anhui university of finance & economics 1/36 economic integration: customs union and free trade...

ANHUI UNIVERSITY OF FINANCE & ECONOMICS 1/36

Economic Integration:Customs Union and

Free Trade Areas

Chapter 10


1 Introduction1 Introduction Examine economic integration in general aExamine economic integration in general and customs unions in particularnd customs unions in particular Discuss the trade-creating customs union, tDiscuss the trade-creating customs union, trade-diverting customs union and the dynamirade-diverting customs union and the dynamic effects of customs unionsc effects of customs unions Discuss the brief history of various attemptDiscuss the brief history of various attempts at economic integrations at economic integration


Key Terms• Economic integration• Preferential trade arrangement• Customs union• Common market• Trade creation and diversion• Theory of second best• Bilateral agreements


2 Definition & Different Forms2 Definition & Different Forms Economic integration is the commercial policEconomic integration is the commercial policy of discriminatively reducing or eliminating trady of discriminatively reducing or eliminating trade barriers only among the nations joining togethee barriers only among the nations joining together. There are different formsr. There are different forms ：：

Preferential trade arrangements (PTA)Preferential trade arrangements (PTA)Free trade areas (FTA)Free trade areas (FTA)Customs unions (CU)Customs unions (CU)Common markets Common markets Economic unions Economic unions


2.1 Preferential Trade Arrangements 2.1 Preferential Trade Arrangements

Preferential trade Preferential trade arrangements provide arrangements provide lower barriers on some lower barriers on some trade among trade among participating nations participating nations than on trade with non-than on trade with non-member nations. It is the member nations. It is the loosest form of loosest form of economic integration. economic integration.


2.2 Free Trade Area2.2 Free Trade Area

A free trade area is the form of economic A free trade area is the form of economic integration wherein all barriers are removed on integration wherein all barriers are removed on trade among members, but each retains its trade among members, but each retains its own barriers to trade with nonmembers, such own barriers to trade with nonmembers, such as as EFTA, NAFTA, Mercosur. EFTA, NAFTA, Mercosur.


2.3 Customs Union 2.3 Customs Union

A customs union A customs union allows no tariffs or other allows no tariffs or other barriers on trade among barriers on trade among members, and in addition members, and in addition it harmonizes trade it harmonizes trade policies (such as the policies (such as the setting of common tariff setting of common tariff rates) toward the rest of rates) toward the rest of the world, such as the world, such as EU, EU, or or European Union.European Union.


2.4 Common Market2.4 Common Market

A common market goes beyond a customs union by also allowing the free movement of labor and capital among member nations. The EU achieved the status of a common market at the beginning of 1993.


2.5 Economic Union 2.5 Economic Union

An economic union An economic union goes still further by goes still further by harmonizing or even harmonizing or even unifying the monetary unifying the monetary and fiscal policies of and fiscal policies of member states. This is member states. This is the most advanced type the most advanced type of economic integration. of economic integration. An example is An example is Benelux. Benelux.


2.6 2.6 Duty-Free ZonesDuty-Free Zones

Duty free zones or free eDuty free zones or free economic zones are areas conomic zones are areas set up to attract foreign iset up to attract foreign investments by allowing rnvestments by allowing raw materials and intermaw materials and intermediate products duty-freediate products duty-free. e.


3 Trade-Creating Customs Union3 Trade-Creating Customs Union A trade creating customs union is a union that leads A trade creating customs union is a union that leads to trade creation only and increases the welfare of both to trade creation only and increases the welfare of both member and nonmember nations.member and nonmember nations.

Trade creation occurs when some domestic productioTrade creation occurs when some domestic production in a nation (a member of the customs union) is replacen in a nation (a member of the customs union) is replaced by lower-cost imports from another d by lower-cost imports from another member nation. member nation.

If all resources are fully employed before the formatioIf all resources are fully employed before the formation of a customs union, a customs union increases the weln of a customs union, a customs union increases the welfare of member nations because it leads to greater specifare of member nations because it leads to greater specialization based on comparative advantage.alization based on comparative advantage.

It also increases the welfare of nonmembers because It also increases the welfare of nonmembers because some of the increase in its real income spills over into insome of the increase in its real income spills over into increased imports from the rest of the world. creased imports from the rest of the world.


3.1 Numerical Illustration of a Tra3.1 Numerical Illustration of a Trade-Creating CUde-Creating CU

Nation A

$10

Nation B

$8

Nation C

$6


Before: 100% tariff.Before: 100% tariff.

Nation A and nation B Nation A and nation B forms a customs union.forms a customs union.

OO

161612121010 88 66

SSCC

SSBB

SSC+TC+T

SSB+TB+T

EE

SSXXDDXX

XX

PP($)($)

Nation A’s Supply and Demand CurvesNation A’s Supply and Demand Curves

3.2 Graphic Illustration of a Tr3.2 Graphic Illustration of a Trade-Creating CUade-Creating CU


3.2 Graphic Illustration of a Tr3.2 Graphic Illustration of a Trade-Creating CUade-Creating CU


4 Trade-Diverting Customs Union 4 Trade-Diverting Customs Union It is a customs union that leads to both trade creation It is a customs union that leads to both trade creation and trade diversion. It may increase or reduce the welfare and trade diversion. It may increase or reduce the welfare of member nations, depending on the relative strength of of member nations, depending on the relative strength of these two opposing forces.these two opposing forces.

Trade diversion occurs when lower-cost imports from Trade diversion occurs when lower-cost imports from outside the union are replaced by higher cost imports frooutside the union are replaced by higher cost imports from a union member. This is because of the preferential tram a union member. This is because of the preferential trade treatment given to member nations. de treatment given to member nations.

Trade diversion reduces welfare because it shifts prodTrade diversion reduces welfare because it shifts production from more efficient producers outside the customuction from more efficient producers outside the customs union to less efficient producers inside the union. Thus, s union to less efficient producers inside the union. Thus, trade diversion worsens the international allocation of retrade diversion worsens the international allocation of resources and shifts production away from comparative adsources and shifts production away from comparative advantage. vantage.


A trade-diverting customs union results in A trade-diverting customs union results in both both trade trade creation and trade diversion, and therefore can increase creation and trade diversion, and therefore can increase or reduce the welfare of union members, depending on thor reduce the welfare of union members, depending on the relative strength of these two opposing forces. The welfe relative strength of these two opposing forces. The welfare of non-members can be expected to decline because tare of non-members can be expected to decline because their economic resources can only be utilized less efficienheir economic resources can only be utilized less efficiently than before trade was diverted away from them. tly than before trade was diverted away from them. While a trade-creating customs union leads only to traWhile a trade-creating customs union leads only to trade creation and unequivocably increases the welfare of mde creation and unequivocably increases the welfare of members and nonmembers, a trade-diverting customs unioembers and nonmembers, a trade-diverting customs union leads to both trade creation and trade diversion, and can leads to both trade creation and trade diversion, and can increase or reduce the welfare of members (and will redn increase or reduce the welfare of members (and will reduce the welfare of the rest of the world). uce the welfare of the rest of the world).

4.1 Trade-Diverting & Trade Creat4.1 Trade-Diverting & Trade Creating CUing CU


4.2 Illustration of Trade-Diverting 4.2 Illustration of Trade-Diverting Customs UnionCustoms Union


4.3 General Equilibrium Analysis of a 4.3 General Equilibrium Analysis of a Trade Diverting Customs UnionTrade Diverting Customs Union


5 Conditions More Likely to Increa5 Conditions More Likely to Increase Welfarese Welfare

1.The higher the preunion trade barriers of member co1.The higher the preunion trade barriers of member countries are, the greater probability it is that formation of tuntries are, the greater probability it is that formation of the customs union will create trade among members rathhe customs union will create trade among members rather than divert trade from nonmembers to members. er than divert trade from nonmembers to members. 2.The lower the customs unions barriers are on trade 2.The lower the customs unions barriers are on trade with the rest of the world, the less likely it is that formatiwith the rest of the world, the less likely it is that formation of the customs union will lead to costly trade diversioon of the customs union will lead to costly trade diversion, because they have already traded each other before.n, because they have already traded each other before. 3.The greater the number of countries in the union and 3.The greater the number of countries in the union and the larger their size are, the greater probability it is that lthe larger their size are, the greater probability it is that low-cost producers fall within the union. ow-cost producers fall within the union.


4.The more competitive the member nations are, the g4.The more competitive the member nations are, the greater opportunities there are for specialization in producreater opportunities there are for specialization in production and trade creation with the formation of the customs tion and trade creation with the formation of the customs union.union. 5.The closer geographically the members of the custo5.The closer geographically the members of the customs union are, the less likely it is that the transportation cms union are, the less likely it is that the transportation costs become an obstacle to trade creation among membosts become an obstacle to trade creation among members.ers. 6.The greater the preunion trade and economic relatio6.The greater the preunion trade and economic relationship among potential members of the customs union is, nship among potential members of the customs union is, the greater the opportunities are for significant welfare gthe greater the opportunities are for significant welfare gains as a result of the formation of the customs union.ains as a result of the formation of the customs union.

5 Conditions More Likely to Increas5 Conditions More Likely to Increase Welfaree Welfare


5.1 Other Static Welfare Effects of 5.1 Other Static Welfare Effects of Customs UnionsCustoms Unions

One is the administration savings from the eliOne is the administration savings from the elimination of customs officers, border patrols, and mination of customs officers, border patrols, and so on. This benefit arises whether the customs unso on. This benefit arises whether the customs union is trade creating or trade diverting. ion is trade creating or trade diverting. Second, a trade-diverting customs union is likSecond, a trade-diverting customs union is likely to improve the ely to improve the collective collective terms of trade of the terms of trade of the customs union. For a trade-creating customs unicustoms union. For a trade-creating customs union, the opposite is true. on, the opposite is true. Finally, any customs union is likely to have mFinally, any customs union is likely to have much more bargaining power, such as EU.uch more bargaining power, such as EU.


5.2 Dynamic Benefits of Customs 5.2 Dynamic Benefits of Customs UnionUnion

The sourses of dynamic benefits:The sourses of dynamic benefits: Increased competitionIncreased competition Economies of scaleEconomies of scale Stimulus to investmentStimulus to investment Better use of economicBetter use of economic

resourcesresources


5.2 Static & Dynamic Benefits

Comparison of the static and dynamic benefits:Comparison of the static and dynamic benefits:

These dynamic gains of a customs union are These dynamic gains of a customs union are presumed to be much greater than the static gaipresumed to be much greater than the static gains and to be very significant. ns and to be very significant.

Recent empirical studies indicate that these Recent empirical studies indicate that these dynamic gains are about five to six times larger dynamic gains are about five to six times larger than the static gains. than the static gains.


6 Economic Integrations6 Economic Integrations

The larger economic intThe larger economic integrationsegrations

• European Union European Union • European Free Trade AssEuropean Free Trade Ass

ociation ociation • North American Free TraNorth American Free Tra

de Agreement (NAFTA)de Agreement (NAFTA)• Asian-Pacific Economic Asian-Pacific Economic

Cooperation (APEC)Cooperation (APEC)


The European Union was founded by the Treaty of RThe European Union was founded by the Treaty of Rome, signed in March 1957 by West Germany, France, Itaome, signed in March 1957 by West Germany, France, Italy, Belgium, the Netherlands, and Luxembourg, and camly, Belgium, the Netherlands, and Luxembourg, and came into being on January 1, 1958. e into being on January 1, 1958.

The common external tariff was set at the average of tThe common external tariff was set at the average of the 1957 tariffs of the six nations. Free trade in industrial he 1957 tariffs of the six nations. Free trade in industrial goods within the EU and a common price for agricultural goods within the EU and a common price for agricultural products were achieved in 1968; restrictions on the free products were achieved in 1968; restrictions on the free movement of labor and capital were reduced by 1970. Memovement of labor and capital were reduced by 1970. Membership increased to 15 after the United Kingdom, Denmbership increased to 15 after the United Kingdom, Denmark, and Ireland joined in 1973, Greece in 1981, Spain amark, and Ireland joined in 1973, Greece in 1981, Spain and Portugal in 1986, and Austria, Finland, and Sweden in nd Portugal in 1986, and Austria, Finland, and Sweden in 1995. It became 25 when Malta, Cyprus, Poland, Hungary,1995. It became 25 when Malta, Cyprus, Poland, Hungary, Czech, Slovakia, Slovenia, Estonia, Latvia, Lithuania joi Czech, Slovakia, Slovenia, Estonia, Latvia, Lithuania joined the EU on May 1, 2004.ned the EU on May 1, 2004.

6.1 Economic Integrations---EU6.1 Economic Integrations---EU


6.1 Economic Integrations---EU6.1 Economic Integrations---EU


The European Free Trade Association was formed by The European Free Trade Association was formed by the United Kingdom, Austria, Denmark, Norway, Portugathe United Kingdom, Austria, Denmark, Norway, Portugal, Sweden, and Switzerland, with Finland becoming an al, Sweden, and Switzerland, with Finland becoming an associate member in 1961. The EFTA achieved free trade ssociate member in 1961. The EFTA achieved free trade in industrial goods in 1967, but only a few special provisin industrial goods in 1967, but only a few special provisions were made to reduce barriers on trade in agriculturions were made to reduce barriers on trade in agricultural products.al products. Iceland joined the EFTA in 1970, Finland became a fulIceland joined the EFTA in 1970, Finland became a full member in 1986, and Liechtensteinin 1991. However, in l member in 1986, and Liechtensteinin 1991. However, in 1973, the UK and Denmark left EFTA, as did Portugal in 1973, the UK and Denmark left EFTA, as did Portugal in 1986. Thus, in 1991, the EFTA had seven members (Aust1986. Thus, in 1991, the EFTA had seven members (Austria, Finland, Iceland, Liechtenstein, Norway, Sweden, anria, Finland, Iceland, Liechtenstein, Norway, Sweden, and Switzerland) with head quarters in Geneva. On January d Switzerland) with head quarters in Geneva. On January 1, 1994, the EFTA joined the EU to form the European Ec1, 1994, the EFTA joined the EU to form the European Economic Area (EEA). In 1995, Austria, Finland, and Swedeonomic Area (EEA). In 1995, Austria, Finland, and Sweden left the EFTA and joined the EU.n left the EFTA and joined the EU.

6.2 Economic Integrations---EFTA6.2 Economic Integrations---EFTA


6.2 Economic Integrations---EFTA6.2 Economic Integrations---EFTA


In September 1993, the United States, Canada,In September 1993, the United States, Canada, and Mexico signed the NAFTA, which took effect and Mexico signed the NAFTA, which took effect on January 1, 1994. This agreement will eventuallon January 1, 1994. This agreement will eventually lead to free trade in goods and services over thy lead to free trade in goods and services over the entire North American area. e entire North American area.

6.3 Economic Integrations---NAFTA6.3 Economic Integrations---NAFTA


NAFTA benefits the United States by increasing competition in product and resource markets, and by lowering the prices of many commodities to U.S. consumers. NAFTA benefited Mexico by (1) Leading to greater export-led growth resulting from increased access to the huge U.S. market (2) Encouraging the return of flight capital (3) Fostering more rapid structural reforms domestically. Mexico suffered a net loss of jobs and incomes in agriculture, but these losses were more than matched by net increases in industry.

6.3 Economic Integrations---NAFTA6.3 Economic Integrations---NAFTA


APEC's 21 Member Economies are Australia; Brunei APEC's 21 Member Economies are Australia; Brunei Darussalam; Canada; Chile; People's Republic of China; Darussalam; Canada; Chile; People's Republic of China; Hong Kong, China; Indonesia; Japan; Republic of Korea;Hong Kong, China; Indonesia; Japan; Republic of Korea; Malaysia; Mexico; New Zealand; Papua New Guinea; Pe Malaysia; Mexico; New Zealand; Papua New Guinea; Peru; The Republic of the Philippines; The Russian Federatru; The Republic of the Philippines; The Russian Federation; Singapore; Chinese Taipei; Thailand; United States ion; Singapore; Chinese Taipei; Thailand; United States of America; Viet Nam.of America; Viet Nam. APEC has 21 members - referred to as "Member EconAPEC has 21 members - referred to as "Member Economies" - which account for more than a third of the worlomies" - which account for more than a third of the world's population (2.6 bill. people), approximately 60% of wd's population (2.6 bill. people), approximately 60% of world GDP (US$19, 254 bill.) and about 47% of world trade.orld GDP (US$19, 254 bill.) and about 47% of world trade. It also represents the most economically dynamic regio It also represents the most economically dynamic region in the world having generated nearly 70% of global ecn in the world having generated nearly 70% of global economic growth in its first 10 years. onomic growth in its first 10 years.

6.4 Economic Integrations---APEC6.4 Economic Integrations---APEC


6.4 Economic Integrations---APEC6.4 Economic Integrations---APEC Purpose and Goals:Purpose and Goals: to further enhance economic gro to further enhance economic growth and prosperity for the region and to strengthen the Awth and prosperity for the region and to strengthen the Asia-Pacific community.sia-Pacific community. Since its beginning, APEC has worked to reduce tariffSince its beginning, APEC has worked to reduce tariffs and other trade barriers, creating efficient domestic ecs and other trade barriers, creating efficient domestic economies and dramatically increasing exports. Key to achonomies and dramatically increasing exports. Key to achieving APEC‘s vision are referred to as the ’Bogor Goalsieving APEC‘s vision are referred to as the ’Bogor Goals‘‘ （茂物宣言（茂物宣言 )) of free and open trade and investment in the Asof free and open trade and investment in the Asia-Pacific by 2010 for industrialised economies and 2020 ia-Pacific by 2010 for industrialised economies and 2020 for developing economiesfor developing economies. These goals were adopted by . These goals were adopted by Leaders at their 1994 meeting in Bogor, Indonesia.Leaders at their 1994 meeting in Bogor, Indonesia.


7 Discussion Questions7 Discussion Questions• What is economic integration? What are the diWhat is economic integration? What are the di

fferent forms?fferent forms?• What is meant by trade creation and trade divWhat is meant by trade creation and trade div

ersion? What are the static welfare effects of ersion? What are the static welfare effects of a trade-creating and trade-diversting customs a trade-creating and trade-diversting customs union?union?

• What dynamic benefits are the nations forminWhat dynamic benefits are the nations forming a customs union likely to receive? How do tg a customs union likely to receive? How do they arise? How large are they?hey arise? How large are they?

• What are the leading economic integrations in What are the leading economic integrations in the world?the world?


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anhui university of finance & economics 1/36 economic integration: customs union and free trade...

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