Topic 8

Regional Economic Integration

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Outline
A. Introduction
B. Level of Economic Integration
C. The Case for Regional Integration
D. Impediments to Integration
E. European Union (EU)
F. Regional Economic Integration in the America
G. Regional Economic Integration in Asia
H. Managerial Implications

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A. Introduction
 Regional Economic Integration
 Agreements among countries in a geographical region
to reduce, and ultimately remove, tariff and non-tariff
barriers to the free flow of goods, services, and factors
of production.
 Aims: Maximizing gains from trade; enhancing the
efficiency of resource allocation; economic growth.
 Examples:
 EU (European Union)
 NAFTA (North American Free Trade Agreement)
 APEC (Asia Pacific Economic Cooperation)
 Regional economic integration: good or bad? 3
B. Level of Economic Integration
 5 types of economic
integration:
 Free Trade Area
 Customs Union
 Common Market
 Economic Union
 Political Union

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B. Level of Economic Integration
 Free Trade Area
 No barrier to trade of goods and services among
members.
 Each member country can determine its own trade
policies towards non-member countries.
 Examples
 EFTA (European Free Trade Association)
 Iceland, Liechtenstein, Norway and Switzerland
 European countries who are not willing to join EU.
 NAFTA (North American Free Trade Agreement)
 U.S., Canada and Mexico
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B. Level of Economic Integration
 Customs Union
 No barrier to trade of goods and services among
members.
 Member countries adopt same trade policies towards
non-member countries.
 Example: Andean Community
 Bolivia, Colombia, Ecuador, Peru. (Venezuela left in 2012)
 Establishes free trade among member countries and imposes a
common external tariff (5%-20%) on products imported from
outside.

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B. Level of Economic Integration
 Common Market
 All characteristics of a Customs Union.
 No barrier to flows of production factors (e.g., labor)
among members.
 Example: MERCOSUR (Southern Common Market)
 Argentina, Brazil, Paraguay, Uruguay and Venezuela.
 A full Customs Union.
 Aim to eventually establish itself as a common market.

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B. Level of Economic Integration
 Economic Union
 All characteristics of a Common Market.
 Members use a common currency.
 Harmonization of tax rates among members.
 Free flow of labor and capital.
 Labor and capital tend to move to lower-tax regions.
 Need to avoid “tax competition” among members.
 Common fiscal policy among members.
 Fiscal discipline is needed to maintain currency value.
 Fiscal rule requiring that fiscal deficit cannot exceed a certain
percentage of GDP (e.g., 3% in EU).
 Common monetary policy among members.
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 Common currency => common interest rate and exchange rate.
B. Level of Economic Integration
 Economic Union (continue)
 Example: European Union
 27 European countries (http://europa.eu/index_en.htm) after
Brexit.
 Common currency is EURO (adopted by 19 EU members).
 Some members (e.g., Denmark, Sweden, Poland) are still using
their own currencies.
 There are still differences in tax rate among members.

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B. Level of Economic Integration
 Political Union
 Economic Union has the following issues:
 How to coordinate common economic policies that may not be
suitable to all members.
 E.g., Some member may need a stronger currency to lower
inflation while some may need a weaker currency to increase
export.
 Need to balance the interests of member countries in order to
coordinate common policies. E.g., Prosperous members need to
financially assist poor members.
 Members may selectively adopt common policies.
 Without a central administrative unit, coordination and
enforcement of common policies are difficult.
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B. Level of Economic Integration
 Political Union (continue)
 Political Union has a central administrative unit to:
formulate, coordinate and enforce common economic,
social and foreign policies for the member countries.
 Example: United States of America – federal republic of
50 states (including Alaska and Hawaii) – governed by
the US Federal Government.
 EU is on the road towards partial political union.
 E.g., European Parliament is elected by citizens in EU.
 E.g., Common monetary policies are set by European Central
Bank, which is jointly managed by member countries’ central
banks.
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C. The Case for Regional Integration
 Economic justifications for integration
 Increases trade and specialization among member
countries.
 Each member specializes in the production of the goods
and services that it can produce more efficiently (note:
refer to the concepts of absolute and comparative advantages).
 Without barrier to capital flows: increases FDI (note:
refer to the benefits of FDI to the host and home countries).
 Resource transfer effect.
 Reversed resource transfer effect.
 Employment effects.
 Increasing market competition.
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C. The Case for Regional Integration
 Economic justifications for integration (continue)
 Higher levels of integration beyond World Trade
Organization.
 WTO: free trade agreement among a large number of
countries with diverse economic, social and cultural
backgrounds.
 Regional Economic Integration: small number of
countries with similar backgrounds – easier to
negotiate for and reach mutually beneficial agreements.
 Due to geographical proximity, Regional Economic
Integration can achieve higher levels of integration
beyond free trade: e.g., free flows of production factors,
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common economic policies, etc.
C. The Case for Regional Integration
 Political justifications for integration
 Political and economic cooperation reduces the chance
of violent/military conflicts.
 By integrating members’ economic power, they can
enhance their political (bargaining) power in the world.
 A united Europe to deal with the U.S. and Soviet Union
super power after WWII.
 Common/coordinated external trade policies give each
member country stronger bargaining power in trade
negotiation/dispute with non-member countries. E.g.,
losing a bigger market is a bigger threat to a country
outside EU.
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D. Impediments to Integration
 Integration is hard to achieve and sustain for 2
reasons:

The country as a whole may benefit but groups

within countries may be hurt.
Example: After the establishment of NAFTA,
Canadian and US firms moved production to Mexico.

Potential loss of sovereignty and control over

domestic economic issues.
Examples:
• The common fiscal and monetary policies may not be suitable
to all member countries.
• Loss of control over immigration (e.g., influx of refugees). 15
D. Impediments to Integration
 Regional Integration (higher trade barriers towards non-
members) has two effects on trade:
 Trade creation: lower-cost/ more efficient producers
within the regional integration replace higher-cost
domestic producers. (e.g., U.S. and Mexico in NAFTA).
=> improvement in overall efficiency.
 Trade diversion: higher-cost/less efficient producers within
the regional integration replace lower-cost/ more efficient
external suppliers from non-member countries. (e.g. Mexico
replaces China in trading with the US).
=> decline in overall efficiency.
Regional Integration reduces the gain from trade if:
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Trade Creation < Trade Diversion
E. Regional Economic Integration
in Europe
 European Union (EU) is the main regional economic
integration in Europe.
 EURO is the common currency (adopted by 19 of 27 EU
members).
 Benefits of adopting a common currency:
 There is foreign exchange risk when a foreign currency is
involved in international transactions (e.g., foreign trade).
 There is no foreign exchange risk if a common currency is
used in international transactions (among member countries)
=> Lower transaction costs of trade.
 Common currency => easier to compare product prices
among member countries.
=> more competitive regional market
=> improve production efficiency. 17
E. Regional Economic Integration
in Europe
 Benefits of adopting a common currency (continue):
 Integration of previously separated capital markets: firms in
each member country can access a larger capital market.
=> supply capital to firms in regions where local capital
markets are too small/ inefficient.
=> lowering the costs of capital.
 Integration of previously separated capital markets:
increases the range of investment options for individual and
institutional investors
=> seeking higher rates of return.
 Remark: the common interest rate could be too low for weak
members with high default risks.
=> excessive debt accumulated in weak member countries.
=> banking crisis in case of default (e.g., Greece in EU). 18
 E. Regional Economic Integration
in Europe
 The benefits of a common currency are maximized in an
“Optimal Currency Area”:
 A large volume of trade among members.
 Similar economic conditions (cycles) among members.
 Costs of adopting a common currency:
 Monetary policies in the Euro zone are determined by European
Central Bank.
 Individual member countries lose autonomy over their monetary
policies.
 EU is not an “Optimal Currency Area” because members’ economies
are very different.
 The common interest rate can be too high for depressed countries (e.g.,
Greece) and too low for booming countries (e.g., Germany).
 Fiscal transfer/financial assistance from prosperous members to depressed
members is needed to narrow the gap. 19
F. Regional Economic Integration
in North America
 North American Free Trade Agreement
 NAFTA - Free Trade Area established in 1994.
 Three members: U.S., Canada and Mexico.
 Aim: eliminate tariffs on most of the goods traded among the
members.
 Substantial Sectoral Coverage: Trade agreements have full
coverage of almost all industrial sectors.
 Exempted from WTO’s MFN requirement - no need to extend
NAFTA trade concessions to WTO members outside NAFTA.
 Other agreements: Setting national environmental standards,
Protecting intellectual property rights, and removing restrictions
on FDI.

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F. Regional Economic Integration
in North America
NAFTA 2.0 (USMCA) in 2018:
 Cars and trucks with at least 75% (previously 62.5%)
of their components made in USMCA enjoy zero
tariffs – trade diversion.
 Restrictions on NAFTA members entering into free
trade deal with “non-market” economies (e.g., China)
– “common external trade policies” of Custom Union.

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F. Regional Economic Integration
in North America
Costs:
Benefits: U.S. low-skilled workers lose jobs.
U.S. & Canadian firms lower
Outflow of capital from U.S. and
production costs by moving
Canada (offset by inflow of
production to Mexico (FDI).
foreign profits).
Mexico receives foreign capital
Mexican firms need to compete
inflow (earnings of FX)
with more efficient U.S. and
Mexico exports more to U.S.
Canadian firms (Mexican firms
More jobs in Mexico.
will become more competitive in
U.S. consumers pay lower prices.
the long-run).
Mexico has higher national
U.S. and Canadian firms may
income => larger demand for
move polluting activities to and
U.S. goods.
overexploit natural resources in
US firms make FDI in Mexico
Mexico: “Global Tragedy of Commons”
=> U.S. exports more intermediate
 Reliance on foreign trade and
goods to Mexico.
capital: loss of national sovereignty22
G. Regional Economic Integration
in Asia
 ASEAN (Association of Southeast Asian Nations)
 Established in 1967.
 Aims:
 Free trade among member countries; Cooperation in industrial
policies.
 Members:
 Brunei, Indonesia, Laos, Cambodia, Malaysia, the Philippines,
Myanmar, Singapore, Thailand and Vietnam.
 Result: Slow progress.
 Reasons: export-driven economic growth; common export
markets; disputes over territory at borders.
 In 2010, ASEAN signed a free trade agreement with China23
to remove tariffs on 90 percent of all traded goods.
H. Managerial Implications
 Opportunities
 Increased access to foreign markets within the
integrated regions.
 Free movement of factor inputs and final goods across
borders, harmonized product standard, and simplified
tax regimes allows MNEs to lower costs through:
 Centralization of the production of a standardized product at a
single location where the mix of factor costs and skills is
optimal.
 Cost saving from economies of scale.
 Example: centralizing the production in Mexico and export to
U.S. and Canada.
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H. Managerial Implications
 Threats
 The integrated market is more competitive – a threat to
inefficient firms in the integrated regions.
 Example: Before 1992, a Volkswagen Golf was 55% more
expensive in Britain than in Denmark.
 Increased market competition (e.g., in EU and NAFTA)
- a threat to inefficient / previously protected firms in
the integrated regions.
 Regional integration becomes a “trade fortress” (higher
trade barriers towards non-members) – firms in non-
member countries face the threat of being shut out of
the integrated markets. E.g. restrictions on NAFTA
members who want to enter trade agreement with 25
China.