International Economics

Li Yumei

Economics & Management School

of Southwest University

International Economics

Chapter 10

Economic Integration: Customs Unions and Free Trade Areas

Organization 10.1 Introduction 10.2 Trade-Creating Customs Unions 10.3 Trade-Diverting Customs Unions 10.4 The Theory of the Second Best and

Other Static Welfare Effects of Customs Unions

10.5 Dynamic Benefits from Customs Unions 10.6 History of Attempts at Economic

Integration Chapter Summary Exercises

10.1 Introduction

This chapter analyzes the economic impact of the formation of regional economic associations (economic integration) on the member nations and on the rest of world

Regional economic associations eliminate tariff and other trade barriers among members but keep them against the outside world

The Theory of Economic Integration

The Theory of Economic Integration The Theory refers to the commercial policy of

discriminatively reducing or eliminating trade

barriers only among the nations joining together. It

includes the preferential trade arrangements to free

trade areas, customs unions, common markets, and

economic unions. Preferential trade agreementsThey provide lower barriers on trade among participating

nations than on trade with non-member nations. It is the loosest

form of economic integration. Such as British Commonwealth

Preference Scheme established in 1932.

The Theory of Economic Integration

A Free Trade AreaIt is the form of economic integration wherein all barriers are

removed on trade among members, but each nation retains its

own barriers to trade with non-members.

Such as European Free Trade Association (EFTA) formed in

1960 (U.K, Austria, Denmark, Norway, Portugal, Sweden, and

Switzerland); North American Free Trade Agreement (NAFTA)

formed in 1993 ( U.S., Canada, Mexico); Southern Common

Market (Mercosur) formed in 1991 ( Argentina, Brazil, Paraguay

and Uguguay)

The Theory of Economic Integration

A Customs UnionIt allows no tariffs or other barriers on trade among members,

and in addition it harmonizes trade policies toward the rest of

the world.

Such as European Union (EU) or European Common Market

formed in 1957 (West Germany, France, Italy, Belgium,

Netherlands and Luxembourg)

A Common MarketIt goes beyond a customs union by allowing the free movement

of labor and capital among member nations.

Such as EU in 1993

The Theory of Economic Integration

An Economic UnionIt goes further by harmonizing or even unifying the monetary

and fiscal policies of member states. It is the most advanced

type of economic integration. Such as EU.

Recent Tendency—Duty-Free Zones or Free Economic Zones

These zones are areas set up to attract foreign investment by

allowing raw materials and intermediate products duty-free.

In this chapter, the main discussion is generally in

terms of customs unions.

10.2 Trade-Creating Customs Unions

Trade Creation Illustration of a Trade-Creating Customs

Union Conclusion

Trade Creation

Take the customs union as the example to analyze

the effects of the economic integration. It has two

kinds of effects: trade creation and trade diversion. Trade CreationIt occurs when some domestic production in a nation that is a

member of the customs union is replaced by lower-cost imports

from another member nation (assuming that all economic

resources are fully employed before and after formation of the

customs union);

It increases the welfare of member nations because it leads to

greater specialization in production based on comparative

advantage.

Illustration of a Trade-Creating Customs Union Figure 10.1

FIGURE 10-1 A Trade-Creating Customs Union.

Illustration of a Trade-Creating Customs Union

Explanation of Figure 10.1 With Tariff, the nation’s production surplus

increases while the consumer surplus decreases, the deadweight loss is the total of protection effect and consumption effect. And it reduces the national welfare;

The formation of a customs union, no tariff, it can increase the national welfare, it is the total of protection effect and consumption effect.

Illustration of a Trade-Creating Customs Union

Theory of A Customs Union Viner, who pioneered the development of the the

ory of customs unions in 1950, concentrated on the production effect of trade creation and ignored the consumption effect;

Meade extended the theory of customs unions in 1955 and was the first consider the consumption effect;

Johnson added the two triangles to obtain the total welfare gain of a customs union.

Conclusion

A trade-creating customs union can increase the national welfare— the trade creation: production welfare and consumption welfare from the comparative advantages

A trade-creating customs union also increases the welfare of non-members because some of the increase in its real income spills over into increased imports from the rest of world

10.3 Trade-Diverting Customs Unions

Trade Diversion Illustration of a Trade-Diverting

Customs Union Conclusion

Trade Diversion Trade Diversion It occurs when lower-cost imports from outside the

customs union are replaced by higher cost imports from a union member

Trade Diversion and Welfare Trade diversion reduces welfare because it shifts

production from more efficient producers outside the customs union to less efficient producers inside the union

Trade Diversion and Resource Allocation Trade diversion worsens the international allocation of

resources and shifts production away from comparative advantage

Trade Diversion

The Effects of a Trade-diverting Customs Union In the end, a trade-diverting customs union results in

both trade creation and trade diversion

Conclusion Whether a trade-diverting customs union can increase or

reduce the welfare of union members, depending on the

relative strength of these two opposing forces While the non-members can be expected to decline

because their economic resources can only be utilized less efficiently than before trade was diverted away from them

Illustration of a Trade-Diverting Customs Union

Figure 10.2

FIGURE 10-2 A Trade-Diverting Customs Union.

Illustration of a Trade-Diverting Customs Union Explanation of Figure 10.2 With free trade, domestic consumption of X is 70

(domestic supply 10X while the imports 60X); With tariff, domestic consumption of X is 50 (domestic

supply 20X while the imports 30X); Form of a trade-diverting customs union, domestic

consumption of X is 60 (domestic supply 15X while the imports from the member 45X)

Static Welfare Effects Within the trade-diverting customs union, the imports are

less than free trade , leading to trade diversion (the loss) Within the trade-diverting customs union, the imports

from members are more than tariff, leading to trade creation (benefit)

Conclusion

A trade-creating customs union leads only to trade creation and un-equivocably increases the welfare of members and non-members

A trade-diverting customs union leads to both trade creation and trade diversion, and can increase or reduce the welfare of members (and will reduce the welfare of the rest of the world)

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

The Theory of the Second Best Conditions More Likely to Lead to

Increased Welfare Other Static Welfare Effects of Customs

Unions Conclusion

The Theory of the Second Best

Take the customs union as the special case of t

he theory of the second best It postulate that when all conditions required to reach ma

ximum social welfare or Pareto optimum cannot be satisfi

ed, trying to satisfy as many of these conditions as possi

ble does not necessarily or usually lead to the second be

st welfare position

Theory: beginning by Viner in 1950, developing by Meade

in 1955, generalizing by Lipsey and Lancaster in 1956

Conditions More Likely to Lead to Increased Welfare

Conditions The higher of the pre-union trade barriers of member

countries, it is more probable that the greater trade creation rather than trade diversion

The lower of the customs union’s barriers on trade with the rest of world, the less likely to costly trade diversion

The more competitive rather than complementary are the economies of member nations, the greater opportunities for specialization in production and trade creation

The closer geographically are the members of the customs union, less transportation costs barriers to trade creation among members

The greater of pre-union trade economic relationship , the greater opportunities for significant gains

Other Static Welfare Effects of Customs Unions

Administrative SavingsIt means the elimination of customs officials, border patrols.

The Improvement in Collective Terms of TradeThis is because a trade-diverting customs leads to the reduction

of its demand for imports and its supply of exports to the rest of

world . It is likely to improve the collective terms of trade

Much More Bargaining PowerSeveral countries act as a single unit in international trade

negotiations. It is more powerful than a single country

Conclusion

Customs Union as a second best to maximize the economic welfare

Customs Union is more likely to lead to the increased welfare: trade creation and trade diversion

Other static effects

10.5 Dynamic Benefits from Customs Unions

Increased Competition

Economies of Scale

Stimulus to Investment

Better Utilization of Economic

Resources

Increased Competition

In the absence of a customs unionProducers are likely (especially those in monopolistic and oligopolistic market ) to sluggish and complacent behind trade barriers With the customs union Producers in each nation must become more efficient to

meet the competition of other producers within the union, merge, or go out of business, reducing the cost of production to the benefit of consumers

The increased level of competition is also likely to stimulate the development and utilization of new technology, reducing the cost of production to the benefit of consumers

Economies of Scale

The Enlarged Market

The formation of a customs union leads to the enlarged

market . It is likely to benefit from the economies of scale.

Such as EU, before the formation of the customs union, some

of several small countries have obtained the economies of

scale through the scale production for domestic consumption

and exports, after the formation EU achieved significant

economies of scale.

Stimulus to Investment

The stimulus to investment to take the advantage of the enlarged market and to meet the increased competition

The formation is likely to spur outsiders to set up production facilities within the customs union to avoid trade barriers imposed on non-union products (called as tariff factories)

Examples for U.S. Investment in EU after 1955 and after 1986

Better Utilization of Economic Resources A customs union is also a common market, it means that the free community wide movement of labor and capital is likely to result in better utilization of the economic resources of the entire community

﹡These dynamic gains from the formation of a customs union are presumed to be much greater than the static gains

﹡ The static and dynamic benefits from the formation of a customs union is the second best solution

10.6 History of Attempts at Economic Integration The European Union The European Free Trade Association U.S. Free Trade Agreements and the

North American Free Trade Attempts at Economic Integration among

Developing Countries Economic Integration in Central and

Eastern Europe and in the Former Soviet Republics

The European Union ( European Community)

History of EU (up to now 27 members) European Common Market : founded in 1957 under the Tr

eaty of Rome by West Germany, France, Italy, Belgium, the Netherlands and Luxembourg came into being on January 1, 1958;

Enlargement of EU

1. till 1995 altogether 15 members including UK, Denmark and Ireland in 1973; Greece in 1981; Spain and Portugal in 1986; Austria, Finland and Sweden in 1995;

2. New 10 EU members May 2004: Cyprus,Czech Republic,Estonia,Hungary,Latvia,Lithuania,Malta,Poland,Slovak Republic,Slovenia

3. New 2 EU members January 2007: Bulgaria, Romania

The European Union ( European Community)

Economic Community

Single European Act in 1992 provided for the removal of all

remaining barriers to the free flow of goods, services, and

resources among members and, in fact, became a single

unified market at the beginning of 1993. The Operation of EU

1. Common value-added tax system;

2. Commission

3. Council of Ministers

4. European Parliament

5. Court of Justice

6. Full Monetary Union

The European Union Main Provisions Common Commercial PolicySince the historic enlargement that took place on 1 May 2004, the 25 Member States of the EU constitute one single market with

a Common Commercial Policy which includes the uniform EU-wide application of Trade Policy Instruments( dispute settlement, trade barriers regulation, anti-dumping, anti-subsidy, safeguard, injurious pricing instrument, trade defense instruments-enlargement, trade defense instruments-small & medium-sized enterprises (SMEs), monitoring of third country commercial defense actions) . On 1 January 2007, the same legislation and measures will be automatically applied also to Bulgaria and Romania, the new EU Member States.

The European Union Common Agricultural Policy (CAP)

It was formed in 1968. EU determines common farm prices, and

then it imposes tariffs so as always to make the imported

agricultural products equal to the high established EU prices. There

are two measures to reach the purpose.

1. Variable Import levies ( 差价税 )

2. Deficiency Payments ( 差额补贴 )

Negative effect: huge agricultural surplus, high storage costs and

subsidized exports

Case Study 9-3 (section 9.3E) and Uruguay Round (section 9.7)

The European Free Trade Association

EFTA It was formed in 1960 by UK, Austria, Denmark, Norway,

Portugal, Sweden, and Switzerland, Finland becoming an

associate member in 1961(full member in 1986). EFTA achieved free trade in industrial goods in 1967, but only a few special provisions were made to reduce barriers on trade in agricultural products

On January 1, 1994, the EFTA joined the EU to form the European Economic Areas (EEA)

U.S. Free Trade Agreements and the North American Free Trade

In September 1985, US negotiated a free trade agreement with Israel. It was the first bilateral trade agreement signed by US

In 1988 a free trade reached with Canada In 1993, North American Free trade Agreement

(NAFTA) agreed among US, Canada and Mexico, which took effect on January 1, 1994

Case Study 10-3 page 336

Attempts at Economic Integration among Developing Countries

Economic Integration in Developing Countries Central American Common Market Latin American Free Trade Association Southern Common Market ( Mercosur) Free Trade Area of Americas (FTAA) Caribbean Free Trade Association East African Economic Community West African Economic Community 19-member Preferential Trade Area of Eastern and Southe

rn Africa Association of Southeast Asian Nations (ASEAN)Case Study 10-4 and 10-5 page 338-339

Economic Integration in Central and Eastern Europe and in the Former Soviet Republics

Council of Mutual Economic Assistance (CMEA or COMECON)

It was formed in 1949 in Soviet Union with the communist bloc

nations in eastern Europe (Bulgaria, Czechoslovakia, East

Germany, Hungary, Poland, and Romania) plus Mongolia

(Cuba, North Korea, and Vietnam jointed later).

Main PurposeIt was to divert trade from Western nations and achieve a

greater degree of self-sufficiency among communist nations

Economic Integration in Central and Eastern Europe and in the Former Soviet Republics Commercial Policy Among the member countries, the state decided and controlled all International transactions through a number

of state trading companies Trade among the member countries conducted on the

basis of bilateral agreements (barter trade and counter trade in which one good was exchanged for another) and bulk purchasing (the agreement of a state trading company to purchase a specified quantity of a commodity of a year or for number of years from a state trading company of another nation )

The End of CMEAAfter the end of 1989, it collapsed all over due to the political changes (Case Study 10-6 page 342)

Chapter Summary

The static and dynamic effects of Economic Integration

trade-creation trade-diversion Economic Integration Organizations Among developed countries Among developing countries Trade Blocs

Exercises

Discussion Problems:

Page 345 to 336 from 1 to 14 questions

Exercises

Additional ReadingThe classic works on the theory of customs unions are: J.Viner, The Customs Union Issue (New York: The Carnegie

Endowment for International Peace, 1953) J.Meade, The Theory of Customs Unions (Amsterdam: North-

Holland, 1955) R.G.Lipsey, “ The Theory of Customs Unions: A general Surv

ey,” Economic Journal, September 1961, pp.498-513, Reprinted in R.E.Caves and H.G.Johnson, Readings in International Economics (Homewood, .: Irwin, 1968), pp.261-278Ⅲ

Internet Materials

http://mkaccdb.edu.int http://www.lib.berkeley.edu/GSSI/eugde.html http://www-tech.mit.edu/Bulletins/Nafta/00.CONTEN

T http://www.embassy.org/uruguay/econ/mercosur http://www.apecsec.org.sg http://www.oecd.org http://www.aseansec.org http://www.citizen.org/trade/nafta/index.cfm