ch.10 economic integration

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InternationalInternational

EconomicsEconomics Tenth Edition

Economic Integration: Customs

Unions and Free Trade AreasDominick Salvatore

John Wiley & Sons, Inc.

Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.

CHAPTER T E N

1010


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In this chapter:

Introduction

Trade-Creating Customs Unions

Trade-Diverting Customs Unions

The Theory of the Second Best and OtherStatic Welfare Effects of Customs Unions

Dynamic Benefits from Customs Unions

History of Attempts at Economic Integration



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Introduction

Economic integrationrefers to the commercialpolicy of discriminatively reducing oreliminating barriers only among the nations

joining together.



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Introduction


Preferential trade arrangementsProvide lower barriers to trade amongparticipating nations than on trade with non-

member nations.The loosest form of economic integration.

Example:British Commonwealth PreferenceScheme, established in 1932 between the United

Kingdom and members of the British Empire.


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Introduction


Free trade areasRemoves all barriers to trade among members, but each nation retains its own barriers to

trade with non-members.Examples:

European Free Trade Association(EFTA), 1960, between United Kingdom, Austria, Denmark,

Norway, Portugal, Sweden and Switzerland North American Free Trade Agreement(NAFTA),1993, between the United States, Canada andMexico


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Introduction


Customs unionRemoves all barriers to trade among membersand harmonizes trade policies toward the rest of

the world.Examples:

European Union(EU), orEuropean Common Market, 1957, between West Germany, France,

Italy, Belgium, the Netherlands, andLuxembourg.

Zollverein, 1834, between large number ofsovereign German states


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Introduction


Common marketRemoves all barriers to trade among members,harmonizes trade policies toward the rest of

the world, and allows free movement of laborand capital among member nations.

Example: European Union(EU) achieved common market

status in 1993.


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Introduction


Economic unionRemoves all barriers to trade among members,harmonizes trade policies towards the rest of

the world, allows free movement of labor andcapital among member nations, and unifiesmonetary and fiscal policies of members.

Most advanced type of economic integration.

Examples: Benelux, formed after World War II betweenBelgium, the Netherlands and Luxembourg


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Introduction


Duty free zones(free economic zones)Areas established to attract foreigninvestments by allowing raw materials and

intermediate products duty free.


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Trade-Creating Customs Unions

Trade creationoccurs when domesticproduction in a member nation is replaced bylower-cost imports from another member

nation.Leads toincreased welfare for membersas nationsspecialize in comparative advantages.

Leads toincreased welfare for non-membersasincreased real income spills over intoincreased imports from rest of the world.



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FIGURE 10-1 A Trade-Creating Customs Union.



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Trade-Diverting Customs Unions

Trade diversionoccurs when lower-costimports from non-members are replaced byhigher cost imports from members.

By itself, trade diversion lowers welfare as itshifts resources away from comparativeadvantages.

Trade diverting customs union also results intrade creation. Change in welfare depends onrelative magnitude of creation and diversion.



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FIGURE 10-2 A Trade-Diverting Customs Union.



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It was once believed that any movement towardfreer trade would increase welfare, so formationof a customs union would necessarily result in

increased welfare for members and non-members.

In 1950, Viner showed that formation of acustoms unioncould increase or reduce welfare,

depending on the circumstances under which ittakes place.



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Theory of the Second Best

If all conditions required to maximize welfarecannot be satisfied, trying to satisfy as many

conditions as possible does not necessarily orusually lead to the second-best position.



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Conditions More Likely to Lead to IncreasedWelfare

1.Higher pre-union trade barriers of member

nations.

2.Lower customs union’s trade barriers withnon-members.

3.Greater number of nations forming customsunion, and the larger their size.



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Conditions More Likely to Lead to IncreasedWelfare

4.More competitive rather than complementary

economies of member nations.

5.Closer geographical proximity of membernations.

6.Greater pre-union trade and economicrelationship among potential member nations.



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Other Static Effects of Customs Unions

1.Administration savings from elimination ofcustoms officers, border patrols, and others.

2.Reduction in demand for imports from andsupply of exports to rest of the world willlikely lead to improvement incollective termsof trade of member nations.

3.By acting as a single unit, customs union willlikely have more bargaining power thanmembers separately.



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Dynamic Benefits from Customs Unions


Dynamic Benefits of Customs Unions

1.Increased competition, leading to greaterefficiencies and technological improvements.

2.Economies of scalefrom the enlarged market.

3.Stimulus of investmentto take advantage ofenlarged market, and to meet increased

competition.4.Better utilization of community resourcesas laborand capital move freely(assumes common market).


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The European Union (EU)

1958 – established common external tariff

1968 – Achieved free trade in industrial goods

within EU, and common price for agriculturalgoods

1970 – Reduced restrictions on movement of laborand capital

1993 – Removed all remaining restrictions on flowof goods, services and resources, becoming largesttrade bloc in the world



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The European Free Trade Association (EFTA)

1960 – formed by “outer seven” nations: UnitedKingdom, Austria, Denmark, Norway, Portugal,

Sweden and Switzerland 1967 – Achieved free trade in industrial goods

1991 – Membership evolved to include Austria,

Finland, Iceland, Liechtenstein, Norway, Sweden,and Switzerland

1994 – Joined EU to form European EconomicArea (EEA)



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The North American Free Trade Agreement(NAFTA)

1994 – formed by United States, Canada and

Mexico, to eventually lead to free trade ingoods and services over entire NorthAmerican area.

Also phased out many other barriers to trade andreduced barriers to cross-border investmentsamong the three member nations.


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