machinery, Electrical machinery, and Textiles [see PROBST (1990)].

With respect to technical requirements, we assume that Switzerland will adopt existing or future EEA regulations. The seven sectors which will be particularly affected are:

Foods, Beverages, Chemicals, Plastics, Machinery, Electrical machinery, and Construc- tion.

The elimination of all NTBs affecting imports is modeled as a reduction of import prices (in foreign currency) by an amount corresponding to the tariff equivalent of the cumulated NTBs. These price reductions, expressed as percentage changes, are shown in the first column of Table 1. Because no evaluations of tariff equivalents for Swiss NTBs are available and because several information necessary to quantify them precisely are lacking, the figures in Table 1 are estimates which rely on the compilation of various official sources and of data from WHALLEY (1985) and PROBST (1990)13.

2) Market Structure: Table 2 indicates for each of the 19 sectors of the model, the corresponding market structure in the benchmark equilibrium. The determination of the appropriate market structure for each sector is based on a variety of information such as market concentration, economies of scale, number of firms and products, and on discussions with experts about pricing behavior. Although it is well known that the Swiss economy is heavily cartelized, we have chosen to model only three sectors as cartels in the status quo equilibrium. The high degree of aggregation associated with each sector explains this choice: even if several Swiss industries are known to be cartelized, it is not appropriate to model the entire sectors to which these industries belong as such unless the share of these industries in the total activity of the sector is significant. In our view, only Beverages, Tobacco and Non-metallic mineral products can possibly satisfy this criterion.

Among the unilateral measures that Switzerland can adopt to increase domestic competition a ban on cartels is probably the most frequently mentioned policy. Accord- ingly, the second experiment consists in replacing the three cartels of the benchmark equilibrium by non-cooperative oligopolies¹⁴.

13. We established first a ranking of the sectors based on the number of industry specific directives to be implemented by Switzerland when joining the EEA. According to this criterion, Food comes first, followed by Beverages, Chemicals, Machines, Plastics and Construction. Then we estimated the implicit tariff rates induced by Swiss procurement policies [see LAIRD and YEATS ( 1990) for the method] : we find 5% for Textiles, 6% for Metal products, 1.5% for Machinery, and 10% for Electrical machinery.

14. See also MERCENIER and SCHMITT (1992) for an alternative way to model the link between economic integration and collusion.

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Table 1: Experiments

Food Beverages Tobacco

Textiles, clothing Chemicals Plastics

Non-metallic mineral prod.

Metal products Machinery

Electrical machinery, watches Wood

Paper

Printing, publishing Leather products Petrol refinery

Jewelry, other manufact.

Construction Others

State, social insurance

NTB reductions in % import

-10 -10

— -5 -10

-5

— -10 -10 -10

—

export to EEA -0.6 -0.6 -0.6 -0.4 -1.0 -0.4 -0.8 -0.4 -1.2 -1.2

— -0.4

— -0.8 -0.2 -0.6

—

Table 2: Industry Structure of the Model

Food Oligopoly Beverages Cartel Tobacco Cartel Textiles, clothing Monopolistic competition Chemicals Oligopoly Plastics Monopolistic competition Non-metallic mineral prod. Cartel

Metal products Monopolistic competition Machinery Monopolistic competition Electrical machinery, watches Monopolistic competition Wood Perfect competition

Paper Oligopoly Printing, publishing Monopolistic competition

Leather products Monopolistic competition Petrol refinery Oligopoly Jewelry, other manufact. Monopolistic competition Construction Perfect competition Others Perfect competition State, social insurance Perfect competition

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3) International Labor Mobility: It is likely that Switzerland will abolish its immi- gration quotas for citizens of EEA countries whether or not it belongs to the EEA. We assume that these quotas are binding in the status quo situation, i.e. that some EEA nationals who would immigrate to Switzerland at the current relative wage rates are prevented from doing so.

The free movement of persons and the assumption of binding immigration quotas have been introduced into the model by changing the equation determining the number of domestic residents. In the status quo, the quotas imply that

N = N° (13) where N is the number of domestic residents in 1985. When immigration quotas are

relaxed, (13) is replaced by:

N = ( / + A/°)

fpj

fi,

⁽¹⁴⁾

where p^L and p*^L represent respectively the domestic and the foreign price of labor, / is an exogenous parameter and y represents the elasticity of migration.

Replacing equation (13) by equation (14) makes N endogenous. Relaxing immigra- tion policies can thus have two effects on the number of domestic residents: an immediate adjustment effect, and a price effect. The former, which should be equal to the rationing effect of past immigration policies, is taken into account by choosing / > 0 equal to the number of persons who would become Swiss residents in the status quo if they were allowed to do so. The second effect, which depends on y, is equal to the change in the number of domestic residents due to changes in the relative price of domestic and foreign labor (p^L/p*^L).

It is clear that the total economic effect of relaxing the immigration policies depends to a large extent on the values of the parameters / and y. Unfortunately, there is a lack of precise economic estimates of these two parameters. To get around this problem, we first introduced realistic values for / (100,000)15 and for y (0.1) for the main simulations and then proceeded with some sensitivity analyses.

15. This number is based on calculations by DHIMA (1991) who estimates an equation explaining the migration flows of workers from 9 Southern countries to 5 Northern European countries. Among the explanatory variables is a qualitative measure of barriers to migrations. Simulating the elimination of these barriers, DHIMA calculates that the South European labor force in Switzerland would increase by 90,000 persons after 5 years.

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4) EEA Barriers to Trade. Suppose now that Switzerland will ultimately be a member of the EEA. An important effect of its participation will be to put an end to discrimination against Swiss products in other EEA countries. This will be the case as EEA public markets will be more open to Swiss products, and as Swiss exports will benefit from mutual recognition of norms and standards as well as from lower administrative costs at the borders. In the model, NTBs affecting exports are treated as tariffs imposed by other EEA countries on imports from Switzerland. The ad valorem tariff equivalents of the NTBs are based on measures of the "costs" of internal market barriers for EC members established by CAWLEY and DAVENPORT (1988). The second column in Table 1 shows the tariff equivalent reductions (in percent) which have been adopted.

Following strictly CAWLEY and DAVENPORT (1988), it could be argued that Swiss firms will see their costs reduced directly by lower foreign NTBs. The sensitivity of our results to this assumption is discussed in Section 4.

5) Entry into the EEA. Like the proposed EEA treaty, any future agreement will most likely include four key economic aspects: the elimination of domestic non-tariff barriers like procurement policies, the adoption of a competition policy consistent with EC laws leading to a de facto ban on cartels, the principle of free movement of persons and a reduction in EEA barriers to trade for Swiss products. Accordingly, we model the entry of Switzerland into the EEA as a simulation where the four measures discussed above are taken into account simultaneously.

4. RESULTS AND SENSITIVITY ANALYSIS

The effects of the various policy experiments are measured as deviations between the values of key variables (GDP, welfare, wages...) in the equilibrium after the policy experiment and in the benchmark equilibrium. The benchmark or status quo equilibrium is defined as the one in which Switzerland does not take any action facilitating its integration into the European economy. It is defined in this way in order to isolate the effects of the various measures of integration. Technically, the benchmark equilibrium is the equilibrium which reproduces the situation of the Swiss economy in 1985 (see Appendix B for data and calibration procedure). This choice of benchmark equilibrium reflects our interest in the adjustment mechanisms rather than in the comparison of

"Alleingang" scenarios with the EEA scenario.

We first analyze separately the outcome of each policy experiment. General evaluations of the results are offered in the conclusion.

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Table 3: Gross Production by Sector: Percentage differences

Food Beverages Tobacco

Textiles, clothing Chemicals Plastics

Non-metallic mineral prod.

Metal products Machinery

Electrical machinery, watches Wood

Paper

Printing, publishing Leather products Petrol refinery

Jewelry, other manufact.

Construction Others

State, social insurance Total gross production

1 -0.96 -4.18 0.80 -0.63 4.28 -2.98 1.95 -6.27 0.07 -0.06 2.31 1.72 1.52 -0.30 1.08 0.54 2.68 1.13 1.69 0.85

Experiments0

2 0.11 7.75 7.96 -1.01 -0.35 -0.06 38.82 1.17 0.16 0.14 1.27 0.63 0.85 -3.07 1.41 -0.73 1.23 0.75 -0.22 1.02

3 1.49 1.67 1.29 1.63 1.13 1.48 1.74 1.18 1.17 1.00 1.04 1.86 1.28 3.22 1.34 1.02 0.56 1.21 3.00 1.33

4 0.19 -0.17 0.02 0.26 0.46 -0.19 -0.44 -0.04 0.45 0.38 0.22 0.02 0.14 1.48 0.25 1.13 0.26 0.01 0.06 0.14

5 1.17 5.41 10.55 0.63 5.88 -1.46 43.82 -3.82 214 1.71 5.22 4.77 4.16 1.99 4.50 2.21 4.97 3.45 5.29 3.73

a Experiment 1: reduction of Swiss NTBs Experiment 2: competition policy Experiment 3: immigration policy Experiment 4: reduction of EC's NTBs Experiment 5: cumulated effects.

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4.1 Removal of Swiss NTBs

The removal of the Swiss procurement policies and the standardization of norms and regulations which protect some of the Swiss manufacturing sectors have both direct and indirect effects. Since the reduction of the NTBs is modeled as the removal of equivalent ad valorem tariffs, the direct effect is a substitution effect common in the international trade literature. Foreign sources become relatively cheaper in sectors where NTBs have been eliminated leading both consumers and producers to substitute foreign imports for domestic products. This direct effect does not automatically imply a reduction of domestic activity because it acts through two distinct channels. First, demand for the domestic substitutes of the cheaper imports tends to contract and to induce a decrease in the domestic production of the sectors whose NTBs are reduced. In the presence of economies of scale, a decrease in production raises unit costs which further contributes to decreases in the demand for the domestic product. Second, at the producer level, cheaper intermediate products decrease costs and thus domestic as well as export prices.

This, of course, favors demand for the domestic products and thus domestic production.

The presence of economies of scale also reinforces this process since an increased volume of production is sufficient to decrease average costs. Considering the direct effect, the sectors where there is no decrease in NTBs are affected only through this second channel.

Hence, as far as production is concerned, the direct effect can lead to different outcomes in the sectors where NTBs are reduced but it must benefit the other sectors.

Table 3 shows the overall variations in production at the sectorial level. The results of the first experiment reflect the two possible outcomes for the sectors where NTBs have been reduced, as well as the positive production effects on the sectors where NTBs have not been reduced. In particular, among the eight sectors where NTBs fall, two (Machinery and Chemicals) see their production increase. The strong increase in production for Chemicals can be attributed to the assumption of the low degree of substitution between chemicals of different origins.

Whatever the implications of the substitution effect for production, relaxing NTBs unambiguously leads to an increase in total imports from the eight sectors for which protection is reduced. In a general equilibrium model, this has a number of indirect effects. The most important one is a depreciation of the real exchange rate, which is necessary to restore the equilibrium of the balance of payments. Interpreting this depreciation as an implicit protection of the economy, its direct effects (on the import side) can be seen as the reverse of those resulting from relaxing NTBs; now, however, all sectors are affected. Depreciation tends to increase demand for domestic products and thus domestic production, except in the sectors which are heavily dependent on imported inputs.

Overall, results in Table 3 show that domestic production rises, increasing thereby the demand for all factors of production. Since only labor is immobile across borders in the present exercice, its price increases in comparison to the price of other factors of

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production. Therefore, sectors that use labor intensively are disadvantaged and capital and intermediate inputs are substituted for labor within each sector.

The reduction in the equilibrium use of labor, despite an upward shift of labor demand, can only be explained by the shape of the labor supply function. In fact, for a given number of residents, the supply of labor is backward bending; this is due to the functional form and the estimated parameters of the utility function16. Hence, an increase in the price of labor decreases the supply by domestic residents, and thus increases their demand for leisure. Given a low price elasticity of labor supply, it is then not surprising that total household income still increases (1.5%) despite a fall (-0.5%) in the supply of labor (see Table 4, Exp. 1).

It is worth noting that welfare increases significantly in this simulation showing that unilateral trade liberalization is sufficient to generate positive welfare effects on the Swiss economy.

Sensitivity Analysis

It has been argued above that the different sectorial outcomes from reductions in NTBs cannot be explained only by differences in magnitude of NTB reduction, but also by structural differences between sectors.

In order to emphasize the role of sector-specific characteristics, an arbitrary 10%

reduction of import NTBs for all industries has been simulated. The results show that this uniform experiment still induces responses which differ substantially from one sector to another. Production of leather products, the sector which benefits most, increases by 8%, whereas production of plastics, the sector which suffers most, decreases by 8%. This difference can largely be explained by the fact that the leather sector combines the highest export demand elasticity with a low "Armington elasticity" whereas the plastics sector represents the opposite case. Because these two parameters appear to be central to explain the effects of trade liberalization, some sensitivity analyses have been performed.

Our estimates of the elasticities of substitution between Swiss exports and competing products for the two foreign regions (EEA countries and rest-of-the-world) are taken from the literature [see HARRISON et al. (1991)]. They are thus less reliable than the elasticities on the import side which have been estimated directly from Swiss data [see MARANON (1991)]. Fortunately, the results also seem to be less sensitive to changes in export elasticities than to those in import elasticities. Doubling export elasticities for

16. A small but negative price elasticity (-0.14 in the long run) is not inconsistent with other studies about labor supply in Switzerland [e.g. KUGLER and SCHWENDENER (1988)]. Tests of the sensitivity of the results to different assumptions about the price elasticity of the labor supply show that the results are remarkably invariant as far as welfare is concerned. With a positive elasticity of labor supply, the experiments show stronger increases in output and disposable income, but their positive effect on welfare is compensated to a large extent by a reduction in leisure time.

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Table 4: Aggregate Results: Percentage differences 1

Experiments

2 3 4 5

Volumes GDP

Household consumption Public cur. expenditures Investment

Exports Imports

Exports towards EEA Imports from EEA Intermediate consumption Labor supply by residents Demand for capital

0.24 1.03 1.71 2.87 1.73 5.61 2.11 7.89 1.40 -0.48 1.34

0.49 0.48 -0.47 1.20 -0.49 -0.49 -0.34 -0.29 1.54 -0.21 0.57

1.50 1.17 3.52 0.37 1.05 0.45 0.96 0.43 1.19 1.70 1.13

0.03 0.15 0.03 0.30 0.32 0.74 1.56 0.75 0.27 -0.07 0.13

2.65 3.14 5.67 4.94 2.89 6.53 4.58 9.05 4.77 1.34 3.50 Real values

Total household income Household saving National saving

1.50 8.68 1.74

0.69 4.17 0.35

1.03 -1.17 0.41

0.21 1.29 0.15

3.72 12.91 2.79 Real prices

Real exchange rate Average export price EEA Average export price RW Average wage rate

0.50 -0.91 -0.39 2.15

-0.33 -0.24 -0.02 1.15

0.58 -0.01 -0.04 -0.34

-0.45 -0.02 0.02 0.33

0.45 -1.17 -0.45 3.25 Population

GNP per capita Disposable income p.c.

0.00 0.22 1.53

0.00 0.42 0.70

1.50 -0.04 -0.45

0.00 -0.01 0.21

1.86 0.58 1.88 Welfare per capita

Equivalent variation 1.81 0.85 -0.61 0.28 2.18

instance increases output by 1% instead of 0.8% and welfare by 2% instead of 1.8%

when Swiss NTBs are lowered. In contrast, doubling import elasticities with the same experiment induces domestic output and welfare to grow by a third less than in the original experiment.

We therefore conclude that relaxing NTBs has strong effects on the Swiss economy.

We also find that, in order to decrease significantly the welfare gains associated with unilateral trade liberalization, one must either lower the average level of NTBs, and/or increase the elasticity of substitution between imports and domestic products to an extent which appears to be unreasonable with respect to the assumptions made in the original experiment.

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4.2 Competition Policy

In this simulation, three cartels responsible for 3% of the overall value added in Switzerland are replaced by Cournot oligopolies. Despite the relatively small weight of these sectors, breaking the cartels has quite a significant effect on the Swiss economy (see Table 3 and 4, Exp. 2). In effect, eliminating cartels in Beverages, Tobacco, and Non-metallic mineral products increases overall domestic production by 1.0%, GDP by 0.5%, income per capita by 0.7% and welfare per capita by 0.9%. In order to appraise these results, it is important to understand the adjustment mechanisms following the breakup of the cartels.

Following our approach, when we replace cartels by Cournot oligopolies, we effec- tively decrease the conjectural variation and impose the zero-profit condition in the three industries. The former change typically leads to a decrease in prices through increased competition among incumbent firms but does not necessarily lead to a decrease in profits.

Indeed, depending on the mark-up of the cartels prior to the change, incumbent firms earn additional profits inducing entry (Tobacco), or make losses inducing exit (Beverages and Non-metallic mineral products). In the latter case, production per firm increases and average costs diminish through better exploitation of scale economies.

The direct effect of breaking cartels is to promote competition and thus to reduce the domestic price relative to the import price of the corresponding products. Hence, one expects an increase in the domestic and foreign demands for these products at the expense of imports. The results show that this substitution effect is strong and that domestic production increases in the three sectors where competition has increased. The results (see Table 3, Exp. 2) also show that the Construction sector which uses Non-metallic mineral products benefits from the price reductions in this sector.

Like in the previous simulation, the entire economy is affected through indirect effects and in particular, through the adjustment of the real exchange rate. In this simulation, the combination of decreasing imports and increasing exports necessarily results in an appreciation of the real exchange rate. This appreciation reduces the relative price of imports with respect to the price of domestic products, weakening thereby the decrease in imports.

Various sensitivity tests have been performed to check the robustness of our results.

First, the elimination of cartels has been simulated again after recalibrating the model with the zero-profit condition imposed on the cartels. This is done in order to separate the effects due to the change in the number of firms from those associated with the conjectural variation. The results show that the change in the conjectural variation accounts for approximately one half of the total effect. Second, recalibrating the model with half the initial number of firms only reduces the welfare change from 0.9% to 0.8%.

Overall, breaking the three cartels has a strong positive welfare effect despite the small weight of these sectors in the Swiss economy. This should not come as a surprise considering that breaking cartels directly aims at reducing a domestic distortion that has both consumption and production allocation effects.

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4.3 Relaxing Immigration Policies

In this Section, the effects of liberalizing the movement of persons between Switzerland and the other EEA countries is analyzed by endogenizing the number of domestic residents. As already explained, this is done by adding equation (14) to the model and thus assuming that migration responds imperfectly to variations of domestic and foreign wages, and that liberalizing labor movement has an initial impact of 100,000 new residents who could not immigrate under the existing quotas.

Relaxing immigration policies has two direct effects on the labor market: a supply and a demand effect. On the supply side, the initial immigration of 100,000 persons clearly increases labor supply. But together with the increase in the elasticity of the aggregate supply of labor induced by improved mobility it also improves the allocation of factors of production. The inflow of new residents has thus a globally strong effect on the supply of labor which increases for each wage level. On the demand side, immigration has an indirect effect which follows from the fact that new residents are also consumers.

Their arrival increases demand for domestic products and therefore domestic production.

The inflow of new residents has thus an effect on the demand of labor as well which increases proportionally to production for each wage level. In our experiment, the increase in demand is smaller than the increase in supply, so that the equilibrium wage rate falls, allowing firms to substitute labor for other inputs.

As expected, the rise in domestic production following the inflow of new residents decreases substantially the unit cost with respect to the marginal cost in the sectors where economies of scale play an important role. This scale effect is particularly strong for Foods, Beverages, Non-metallic mineral products and Papers.

Two additional points are worth noting. First, the net immigration is less than the initial 100,000 new residents (98,000) which means that the fall in domestic wage induces some emigration. Second, both the increase in final demand and in production favor imports. Hence, the introduction of free movement of persons results in a strong depreciation of the real exchange rate and in a deterioration of the Swiss terms of trade.

The latter effect is due to the way foreign trade is modeled: import supply is perfectly elastic, whereas export demand has a finite elasticity. This treatment of foreign trade has been questioned in the literature as it tends to amplify the terms-of-trade effect [see DE

MELO and ROBINSON (1989)]. A detailed discussion of the effects of immigration, comparing different assumptions on the treatment of foreign trade, can be found in MÜLLER (1993). Accordingly the negative welfare effect of immigration (see Table 4, Exp. 3) might well be overestimated.

Given these results, and particularly the decrease of the wage rate and the increase of the individual supply of labor, it is not surprising that welfare (as a per capita measure) deteriorates (see Table 4, Exp. 3). Since this result clearly depends on the values of / and y, we further investigate this issue in the next Section by varying these two parameters.

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4.4 Entry into the EEA Reciprocity and NTBs

The elimination of NTBs affecting Swiss products in the EEA is modeled as the reduction of an equivalent tariff ranging from 0.2% to 1.2% on Swiss export prices (in foreign currency) in 14 sectors (see Table 1).

The direct effect of removing export NTBs is to increase foreign demand for domestic products in all sectors directly affected by the reduction in NTBs. This effect is stronger for sectors exporting a large part of their production (Jewelry) or facing a highly elastic foreign demand (Leather products).

To restore the equilibrium of the balance of payments which is disturbed by the increase in export demand, the real exchange rate appreciates, decreasing the price of imports in all sectors. Like in the first simulation, the effect of the exchange rate variation on the activity of the various sectors is twofold. On the one hand, the appreciation tends to decrease demand for domestic products, and thus production. This effect is stronger in sectors where the elasticity of substitution between domestic and imported products is high (Plastics, Non-metallic mineral products, Metal products, Paper). On the other hand, the appreciation reduces the costs of domestic producers in sectors that are more dependent on imported intermediate inputs (e.g. Petrol refinery). Another consequence of the appreciation of the exchange rate is a fall in exports of Swiss products to non-EEA markets. The aggregate results of this simulation are not very strong (see Table 4 , Exp.

4). This is due to the fact that, for each sector, the absolute change in NTBs on the export side is small.

One might object that these results follow from our decision to model NTBs as tariff equivalents. We have thus rerun the present simulation by interpreting the percentage changes shown in the last column of Table 1 as cost reductions and weighting them for each sector by the share of its production exported to the EEA. Surprisingly, the aggregate results are similar to those obtained with the NTBs treated as tariffs, except for domestic production and imports. In effect, production increases much more and imports increase much less under the cost hypothesis than under the ad valorem tariff rate hypothesis.

This result is easily explained: the cost-reduction hypothesis promotes internal trade since it lowers the cost of domestic supply relative to foreign sources. Hence, domestic production rises at the expense of imports. The important point however is that, except for production and imports, the modeling of NTBs through equivalent ad valorem tariff rates does not distort the overall results even if, in some cases, it might be more appropriate to model the reductions of NTBs as cost reductions rather than as tariff reductions.

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Cumulated Effects

As explained, simulating the four previous measures simultaneously can be interpreted as simulating the entry of Switzerland into the EEA. Since the model is non linear and since liberalizing the movement of persons has been shown to have a negative welfare effect (as a per capita measure), we are especially interested in the net welfare effect of the four policy measures associated with the EEA agreement.

Overall, gross production increases by 3.7%. This increase is not equally shared between the 19 sectors (see Table 3, Exp. 5). Activity increases most where cartels are eliminated (Beverages, Tobacco and Non-metallic mineral products). It diminishes only in the two sectors (Plastics and Metal products) that suffer most from a reduction in Swiss NTBs because the product they sell is highly substitutable to the competing imports.

The individual simulations have revealed that a reduction in Swiss NTBs and the elimination of immigration quotas tend to depreciate the real exchange rate, while a decrease in NTBs in other EEA countries and a ban on cartels have the opposite effect.

The present simulation shows that, taken together, the policy measures have a tendency to increase imports more than exports, forcing a depreciation of the real exchange rate.

Labor demand and supply both shift to the right, but the increase in demand is now stronger than the increase in supply despite the initial impact of immigration. Hence, the domestic price of labor rises with respect to the foreign wage contributing further to attracting new residents. The net effect of these policies is to increase the domestic wage rate by about 3% and the number of new residents by 122,000 persons.

The results (Table 4, Exp. 5) also show a significant improvement of welfare per capita (2.2%). This means that the welfare improving effects of all the measures concerning NTBs and cartels are not compensated by the negative effect induced by abolishing immigration quotas. Hence, even if the effect induced by the increase in labor mobility is negative, the gains from trade liberalization are large enough to compensate all the residents. Note that the improvement would be even stronger if our welfare measure took into account the significant increase in public consumption (5.7%).

These results depend strongly on our assumptions about labor mobility and immigration, and thus on the number of persons who would become Swiss residents in the benchmark equilibrium if they were allowed to (/) and on the elasticity of migration (y).

To check the robustness of our results, both / and y were varied. The results of the simulations are summarized in Figure 1. The lower graph shows the relationship between the welfare effect of the entry of Switzerland into the EEA and /. It indicates that when 1 = 0 welfare increases by 2.8% with respect to the benchmark equilibrium, and that / must exceed 400,000 persons, and thus 6% of the domestic residents in 1985, in order to eliminate all the welfare gains of the other components of the EEA agreement¹⁷. The

17. Note that / = 0 does not imply zero immigration but only means that the quotas are not binding in the status quo. In fact, immigration still occurs (26,000 persons) when 7 = 0 due to the relative wage effect of the EEA agreement.

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664 ANTILLE^ACCHETTA/CARLEVARO/MÜLLER/SCHMITT

upper graph shows that increasing the elasticity of the number of residents to relative wages reduces the welfare gain due to the creation of the EEA. In other words, when mobility is made easier by an increase in y, the integration of Switzerland in the EEA leads to more immigration which in turn decreases the welfare gain. The interesting point is that y has to exceed the extremely high and unrealistic value of 2.5 to eliminate all welfare gain generated by the agreement.

1 2 3 4 5

Elasticity of migration (y)

I

li

§

.£3

u

0 200 400 600 800 1000 Exogenous immigration (I) in thousands

Figure 1: Sensitivity Analyses

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5. CONCLUSIONS

In order to investigate the impact on the Swiss economy of various policy options including the participation to the EEA, we have proposed a model which takes into account changes in barriers to trade, market structure, and labor migration. The results show that reducing NTBs and breaking the cartels bring positive and significant economic gains to the Swiss economy.

To appreciate these results, one must bear in mind that in the model firms cannot price-discriminate across markets. Hence, contrary to several recent studies on European integration [e.g. SMITH and VENABLES (1988), MERCENIER (1993) for instance], our model does not explain welfare gains by the change from the segmented to the integrated market hypothesis. What then does explain the economic gains found in the simulations?

Two effects clearly account for most of them: lower NTBs and the competitive forces unleashed by closer economic integration.

A simple way to evaluate the role of increasing returns and imperfect competition in the model is to run simulations assuming that all the sectors of the Swiss economy exhibit constant returns to scale and are perfectly competitive. Doing so reveals that the cumulated welfare gains of the EEA are lowered by 40%.

Relaxing NTBs is by far the most crucial determinant of the welfare gains. In fact, the unilateral decreases in NTBs affecting imports are sufficient to generate welfare gains. This result is important even though it is not particularly new. In effect, these sorts of gains were already at the origin of the push for free trade in the Swiss manufacturing sector during the 19th century. It is particularly important that intermediate inputs are available at the cheapest possible price when natural resources are scarce.

Finally, as far as labor mobility is concerned, the results show that eliminating immigration quotas induces small welfare losses for Swiss residents. The per capita welfare gains of EEA membership would be higher if immigration quotas could be maintained, but new residents, by the demand they generate and the increase in supply they induce, increase economic activity so as to leave the pre-EEA residents almost as well off as they initially were.

We therefore conclude that the formation of the European Economic Area as captured by its effect on international trade, domestic distortions, and labor mobility is beneficial to the Swiss economy. However, short of an EEA agreement, we also find that the Swiss government has policy options which even if adopted unilaterally would be beneficial.

One should nonetheless be extremely careful before concluding that the two strategies have similar implications. To do so would suppose that one accepts at least two crucial assumptions: first, that the Swiss government would be willing to adopt unilateral policies which are equivalent to those it will be forced to adopt under an international agreement, and second, that the dynamic implications of the "lonesome" strategy are equivalent to those implied by the formation of the EEA.