theories of economic integrtaion: a survey of the economic and political literature

8/10/2019 Theories of Economic Integrtaion: A Survey of the Economic and Political Literature

1/23

International Journal of Economy, Management and Social Sciences, 2(5) May 2013, Pages: 133-155

TI Journals

International Journal of Economy, Management and Social Scienceswww.waprogramming.com

ISSN2306-7276

* Corresponding author.Email address: [email protected]

Theories of Economic Integration:A Survey of the Economic and Political Literature

Amr Sadek Hosny

Department of Economics, University of Wisconsin-Milwaukee, Northwest Quadrant Building B, Room 4428, M ilwaukee, WI 53201, USA.

A R T I C L E I N F O A B S T R A C T

Keywords:

economic integrationpolitical de termiants of integrationdeveloping countries

This paper aims at presenting a survey of the literature on economic integration theories, both from

an economic and a political perspective with a special attention to the case of developing countries.More specifically, we start by defining economic integration, and its forms. Then, a survey oftheories of economic integration, both tradi tional and new is presented in section two. Section threefocuses on economic integration theories adjusted to the special needs of developing countries.Section four discusses the political incentives or determinants of economic integration. Finally,section five provides an executive summary and concludes.

2013 Int. j. econ. manag. soc. sci. All rights reserved for TI Journals.

1. Introduction

Economic integration according to Balassa (1961) is defined as "the abolition of discrimination within an area". And according to Kahnertet al (1969) economic integration is "the process of removing progressively those discriminations which occur at national borders". Therefore, scientifically, measures which merely diminish discrimination between countries are considered forms of cooperation notintegration. According to Allen (1963, p.450) economic integration may mean something different to nearly everyone. That's why Allen(1963, p.450) argues that one of the many useful elements of the well known Balassa (1961) book is that it evidently defines integration,clearly differentiating between it and cooperation.

Furthermore, Lipsey (1960, p.496) provided the following definition of the customs union theory (economic integration theory)as follows: "The theory of customs unions may be defined as that branch of tariff theory which deals with the effects of geographically discriminatorychanges in trade barriers [among countries]"

Integration according to Machlup (1977) is the process of combining separate economies into a larger economic region. Machlup(1977) and Staley (1977, p.243) further argue that integration is concerned with the "utilization of all potential opportunities of efficientdivision of labor".

An important question arises, and it is why study economic integration theories? Chou (1967) answered this question when heargued that the main reason behind studying the traditional theory of economic integration is to evaluate the desirability of a customs unionfrom the world's welfare point of view using static effects as criteria. New (dynamic) theory of economic integration has introduceddynamic effects of economic integration to this analysis. This is what we will study in-detail in section two of this paper.

1.1. Forms of Economic Integration

One cannot talk about the different forms of economic integration without mentioning the work of Balassa (1961) which is considered thecornerstone of any work done on issues of economic integration. Balassa's book written in 1961, titled: " The Theory of Economic

Integration" has been reviewed by many authors in internationally recognized journals. Some of these book reviews include Allen (1963,p.449-454) who described the book as an important contribution to an adequate understanding of economic integration. Havens (1962,p.47-48) also describes the book as making a worthwhile contribution to the theory of economic integration. In Ingram's (1962, p.612-614)review of the book, the author argues that Balassa has succeeded extremely well in explaining the theory of economic integration. Other

book reviews of Balassa's work include Eastman (1962, p.466-467), Meyer (1962, p.389-391), and Hasson (1962, p.614-615). Balassa'sbook is widely cited in any book, article, or paper discussing economic integration whether theory or policy.

According to Allen's (1963, p.450) review of Balassa's book: the basic ingredient of any integration form is the elimination ofbarriers to trade among two or more countries. Allen (1963, p.450) also stresses the point that although traditional international trade theoryhas dealt with the effects of reduction of trade barriers, a separate theoretical framework is needed to study issues of economic integration.


2/23

Amr Sadek HosnyInternational Journal of Economy, Management and Social Sciences, 2(5) May 2013

134

Economic integration can take many forms. According to Balasaa (1962) there are four different stages of economic integration.The first is a Free Trade Area (FTA), then a Customs Union (CU), then a Common Market (CM), and finally an Economic Union.

Panagariya (1998, p.2; and 2000, p.288) argue that the term PTA, whether used to stand for Preferential Trade Area, PreferentialTrade Agreementor Preferential Trade Arrangement, has an advantage of being wider in that it can be used to describe FTAs, CUs andarrangements involving partial trade preferences.

Preferential Trade Arrangements (PTAs)

1

usually entail lower tariff barriers among participating nations than with non-membernations. Panagariya (1998, p.2; and 2000, p.288) describe PTAs as an arrangement between two or more countries in which goodsproduced within the union are subject to lower trade barriers than the goods produced outside the union. The trade arrangement among theeight Muslim countries of the Developing 8 Organization is an example of a PTA.

A Free Trade Agreement (FTA) 2is a PTA in which member countries do not impose anytrade barriers (zero tariffs) on goodsproduced within the union. However, each country keeps its own tariff barriers to trade with non-members. This is usually referred to as"trade integration". A good example is the North American Free Trade Agreement (NAFTA) formed by the United States of America(USA), Canada, and Mexico in 1993. More specifically, paragraph (8) of article (XXIV) of the GATT defines a free trade area as follows:

"For the purposes of this Agreement:

(b) A free-trade area shall be understood to mean a group of two or more customs territories in which the duties and other restrictive regulations

of commerce . are eliminated on substantially all the trade between the constituent territories in products originating in such territories."

quoted from Par.8, art. XXIV, GATT

A Customs Union (CU) is an FTA in which member countries apply a common external tariff on a good imported from outsidecountries. This common external tariff can, of course, differ across goods but not across union partners. The most famous example is theEuropean Community (EC), formed in 1957 by West Germany, France, Italy, Belgium, the Netherlands, and Luxembourg. Morespecifically paragraph (8) of article (XXIV) of the GATT defines a Customs Union as follows:

"For the purposes of this Agreement:

(a) A customs union shall be understood to mean the substitution of a single customs territory for two or more customs territories, so that

(i) duties and other restrictive regulations of commerce ... are eliminated with respect to substantially all the trade between the constituentterritories of the union or at least with respect to substantially all the trade in products originating in such territories, and,

(ii) subject to the provisions of paragraph 9, substantially the same duties and other regulations of commerce are applied by each of the members

of the union to the trade of territories not included in the union"

quoted from Par.8, art. XXIV, GATT

A Common Market (CM) is a CU which further allows free movement of labor and capital among member nations. This isusually referred to as "factor integration". At the beginning of 1993, the EU achieved the status of a CM.

The most advanced type of economic integration is the Economic Union, where the monetary and fiscal policies of member statesare harmonized and sometimes even completely unified. This is usually referred to as "policy integration". The extreme case of an

Economic Union could be aMonetary Union (MU). A good example for the former is the countries of the EU who use a single currency,the Euro.

2. The Gains from Economic Integration

Bhagwati and Panagariya (1996, p.82) argue that the theory of preferential trade agreements (theory of economic integration) hasundergone two phases of evolution, each reflecting the contrasting policy concerns of its time. Therefore, the purpose of this section will betwo-fold. In sub-section one, we will identify traditionaleconomic integration or PTA theories that explain possible gains from trade andeconomic integration, or what is commonly referred to as the static analysis of PTAs. Then we will review the historical developments ofthese theories. In sub-section two, we will discuss neweconomic integration theories that have evolved with changing economic conditionsand trade environments, or what is commonly referred to as the dynamic analysis of economic integration.

2.1. Traditional Economic Integration Theories

Studies discussing trade integration gains and explaining the theoretical implications of preferential trade agreements are based on thepioneering study of Viner (1950). Viner's book titled: "The Customs Union Issue" was reviewed by many economists in well knownjournals. These include Catudal (1951, p.210) who describes Viner's work on the economics of customs unions as the first time that anyonehas subjected the issue of gains from economic integration to such a detailed and critical analysis from a purely economic point of view.Salera (1951, p.84) has also described Viner's book as the first rigorous treatment of the subject. Other book reviews of Viner's bookinclude Cheng (1952, p.126), Ellsworth (1951, p.466-467), Imlah (1951, p.60), Henderson (1951, p.398-400), Martin (1951, p.75), Stopler(1951, p.989-991), and Kreps (1950, p.207-208). We will review Viner's traditional customs unions theory, as well as the subsequentdevelopments made by many authors, especially Meade (1955) and Lipsey (1957, 1960).


3/23

Theories of Economic Integration: A Survey of the Economic and Political Literature

International Journal of Economy, Management and Social Sciences, 2(5) May 2013

135

2.1.1. Viner's Traditional Customs Unions Theory

Viner's study was the first to identify concrete criteria to distinguish between the possible advantages and disadvantages of economicintegration. Viner's so called "static analysis" of economic integration has divided possible effects of economic integration into the wellknown trade creation and trade diversion effects.

Trade creationrefers to the case when two or more countries enter into a trade agreement, and trade shifts from a high-cost

supplier member country to a low-cost supplier member country in the union.

Trade diversion may occur when imports are shifted from a low-cost supplier of a non-member country of the union (thirdcountry) to a high-cost supplier member country inside the union. This may be the case if common tariff after the union protects the high-cost supplier member country inside the union.

This can be illustrated by the following example in table (1). Suppose that country A enters a customs union with country B or C.In both cases, country A will be better off since the domestic price of commodity X in country A (36) is higher than in country B (25) or C(15). The direction of trade will shift from a high-cost member (country A) to a low-cost member (country B or C). This is an example oftrade creation.

Table 1.Price of commodity X in three countries

Country A Country B Country C

Price of commodity X 36 25 15

If, however, country A levies a tariff of 100% on commodity X, then it would buy it from country C which is the low-costproducer in this case. If country A enters a customs union with country B, then country A will buy commodity X from country B (selling at25), not from country C (selling at 30). The direction of trade has therefore shifted from an originally low-cost non-member country(country C) to a high-cost member country (country B). This is an example of trade diversion.

Therefore, we can see that the whole customs union issue can be disentangled in the free trade-protection argument. As Salera(1951, p.84) points out that the main purpose of any customs union is to shift sources of supply. Hence, if this shift is from a high-cost to alow-cost source, then customs unions are considered a movement towards free trade. If the shift is in the other direction, then customsunion may become a device for making tariff protection more effective. Viner (1950) claimed that trade creation raises the home country'swelfare 3, while trade diversion lowers it.

Viner (1950) has also made the case that size does matter. He identified economies of scale, where t he larger the economic areaof the customs union, the more likely is a customs union to operate in the free trade direction.

Viner's General Conclusion

According to Kreps (1950, p.207) Viner's general conclusion concerning customs union is rather negative. Viner has concluded thatcustoms unions are unlikely to provide more economic gains than harm, unless strict circumstances prevail. This can be seen from thefollowing paragraph taken from Viner's book, and cited in Kreps (1950, p.207).

"Customs unions are not important, and are unlikely to yield more economic benefit than harm, unless they are between sizable countries which

practice substantial protection of substantially similar industries"

quoted from Viner (1950,p.135)

This conclusion is supported by the idea that trade-diverting effects of customs union may outweigh their trade-creating effects,even if the resulting union tariff is lower than the average level of the previous tariff (Martin 1951, p.75). Therefore, Viner in his conclusioncalls for worldwide non-discrimination of trade barriers. Imlah's (1951, p.60) study includes Viner's conclusion on the role of customsunion in raising the economic well-being for the peoples of the world in general as follows:

" customs union is only a partial, uncertain, and otherwise imperfect mean of doing what a world-wide non-discriminatory reduction of trade

barriers can do more fully, more certainly, and equitably"

quoted from Viner (1950,p.135)

In a nutshell, Viner's theory basically stipulates that countries are motivated to integrate if integration is likely to produce staticgains more than losses. Or in other words, trade creation more than trade diversion.

2.1.2 Developments made to the Viner Analysis

Many developments have been made to the Viner static analysis of economic integration effects. This sub-section will try to identify themajor developments.


4/23


136

Trade expansion vs. Trade creation and diversion

According to Hay (1957, p.85), Meade (1955) has admired but criticized Viner's notion of trade diversion where a customs union mayactually lead to misallocation of the world's resources. Meade (1955) argued that Viner's analysis is only true under conditions of inelasticdemand and completely elastic supply. So if demand was allowed to be more elastic, Meade concludes that a customs union may actuallyincrease the volume of trade even though there is trade diversion. This effect was named "trade expansion" by Meade. Meade (1955)argues that this effect should be added to the traditional Viner analysis of trade creation and diversion, as trade diversion in this case may

not be that harmful.

Production and Consumption effects of Customs Unions

This point is perhaps the most important contribution to the theory of customs unions. Lipsey (1957, p.40) argues that Viner has concludedthat trade creation in the sense that production shifts from the high-cost source to the low-cost source is considered the "good thing", whiletrade diversion is considered the "bad thing" in terms of economic welfare. However, as Lipsey (1957, p.40-41) argues this must not be thecase, as economic welfare includes both production and consumption effects. The Viner analysis has concentrated on the production sideonly, neglecting the consumption effect. This is illustrated as follows: when a customs union is formed, relative prices in the domesticmarkets of member countries change as a result of the reduction in tariff barriers between them. These price changes have two effects. A

production effect as illustrated by Viner (1950), and secondly, a consumption effect where union members will obviously increase theirconsumption of each other's products, while reducing consumption from countries outside the union. According to Sheer (1981, p.44), theweakness in Viner's analysis was the assumption that consumption is independent of these relative price changes. Therefore, even if world

production is fixed, there will still be some changes in world consumption due to the relative change in prices. Gehrels (1956-1957, p.61)identified consumption effects as the response of consumers to the drop in import prices caused by the tariff removal.

Studies by Lipsey (1957, p.40; and 1960, p.504) argue that the first effect "production effect of the union"has been taken intoaccount by Viner, while the second effect "consumption effect of the union"has not. Lipsey (1957, p.40-41; and 1960, p.504) claimed thatViner's conclusion that trade diversion is a bad thing implies a welfare judgment. However, a welfare judgment in turn requires thecombination of the two effects just mentioned, not only one. Consequently, Lipsey (1957, p.41) concludes that although the Vinerclassification of trade creation and trade diversion is fundamental to classify changes in the production effect, it cannot be used to make

judgments regarding the economic welfare of customs unions. This same point of view is shared by Gehrels (1956-1957, p.61), Lipsey(1960, p.499), and Krauss (1972, p.417).

Another important study by Lipsey (1960, p.504) reviewed the issue of the production effect and consumption effect of customsunions as argued by Lipsey (1957, p.40) and Gehrels (1956-1957, p.61). The paper reached the conclusion that this distinction is not fullysatisfactory. Viner's analysis, according to the paper, emphasized substitution in production, while ruling out substitution in consumption.Lipsey (1960, p.504) argued that this distinction is misleading because consumption changes in themselves will stimulate productionchanges. Therefore, he suggested that a more satisfactory distinction be made, and that is between "inter-country substitution"and "inter-commodity substitution". Inter-country substitution is when one country is substituted by another as Viner's original trade creation anddiversion analysis explains. While, inter-commodity substitution is when one commodity is substituted by another as a result of the relative

price change.

Trade-Diversion and Welfare

Studies by Cooper and Masselll (1965a, p.742), Johnson (1975, p.117), and Pomfret (1997, p.182) summarized the implications of the issueof production and consumption effects of a customs union in simple words. Johnson (1975, p.117), for example, said that trade-diversionmay actually be welfare-increasing if we take into account both production and substitution effects, in the sense that the welfare lossesresulting from the diversion to a high-cost supplier country may be more than outweighed by the welfare gains resulting from the reduced

prices to consumers due to the elimination of tariff on imports. Pomfret (1997, p.182) argues that this results in increased consumer surpluswhether or not the increased imports were from the least-cost supplier.

Secondary effects

Another development to the Viner study cited in Meade (1955) is the idea that Viner has concentrated his analysis on the effect of tariffreduction on a single commodity. Meade (1955, p.67-82) according to Hawtrey (1956, p.338) argues that additional welfare may be gainedif we consider the secondary effects on complements and substitute goods. He cites the example of Holland reducing its duty on imports of

beer from Belgium, while the duty on beer from other countries remains unchanged. Meade (1955, p.83) according to Hawtrey (1956,p.338) argues that one must trace out the repercussions of this tariff reduction of a single commodity on all the quantities of all the productstraded internationally to be able to assess the actual effect of this change on economic welfare of the country.

Small vs. Large Tariff reductions

Another study by Lipsey and Lancaster (1956-1957) made an important contribution to the Viner analysis. This study differentiatedbetween small and large tariff reductions in a customs union. They argue that a small reduction in tariffs must raise welfare, while a largereduction may raise or lower it. The same view is shared by the studies by Meade (1955, p.50-51) and Lipsey (1960, p.507), and De Melo,Panagariya, and Rodrik (1993, p. 171-172) which claim that economic welfare is more likely to raise in the case of tariffs being merelyreduced, than being completely removed.


5/23



137

Gradual Tariff reductions

Lipsey and Lancaster (1956-1957, p.21) also dealt with the consequences of reducing tariffs in stages. They concluded that initial stages oftariff reductions raise welfare, while final stages lower it, depending on the specific assumptions made in that study.

The Terms of Trade effect

Krauss (1972, p.421) argued that studies analyzing the welfare impacts of economic integration so far have assumed that the country atquestion is a small country with no effect on world prices. However, this may not always be true. If the country is large enough to changeworld prices, and if this country levies a tariff, it will reduce the demand for imports and will therefore cause the prices of those importedgoods to fall in world markets relative to its exports, and thus improving its terms of trade. This process is known as the terms of tradeeffect. Krauss (1972, p.421) argued that allowing for the terms of trade effect, will dramatically alter the perspective of the analysis.

Integration between Competitive vs. Complementary countries

Viner (1950), Meyer (1956, p.328-330), and Lipsey (1960, p.499) claimed that gains will arise between countries of a union if they areproducing the same commodity. Makower and Morton (1953, p.41) claimed that these gains will be larger the larger is the differencebetween the costs at which the same commodity is produced in the countries of the union, under the assumption of fixed demand. Sheer(1981, p.45) agrees with the above two arguments. Meyer (1956, p.323) defined complementary goods as where the consumption of onegood enhances the satisfaction yielded by the other. While, competitive goods are where the consumption of one good is a substitute for theother, diminishing the satisfaction it can provide. A simple example is cars and petrol, in comparison to blue cars and green cars.

Meade (1955, p.107-111) suggested that a customs union may be welfare increasing if the partner countries are actuallycompetitive but potentially complementary, if the initial tariff levels were very high, and if each partner is the principle supplier to the otherpartner of the traded products (Hillmann 1957, p.492; and Sheer 1981, p.45).

Trade between countries of similar vs. different levels of income

On one hand, the Heckscher-Ohlin (H-O) model of factor-proportions states that a country will have a comparative advantage in tend toexport those products which require factors of production that are relatively abundant and therefore relatively cheap within its borders.The factor-price equalization theorem originating from the H-O model argued that countries with different factor endowments and atdifferent levels of development (different per capita income) are expected to trade with each other the most, and that the prices of thefactors of production will tend to converge between the two countries after trade or integration occurs.

On the other hand, Linder (1961, p.87-90), according to Auten (1962, p.53-54), Kravis (1963, p.184-185), Watkins (1963, p.122),and Sakamoto (1969, p.298-301), argued that the H-O model although holding true for natural-resource intensive products such asagriculture, does not hold for manufacturing products as data on the flows of foreign trade reveal. Linder then argues that a country cannotenjoy a comparative advantage in any good without it being produced or demanded for the domestic market first. Therefore, it follows that

if comparative advantage is related to demand preferences; trade should most likely occur between countries of similar demand structures.Linder (1961, p.110-117), according to Bhagwati (1962, p.517) and Kravis (1963, p.185), argued that per capita income may be consideredan index of consumption preferences or a primary determinant of demand structures. Therefore, Linder's main conclusion is that countrieswith similar per capita incomes (similar demand) would develop similar industries, and that they would enjoy more trade potential with oneanother in similar but differentiated products (Linder 1961; and Kemp 1965, p.200).

The above debate was mainly cited in international trade literature, rather than in economic integration literature. Sakamoto(1969, p.300-301) made an interesting contribution to Linder's hypothesis in this respect, by applying it specifically to the case of economicintegration. As countries integrate, markets are enlarged, and in order that a country may benefit from economies of scale, its product must

be demanded in the new member country of the union. Therefore, similarity of demand preferences, proxied by similarity of per capitaincome, is an important element in the success of economic integration efforts. In other words, the Linder hypothesis suggests that similardemand structures determine trade in manufacturing goods rather than differences in supply side factors (i.e. H-O's factor endowments).

To conclude, countries should enjoy more trade potential if they have similar per capita incomes according to the Linderhypothesis, or different per capita incomes according to the comparative advantage theory or the H-O model.

Intra-industry trade vs. Inter-industry trade

Intra-industry trade (IIT) differs from inter-industry trade. Intra-industry trade refers to trade between two countries of products belongingto the same industry, while Inter-industry trade refers to trade between two countries of products of different industries. A distinction hasalso been made between horizontal IIT (where goods are differentiated by attributes) and vertical IIT (where goods are differentiated byquality).

Pelzman (1978, p.297), and Zdenek and Greenway (1984, p.444) argued that the traditional customs unions theory concluded thatinter-industry specialization is what drives trade integration. However, recent empirical studies have concluded that intra-industryspecialization is the driving force. For example, Menon and Dixon (1995, p.19) empirically proved that IIT has contributed to more thanhalf the growth of trade between Australia and New Zealand on average during the period 1986-1991. Likewise, a study by Koyigit and


6/23


138

Sen (2007, p.80-81) concluded that Turkey's pattern of external trade with the EU has been increasingly of the IIT type after the formationof the customs union agreement between them in 1996.

This debate although important, is not the intention of this study. What is important to us here is the link between per capitaincome and the pattern of trade.

Linking Per capita income with the Pattern of trade

Studies dating back to Lancaster (1980), Greenway (1981), and Zdenek and Greenway (1984, p.445-448) concluded that the greater theoverlap of preferences in demand (similarity of per capita income) between potential trade partners, the greater the scope for intra-industrytrade. Furthermore, recent studies such as Clark and Stanley (1999, p.91) have also concluded that intra-industry trade tends to fall betweencountries having different factor endowments proxied by differences in per capita income.

Therefore, to bring the above debate to a close, one can conclude that the impact of per capita income on trade is not settled in theliterature. On one hand, the Linder hypothesis states that intra-industry trade should increase when countries have similar per capitaincome. On the other hand, comparative advantage theory states that inter-industry should increase when countries have dissimilar percapita incomes. Therefore, the increase or decrease in trade flows between member countries of a union will be determined by the similarityof per capita income and the pattern of trade; whether it follows the lines of inter-industry or intra-industry trade.

Other Contributions to the Viner analysis

Other contributions to the theory of customs unions include Lipsey (1960, p.508-509), Spraos (1964), and Bhagwati (1971). Lipsey (1960,p.508-509), for example, reached two rather interesting conclusions. The first is that given a country's volume of international trade, a

customs union will more likely produce welfare gains the higher is the proportion of trade with its partner in the union, and the lower theproportion with the rest of the world. The second is that countries most likely to benefit from economic integration are those making a highproportion of their total expenditure on domestic trade. Or in other words, the lower the volume of foreign trade as a percentage of thecountries' GDP.

Conclusion of theoretical developments to the Viner analysis

Finally, an important note to emphasize is that developments made to Viner's theory of customs unions have all generally concluded thatthere is no possible direct answer to whether a customs union increases world welfare or not. Meade (1955) has summarized it all when hewrote the following:

"Our main conclusion must be that it is impossible to pass judgment upon customs union in general. They may or may not be instruments for

leading to a more economic use of resources. It all depends upon the particular circumstances of the case"

quoted from Meade (1955), as in Rosseaux (1957,p.75)

2.2. New Economic Integration Theories

The best way to start discussion of this sub-section is to present the following conclusion from Hasson's (1962) study:

"Static analysis of trade division and trade creation is insufficient"

quoted from Hasson (1962,p.614).

Why is static analysis of PTAs insufficient?

Krauss (1972, p.417-419) argued that studies by Viner (1950, p.135) and Cooper and Massell (1965a, p.743) have concluded that a non-preferential tariff policy (free trade) is superior to customs unions as a trade liberalizing device. In other words, these studies haveconcluded that the argument that the reason behind forming customs unions is a better allocation of resources is no longer valid. Therefore,one should stop analyzing the welfare impacts of customs union using static effects. As a result, Balassa (1962), and Cooper and Massell(1965a, p.743) have introduced another tool (dynamic effects) into the analysis of the welfare effects of economic integration, as a moreefficient economic reason or rationale behind the formation of customs unions or economic integration schemes in general.

Likewise, Sheer (1981, p.53) concluded that the main theorem of international economics was that free trade in competitivemarkets ensures production and consumption efficiency in each country and for the whole world. The trend towards forming PTAs guided by the static analysis of PTAs in terms of trade creation and trade diversion was first regarded as a movement toward free trade,and a tool for increasing real income. This has proved wrong during the years. Therefore, Sheer (1981, p.53) concluded that static analysisof economic integration theory provides no simple maxims or principle, and that it is the dynamic analysis of economic integration that hasto be stressed.

Dynamic vs. Static analysis of integration

Balassa (1962), and Cooper and Massell (1965a, p.743) were perhaps the first to ever introduce the concept of dynamic effects of economicintegration. This analysis added a new dimension to this area of study. Balassa's dynamic theory of economic integration proved that the


7/23



139

static analysis in terms of trade creation and trade diversion is simply not enough to fully capture or analyze welfare gains from economicintegration.

According to Allen (1963. p.451), Balassa (1962) listed the principle dynamic effects of integration as large-scale economies,technological change, as well as the impact of integration on market structure and competition, productivity growth, risk and uncertainty,and investment activity. The same view is shared by Kreinin (1963, p.193). According to Brada and Mendez (1988, p.163-164) integrationis assumed to raise investment and reduce risks. This can be explained by the fact that a larger market will raise the expected return on

investments and reduce uncertainty by enabling firms to lower their costs as a result of increased economies of scale, and a bigger pool ofconsumers. Schiff and Winters (1998, p.179) summarized the definition of the dynamic effects of economic integration schemes asanything that affects the country's rate of economic growth over the medium term.

Old Regionalism vs. New Regionalism

A number of recent studies have referred to the static effects and developments of the theory of economic integration so far (Viner anddevelopments) as "old regionalism", while "new regionalism"is represented by dynamic effects such as increased competition, investmentflows, economies of scale, technology transfer, and improved productivity. (Sheer 1981, p.47; El-Agra 1988; De Melo and Panagariya1993, p.17; Fernandez 1997, p.6; Lawrence 1997, p.19-24; Burfisher, Robinson, and Thierfelder 2003, p.3; UNCTAD 2007, p.54).Bhagwati (1993, p.28-31) referred to the same processes as "first regionalism"and "second regionalism".Goldstein (2002, p.11) arguesthat integration agreements are now about much more than merely reducing tariffs and quotas.

Lawrence (1997, p.19) made a simple comparison between old and new regionalism as in the following table.

Table 2.Regionalism: The old and the new

Old Regionalism New Regionalism

Import substitution Export orientationPlanned allocation of resources Market allocation of resourcesLed by governments Led by private firmsMainly industrial products All goods, services and investment

Source:Lawrence (1997, p.19)

Current forces driving integration

It is now obvious that new regional integration theories have emerged with the changing of economic environments and conditions.Lawrence (1997, p.18) pointed out that the forces driving the current integration developments differ radically from those driving previouswaves of regionalism. Issues of private sector participation, competition, foreign direct investment (FDI), and the increased importance ofservices all contributed to changing the scenes from those that prevailed during the Viner and following near period.

Economies of Scale

Corden (1972, p.465) first introduced the concept of economies of scale into the customs union theory. Economies of scale reductions ininputs per unit of output result from the efficient use of factors of production at large outputs. Balassa and Stoutjesdijk (1975, p.38) arguethat small markets increase costs, limit the extent of product specialization, reduce competition, and lessen the incentives for technologicalimprovements.

Investment creation and Investment diversion

Studies by Baldwin, Forslid, and Haaland (1995), and Dunning and Robson (1998) introduced the concepts of investment creation anddiversion as an extension of Viner's theory. Studies by and Baldwin, Forslid, and Haaland (1995), and Dee and Gali (2003), Kalotay (2007)applied these concepts to the case of the European Union.

When investment barriers are removed, investment creation according to Dee and Gali (2003, p.7) is the case when production ismoved from a high-cost source to a lower-cost source in the union. Investment diversion occurs when production is moved from a low-costnon-member country to a higher-cost member country of the union as a result of the PTA.

Increased importance of Private sector participation

An interesting fact according to Lawrence (1997, p.19), is that the current wave of regionalism or integration is actually supported byprivate firms. This can be seen from the case of the NAFTA, where the US Chamber of Commerce in the USA, and the CanadianManufacturers Association in Canada were the main supporters of the conclusion of this trade agreement.

Increased importance of Services

The world services sector has been booming both in terms of contribution to world trade and world GDP. As figure (1) shows, the share ofthe services sector to world GDP has been steadily increasing over the last three decades from nearly 50% of world GDP in the 1970s tonearly 70% in the 2000s. Likewise, services exports have dramatically increased from nearly $185 bn in 1975 to nearly $2,768 bn in 2006.


8/23


140

Figure 1. The Importance of the Services Sector to Trade and GDP (1971-2006)

Source: WDI online

Moreover, Lawrence (1997, p.20) argued that FDI in services has been growing more rapidly than in goods. As manufacturingfirms move to other countries, other services firms providing complementary inputs and services such as banking, advertising, andtransporting also accompany them. The rising importance of the services sector has significantly changed the world economic environmentand created new incentives of integration.

Increased importance of Foreign Direct Investment

Direct investment according to Ethier (1998, p.1150) is nowadays much more prominent, and is growing faster than trade. Foreign directinvestments are nowadays considered a major incentive of integration between countries, especially if integration is between developingcountries, because of its link with two important variables; exports and economic growth.

Lawrence (1997, p.19-20) argued that foreign investment and exports are increasingly becoming complementary activities, andthat the relation between them may work in both ways. Some argue that FDI can lead to better economic integration benefits in terms oftrade expansion, while others argue that economic integration can lead to more FDI flows to the region. Regarding the former, Shams(2003, p.3) claimed that FDI can boost market-driven integration schemes, as they create more scope for mutual trade and increase thedegree of market interpenetration. Regarding the latter, Inotai (1991, p.38) claimed that the formation of an economic integration scheme

by itself may lead to increased FDI flows to the integrated region as a whole.

Regarding the link between FDI and economic growth, studies have proved that increased investments and more rapidtechnological change as a result of integration may significantly contribute to the economic growth of member countries. This argumentcan be especially important to the case of developing countries, where FDI can be thought of as a route through which developing countriescan modernize (Schiff and Winters 1998, p.180). For example, Brada and Mendez (1998, p.163) concluded that these dynamic effects ofthe free trade area between the countries of Latin America (LAFTA) led to an increase of 1.09% in these countries GNP in 1977.

Conclusion of the New (Dynamic) Theories of Economic Integration

First of all, we have seen that whether it is called old and new regionalism, or first wave and second wave of regionalism, they all refer tostatic and dynamic effects of economic integration. Current Studies have concluded that dynamic effects of economic integration haverecently emerged as a result of recent changes that are shaping the world economy today. However, some analysts have argued thateconomic integration theories - especially those of the Viner period - may be irrelevant to the case of developing countries. This issue is the

primary concern of the following section.

3. Theories of Economic Integration for Developing Countries

Balassa (1965, p.16) argued that the theoretical literature of economic integration has dealt almost exclusively with customs union amongindustrialized countries. These countries problems are not of economic development, but with relative marginal adjustments in productionand consumption patterns. A number of studies have, consequently, repudiated the standard customs union theory, and rejected thetraditional trade creation, trade diversion analysis. Studies by Meier (1960), Abdel Jaber (1971, p.256), and Andic, Andic and Dosser(1971, p.25) have argued that the Viner analysis of economic integration has limited relevance, if any, to the case of developing countries.

Therefore, new theories of economic integration adjusted to the special needs of developing countries have emerged followingthe Viner period. Studies most cited in the literature include Allen (1961), Brown (1961), Bhambri (1962), El-Naggar (1964), Cooper andMassell (1965b), Mikesell (1965), Chou (1967), Kahnert et al (1969), and Andic, Andic and Dosser (1971).

In short, Makower and Morton (1953, p.33) and Abdel Jaber (1971, p.260) argued that traditional economic integration theoryhas attempted to answer the two following questions:


9/23



141

1. What is the effect of economic integration on world welfare?

2. What are the factors that affect the desirability of economic integration?

From a developing country point of view, we will discuss the limitations of the answer to the first question in sub-section one,and the limitations of the answer to the second question in sub-section two. Sub-section three will stress the importance of other factorsaffecting the desirability of economic integration between developing countries.

3.2. Limitations of the Production effects

Mikesell (1965, p.205-229) argued that although developments made by Lipsey (1957, p.40; and 1960, p.504) to the traditional theory ofeconomic integration in the sense that production effects are not sufficient to judge the welfare impact of economic integration, there arefurther limitations to this analysis if one looks at it from a developing country perspective.

Employment and productivity effects

It is established that in most developing countries, there exists a situation of generally low productivity, plus mounting unemployment.Therefore, if trade diversion occurs and moves labor from low-productive to high-productive sectors or activities, it will increase welfare.In the case of unemployment, the gain in welfare will be more obvious (Demas 1965, p.87, Sakamoto 1969, p.283). Therefore, according toAbdel Jaber (1971, p.259), welfare impacts of economic integration among developing countries should not be confined to production andconsumption effects only, but should also include employment, productivity, and income effects.

The need for a development perspective

A number of studies have argued that economic integration in the case of developing countries should be treated as an approach toeconomic development, not as a tariff issue (Andic, Andic and Dosser 1971, p.25; Abdel Jaber 1971, p.256; Balassa and Stoutjesdijk 1975,

p.45; Axline 1977, p.83; and Khazeh and Clark 1990, p.317). Furthermore, Robertson (1970, p.771) in his review of Kahnert et al (1969)argued that integration theory has been merely concerned with the benefits of better resource allocation, whereas development is concernedwith the benefits of faster growth in the long run and the employment of idle or under-utilized resources.

Shams (2003, p.31) presented a case study of the Southern African Development Community (SADC) and concluded that theutmost purpose of regional integration in that region is the economic development of its members as its name reveals, rather than formingdifferent degrees of PTAs. Member countries of SADC since its origins in the 1970s have been focusing their efforts on implementingcertain development projects such as alleviating poverty, promoting health and education, and combating HIV/AIDS, rather than reducingtariffs and promoting intra-regional trade.

Changing pattern of trade with developed countries

Mikesell (1965, p.209) made another important point. He argued that most imports of developing countries from developed countries arecapital goods. From a dynamic point of view, integration among developing countries will require larger investments. Since an alreadylarge part of this investment is imported from developed countries as capital goods, the level of imports of integrated developing countriesmight then increase. Mikesell (1965, p.209) concluded that the long-run objective of integration between developing countries should not

be to decrease trade with the rest of the world, but rather to change its pattern over time.

Another way of looking at this issue is based on the assumption that an important factor of the determinants of the level of actualimports of most developing countries is their level or availability of foreign exchange. Therefore, according to Kitamura (1966, p.50),Mikesell (1965, p.209), and Sakamoto (1969, p.293) if trade diversion occurs as a result of integration between developing countries inconsumer goods, this would release more foreign exchange to be directed to more imports of capital goods from the outside (developed)world. Once again, on balance the volume of trade with the outside world may not change, or in fact it may increase, but the importantthing is that the pattern of this trade will change.

The importance of being unimportant

Kreinin (1964, p.193-194) claimed that potential gains from economic integration are especially pronounced in small and medium-sizedmember countries. This can be explained by the fact that if integration or trade in general takes place between a small country and a largerone whether they are developing or developed countries - the small country will tend to gain more because its exports will now bedemanded by a larger pool of consumers. This will be especially relevant to the case of a small developing country if it integrates with alarger developed country with higher purchasing power.

Benefits of trade diversion

A number of studies have claimed that trade diversion may actually be beneficial in the case of developing countries (Bhambri 1962, p.245;Demas 1965, p.87-88; Chou 1967, p.354; and Sakamoto 1969, p.297). First, it will enlarge the size of the market and help reduce costs dueto economies of scale. Second, import substitution over a wider area will enable the integrated region as a whole to spend higher

proportions of its foreign exchange on imports of capital goods, therefore contributing to increased levels of investment and economic


10/23


142

growth (Linder 1966, p.39, Sakamoto 1969, p.283, and Axline 1977, p.85). Another argument for trade diversion is that it will allowconsumers to purchase imports at lower prices after the removal of tariffs, thus increasing consumer surplus. However, as Elkan (1975,

p.59) argues, this has to be weighed against the tariff revenue lost in this process. This may be of special importance to developingcountries, as most of them rely on tariff revenue as a principle source of overall government revenue.

Efficient Trade Diversion

Linder (1966) and Sakamoto (1969, p.297) introduced an interesting term; that is efficient trade diversion. They argue that if economicintegration between a group of developing countries occurs and leads to trade diversion, it must not be welfare reducing. The shift inproduction will occur from an efficient developed country (third country) to the relatively efficient developing country member within thenew union, putting aside the expected employment and income effects.

Protection for Industrial development

Viner (1950, p.41-49) and Meyer (1956, p.330) have argued that a customs union, or more generally economic integration, may besometimes regarded as a step towards free trade, or sometimes a step towards more protection. Some studies dealing with the case ofdeveloping countries in particular have argued that protection may be beneficial. For example, Cooper and Masselll (1965b, p.462) andSakamoto (1969, p.304) claimed that the principle objective of any integration scheme among developing countries should be to fosterindustrial development, which can be economically achieved through protection. This is because protection resulting from economicintegration is, according to Sakamoto (1969, p.283-284), Axline (1977, p.84) and Andic, Andic, and Dosser (1971, p.16), the equivalent ofimport substitution on a wider scale, which is an important tool of industrial development. Cooper and Masselll (1965b, p.468) concludedthat the evaluation of the impact of a customs union on a member country must take into account not only the changes in each country'snational income, but also the changes in each country's size of industrial sector.

Although the analysis of Cooper and Masselll (1965b) has been based on the assumption that integration takes place between aNorth developed country and a South developing country, one can still make conclusions relevant to the case of two developing countriesentering a union. If two developing countries enter a union and trade diversion occurs in industrial products, welfare in terms ofconsumption will increase as prices will decrease after the tariff removal. While, welfare in terms of production will decrease welfaremeaning the efficient use of resources - because production is now shifted towards one of the two inefficient developing countries in theunion compared to the outside efficient world. However, this trade diversion in industrial products, plus a common external tariff that

protects their domestic industries, may lead to the development of the industrial sectors in the two countries. This case will be especiallybeneficial if the two developing countries are complementary, because this will mean that each country will expand its industrial productionto supply the other's market (inferred from Cooper and Masselll 1965b, p.475).

An important note, however, has to be made in this regard. Hansen (1969, p.257) and Elkan (1975, p.59-68) argued that the fruitsof industrial development pertaining to the developing countries as a result of integration may be unequally distributed among membercountries of the union. Elkan (1975, p.59) calls this "backwash", where a large proportion of the economic benefits of integration areconcentrated in one or few member countries. Elkan (1975, p.68), and Axline (1977, p.86-87) argue that the economically weaker andgeographically remote member countries tend to benefit less than their counterparts in the union.

The Training Ground Theory

The above argument that favors protection for the sake of stimulating industrial development in economic integration schemes ofdeveloping countries is more thoroughly discussed or theorized in what is called the "Training Ground Theory". This theory, according toHeimenz and Langhammer (1990, p.4), Inotai (1991, p.6-7), and Inotai (1997, p.529), depends on the hypothesis that during the first phaseof integration between developing countries, international competitiveness of developing countries can be gradually improved by relyingon the regional market in the first phase of industrialization. Free trade among member countries plus the usually high common externaltariff on imports from the outside world should provide temporary protection of infant industries as well as a sufficient large market forfuture industrial development. This process - termed "import-substituting industrialization" by Rueda-Junquera (2006, p.4) - will securesufficient time for the development of the industrial sectors of the member developing countries. Entrance or openness to world marketsmay then come at a later stage after developing countries have reached a reasonable degree of efficiency and technical development. Thus,economic integration among developing countries may be considered as a transitional period or a stepping stone towards open competitionwith the outside world after a short period of learning or training; hence the name training ground theory.

Despite the theoretical soundness of this theory, a study by Inotai (1991, p.7) presented some arguments against its actualimplementation. This study argued that (a) developing regional markets created were in many cases not large enough to allow industrialdevelopment or economy of scale advantages, (b) little or no actual structural upgrading took place as a consequence of the graduallearning process, and (c) there are wide differences in the pattern and nature of demand and tastes of extra versus intra-regional trade.Furthermore, there is no guarantee that developing countries will eventually commit themselves to opening or liberalizing trade with therest of the world. Eventually, protection instead of being temporary may actually become permanent.

The Static vs. Dynamic approach

A number of studies have suggested that emphasis should be put on dynamic rather than static effects in evaluating the desirability ofeconomic integration among developing countries (Sakamoto 1969, p.283-284; Abdel Jaber 1971, p.256; Axline 1977, p.85; and Khazehand Clark 1990, p.318). Moreover, Rueda-Junquera (2006, p.3-4) argues that the traditional theory of economic integration, centered on the


11/23



143

static effects of resource allocation, suggest that there is little scope of benefits accruing to developing countries from economic integration.The paper therefore concludes that the basic rationale for economic integration among developing countries should be a dynamic one.

Furthermore, Abdel Jaber (1971, 264-265) argued that the production effects of the simple static analysis are concerned withchanges in the production mix on a givenproduction possibility frontier (PPF). Changes in production of goods being traded in the unionwill occur at a higher or lower point on the PPF. Demas (1965, p.85-86) and Abdel Jaber (1971, p.265) claimed that the traditionaleconomic integration theory relies heavily on the neo-classical assumptions of full employment, perfect competition, constant returns to

scale, and perfect mobility of factors of production, therefore its analysis was confined to the study of static effects of economic integration.Meanwhile, Kitamura (1966, p.55-56) and Mikesell (1965, p.206), according to Abdel Jaber (1971, p.265), concluded that dynamic effectsof economic integration are far more important than static effects. Dynamic effects of economic integration may lead to higher rates ofgrowth and exploitation of unused economic capacities, which in turn may lead to shifting the PPF itself. Obviously, larger gains ofintegration will be achieved if the whole PPF is shifted outwards, rather than movements along the PPF itself.

An obvious drawback, however, of the dynamic approach in comparison to the static approach of estimating the welfare effects ofeconomic integration is that no reliable method exists to quantify dynamic effects, unlike static effects.

Economies of Scale

Developing countries in general are known to be specialized in primary products. Abdel Jaber (1971, p.256-257) argued that there's nothingwrong with specialization in primary products, if the economic surplus from the primary sector could be redistributed or reinvested

productively to other sectors. However, as these assumptions are far from reality, developing countries have advocated a policy ofdiversification and import substitution to different extents in an attempt to accelerate economic growth. However, according to Demas

(1965, p.36), balanced growth can be achieved by small developing countries by increasing the size of the market, benefiting fromeconomies of scale, and expanding their inter-industry transactions. Demas (1965, p.36), as reviewed by Villamil (1966, p.213) andYotopoulos (1967, p.246), therefore argued that economic development can be attained to developing countries through economicintegration. A study by Pearson and Ingram (1980, p.1006-1007) on the gains from industrial integration between Ghana and the IvoryCoast reaffirms this conclusion.

International competitiveness

We have argued that developing countries, in the past, have pursued economic integration based on arguments such as the benefits of tradediversion, the benefits of import-substituting industrialization, and the training ground theory. Then, with the introduction of the conceptsof dynamic effects of integration, developing countries started to base their arguments for integration on issues like economies of scale andinvestment creation. Nowadays, new initiatives of economic integration between developing countries, according to Rueda-Junquera (2006,

p.8), go beyond these previous arguments. Most developing countries are now adopting trade liberalization and deregulation policies, aspart of their overall stabilization and adjustment programs as agreed with international organizations. This recent approach aims at makingeconomic integration policies compatible with, and complementary to, other policies to enhance international competitiveness in general.Therefore, developing countries are now looking at economic integration schemes as an instrument for a more competitive insertion into

the global economy.

3.3. Limitations of the Factors affecting the desirability of Economic Integration

Traditional economic integration theory has depended on a number of factors to reach the conclusion that net static effects determine thewelfare impacts of integration. Based on these factors, according to Abdel Jaber (1971, p.261), some generalizations about the desirabilityof economic integration have been concluded.

Competitiveness and Complementarity

We recall that Viner (1950) and Lipsey (1960, p.499) suggested that more benefits of economic integration will accrue to competitivecountries (countries producing similar products) than to complementary countries (countries producing dissimilar products). Makower andMorton (1961, p.35) added that these gains of integration will be larger the larger the cost differences of producing the same good in the

potential member countries of a union.

This analysis tends to be in favor of developing countries, as most developing countries specialize in exports of primary products,therefore developing countries may be said to be competitive in the Vinerian way. Although this is true, the fact that most of these exportsare targeted at developed country markets hinders the benefits of economic integration between developing countries because it may notactually expand their levels of intra-trade (El-Naggar 1964, p.13-14). However, as argued by Abdel Jaber (1971, p.261), the category of

primary products itself is too large, and once disaggregated, potential benefits may arise. Therefore, Balassa (1965, p.25) argued that theprevious understanding of the criterion of competitiveness and complementarity is not at all relevant to the case of developing countries. Infact, Mikesell (1965, p.212) claimed that developing countries should aim at reaching a substantial degree of complementarity betweenthem.

More recently, papers like Heimenz and Langhammer (1990, p.68), Inotai (1991, p.5-6), and Shams (2003, p.2) have continued toargue that complementarity or dissimilarity of economic structures would be better to the case of economic integration among developingcountries. Greenway and Milner (1990, p.59), for example, argue that one significant problem of the poor trade and integration


12/23


144

performance between South-South countries is that they are at comparable stages of development and therefore have comparableproduction structures. A union among similar (competitive) countries assumes that trade will come from intra-industry specialization. Suchtrade expansion has been evident in the case of developed industrialized countries, where market size and incomes may support suchspecialization. However, this is obviously less possible in the case of smaller poorer markets that characterize developing country markets.Therefore, a union among dissimilar (complementary) countries is encouraged.

Size of the union

Traditional theory suggests that the bigger the size of the countries entering the union, the larger the benefits of economic integration.Abdel Jaber (1971, p.262) argues that if we take GNP as a measure of economic size, developing countries' gains from integration willdefinitely be small or even negligible. However, as Balassa (1961, p.38) argues the gains of economic integration do not only depend on thesize of the union, but also on the rate at which it increases. And since most developing countries are growing at higher rates than alreadydeveloped countries, developing countries can still benefit largely from integration based on this criterion. Furthermore, if we take the sizeof the union to mean population size, developing countries will surely benefit from integration as they are usually over populated.

Proportion of trade with member countries

As we have previously shown in section two of this paper, Lipsey (1960, p.508-509) argued that a customs union will more likely producewelfare gains the higher is the proportion of trade with its partner in the union, and the lower the proportion with the rest of the world. It isestablished that trade between developing countries over the years has always been rather small in comparison to trade between developedcountries, implying that welfare gains of economic integration between developing countries will tend to be small.

However, studies by Balassa (1965, p.32-34), Bhambri (1962, p.237-238), and Abdel Jaber (1971, p.263) argue that this

implication should not be taken as given. These studies list several factors that limit trade between developing countries, and claim that ifthese obstacles are removed, trade is likely to increase between developing countries entering a trade agreement. These factors include (a)low level of economic development, (b) inadequate transport facilities, (c) foreign exchange controls and other import restrictions, (d)inadequate marketing, and (e) absence of standardized specifications.

The setting of growing regional trade as a target

It is widely agreed that the best indicator of a successful economic integration agreement is the growing level or share of intra or inter-regional trade to total trade of the member countries. Although this is an important aspect of integration, Inotai (1991, p.10) argues that itshould not be the only target. Other targets such as joint industrial development and establishment of infrastructural links are of equalimportance. Furthermore, growing regional trade may actually be the result of trade diversion from other more efficient, more competitiveexternal countries. Therefore, growing regional trade can be seen as a positive development only if it is accompanied by improvements inits overall competitiveness in world markets.

3.4. Other factors affecting the desirability of Economic Integration

This sub-section aims at identifying factors that have been cited in the traditional economic integration theory, and are of particularimportance to the case of developing countries. Factors that need special elaboration include initial tariff rates, volume of foreign trade as a

percentage of GDP, transport costs, coordination of macro-economic policies, and the package approach.

Initial tariff rates

As we can recall, Meade (1955) and Hillmann (1957, p.492) have suggested that the higher the initial tariff rates between countries enteringa customs union, the larger are the expected gains of economic integration between these countries. This point is of special relevance to thecase of developing countries, because initial domestic tariffs of most developing countries are quite high, either due to revenue or

protection purposes.

Volume of Foreign trade as a percentage of GDP

As we have previously shown in section two of this paper, Lipsey (1960, p.508-509) argued that a customs union will more likely producewelfare gains, the lower is the percentage of foreign trade to the member countries' GDP. This factor is especially important for developingcountries because, as fig. (2) shows, trade as a percentage of GDP of low income groups has always been lower than that of high incomecountry groups, although this ratio has increased in the past few years.

This observation, however, has to be taken with caution because both middle income country groups and LDCs have tradepercentages of GDP higher than that of the high income group. We can therefore conclude that this criterion has no definite finalimplication, as sub-groups within developing countries may have higher or lower ratios of trade to GDP than do high income groups.


13/23



145

Figure 2. Trade as a percentage of GDP in selected country groups

Source: WDI Online

Distance or Transport costs

Transport costs tend to diminish the potential gains from trade integration between any set of countries. Moreover, Clark and Stanley(1999, p.91) have concluded that distance negatively influences intra-industry trade in particular. This is especially important for the case ofdeveloping countries entering into trade agreements with each other for at least two reasons. The first is that the Linder hypothesis as

previously discussed states that countries with similar per capita incomes tend to depend on intra-industry trade. The second is thattransport facilities in general are relatively poor, or even absent. However, some transport infrastructure for trade purposes may exist indeveloping countries, but as Bhambri (1962, p.338) argues these facilities were originally designed to encourage the transport of exports of

primary products of developing countries to the industrialized countries of Europe and North America. Thus, as Balassa (1965, p.31) arguestransport costs between two neighboring developing countries may be actually higher than between one of them and a remote developedcountry. This point needs to be taken with careful consideration when discussing economic integration between developing countries, andthat's why Abdel Jaber (1971, p.262) suggests that the issue of improvement of existing transport facilities should be included and

emphasized in economic integration schemes and preparations between developing countries.

Coordinating macroeconomic policies

A study by Shams (2003, p.9-10) argued that even if all trade prerequisites were present at the conclusion of an economic integrationagreement between developing countries, differences in macroeconomic policies in general plus the lack of coordination between membercountries may be the reason behind limited trade growth between member countries. The study cites the example of MERCOSUR wherethe two most important countries, Brazil and Argentina, lacked coordination at the macroeconomic policy level, especially in exchange rate

policy. Therefore, we can see that although Brazil and Argentina satisfied a number of pre-integration desirability factors such as lowtransport costs and large market size, they still needed better coordination of macroeconomic policies to achieve full trade potential ofintegration. Shams (2003, p.11) therefore concludes that MERCOSUR needs to formulate a common exchange rate policy, in order to

prevent large swings in exchange rates and subsequent lobbying for protection from import-sensitive sectors.

It is worth mentioning that the issue of policy coordination between member countries of a union dates back to Kahnert et al(1969) and Hirschman (1971, p.22). Hirschman (1971, p.22), for example, argued that in order that trade agreements be durable,

participating countries should try to uniform their internal monetary and foreign exchange policies. He further argues that such adevelopment might actually be more important in promoting trade between the member countries than the customs preferences themselves.De Melo, Panagariya, and Rodrik (1993, p. 176-177) further argue that such required coordination is not confined to these policies alone,

but can be extended to include industrial policies, environmental policies, and social and welfare policies as well.

Lorenz (1992, p.86) stressed the point that harmonization of policies among member countries of a union may definitely harmsome members more than others, He, therefore, stresses the importance of adjustment and compensating policies in this regard.

The Package Approach

According to Balassa and Stoutjesdijk (1975, p.53), this approach specifically and explicitly aims at facilitating the integration process andenhancing the stability of an integration agreement by assuring that each member country is responsible for a single integration project


14/23


146

from a package of such projects. Integration projects may include transportation, communication, public utilities, education and research,agriculture, or mining and industry.

An important condition for the successful application of the package approach, however, is that comprehensive informationregarding the distribution of benefits and costs of each project on each member country should be available. Balassa and Stoutjesdijk (1975,

p.54) argue that although this approach may seem plausible, problems such as financing, monitoring and controlling may arise.

4. The Political Determinants of Economic Integration

The study of the political determinants or incentives of economic integration is indispensable. Allen (1963, p.450) has argued that Balassa's(1961) pioneering book on the theory of economic integration has ignored the political, and other non-economic, aspects of integration,despite its obvious concreteness of the subject. One cannot deny that both elements of integration - economic and political - are closelyconnected and interrelated. Ezenwe (1978, p.158) argued that economic integration must be seen as part of a process in which the finaloutcome will be essentially determined by political factors. Grossman and Helpman (1994, p.833) said that "politics" is the answer to thequestion of why free trade is so often preached but rarely practiced. Allen (1963, p.450) further says that:

". It is not really possible to separate the economic from the political elements of integration. Economic losses and gains from

integration are in some cases systematically related to political factors".quoted from Allen (1963, p.450)

Political officials are the ones who eventually sign economic integration agreements. Therefore, political motives and incentivesare vital determinants to their conclusion. Some studies, for example World Bank (2000, p.11) have argued that the purpose of integration

is often political, and that the economic consequences good or bad are the side effects of the political decision. This section will discusspolitical factors or determinants of economic integration of general importance in sub-section one. Sub-section two will concentrate on thepolitical factors of specific importance to developing countries. Finally, sub-section three will relate the political and economicdeterminants of economic integration together.

4.1. Political factors of General Importance

A number of studies have identified a number of factors that can act as political incentives or disincentives of economic integration (Haas1958; Inotai 1991; Moravcsik 1991; Morrow, Siverson, and Tabares 1998; and World Bank 2000). This sub-section will discuss the

political incentives of economic integration that are of general importance to all countries.

International Negotiations

Heimenz and Langhammer (1990, p.9) argued that one of the possible gains of integration is the ability of the member countries to extractbetter terms if they bargain together in international negotiations. This same view of increased bargaining power as an incentive to

integration is shared by Kitamura (1966), Inotai (1991, p.37), De Melo, Panagariya, and Rodrik (1993, p. 174-175), Fernandez (1997, p.22-23), World Bank (2000, p.17-21), and Schiff and Winters (2003, p.180-183). Recent Studies have argued that Western European countries,for example, have been able to cut out better deals with the USA in their position as members of the European Community, than wouldhave been possible if they had dealt individually with the USA. Likewise, the formation of the Organization of Petroleum ExportingCountries (OPEC) managed to control oil supply and prices in international negotiations.

Interest group support

Numerous studies have argued that public officials may enter into t rade agreements to gain support of certain interest groups/lobbies,whether export-oriented or import-competing sectors, or others such as certain labor unions or those responsible for fiscal sustainabilityfearing import duty losses (Axline 1977, p.89; Lorenz 1992, p.86; Grossman and Helpman 1994, p.833 and 1995, p.670; Levy 1997,

p.506); Krishna 1998, p.227; Maggi and Rodriguez-Clare 1998, p.577; Schiff and Winters 1998, p.188; Mansfield and Milner 1999, p.603;World Bank 2000, p.26-27; and Albertin 2008, p.18).

However, as it is almost impossible for a single trade agreement to satisfy all politically potent sectors or players, Grossman andHelpman (1995, p.680-687) argue that officials may allow for extended periods of adjustment or even exclude sensitive sectors from a trade

agreement in order to successfully implement it. Here we can cite the example of the European Community excluding agriculture, and theCaribbean Basin Initiative excluding sugar.

A number of studies have considered producers as an interest group as having more political weight or power than consumergroups (Grossman and Helpman 1995, p.673; Krishna 1998, p.229; World Bank 2000, p.26-27; and Ornelas 2005, p.1476-1477).According to this argument, one can make two points. First, a PTA in general will be favored politically than free non-preferential trade.This is because it will limit producers' general exposure to competition maintaining high external protection from the rest of the world(Grossman and Helpman 1995, p.673-680; Krishna 1998, p.229; and World Bank 2000, p.27). Second, a PTA that is trade-diverting will befavored politically than a PTA that is trade-creating (Krishna 1998, p.244). This is because producers will be granted a bigger chance ofachieving gains or profits. If producers in a given country were originally producing at low costs (efficient) before integration, then theywill continue to produce and sell to their partner country after integration. But if they were producing at high costs (inefficient) and tradediversion occurs away from the rest of the world, the tariff reduction after integration will allow them to produce and sell to their partner


15/23



147

country, gaining a new market share which was previously not there. It follows that the greater the trade diversion, the more likely it is thatpoliticians will gain support from interest groups such as producers (Krishna, p.229).

An important note, however, needs to be made and that is that politicians must strike a balance between accommodating interestgroups' support and promoting the economic welfare of their countries. Gaining support of certain lobbies although beneficial to politicians,may not be beneficial to the country's welfare at large.

Regional Leadership

Many articles have emphasized the importance of political leadership in any economic integration initiative (Milne 1974, p.293-294;Moravcsik 1991, p.23-24). Rueda-Junquera (2006, p.14) argued that the non-clear existence of a regional leader in any regional integrationscheme may be a setback to the whole integration effort. He cites an example of the case of the Central American Common Market, wherethe lack of a regional leader has been a main reason behind its weak implementation.

Political Regimes or Institutions

It is quite obvious that countries with different political regimes and institutions will probably face more difficulties in forming effectivePTAs. Mansfield and Milner (1999, p.607) claim that in order for a PTA to succeed, substantial institutional heterogeneity is needed. Thisis why, according to the authors, the European Community Act has succeeded relative to the integration efforts in Asia where there exists awide variation in its countries political regimes. In this regard, a study by Axline (1977, 103-104) suggested that if a large group ofcountries established an integration scheme that failed to succeed, a "new start" can include more intensive integration on a less intensivescale, whereby a smaller group of the former members of the unsuccessful integration scheme may launch a successful integration scheme

of their own. So, if countries in Asia as a whole did not succeed to integrate, a sub-group of Asian countries may stand a better chance ofsuccess.

Legal and Institutional System

A study by Lawrence (1997, p.22-24) introduced the concepts of " shallow integration" and "deep integration". According to this study,deeper integration is currently becoming more important than simple shallow integration. Shallow integration means that after a tradeagreement is concluded, the only thing changed is the tariff or what he termed "border barriers". However, once tariffs are removed, therestill remain complex problems between the union countries due to different regulatory policies. Deep integration, therefore, refers to theneed to further change "other barriers" such as reconciling different national practices with common rules and supra-nationalimplementation mechanisms. These national practices according to Lawrence (1997, p.24), De Rosa (1998, p.47), Ethier (1998, p.1152),Panagariya (1998, p.43), and Pomfret (2005, p.8-10) may include competition policy, product standards, tax policy, administrative

procedures, investment policy, and labor or environmental standards. De Melo and Panagariya (1993, p.17) have described this "secondwave of regionalization"as having an additional focus on the coordination of the whole legal and institutional setup in member countries ofa union.

Hirschman (1971, p.22) made an important note when he argued that the prospect of less freedom in implementation of suchinternal policies is precisely what makes governments so skittish about entering into effective trade integration agreements.

This issue of harmonizing domestic policies will be especially important if member countries in the union are of different levelsof development. Panagariya (1998, p.44) argues that the agenda for deep integration is likely to be determined by rich, developed countriesin the union. And it is the smaller, developing countries that will have to adjust their standards to those of the developing countries,regardless of whether these are appropriate to their conditions.

Political Commitment

Economic integration schemes require strong political commitment on the part of member countries to be able to advance to commonobjectives. Rueda-Junquera (2006, p.9) claims that the strong and sustained political commitment of the member countries of the EuropeanUnion was the driving force behind its successful evolution. Lack of political commitment, according to Rueda-Junquera (2006, p.14), may

be reflected in governments not complying with commitments signed in the integration agreement, for example not abiding with tariffreductions, or removing certain sensitive goods or services from the schedule of commitments, or imposing non-tariff restrictions.

Lack of political commitment to the successful conclusion of any integration agreement is an obvious reason of why manyintegration schemes have not reached their full potential. Shams (2003, p.16) argues that there are generally two explanations for thissituation. The first is the different political ideologies of member countries as well as their different external alliances. The secondexplanation is the question of the distribution of gains of integration. This point was originally provided by Hansen (1969, p.257-263). If

potential gains of integration are unequally distributed and if an adequate compensation mechanism is absent, member countries will notencourage integration schemes that threaten their sovereignty.

Competitiveness and Complementarity

We have used the same sub-title when we previously discussed the factors affecting economic integration between countries in general andin developing countries as well. This time we are talking about political complementarity and competitiveness. Haas and Schmitter (1964,


16/23


148

p.712) argued that complementarity between political elites is an essential factor affecting the success of any economic integrationinitiative. Corresponding political groups, for example military men and labor leaders, should think alike and share similar values. In otherwords, they should be complementary in their ideals not competitive.

Integration for Security

Study by the World Bank (2000, p.12-16), and Schiff and Winters (2003, p.168-174) argued that many leading economic integration

schemes were originally created to encourage intra-regional security. These studies cite the example of the EU, MERCOSUR, and ASEANeconomic groups. It is argued that increasing trade as a result of integration reduces risks of internal conflict, as cross-national traderelations and mutual interests are established. Furthermore, Shams (2003, p.15) also argued that the treaty establishing the EconomicCommunity of West African States (ECOWAS) included principles on political cooperation and maintain regional peace and security. Theauthor claimed that this group is behaving more as a security organization, rather than an economic organization.

Likewise, World Bank (2000, p.16-17) argued that countries may also enter into integration agreements for the sake of extra-regional security. Examples are the formation of the Gulf Cooperation Council (GCC) in 1981 in response to the regional hegemony ofIran, Iraq, and Israel (Kechichian 1985, p.853-854), and the formation of ASEAN in response of spreading communism in the region.

Religion

A study by Ali (2005, p.1) argued that religion has played a significant role in shaping political, economic, and cultural characteristics ofcountries. The same study argues that religion has been an important factor in enhancing cooperation and integration at the national andglobal levels. A clear example in this regard is the Protocol on the Preferential Tariff Scheme for TPS-OIC (PRETAS) between the membercountries of the Organization of the Islamic Conference (OIC) comprising all Islamic nations of the world. The incentive behind forming

this agreement is clearly political, as the only criterion that approves a country's membership is the Islamic religion, not any economiccriteria as with other PTAs of the world.

Migration

Schiff and Winters (1998, p.185; and 2003, p.174-175) argue that economic integration agreements between neighboring countries inparticular (regional integration agreements) can reduce the probabilities of illegal border migration and all its associated problems. Themost evident case of this argument is the NAFTA, where one of the most important reasons that led the US to sign this agreement was its

border problems with its less-developed southern neighbor Mexico.

However, as Schiff and Winters (2003, p.175) argue, migration of workers may still take place if the PTA reaches the level of acommon market or economic union where factors become freely mobile between member countries. This is the why the EU required Spainand Portugal to wait for a transitional period of thirteen years before being granted free access to other EU member's labor markets.Likewise, this same concern is perhaps one of the reasons why the EU has so far been reluctant to consider Turkish accession seriously.

International Political Economy

According to Schiff and Winters (1998, p.186-187), the term international political economy describes how individual economies makedecisions about their international relations with other countries in terms of political economy. In terms of economic analysis, Mansfieldand Milner (1999, p.610) claim that allie

theories of economic integrtaion: a survey of the economic and political literature

Documents