Case for Brexit Based on Models of Trade

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Introduction

The impacts of the UK leaving the European Union (EU) have been one of the most debated issues around the world. There have been several studies that have been conducted to predict the impacts of Brexit and majority have had almost similar conclusions. Evidence on the benefits and drawbacks of Brexit have been widely discussed from an economic, social, and political angle, but there has not been a single conclusion on where the justify the exit or stay.  This is due to the fact that scholars arguing for Brexit have faced a backlash from those supporting the stay vote. To this end, further evidence is necessary to continue demystifying the pros and cons of Brexit from different perspectives. In this analysis, a theoretical approach is undertaken to build a case for Brexit by discussing both the benefits and cons the UK will experience after leaving the EU. Among the major theories discussed include comparative advantage, Keynesian consumption and cross model approach, Heckscher-Ohlin theorem, intra-industry trade, strategic trade theory, and Tobin’s Q theory of investment approaches. Also, other relevant theories have been discussed to support several arguments alongside the major theories. The EU is a form of economic integration with 28-member states located in Europe motivated by political, social, and economic reasons. However, the main motivating factor for the formation of the EU is welfare improvement by allowing the free movement of goods, services and production factors between these countries by removing all barrier to trade such as tariffs and opening up foreign markets to encourage trade.

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Positive Impacts of Brexit to the UK

There are mechanisms through which the UK will enjoy welfare gains from trade by staying within the EU. As discussed by the Heckscher Ohlin model and Ohlin, the gains from trade can be viewed in terms of comparative advantage (Teulings 2017). A country with a comparative advantage in a certain good produces this good relatively more efficient than other countries and this leads to specialization, if trade is liberalized. The UK has significant comparative advantage in manufacturing as compared to other EU member states, which implies a trading advantage (Teulings 2017). As such, staying within the EU and trading with the member states at low costs leads to welfare gains. Krugman introduces economies of scale, which further demonstrates how the UK can benefit from trading, while within the EU. The opening up of foreign markets, which is one of the major goals of the EU, has led to a larger market and gives the UK firms opportunity to improve their economies of scale (Teulings 2017). This has the ripple effect of lower costs, thus, ability to compete by pricing strategically. Also, the UK citizens benefit from the expanded markets by accessing a variety of products increasing consumer’s utility.

According to Rivera-Batiz & Romer (1991), economic integration extends the market and, therefore, leads to an endogenous rise in economic growth, due to economies of scale. Thus, the participation of the UK in the EU is likely to continue experiencing economic growth. Melitz (2003) explains that on a micro level, country heterogeneity matters. Trade liberalization as a result of integration increases intra industry trade, which leads to a reallocation of resources to the more efficient producers increasing the aggregate industry productivity leading to welfare gains (Teulings 2017).

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Economic integration also makes further economic integration efficient. This means that by staying within the EU, UK’s integration with other trade areas is likely to increase the welfare gains further. This argument is supported by the optimum currency area theory by Mundell (1961). The theory argues that if countries are sufficiently integrated, it is efficient to introduce a single currency. The introduction of the Euro has made the EU competitive in the money market, which has led to inflows of foreign direct investments.

The EU has made Europe a stable political union main political. As a result, the UK will continue to enjoy the political goodwill that other EU member states enjoy giving it a higher bargaining power in preventing political conflicts that are likely to paralyze economies. It can also enjoy the bargaining power in policy formulation, especially the foreign policy, which will influence the creation of a better environment for the conduction of trade. According to the intra industry trade theory, the UK benefits more by staying in the EU as it enjoys intra industry trade, like trade in vehicles, with Germany. This is due to the perceived differences between the German and UK cars stimulating demand (Dhingra, Ottaviano, Rappoport, Sampson, and Thomas 2017).

Further, Brexit will lead to the imposition of higher tariffs and lifting of subsidies on UK goods and services reducing trade. This is due to the fact that the cost of trade between the UK and the EU members will increase reducing imports and exports. As such, the UK will not enjoy from its comparative advantage in manufacturing as it will trade with EU members and other countries at a comparatively high costs. The intra industry trade will also become more expensive further limiting trade. Also, losing the EU status rising export costs, which will lead to high pricing of the UK products making the UK companies less competitive. Also, the import prices will raise, which will create inflation and negatively affecting the living standards of the UK citizens (Dhingra, Ottaviano, Sampson, and Reenen 2016).

Furthermore, according to the IS curve model, output growth can be stimulated by lowering the interest rates. When Brexit occurs, banks will hike interest rates in an effort to account for the high risk that will be introduced by speculators. The rise in interest rate will slow down economic growth. This can be argued based on the fact that investments will decline as it becomes hard to access capital for investment from major lenders. The low levels of investments will cut employment opportunities further slowing the GDP growth (Kaboub, 2010). However, if the government intervenes and regulates the changes in interest rate, the arguments based on this theory collapse.

Leaving the EU lower employment and income levels of the UK citizens. The Keynesian consumption function necessitates the need for UK staying in the EU. According to the theory, the exit will lead to the shrinking of the GDP. This is based on the argument that leaving the EU will lead to reduction of the aggregate demand in the economy as the number of consumers will have reduced and less profits for firms (Keynes 2016). Some firms will shut down and others cut the number of employees, which will reduce the aggregate levels of production, significantly lowering the GDP. The argument is supported by the Keynesian cross model, which states that if the number of consumers reduce or disposable income declines, the aggregate demand declines lowering the total national output (Keynes 2016). Also, Tobin’s Q theory supports the need for the UK to stay within the EU. According to the theory, when the market value of shares of a firm divided by the cost of replacing the firm’s assets is high, it makes sense to invest is such companies (Bernardo, Stockhammer, and Martinez, 2015). By leaving the EU, the companies in the UK will loss value from the investors perspective and crowd out investments.  The decrease in investments and foreign direct investments inflows will lower the overall productivity of the economy affecting the GDP and employment negatively. Thus, in this context, the UK’s economy will be adversely affected if Brexit occurs.

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Negative Impacts of Brexit to the UK

On the other hand, the formation of the EU has had its drawbacks, which supports the Brexit. The reduction of trade barriers among participating countries and implementing common trade barriers towards non-participating countries has led to trade diversion. “Economic integration is overall welfare increasing, but there are countries that gain and countries that lose and only by redistributing the welfare gains it can be ensured that all countries gain from economic integration” (Teulings 2017). Most of the economist advocating for Brexit have argued that the single market is trade diverting leading to welfare losses and negative impact of the UK economic growth. Imposing tariff barrier to non-member states has limited UK’s ability to trade with other countries. This has limited the market size only to the Europe that the UK can effectively trade with.

According to the critiques of strategic trade theory, it is important to eliminate trade policies that are protectionist to stimulate trade; the critiques advocate for the adoption of free trade strategies. The EU agreement has imposed tariffs and quotas on non-member countries in an effort to protect the industries of member states, which is significantly hampering the economic of the UK. This is due to the fact that the UK does not enjoy intra-industry trade with non-member states such as Japan and China (Dhingra, Ottaviano, Sampson, and Reenen 2016). Also, as explained by the strategic trade theory, economic integration agreements to promote trade in the region is based on a narrow view such that only regional interested groups benefit leaving out other major players like the US., which would have a larger impact on the economies of the countries in this region. By leaving the EU, the UK will thus enjoy more gains from international trade by entering trade promoting agreements than the one signed by the EU.

On relaxing the assumptions of the theories that argue against Brexit, several weakness support Brexit exist. The comparative advantage and the Heckscher-Ohlin theorem advocate for removing of tariffs and offering subsidies to member states to promote trade. This has allowed entry of less efficient firms into the UK raising industry average costs. Also, the theories operate in a competitive market structure but currently firms today operate in an oligopolistic or competitive structures watering down the arguments against Brexit.

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Leaving the EU is likely to increase employment opportunities and welfare of UK citizens. According to the models of the natural rate of unemployment, the supply of labour will reduce leading to firms offering wages above the efficiency levels to attract more productive workers, which will encourage economic growth (Weiss 2014). This will further increase profitability of industries due to high output, which will lead to demand for more labour. As explained by the Keynesian consumption and investment function, increase in consumer’s purchasing power is likely to foster economic growth. An increase in levels of income increases disposable income, which increases the propensity to save. With higher saving, investments in the economy rise, which is followed by an increase in level of output increasing the level of GDP (Keynes 2016).

Conclusion

Thus, the advantages and limitations of Brexit exist and can be supported by several trade theories. The major advantages that the UK will experience if it continues staying within the EU is economies of scales that arises due to increased trade volumes as discussed by the comparative and Heckscher Ohlin theories. On the down side, the single market operations will continue limiting the economic growth of the UK as well as the welfare of its citizen by diverting as backed by the advocates of free trade theory. However, the relaxation of the assumptions upon which the arguments for and against Brexit are based, such as trade in homogenous goods and existence of competitive markets, collapses these views necessitating empirical evidence upon which they can be justified. This is due to the fact that companies do not trade in a competitive market but in a mixture of oligopolistic and monopolistic environments, where these assumptions do not apply. Therefore, a critical review of the theories that explains the benefits and disadvantage of Brexit reveals weaknesses that require improvements. However, as this discussion presents significant number of theoretical models against Brexit by supporting the view that it is likely to hurt the UK’s economy.

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  1. Bernardo, J.L., Stockhammer, E. and Martinez, F.L., 2015. A post-Keynesian theory for Tobin’s q in a stock-flow consistent framework (No. PKWP1509).
  2. Dhingra, S., Ottaviano, G., Rappoport, V., Sampson, T. and Thomas, C., 2017. UK trade and FDI: A post‐Brexit perspective. Papers in Regional Science.
  3. Dhingra, S., Ottaviano, G.I., Sampson, T. and Reenen, J.V., 2016. The consequences of Brexit for UK trade and living standards.
  4. Kaboub, F., 2010. IS-LM Model. 21st Century Economics. A Reference Handbook, pp.341-347.
  5. Keynes, J.M., 2016. General theory of employment, interest and money. Atlantic Publishers & Dist.
  6. Melitz, Marc J. 2003. The Impact of Trade on Intra-Industry Reallocations and Aggregate Industry Productivity. Econometrica, 71(6), pp. 1695–1725.
  7. Mundell, Robert A. 1961. A Theory of Optimum Currency Areas. The American Economic Review, 51(4), 657–665.
  8. Rivera-Batiz, Luis A., & Romer, Paul M. 1991. Economic Integration and Endogenous Growth. The Quarterly Journal of Economics, 106(2), pp. 531–555
  9. Teulings, R., 2017. Brexit and The Impact of Gradual Economic Integration on Export.
  10. Weiss, A., 2014. Efficiency wages: Models of unemployment, layoffs, and wage dispersion. Princeton University Press.
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