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International Economics 11th Edition

Instructors Manual

CHAPTER 10
ECONOMIC INTEGRATION: CUSTOMS UNIONS AND FREE TRADE AREAS
OUTLINE
10.1 Introduction
10.2 Trade-Creating Customs Unions
10.2A Trade Creation
10.2B Illustration of a Trade-Creating Customs Union
10.3 Trade-Diverting Customs Unions
10.3a Trade Diversion
10.3b Illustration of a Trade-Diverting Customs Union
10.4 The Theory of the Second Best and Other Static Welfare Effects
10.4A The Theory of the Second Best
10.4B Conditions More Likely to Lead to Increased Welfare
10.4C Other Static Welfare Effects of Customs Unions
10.5 Dynamic Benefits of Customs Unions
*10.6 History of Attempts at Economic Integration
10.6A The European Union
Case Study 10-1: Economic Profile of the EU, NAFTA, and Japan
Case Study 10-2: Gains from the Single EU Market
10.6B The European Free Trade Association
10.6C The North American and Other Free Trade Agreements
Case Study 10-3: Mexico's Gains from NAFTA Expectations and Outcome
10.6D Attempts at Economic Integration Among Developing Nations
Case Study 10-4: Economic Profile of Mercosur
Case Study 10-5: Changes in Trade Patterns with Economic Integration 344
10.6E Economic Integration in Central, Eastern Europe & Former Soviet Republics
Appendix:

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A10.1 General Equilibrium Analysis of Static Effects of a Trade-Diverting


Customs Union
A10.2 Regional Trade Agreements Around the World

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Dominick Salvatore

International Economics 11th Edition

Instructors Manual

Key Terms
Economic integration
Preferential trade arrangements
Free-trade area
Customs union
Common market
Economic union
Duty-free zones
Trade creation
Trade diversion
Trade-diverting customs union
Theory of the second best
Tariff factories
European Union (EU)

Variable import levies


European Free Trade Association (EFTA)
Trade deflection
North American Free Trade Agreement (NAFTA)

Southern Common Market (Mercosur)


Council of Mutual Economic Assistance (CMEA)

State trading companies


Bilateral agreements
Bulk purchasing
Central and Eastern European Countries (CEEC)
New Independent States (NIS)
Commonwealth of Independent States (CIS)
Central European Free Trade Association (CEFTA)

Baltic States Free Trade Area (BAFTA)


Lecture Guide:
1.

This is not a core chapter and I would skip it except for section 6. Section 6 is an
important section and can be regarded as an extension of Chapter 9, which is a core
chapter. Section 6 deals with a very important set of current events.

2.

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

3.

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

4.

In a one-year course in international economics, I would cover the entire chapter.


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

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Dominick Salvatore

International Economics 11th Edition

Instructors Manual

Answers to Problems:
1.

If Nation A imposes a 100 percent ad valorem tariff on imports of commodity X


from Nation B and Nation C, Nation A will produce commodity X domestically
because the domestic price of commodity X is $10 as compared with the tariffinclusive price of $16 if Nation A imported commodity X from Nation B and $12
if Nation A imported commodity X from nation C.

2. a)

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


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

b)

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

3.

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


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

4. a)

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


commodity X from Nation B at the price of $8 instead of importing it from
Nation C at the tariff-inclusive price of $9.

b) When Nation A forms a customs union with Nation B this would be a trade-diverting
customs union because it replaces lower-price imports of commodity X of $6 (from
the point of view of Nation A as a whole) with higher priced imports of commodity
X from Nation B at $8.
Specifically, Nation A's importers do not import commodity X from Nation C
because the tariff-inclusive price of commodity X from Nation C is $9 as compared
with the no-tariff price of $8 for imports of commodity X from Nation B. However,
since the government of Nation A collects the $3 tariff per unit on imports of
commodity X from Nation C, the net effective price for imports of commodity X
from Nation C is really $6 for Nation A as a whole.
5.

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

6.

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

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Dominick Salvatore

International Economics 11th Edition

Instructors Manual

7.

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

8.

The welfare loss that Nation 2 receives from joining Nation 1 to form a customs union
is given by C'JJ'+B'HH'- MNH'J'=$11.25 in Figure 10-2 in the text.
Any similar figure and sum of corresponding triangles minus the area of corresponding
rectangle would, of course, be adequate.

9.

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

10.

The net gain from the trade-diverting customs union shown in Figure 1 is given by
C'JJ'+B'HH'-MJ'H'N. As contrasted with the case in Figure 10-2, however, the sum
of the areas of the two triangles (measuring gains) is greater than the area the rectangle
(measuring the loss). Thus, the nation would now gain from the formation of a custom
union. Had we drawn the figure on graph paper, we would have been able to measure
the net gain in monetary terms also.

11.

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


nation (1) the smaller is the relative inefficiency of nation 3 with respect to nation 1,
(2) the higher is the level of the tariff, and (3) the more elastic are Dx and Sx in nation
2. These can seen by comparing Figure 10-2 in the text with Figure 1 on the next page.

12.

See Figure 2. The formation of the customs union has no effect.

13.

NAFTA created much more controversy because the very low wages in Mexico led to
great fears of large job losses in the U. S.

14.

The possible cost to the U.S. from EU92 arose from the increased efficiency and
competitiveness of the E.U. The benefit arose because a more rapid growth in the EU
spills into a greater demand for American products, which benefits the U. S.
App. Compare points B' and H' in Figure 10-3 with the corresponding points in
Figure 3.

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Dominick Salvatore

International Economics 11th Edition

Instructors Manual

Multiple-choice Questions:
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Dominick Salvatore

International Economics 11th Edition

Instructors Manual

1. Which of the following statements is correct?


*a. In a customs union, member nations apply a uniform external tariff
b. in a free-trade area, member nations harmonize their monetary and fiscal policies
c. within a customs union there is unrestricted factor movement
d. a customs union is a higher form of economic integration than a common market
2. A customs union that allows for the free movement of labor and capital among its member
nations is called a:
a. preferential trade arrangement
b. free-trade area
*c. common market
d. all of the above
3. A trade-creating customs union is one where:
a. lower-cost imports from outside the customs union are replaced by higher-cost imports
from a union member
*b. some domestic production in a member nation is replaced by lower-cost imports from
another member nation
c. trade among members increases but trade with nonmembers decreases
d. trade among members decreases while trade with nonmembers increases
4. A trade-diverting customs union:
a. increases trade among union members and with nonmember nations
b. reduces trade among union members and with nonmember nations
*c. increases trade among members but reduces trade with non-members
d. reduces trade among union members but increases it with nonmembers
5. A trade-diverting customs union results in:
a. trade diversion only
b. trade creation only
*c. both trade creation and trade diversion
d. we cannot say

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Dominick Salvatore

International Economics 11th Edition

Instructors Manual

6. The formation of a trade-creating customs union where all economic resources of member
nations are fully employed before and after the formation of the customs union leads to an:
*a. increase in the welfare of member and nonmember nations
b. increase in the welfare of member nations only
c. increase in the welfare of nonmember nations only
d. increase or decrease in the welfare of member and nonmember nations
7. A trade-diverting customs union:
a. increases the welfare of member and nonmember nations
b. reduces the welfare of member and nonmember nations
c. increases the welfare of member nations but reduces that of nonmembers
*d. reduces the welfare of nonmembers and may increase or reduce that of members
8. A trade-diverting customs union is more likely to lead to trade creation:
a. the lower are the pre-union trade barriers of the member countries
*b. the lower are the customs union's barriers on trade with the rest of the world
c. the smaller is the number of countries forming the customs union and the smaller their size
d. the more complementary rather than competitive are the economies of the nations forming the
customs union
9. The theory of customs union is a special case of the theory of:
a. effective protection
*b. the second best
c. the product cycle
d. comparative advantage
10. Which is not a dynamic benefit from the formation of a customs union?
a. increased competition
b. economies of scale
c. stimulus to investment
*d. trade creation
11. The formation of the EU resulted in:
a. trade creation in industrial and agricultural products
b. trade diversion in industrial and agricultural products
*c. trade creation in industrial products and trade diversion in agricultural products
d. trade diversion in industrial products and trade creation in agricultural products
12. The benefit that the United States is likely to receive from NAFTA:
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Dominick Salvatore

International Economics 11th Edition

Instructors Manual

*a. increasing competition in product and resource markets


b. greater technical innovation
c. improvements in its terms of trade
d. all of the above
13. The benefit that Mexico is likely to receive from NAFTA:
a. greater export-led growth
b. encouraging the return of flight capital
c. more rapid structural change
*d. all of the above
14. Which is a stumbling block to successful economic integration among groups of
developing nations?
a. benefits are not evenly distributed among nations
b. many developing nations are not willing to relinquish part of their newly-acquired sovereignty
to a supranational community body, as required for successful economic integration
c. the complementary nature of their economies and competition for the same world markets for
their agricultural exports
*d. all of the above
15. The formation of a free trade area among the countries of Eastern Europe is advocated
in order to:
a. restore trade trading
*b. retain the traditional trade links that can be justified on market principles
c. reduce the need for structural change
d. none of the above

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Dominick Salvatore