Lecture 1: Economic Integration

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Economic Integration:
Preferential Trade arrangements
Free Trade Area
Customs Union
Common Market
Economic union
Trade Creating and Diverting Customs Unions
Dynamic Effects of Customs Union
The European Union and NAFTA

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 Economic integration
Economic integration refers to the
discriminatively reduction or/ and the
elimination of trade barriers only among the
members that form this particular union
There are various forms of economic
integration
Preferential Trade arrangements
Free Trade Area
Customs Union
Common Market
Economic union

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 Preferential Trade Arrangements

Provide lower barriers on trade among participating

nations. The trading bloc gives preferential access to
certain products from the participating countries by
reducing tariffs, but not by abolishing them completely.
The weakest form of economic integration the first
stage of economic integration main goal is to
become a free trade area
It departs from the normal trade relations principal that
WTO members should apply the same tariff to other
WTO members
A good example is the British Commonwealth
Preferences Scheme, established in 1932 by the UK
with member and some former members of the British
empire.
Free Trade Area (FTA)
All barriers are removed on trade among members,
but each nation maintains its own barriers to trade with
non member states—the second stage of economic
integration.
Countries choose FTA if their economic structures are
complementary.
Aim: reduce trade barriers that trade can grow because
of specialisation, division of labour, and most
importantly via comparative advantage.
Example: the North American Free Trade Agreement
(NAFTA), formed by the USA, Canada and Mexico
Customs Union (CU)
 It allows no tariffs or other barriers on trade among
members and harmonises trade policies (i.e. setting of
common tariff rates) with the rest of the world—the
participant countries set up common external trade policy,
but in some cases they use different import quotas—the
third stage of economic integration.
 Aim: to increase economic efficiency and establish closer
political and cultural ties between the member countries.
 Examples include European Union (EU) or the European
Common Market formed in 1957 by West Germany ,
France, Italy, Belgium, Netherlands and Luxemburg
Common Market (CM)
 Common market is CU but also allows the free movement of
labour and capital among member states—the fourth stage of
economic integration
 The goal: to ease the movement of capital, labour, goods, and
services between the members states.
 The EU became a common market in 1993
 Sometimes a single market is differentiated as a more advanced
form of common market. It makes more efforts on removing
barriers, such as borders, standards and taxes, among the
member states—the member states need political will and they
have to formulate common economic policies.
 The European Economic Area (EEA) was established as a single
market on 1 January 1994
 Economic union
An economic union goes still further by harmonizing
monetary and fiscal policies  formally coordinated
labour market, regional development, transportation and
industrial policies.
An economic union frequently includes the use of a
common currency and a unified monetary policy.
Eliminating exchange rate uncertainty improves the
functioning of an economic union.
This is the most advanced type of economic
integration
A complete economic and monetary union is US

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 Economic integration

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 Economic integration
Countries are free to negotiate economic integration
agreements as they see fit
In practice, formal agreements rarely fall neatly into one of the
four stages discussed above.
Some confusion of terminology and the state of
economic integration in some parts of the world.
For example, Canada
It is part of a FTA—NAFTA that includes provisions partially
liberating the flow of labour and capital in the region an
element of a common market
Canada has in the past pushed to reduce the use of trade
remedy measures within North America representing a
desire to advance North American integration towards the next
formal step – a customs union

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Trade Creating Custom Unions
Static effects of forming a customs union are measured
in terms of trade creation and trade diversion
Trade creation occurs when some domestic production
in a member nation is replaced by lower-cost imports
from another member nation in the custom union
This increases the welfare of member nations because
it leads to greater specialization in production based on
comparative advantage
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 the world
 Trade diverting Customs Union
Trade diversion occurs when lower-cost imports
from outside the CU are replaced by higher cost
imports from a union member
It reduces welfare because it shifts production from
more efficient producers outside the CU to less
efficient producers inside the CU it worsens the
international allocation of resources and shifts
production away from comparative advantage
A trade-diverting customs union results in both trade
creation and trade diversion whether increases the
welfare of union members depending on the relative
strength of these two opposing forces

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Dynamic Effects of Customs Unions
Increased Competition:
Trade barriers are eliminated, producers in each nation
must become more efficient within the union otherwise
merger or go out of the business.
Encourage to develop and use technology
Economies of Scale from enlarged market
Firms from relatively small countries ( i.e. Belgium and
the Netherlands) can get benefits form exploiting a larger
market.
Research has proved that firms from the above countries
due to exploitation of scale economies become of similar
size with their US counterparts.
 Dynamic Effects of Customs Unions
Stimulus of investment
To get benefits of economies of scale and
correspond successfully to increased competition,
industries and firms should make investment that
improve their operational capabilities.
Better utilisation of the resources due to the
free community-wide movement of labour and
capital within a common market
Leading to a more effective production with
relatively lower costs, thus making consumers better
off

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 The European Union
 The EU was founded by the Treaty of Rome in March 1957
among six nations –West Germany, France, Italy, Belgium,
the Netherland, and Luxembourg
In 1968, free trade in industrial goods and a common price for
agricultural products
By 1970, restrictions on the free movement of labour and capital
were reduced
On 1 Jan 1993, the EU removed all remaining restrictions on
trade and resources (including labour) movement  a single
market
 In 1995, EU expanded to 15  largest trading bloc
 UK, Demark and Ireland joined in 1973; Greece in1981; Spain and
Portugal in 1986; Austria, Finland, and Sweden in 1995.
 10 CEE countries joined in 2004 and Bulgaria and
Romania in 2008

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 The European Union
The formation of EU also expanded trade in industrial
goods with non-members
Rapid growth of EU demanded more imports from
outside the union
Reduction in tariff as a result of the Kennedy and Tokyo
Rounds
It led to trade diversion in agricultural commodities
CAP was particularly troublesome for the EU
sacrificed consumers’ interests to those of EU farmers
particularly French farmers

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 The European Union
The greatest benefits has been political
The static welfare benefits resulting from the
formation of EU are estimated to be 1-2% of GDP
The dynamic benefits estimated to be much larger

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The Case of NAFTA
In Sep 1993, US, Canada and Mexico signed the
NAFTA free trade in Goods and services
In 1989 Canada and US reached free trade agreement:
eliminating most of the remaining tariff and NTBs by
1998
NAFTA also will phase out many other barriers to
trade and reduce barriers to cross-border investment
among the three countries
At that time Mexico was already the third major
partner of US after Canada and Japan.
The implementation of NAFTA benefits US by
increasing competition in product and resources
markets as well as lowering price for US consumers.
 The Case of NAFTA
 1994-2004, trade between US and Mexico
increased by 166%
 In US, there was a substantial loss of
unskilled jobs, why?
 Wages in US were six times higher than Mexico’s a loss of
unskilled jobs, but an increase of skilled jobs net increase
in employment
 US industries import labour-intensive components from
Mexico to keep some jobs in US
 US also negotiated a series of supplemental
agreement with Mexico governing workplace
and environmental standards
to prevent US firms from moving their
operations to Mexico for more lax labour and
environmental regulations
to protect some American industries against
import surges
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 The Case of NAFTA
Mexico gained more than US a good
example of the argument “ small countries gain
more than large countries in free trade”
NAFTA led to greater export-led growth from
increase access to the huge US market:
Economies of scale
Inward FDI increased
However, Mexico’s ability to benefit from
NAFTA has been limited by weak economic
institutions and inadequate structural reforms of
the economy

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 Impacts of NAFTA
Lower prices of goods and services benefited consumers
and exporters. Some US producers benefited from
reduction in trade barriers.
Effect on US agriculture sector—southern California
where agriculture is overwhelmingly dependent on
irrigation and the water is heavily subsidized.
NAFTA caused southern California agriculture to contract
free up water from a use in which it had a very low marginal
social product
There were productivity gains in all three NAFTA
countries. Labor costs fell in all three countries.
The losers are primarily those companies who benefited
from the trade protection

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