CHAPTER 10

International Economics 11th Edition

Instructors Manual

CHAPTER 10

ECONOMIC INTEGRATION: CUSTOMS UNIONS AND FREE TRADE AREAS

OUTLINE

10.1 Introduction

10.2 Trade-Creating Customs Unions

10.2A Trade Creation

10.2B Illustration of a Trade-Creating Customs Union

10.3 Trade-Diverting Customs Unions

10.3a Trade Diversion

10.3b Illustration of a Trade-Diverting Customs Union

10.4 The Theory of the Second Best and Other Static Welfare Effects

10.4A The Theory of the Second Best

10.4B Conditions More Likely to Lead to Increased Welfare

10.4C Other Static Welfare Effects of Customs Unions

10.5 Dynamic Benefits of Customs Unions

*10.6 History of Attempts at Economic Integration

10.6A The European Union

Case Study 10-1: Economic Profile of the EU, NAFTA, and Japan

Case Study 10-2: Gains from the Single EU Market

10.6B The European Free Trade Association

10.6C The North American and Other Free Trade Agreements

Case Study 10-3: Mexico's Gains from NAFTA Expectations and Outcome

10.6D Attempts at Economic Integration Among Developing Nations

Case Study 10-4: Economic Profile of Mercosur

Case Study 10-5: Changes in Trade Patterns with Economic Integration 344

10.6E Economic Integration in Central, Eastern Europe & Former Soviet Republics

Appendix:A10.1 General Equilibrium Analysis of Static Effects of a Trade-Diverting Customs Union

A10.2 Regional Trade Agreements Around the World

Key Terms

Economic integration

Variable import levies

Preferential trade arrangements

European Free Trade Association (EFTA)

Free-trade area

Trade deflection

Customs union

North American Free Trade Agreement (NAFTA)

Common market

Southern Common Market (Mercosur)

Economic union

Council of Mutual Economic Assistance (CMEA)

Duty-free zones

State trading companies

Trade creation

Bilateral agreements

Trade diversion

Bulk purchasing

Trade-diverting customs union

Central and Eastern European Countries (CEEC)

Theory of the second best

New Independent States (NIS)

Tariff factories

Commonwealth of Independent States (CIS)

European Union (EU)

Central European Free Trade Association (CEFTA)

Baltic States Free Trade Area (BAFTA)

Lecture Guide:

1.This is not a core chapter and I would skip it except for section 6. Section 6 is an

important section and can be regarded as an extension of Chapter 9, which is a core

chapter. Section 6 deals with a very important set of current events.

2. Section 6 is a long section and may require two classes to be adequately presented. I would cover subsections a-d in one class and subsection e as well as both case studies in the second class. Case Studies 10-1 to 10-6 can be used for a very\stimulating class discussion.

3.While section 6 can be presented without covering the material in sections 1-5, some terms discussed in sections 1-5 (such as trade creation and trade diversion) need to be defined.

4. In a one-year course in international economics, I would cover the entire chapter. I would then cover sections 10-1 to 10-3 in one class and sections 10-4 and 10-5In the second class. In the first class, the most important aspect would be the presentation and clear explanation of Figures 10-1 and 10-2.

Answers to Problems:

1.If Nation A imposes a 100 percent ad valorem tariff on imports of commodity X from Nation B and Nation C, Nation A will produce commodity X domesticallybecause the domestic price of commodity X is $10 as compared with the tariff-inclusive price of $16 if Nation A imported commodity X from Nation B and $12 if Nation A imported commodity X from nation C.

2. a) If Nation A forms a customs union with Nation B, Nation A will import

commodity X from Nation B at the price of $8 instead of producing it itself at $10 or importing it from Nation C at the tariff-inclusive price of $12.

b)When Nation A forms a customs union with Nation B this would be a trade- creating customs union because it replaces domestic production of commodity X at Px=$10 with tariff-free imports of commodity X from Nation B at Px=$8.

3. If Nation A imposes a 50 percent ad valorem tariff on imports of commodity X from

Nation B and Nation C, Nation A will import commodity X from nation C at the tariff-inclusive price of $9 instead of producing commodity X itself or importing it from Nation B at the tariff-inclusive price of $12.

4. a)If Nation A forms a customs union with Nation B, Nation A will import commodity X from Nation B at the price of $8 instead of importing it from Nation C at the tariff-inclusive price of $9.

b) When Nation A forms a customs union with Nation B this would be a trade-diverting customs union because it replaces lower-price imports of commodity X of $6 (from the point of view of Nation A as a whole) with higher priced imports of commodity X from Nation B at $8.

Specifically, Nation A's importers do not import commodity X from Nation C because the tariff-inclusive price of commodity X from Nation C is $9 as compared with the no-tariff price of $8 for imports of commodity X from Nation B. However, since the government of Nation A collects the $3 tariff per unit on imports of commodity X from Nation C, the net effective price for imports of commodity X from Nation C is really $6 for Nation A as a whole.

5. See Figure 10-1 in the text. Any figure similar to Figure 10-1 in the text would do.

6. The welfare gains that Nation 2 receives from joining Nation 1 to form a customs Union is given by the sum of the areas of triangles CJM and BHN in Figure 10-1 in the text. Any similar figure and sum of corresponding triangles would, of course, be adequate.

7. See Figure 10-2 in the text. Any figure similar to Figure 10-2 in the text would do.

8. The welfare loss that Nation 2 receives from joining Nation 1 to form a customs union

is given by C'JJ'+B'HH'- MNH'J'=$11.25 in Figure 10-2 in the text.

Any similar figure and sum of corresponding triangles minus the area of corresponding

rectangle would, of course, be adequate.

9. See Figure 1 and compare it to Figure 10-2.

10. The net gain from the trade-diverting customs union shown in Figure 1 is given by

C'JJ'+B'HH'-MJ'H'N. As contrasted with the case in Figure 10-2, however, the sum

of the areas of the two triangles (measuring gains) is greater than the area the rectangle

(measuring the loss). Thus, the nation would now gain from the formation of a custom

union. Had we drawn the figure on graph paper, we would have been able to measure

the net gain in monetary terms also.

11. A trade-diverting customs union is more likely to lead to a welfare gain of a member

nation (1) the smaller is the relative inefficiency of nation 3 with respect to nation 1,

(2) the higher is the level of the tariff, and (3) the more elastic are Dx and Sx in nation

2. These can seen by comparing Figure 10-2 in the text with Figure 1 on the next page. 12. See Figure 2. The formation of the customs union has no effect.13. NAFTA created much more controversy because the very low wages in Mexico led to

great fears of large job losses in the U. S. 14. The possible cost to the U.S. from EU92 arose from the increased efficiency and

competitiveness of the E.U. The benefit arose because a more rapid growth in the EU

spills into a greater demand for American products, which benefits the U. S.

App. Compare points B' and H' in Figure 10-3 with the corresponding points in

Figure 3.

Multiple-choice Questions:

1. Which of the following statements is correct?

*a. In a customs union, member nations apply a uniform external tariff

b. in a free-trade area, member nations harmonize their monetary and fiscal policies

c. within a customs union there is unrestricted factor movement

d. a customs union is a higher form of economic integration than a common market

2. A customs union that allows for the free movement of labor and capital among its member nations is called a:

a. preferential trade arrangement

b. free-trade area

*c. common market

d. all of the above

3. A trade-creating customs union is one where:

a. lower-cost imports from outside the customs union are replaced by higher-cost imports from a union member

*b. some domestic production in a member nation is replaced by lower-cost imports from another member nation

c. trade among members increases but trade with nonmembers decreases

d. trade among members decreases while trade with nonmembers increases

4. A trade-diverting customs union:

a. increases trade among union members and with nonmember nations

b. reduces trade among union members and with nonmember nations

*c. increases trade among members but reduces trade with non-members

d. reduces trade among union members but increases it with nonmembers

5. A trade-diverting customs union results in:

a. trade diversion only

b. trade creation only

*c. both trade creation and trade diversion

d. we cannot say

6. The formation of a trade-creating customs union where all economic resources of member

nations are fully employed before and after the formation of the customs union leads to an:

*a. increase in the welfare of member and nonmember nations

b. increase in the welfare of member nations only

c. increase in the welfare of nonmember nations only

d. increase or decrease in the welfare of member and nonmember nations

7. A trade-diverting customs union:

a. increases the welfare of member and nonmember nations

b. reduces the welfare of member and nonmember nations

c. increases the welfare of member nations but reduces that of nonmembers

*d. reduces the welfare of nonmembers and may increase or reduce that of members

8. A trade-diverting customs union is more likely to lead to trade creation:

a. the lower are the pre-union trade barriers of the member countries

*b. the lower are the customs union's barriers on trade with the rest of the world

c. the smaller is the number of countries forming the customs union and the smaller their size

d. the more complementary rather than competitive are the economies of the nations forming the customs union

9. The theory of customs union is a special case of the theory of:

a. effective protection

*b. the second best

c. the product cycle

d. comparative advantage

10. Which is not a dynamic benefit from the formation of a customs union?

a. increased competition

b. economies of scale

c. stimulus to investment

*d. trade creation

11. The formation of the EU resulted in:

a. trade creation in industrial and agricultural products

b. trade diversion in industrial and agricultural products

*c. trade creation in industrial products and trade diversion in agricultural products

d. trade diversion in industrial products and trade creation in agricultural products

12. The benefit that the United States is likely to receive from NAFTA:

*a. increasing competition in product and resource markets

b. greater technical innovation

c. improvements in its terms of trade

d. all of the above

13. The benefit that Mexico is likely to receive from NAFTA:

a. greater export-led growth

b. encouraging the return of flight capital

c. more rapid structural change

*d. all of the above

14. Which is a stumbling block to successful economic integration among groups of

developing nations?

a. benefits are not evenly distributed among nations

b. many developing nations are not willing to relinquish part of their newly-acquired sovereignty to a supranational community body, as required for successful economic integration

c. the complementary nature of their economies and competition for the same world markets for their agricultural exports

*d. all of the above

15. The formation of a free trade area among the countries of Eastern Europe is advocated

in order to:

a. restore trade trading

*b. retain the traditional trade links that can be justified on market principles

c. reduce the need for structural change

d. none of the above

(Ch10_Salvatore 11e.doc)10-2 Dominick Salvatore