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Regional Economic

IntegrationCourse Facilitator: Rajesh KP

Introduction

Basically there are two approaches to international trade liberalisation and economic integration: the international approach and the regional approach.

The international approach involves international conferences under WTO. The purpose of these international conferences is to reduce barriers to international trade and investment.

The regional approach involves agreements among a small number of nations whose purpose is to establish free trade among themselves while maintaining barriers to trade with the rest of the world.

Regional Economic Integration

Agreement between countries in a geographic region to reduce and ultimately remove tariff and non tariff barrier to the free flow of good, services and factors of production among each other.

• By entering into regional agreements groups of countries aim to reduce trade barriers more rapidly than can be achieved under the auspices of the WTO.

Levels of Economic Integration

Preferential

Trade Area

Free Trade Area

Customs

Union

Common

Market

Economic

Union

Level of Integration

Political Union

Types of Integration Regional Economic Integration

Preferential Trade Area:

Preferential trade agreements provide lower barriers on trade among participating nations than on trade with nonmember nations. That is, lower tariffs on imports of each other.

This is the loosest form of economic integration.

A good example is the Commonwealth Preference System, which was established in 1932 among 48 Common wealth countries of the British empire.


Free Trade Area:

A free trade area is an association of trading nations whose members agree to remiove all tariff and non tariff barriers to the trade of goods and services among themselves. Each member, however, maintains its own set of trade restrictions against outsiders.

The best examples are the European Free Trade Association (EFTA), formed in 1960 by UK, Austria, Denmark, Norway, Portugal, Sweden, and Switzerland (with Finland joining as an associate member in 1961); and the North American Free Trade Agreement (NAFTA, consisting of Canada, Mexico, and the United States, which is formed in 1993).


Customs Union

A Customs Union is an agreement between two or more trading parteners to remove all trade barriers among themselvs and adopt a common external trade policy.

A well known example is Benelux (Belgium, the Netherlands, and Luxumberg), formed in 1948.


Common Market:

A common market goes beyond a customs union by also allowing the free meovement of labor and capital among nations.

Thus,a common market is a group of trading nations that permits (1) the fre movement of goods and services among member nations, (2) the initiation of common external trade restrictions against nonmembers, (3) the free movement of factors of production across national borders within the bloc.

Thus, labour and capital are free to move, as there are no restrictions on immigration, emigration, or cross-border flows of capital between member-countries.

The European Uninon (EU) achieved the status of a common market in 1992.


Economic Union:

• An Economic Union involves the free flow of products and factors of production between member-countries and the adoption of a common external trade policy.

• A full economic union also requires a common currency, harmonization of the member-countries tax rates and a common monetary and fiscal policy.

• Belgium and Luxumberg formed an Economic Union in 1920s.


Political union:

This is the ultimate integration, when an economic union is fully integrated to become one nation.

United States serves as an example of Political union.

Levels of Regional Integration

Coordinate aspects of members’ economic and political systemsPolitical UnionPolitical Union

Remove barriers to trade, labor, and capital;set a common trade policy against nonmembers; and coordinate members’ economic policies

Economic Economic UnionUnion

Remove all barriers to trade, labor, and capitalamong members; and set a common trade policy against nonmembers

Common MarketCommon Market

Remove all barriers to trade among members, and set a common trade policy against nonmembers

Customs Customs UnionUnion

Remove all barriers to trade among members, but each country has own policies for nonmembers

Free-Trade Free-Trade AreaArea

Forms of Regional Economic Integration

Stage of Integration

Elimination of Tariffs and Quotas Among Members

Common Tariff and Quota System

Elimination of Restrictions on

Factor Movements

Harmonization and Unification of

Economic and Social Policies and Institutions

Free Trade Yes No No No

Customs Union Yes Yes No No

Common Market Yes Yes Yes No

Economic Union Yes Yes Yes Yes

NEED FOR REGIONAL ECONOMIC INTEGRATION

Economic case for integration

Unrestricted free trade will allow countries to specialize in the production of goods and services that they can produce most efficiently.

Opening a country to free trade stimulates economic growth in the country, which in turn creates dynamic gains from trade.

Increases FDI and the flows of FDI can transfer technological, marketing and managerial know-how to host nations.

Larger markets

Increased competition

Broadening of consumer market

Increased competition that improves quality of goods and prices.

Economic case for integration (Contd.)Economic case for integration (Contd.)

Political Case for Economic Integration

• Economic interdependence creates incentives for political cooperation and reduces potential for violent confrontation.

• By grouping their economies together, the countries can enhance their political weight in the world.

Effects of Regional Economic Integration

Potentialbenefits

Potentialdrawbacks

Trade diversion

Shifts in employment

Loss of sovereignty

Backlash of Globalization

Trade diversion

Shifts in employment

Loss of sovereignty

Backlash of Globalization

Trade creation

Greater consensus

Political cooperation

Creates jobs

Foreign competition

Economic Effects of Regional Integration:THE THEORY OF CUSTOMS UNION What are the possible welfare implications of regional trading

agreements?

The theory of customs union discusses the benefits and cost of regional economic integration from two perspectives:– Static effects: Short-term effects – Dynamic effects: Long-term effects

Combined, these static and dynamic effects determine the overall welfare gains or losses associated with the formation of a regional trading agreement.

The theory of customs union was first developed systematically by Jacob Viner in 1950. Meade, Lipsey, Cooper and Massel, Vanek, Bhagavati and many others have contributed much in improving upon Vinerian analysis of customs union.

THE THEORY OF CUSTOMS UNIONStatic Effects: The static welfare effects from the formation of a customs union are

measured by the extent to which it leads to trade creation and trade diversion; but whereas trade creation is good and tends to increase welfare, trade diversion is bad and tends to decrease welfare.

The final effect on welfare depends which of these opposing influences, trade creation or trade diversion, is stronger.

THE THEORY OF CUSTOMS UNIONStatic Effects:

Trade Creation:Trade creation occurs when some higher-cost domestic production in a nation that is a member of the customs union is replaced by lower-cost imports from another member nation. This increases welfare.

Figure-1: A Trade-Creating Customs Union (Summary)DX and SX represent Nation

2’s domestic demand and supply curves of commodity X. At the tariff inclusive Px = $ 2 before the formation of the customs union, Nation 2 consumes 50X (GH), with 20 X (GJ) produced in Nation 2 and 30X (JH) imported from Nation 1. Nation 2 also collects a tariff revenue of $30 (MJHN). Nation 2 does not import commodity X from Nation 3 because of the tariff inclusive PX>$2 ($3).

After Nation 2 forms a customs union with Nation 1 only, Nation 2 consumes 70X (AB), with 10X (AC) produced domestically and 60X (CB) imported from Nation 1 at PX = $1. The tariff revenue disappears, and area AGJC represents a transfer from domestic producers to domestic consumers. This leaves net static gains to Nation 2 as a whole equal to $15, GIVN by the sum of the areas of shaded triangles CJM and BHN.

THE THEORY OF CUSTOMS UNIONStatic Effects:

Trade Diversion: Trade diversion occurs when lower-cost imports from outside the customs union are replaced by higher-cost imports from a union member. This results because of preferential trade treatment given to member nations.

Trade diversion, by itself, reduces welfare because it shits production from more efficient producers outside the customs union to less efficient producers inside the union.

Since the formation of customs union usually results in both trade creation and trade diversion, the welfare of the nation forming or joining a customs union can increase or decrease, depending on the relative strengths of these two opposing forces.

Figure-2: A Trade-Diverting Customs Union (Summary)

DX and SX represent Nation 2’s domestic demand and supply curves of commodity X, while S1 and S3 are the free trade perfectly elastic supply curves of Nation 1 and Nation 3, respectively. With a non discriminatory 100 percent tariff, Nation 2 imports 30X (JH) at PX = $2 from Nation 1.

After forming a customs union with Nation 3 only, Nation 2 imports 45X (C’B’) at PX = $1.5 from Nation 3. The welfare gain in Nation 2 from pure trade creation is $3.75 (given by the sum of the areas of shaded triangles). The welfare loss from trade diversion proper is $15 (the area of shaded rectangle). Thus, this trade diverting customs union leads to a net welfare loss of $11.25 for Nation 2.

THE THEORY OF CUSTOMS UNIONDynamic Effects:

besides the static effects of trade creation and trade diversion, customs union have some interesting dynamic effects such as:

Increased competition Economies of large scale production Stimulus to investments

These dynamic gains resulting from the formation of a customs union are believed to be much larger than the static gains discussed earlier and to be very significant.

APPENDIX I

THEORY OF CUSTOMS UNIOPN

Detailed Illustration of Trade-Creating &

Trade-Diverting Customs Union

Illustration of Trade-Creating Customs Union

The effects of trade creating customs union are illustrated in Figure 1. DX and SX in Figure 1 are Nation 2’s domestic demand and supply curves of commodity X. Suppose the free trade price of commodity X is PX=$1 in Nation 1 and PX = $1.5 in Nation 3 (or rest of the world) and Nation 2 is assumed to be too small to affect these prices. If nation 2 initially imposes a non discriminatory ad valorem tariff of 100 percent on all imports of commodity X, then Nation 2 will import commodity X from Nation 1 at PX = $2.

Figure-1: A Trade-Creating Customs Union.


At the tariff inclusive Px = $ 2 before the formation of the customs union, Nation 2 consumes 50X (GH), with 20 X (GJ) produced domestically and 30X (JH) imported from Nation 1. Nation 2 also collects a tariff revenue of $30 (MJHN). In the figure, S1 is Nation 1’s perfectly elastic supply curve of commodity X to Nation 2 under free trade, and S1+T is the tariff-inclusive supply curve.Nation 2 does not import commodity X from Nation 3 because of the tariff inclusive price of commodity X imported from Nation 3 would be PX=$3.



Nation 2 now forms a customs union with Nation 1 (i.e., removes tariffs on its imports from Nation only), PX = $1 in Nation 2.

At this price Nation 2 consumes 70X (AB) of commodity X, with 10X (AC) produced domestically and 60X (CB) imported from Nation 1.

In this case, Nation 2 collects no tariff revenue.



The benefits to consumers in Nation 2 resulting from the formation of customs union is equal to AGHB (the increase in consumer surplus). However, only part of this represents a net gain for Nation 2 as a whole that is, area AGJC represents a reduction in producer surplus, while MJHN represents the loss of tariff revenues. This leaves the sum of the areas shaded triangles CJM and BHN, or $15, as the net static gains to Nation 2.



Triangle CJM is the production component of the welfare gain from trade creation and results from shifting the production of 10X (CM) from less efficient domestic producers in Nation 2 (at a cost of VUJC) t more efficient producers in Nation 1 ( at a cost of VUMC).Triangle BHN is the consumption component of the welfare gain from trade creation and results from the increase in consumption of 20X (NB) in Nation 2 giving a benefit of ZWBH with an expenditure of only ZWBN.


Illustration of Trade-Diverting Customs Union

The effects of trade diverting customs union are illustrated in Figure 2.

In this figure, DX and SX are Nation 2’s domestic demand and supply curves of commodity X, while S1 and S3 are the free trade perfectly elastic supply curves of Nation 1 and Nation 3, respectively.

.

Figure-2: A Trade-Diverting Customs Union.


With a non discriminatory 100 percent tariff on imports of commodity X, Nation 2 imports commodity X from Nation 1 at PX = $2, Nation 2 consumes 50X (GH), with 20X (GJ) produced domestically and 30 X (JH) imported from Nation 1. Nation 2 also collects $30 (MJHN) in tariff revenue.



If Nation 2 now forms a customs union with Nation 3 only (i.e., removes tariffs on its imports from Nation 3 only), Nation 2 finds it cheaper to import commodity X from Nation 3 at PX = $1.5. At PX = $1.5, Nation 2 consumes 60X (G’B’), with 15X (G’C’) produced domestically and 45X (C’B’) imported from Nation 3. In this case Nation 2 collects no tariff revenue.



The import of commodity X into Nation 2 have now been diverted from the more efficient producers in Nation 1 to the less efficient producers in Nation 3 because the tariff discriminates against imports from Nation 1 (which is outside the union).

Note that Nation 2’s imports of commodity X were 30X before formation of the customs union and 45X afterward. Thus, the trade-diverting customs union also leads to some trade creation.



the static welfare effects on Nation 2 resulting from the formation of a customs union with Nation 3 can be measured from the shaded area shown in the figure. The sum of the areas of shaded triangles C’JJ’ and B’HH’ ($3.75) is the welfare gain resulting from pure trade creation, while area of shaded rectangle MNH’J’ ($15) is the welfare loss from diverting the initial 30X (JH) of imports from lower cost Nation 1 to higher cost Nation 3.



Specifically, of the gain in consumer surplus of G’GHB’ resulting from producer to consumer surplus in Nation 2 and therefore washes out (i.e., leaves no net gain or loss for Nation 2 as a whole).Of the JMNH ($30) tariff revenue collected by Nation 2 before the formation of the customs union with Nation 3, J’JHH’ is transferred to consumers in Nation 2 in the form of lower price of commodity X after the formation of the union. This leaves only shaded triangle C’JJ’ and B’HH’ as net gain to Nation 2 and shaded rectangle MNH’J’ as the still unaccounted for loss of tariff revenue.



Since the area of the shaded rectangle ($15) measuring the welfare loss from trade diversion proper exceeds the sum of the areas of the shaded triangles ($3.75) measuring the welfare gain from pure trade creation, this trade diverting customs union leads to a net loss of $11.25 for nation 2. This need not always be the case, however.


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Documents

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