The economic effects of goods and factor market integration

Lorenzo Caliendo, Luca David Opromolla, Fernando Parro, Alessandro Sforza

The effects of international trade and of international migration have been central to the recent debate on economic integration. Evaluating trade and migration policies is challenging, however, because they often take place at the same time and reinforce each other, making it hard to distinguish their effects. This column uses a general equilibrium approach to quantify the effects of the 2004 EU enlargement. It finds that all EU countries gained from enlargement, but that the largest winners were the new member states, and in particular their low-skilled workers.

The economic effects of economic integration are a central topic of debate in Europe, the US, and other countries around the world. This is mainly due to an increased resistance to the process of globalisation in recent years. Two aspects of economic integration that have been specially questioned are the economic effects of international trade and the economic effects of international migration. In the case of Europe, the effects of trade and migration have been a central topic historically (for instance, during the process of the EU enlargement; e.g. Buti et al. 2009) as well as nowadays, with the influx of refugees from war-torn countries (Hatton 2011), and with Brexit (Baldwin 2016). What are the welfare and other economic effects of relaxing migration and/or trade restriction across countries?

The evaluation of the economic effects of changes to trade and migration policies is challenging in at least three dimensions.

First, countries have different production structures, endowments of infrastructure, and composition of labour force. Also, firms and workers across countries face different restrictions to move goods across countries or to migrate to other countries. Therefore, any evaluation must take into account these multidimensional interactions between heterogeneous countries.

The second challenge is to recognise that migration and trade go hand-in-hand not only because most free trade agreements have an explicit commitment to liberalise factor markets, but also because trade in goods has feedback effects on a country’s productivity and real wages, and, in turn, on the labour market impact of immigration.

Third, when evaluating changes to trade and migration policies, these policy changes must be measured. This is relatively straightforward for the case of trade policy since changes in tariffs are observed. However, it is more difficult to measure change to migration policy since the resulting change in mobility costs is not directly observable.

Quantifying the economic effects of the 2004 EU enlargement

In a recent paper, we propose an approach to overcome these challenges, and we use our approach to quantify the general equilibrium effects of the actual changes to trade and migration policies from the 2004 EU enlargement (Caliendo et al. 2017a). The 2004 enlargement is an agreement between member states of the EU and new member states that includes both goods market integration, and factor market integration. On the integration in the goods market, tariffs were reduced to zero starting in 2004, and the new member states resigned from previous free trade agreements (FTAs) and joined the EU's FTAs. On factor market integration, migration restrictions were eliminated, although the timing of these changes to migration policies varied across countries.

To quantify the economic effects of the 2004 enlargement, we first build a quantitative multi-country dynamic general equilibrium model with costly trade and costly migration. After that, we construct a complete dataset of bilateral gross migration flows by nationality and skill across 17 EU countries for the period 2001-2010. The raw data to construct these gross flows are from the European Labour Force Survey, a large household sample survey providing harmonised data. We then use our constructed data to identify the changes in migration costs due to the changes in policy. Finally, we feed into our structural model these estimates, as well as the observed changes in tariffs, and quantify the welfare and migration effects of the 2004 EU enlargement.

Our dynamic structural model features households of different skills and nationality with forward-looking relocation decisions. The decision to migrate depends on the household’s location, nationality, skill, migration costs that are affected by policy, and an idiosyncratic shock à la Artuç et al. (2010). Keeping track of each household's nationality is relevant in the context of changes to migration policies, as households of different nationalities living in the same country potentially face different migration restrictions to other countries because of the state of migration policy in each country. The dynamic decision of households on where and when to migrate is particularly important in the context of the EU enlargement, since countries reduced migration restrictions sequentially over time. Moreover, it turns out that the possibility to move in the future to another country whose real wages have increased adds to the welfare of a worker by raising her option value of being in a given location. In fact, even if migrants and natives obtain the same real wage in a given country, they value each location differently since they face different continuation values as a result of different migration costs.

The production side of our framework features producers of differentiated varieties in each country with heterogeneous technology as in Eaton and Kortum (2002). Goods in each country are produced with workers of different skills, fixed factors (structures, land), and the level of technology is assumed to be proportional to the size of the economy. The technology assumption captures the idea that there are benefits from firms and people locating next to each other. The fixed factor in the production function takes into account the fact that immigration can strain infrastructure in countries that lack of it. Goods are traded across countries subject to trade costs which depend on geographic barriers and trade policy (tariffs) as in Caliendo and Parro (2015). In the model, a change to trade policy impacts the terms of trade which in turn influences the effect of a change to migration restrictions. All these features shape the economic effects of trade and labour market integration. Understanding the overall contribution of these channels is a quantitative question that we answer in the context of an actual change in policy.

As mentioned above, evaluating the effects of the EU enlargement requires information on how trade and migration costs changed due to the policy. To identify the changes in migration costs due to the change in policy, we exploit the cross-country variation in the timing of the adoption of the new migration policy. We estimate the whole set of changes in migration costs due to the EU enlargement over the period 2002-2007. That is, for NMS nationals that migrate from NMS countries to EU countries, for NMS nationals that migrate across NMS countries, and for EU nationals that migrate from EU countries to NMS countries. Our identification strategy relies on the assumption that the trend in migration costs between countries that change migration policy and those that do not would have been the same in the absence of the EU enlargement. An assumption that we confirm by running several placebo tests. In terms of trade policy, we measure changes in trade policy with the observed changes in tariffs across countries.

We then feed into our structural model our estimated changes in migration costs due to the change in policy and the observed change in tariffs. We compute the model using the ‘dynamic hat algebra’ methodology developed in Caliendo et al. (2017b), and quantify the effects of the 2004 EU enlargement.

Our results

Starting with the migration effects, we find that the response of migration to the change in policy takes time, that is, we find a small increase in migrants from new member states into the EU countries in the short run, but a much larger increase in the long run. We find that the EU enlargement primarily fostered the migration of low-skilled workers and that trade policy helped to moderate migration flows and mitigate congestion effects.

Turning to the welfare effects, we find that the largest winners were the new member states, and in particular their low-skilled workers, although we find positive welfare effects for high-skilled workers as well. EU countries are also better off with the enlargement, but welfare gains were smaller. Importantly, we find that in the absence of changes to trade policy, the EU countries would have been worse off after the enlargement. We also find that the level of trade openness quantitatively impacts the welfare evaluation of changes to migration policy. Our results are robust to the inclusion of other mechanisms in our framework, such as the presence of public goods financed with labour taxes.

Concluding remarks

We provide a quantitative assessment of the general equilibrium economic effects of goods and labour market integration. The results of this study could be used to discipline the current debate. Yet, more needs to be done and we hope that more quantitative tools are used and developed to guide future discussions on the economic effects of economic integration.

Overall, our research contributes to the literature on trade and migration by proving a novel approach to quantify general equilibrium effects of actual changes to trade and migration policy. Crucially, our results show that abstracting from modelling the interactions across heterogeneous countries, and in particular from international trade, lead to an incorrect welfare evaluation of trade and migration policies. Our results for the case of the 2004 EU enlargement have also shown that economic integration, that includes both trade in good and migration, is not a zero-sum game, and can be mutually beneficial for countries even when they are heterogeneous in their level of development and skill composition.

References

Artuc, E, S Chaudhuri and J McLaren (2010): “Trade Shocks and Labor Adjustment: A Structural Empirical Approach,” The American Economic Review 100: 1008–1045.

Baldwin, R (ed.) (2016), Brexit Beckons: Thinking ahead by leading economists, A VoxEU.org eBook.

Buti, M., I. Székely and F Keereman (2009), “Five years after the enlargement of the EU”, VoxEU.org, 20 June.

Caliendo, L and F Parro (2015), “Estimates of the Trade and Welfare Effects of NAFTA,” The Review of Economic Studies 82: 1–44.

Caliendo, L, L Opromolla, F Parro and A Sforza (2017a), “Goods and Factor Market Integration: A Quantitative Assessment of the EU Enlargement,” NBER Working Paper No. 23695.

Caliendo, L, M Dvorkin and F Parro (2017b), “Trade and Labor Market Dynamics: General Equilibrium Analysis of the China Trade Shock,” mimeo, Yale University.

Hatton, T (2011), “Refugees from North Africa: A case for cooperation?”, VoxEU.org, 2 May.