CHAPTER S E V E N

An Introduction to International
Economics
Third Edition

Economic Integration

Dominick Salvatore
John Wiley & Sons, Inc.

1
Economic integration
 Economic integration refers to the
commercial policy of discriminately
reducing or eliminating barriers to trade
between a selected group of countries.

2
Forms of economic integration
 Preferential trade arrangements
 Provides lower barriers to trade among
participating nations than on trade with non-
participating nations.
 The loosest form of economic integration.

3
Forms of economic integration
 Preferential trade arrangements
 Free trade areas
 Removes all barriers to trade among
members, but each nation retains its own
barriers on trade with non-members.
 The North American Free Trade Agreement
(NAFTA) is a free trade area.

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Forms of economic integration
 Preferential trade arrangements
 Free trade areas
 Customs union
 Removes all barriers to trade among members
and harmonizes trade policies toward the rest
of the world.

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Forms of economic integration
 Preferential trade arrangements
 Free trade areas
 Customs union
 Common market
 Removes all barriers to trade among members,
harmonizes trade policies toward the rest of the
world, and allows free movement of labor and
capital among member nations.
 The European Union (EU) is an example of a
common market.
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Forms of economic integration
 Preferential trade arrangements
 Free trade areas
 Customs union
 Common market
 Economic union
 Removes all barriers to trade among members,
harmonizes trade policies towards the rest of the
world, allows free movement of labor and
capital among member nations, and unifies
monetary, fiscal, and tax policies of members.
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Forms of economic integration
 Preferential trade arrangements
 Free trade areas
 Customs union
 Common market
 Economic union
 Duty free zones
 Areas established to attract foreign
investments by allowing raw materials and
intermediate products in duty free.
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Trade creation and diversion
 Prior to entering a
P S
customs union a
country faces the
following trade options:
 Purchase from Mexico
at a higher price or PMexico w/ tariff
from Japan at a lower PJapan w/ tariff
price.
D
 Clearly the preferred
choice is to purchase
Q
goods from Japan at a
lower price.

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Trade creation and diversion
 If the country enters a
P S
customs union with
Mexico, commodities
from Mexico no longer
pay the tariff.
 This lowers the price PMexico w/ tariff
of goods from Mexico PJapan w/ tariff
to potentially below PMexico w/o tariff
the price of goods from D
Japan.
 This change makes
Q
Mexico the preferred
provider of the
commodity.
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Trade creation and diversion
 By Mexico becoming
P S
the preferred provider,
trade is created by the
customs union.
 Imports were initially
quantity A.
PJapan w/ tariff
 After the customs union
PMexico w/o tariff
comes into effect, trade
A D
expands to quantity B.
 In this way, a customs B Q
union may create
international trade.
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Trade creation and diversion
 The movement to
P S
increased international
trade comes at the
expense of Japan.
 Its former exports of
quantity A fall to zero.
 Hence, the customs PJapan w/ tariff
union diverts trade PMexico w/o tariff
from the low cost D
A
provider of the good
(Japan) to a higher cost
provider (Mexico) that Q
happens to be part of
the customs union.
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Trade-Creating Customs Unions- Example

Trade Creation
 Trade creation occurs when some domestic production in a member
nation is replaced by lower-cost imports from another member nation.
 A trade-creating customs union therefore raises the welfare of member
nations.
 A trade-creating customs union may also raise the welfare of
nonmembers because some of the increase in its real income spills
over into increased imports from the rest of the world
 Trade-Creating Customs Unions - Example
(1) Before CU (Home country
=N2)
- Price of X (Px1 = $1, Px2 =
$3, Px3 = $1.50)
- Price of X in N2 with 100%
tariff = $2
- demand : 50X
- supply : 20X
- import : 30X from Nation 1

(2) After CU (N2 & N1)

- Price of X in N2 = $1
- demand : 70X
- supply : 10X
-import : 60X
-Net welfare gain =
FIGURE- A Trade-Creating Customs Union . CJM+BHN
Trade-Diverting Customs Unions - Example

Trade Diversion
 Trade diversion occurs when lower-cost imports from
outside the customs union are replaced by higher-cost
imports from a member nation.
 A trade-diverting customs union results in both trade
creation and trade diversion, and therefore can increase
or reduce the welfare of union members.
 Trade-Diverting Customs Unions - Example
(1) Before CU (Home country
=N2)
- Price of X (Px1 = $1, Px2 =
$3, Px3 = $1.50)
- Price of X in N2 with 100%
tariff = $2
- demand : 50X
- supply : 20X
- import : 30X from Nation 1

(2) After CU (N2 & N3)

- Price of X in N2 = $1.50
- demand : 60X
- supply : 15X
-import : 45X
-welfare gain = C’JJ’+B’HH’
FIGURE- A Trade-Diverting Customs Union . -welfare loss = J’H’MN
-Net welfare = ?
Dynamic benefits from customs
unions
 Increased competition
 Competitive pressures tend to spur more
rapid innovation and growth
 External competition limits the ability of a
domestic producer to exercise its monopoly
power

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Dynamic benefits from customs
unions
 Increased competition
 Economies of scale in production
 By being a member of a customs union,
producers have access to larger markets that
allow them produce on a larger scale and
exploit any available economies of scale.

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Dynamic benefits from customs
unions
 Increased competition
 Economies of scale in production
 Stimulus to investment
 Production within a customs union may be
sold within the customs union without tariffs.
 This advantage may induce investors outside
the customs union to invest in production
facilities within the customs union.

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The European Union (EU)
 The EU developed from the European
Economic Community that was initially
established in 1958.

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The European Union (EU)
 The EU developed from the European
Economic Community that was initially
established in 1958.
 The EU formally came into existence with
passage of the Treaty of Maastricht in 1992.
 The Treaty of Maastricht also laid the
foundation for the introduction of a unified
European currency: the euro.

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The European Union (EU)
 The EU developed from the European
Economic Community that was initially
established in 1958.
 The EU formally can into existence with
passage of the Treaty of Maastricht in 1992.
 Currently the EU has 27 member nations
with an aggregate population of nearly half
a billion.

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The European Union (EU)
 Institutions of the EU
 European Parliament
 EU legislative body

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The European Union (EU)
 Institutions of the EU
 European Parliament
 Council of the European Union
 Represents the governments of the member
states to the EU government

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The European Union (EU)
 Institutions of the EU
 European Parliament
 Council of the European Union
 European Commission
 The executive branch of EU government

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The European Union (EU)
 Institutions of the EU
 European Parliament
 Council of the European Union
 European Commission
 Court of Justice
 Judicial branch of EU government

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The European Union (EU)
 Institutions of the EU
 European Parliament
 Council of the European Union
 European Commission
 Court of Justice
 Court of Auditors
 Budgeting authority of EU government

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The European Union (EU)
 Institutions of the EU
 European Parliament
 Council of the European Union
 European Commission
 Court of Justice
 Court of Auditors
 European Economic and Social Committee
 Consultative body of labor, social, and
environmental issues that comments on the
implications of legislative actions.
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The European Union (EU)
 Institutions of the EU
 European Parliament
 Council of the European Union
 European Commission
 Court of Justice
 Court of Auditors
 European Economic and Social Committee
 Committee of the Regions
 European Central Bank
 Central bank of the EU
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The European Union (EU)
 Institutions of the EU
 European Parliament
 Council of the European Union
 European Commission
 Court of Justice
 Court of Auditors
 European Economic and Social Committee
 Committee of the Regions
 European Central Bank
 European Ombudsman
 Responsible for addressing citizen complaints about
maladministration by any EU body
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The European Union (EU)
 Institutions of the EU
 Steps towards economic unification
 Internal tariffs and duties have been
removed.

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The European Union (EU)
 Institutions of the EU
 Steps towards economic unification
 Internal tariffs and duties have been removed.
 Impediments to the free movement of labor
and capital have been removed.

32
The European Union (EU)
 Institutions of the EU
 Steps towards economic unification
 Internal tariffs and duties have been removed
 Impediments to the free movement of labor
and capital have been removed.
 Corporate law practices have been
harmonized.

33
The European Union (EU)
 Institutions of the EU
 Steps towards economic unification
 Internal tariffs and duties have been removed
 Impediments to the free movement of labor
and capital have been removed.
 Corporate law practices have been
harmonized.
 Environmental regulations have been
harmonized.

34
The European Union (EU)
 Institutions of the EU
 Steps towards economic unification
 Internal tariffs and duties have been removed
 Impediments to the free movement of labor and
capital have been removed.
 Corporate law practices have been harmonized.
 Environmental regulations have been
harmonized.
 Labor standards have been harmonized.

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The European Union (EU)
 Institutions of the EU
 Steps towards economic unification
 Further information on the EU
 EUROPA is in the Internet portal for the EU
government
 http://europa.eu/index_en.htm

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NAFTA
 The North American Free Trade Agreement
(NAFTA) came into force in 1994.

37
NAFTA
 The North American Free Trade Agreement
(NAFTA) came into force in 1994.
 Objectives of NAFTA
 Eliminate barriers to trade between the US,
Mexico, and Canada.

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NAFTA
 The North American Free Trade Agreement
(NAFTA) came into force in 1994.
 Objectives of NAFTA
 Eliminate barriers to trade between the US,
Mexico, and Canada.
 Improve intellectual property rights
protections between the member nations.

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NAFTA
 The North American Free Trade Agreement
(NAFTA) came into force in 1994.
 Objectives of the NAFTA
 Eliminate barriers to trade between the US,
Mexico, and Canada.
 Improve intellectual property rights
protections between the member nations.
 Provide a dispute resolution mechanism for
trade disputes under this agreement.

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NAFTA
 The North American Free Trade Agreement
(NAFTA) came into force in 1994.
 Objectives of the NAFTA
 An extension of NAFTA?
 The proposed Free Trade Area of the
Americas (FTAA) is broadly modeled on
NAFTA.
 The FTAA is designed to generate a free
trade area throughout the western
hemisphere (excluding Cuba).
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NAFTA
 The North American Free Trade Agreement
(NAFTA) came into force in 1994.
 Objectives of the NAFTA
 An extension of the NAFTA?
 Further information
 NAFTA Secretariat

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NAFTA
 The North American Free Trade Agreement
(NAFTA) came into force in 1994.
 Objectives of NAFTA
 An extension of NAFTA?
 Further information
 NAFTA Secretariat
 Official Site of the Free Trade Area of the
Americas
 https://www.nafta-sec-us.org/Default.aspx
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Other Examples of Economic Integration

 Central American Common Market (CACM)

 Costa Rica, El Salvador, Guatemala, Honduras, Nicaragua

 Latin American Free Trade Association (LAFTA)

 Mexico and most of South America

 Southern Common Market (Mercosur)

 Argentina, Brazil, Paraguay, Uruguay, Bolivia, Chile, Peru

 Southern Africa Development Community (SADC)

 12 southern African nations

 Association of Southeast Asian Nations (ASEAN)

 Brunei, Darussalam, Cambodia, Indonesia, Laos, Malaysia, Philippines,
Singapore, Thailand and Vietnam.
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