Economic Integration: Customs Union and Free Trade Areas

Chapter 10

ANHUI UNIVERSITY OF FINANCE & ECONOMICS

1/36

1 Introduction
Examine economic integration in general

and customs unions in particular Discuss the trade-creating customs union, trade-diverting customs union and the dynamic effects of customs unions Discuss the brief history of various attempts at economic integration

ANHUI UNIVERSITY OF FINANCE & ECONOMICS

2/36

Key Terms
Economic integration Preferential trade arrangement Customs union Common market Trade creation and diversion Theory of second best Bilateral agreements

ANHUI UNIVERSITY OF FINANCE & ECONOMICS

3/36

2 Definition & Different Forms

Economic integration is the commercial policy of discriminatively reducing or eliminating trade barriers only among the nations joining together. There are different forms Preferential trade arrangements (PTA) Free trade areas (FTA) Customs unions (CU) Common markets Economic unions

ANHUI UNIVERSITY OF FINANCE & ECONOMICS

4/36

2.1 Preferential Trade Arrangements

Preferential trade arrangements provide lower barriers on some trade among participating nations than on trade with nonmember nations. It is the loosest form of economic integration.

ANHUI UNIVERSITY OF FINANCE & ECONOMICS

5/36

2.2 Free Trade Area

A free trade area is the form of economic integration wherein all barriers are removed on trade among members, but each retains its own barriers to trade with nonmembers, such as EFTA, NAFTA, Mercosur.

ANHUI UNIVERSITY OF FINANCE & ECONOMICS

6/36

2.3 Customs Union

A customs union allows no tariffs or other barriers on trade among members, and in addition it harmonizes trade policies (such as the setting of common tariff rates) toward the rest of the world, such as EU, or European Union.
ANHUI UNIVERSITY OF FINANCE & ECONOMICS 7/36

2.4 Common Market

A common market goes beyond a customs union by also allowing the free movement of labor and capital among member nations. The EU achieved the status of a common market at the beginning of 1993.
ANHUI UNIVERSITY OF FINANCE & ECONOMICS 8/36

2.5 Economic Union

An economic union goes still further by harmonizing or even unifying the monetary and fiscal policies of member states. This is the most advanced type of economic integration. An example is Benelux.

ANHUI UNIVERSITY OF FINANCE & ECONOMICS

9/36

2.6 Duty-Free Zones

Duty free zones or free economic zones are areas set up to attract foreign investments by allowing raw materials and intermediate products duty-free.

ANHUI UNIVERSITY OF FINANCE & ECONOMICS

10/36

3 Trade-Creating Customs Union

A trade creating customs union is a union that leads to trade creation only and increases the welfare of both member and nonmember nations. Trade creation occurs when some domestic production in a nation (a member of the customs union) is replaced by lower-cost imports from another member nation. If all resources are fully employed before the formation of a customs union, a customs union increases the welfare of member nations because it leads to greater specialization based on comparative advantage. It also increases the welfare of nonmembers because some of the increase in its real income spills over into increased imports from the rest of the world.
ANHUI UNIVERSITY OF FINANCE & ECONOMICS 11/36

3.1 Numerical Illustration of a Trade-Creating CU

Nation B $8

Nation A $10

Nation C $6

ANHUI UNIVERSITY OF FINANCE & ECONOMICS

12/36

3.2 Graphic Illustration of a Trade-Creating CU

P($) 16 12 10 8 6 DX SX SB+T

Before: 100% tariff. Nation A and nation B forms a customs union.

SC+T
SB SC

O
Nation As Supply and Demand Curves

X
13/36

ANHUI UNIVERSITY OF FINANCE & ECONOMICS

3.2 Graphic Illustration of a Trade-Creating CU

ANHUI UNIVERSITY OF FINANCE & ECONOMICS

14/36

4 Trade-Diverting Customs Union

It is a customs union that leads to both trade creation and trade diversion. It may increase or reduce the welfare of member nations, depending on the relative strength of these two opposing forces. Trade diversion occurs when lower-cost imports from outside the union are replaced by higher cost imports from a union member. This is because of the preferential trade treatment given to member nations. Trade diversion reduces welfare because it shifts production from more efficient producers outside the customs union to less efficient producers inside the union. Thus, trade diversion worsens the international allocation of resources and shifts production away from comparative advantage.
ANHUI UNIVERSITY OF FINANCE & ECONOMICS 15/36

4.1 Trade-Diverting & Trade Creating CU

A trade-diverting customs union results in both trade creation and trade diversion, and therefore can increase or reduce the welfare of union members, depending on the relative strength of these two opposing forces. The welfare of 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. While a trade-creating customs union leads only to trade creation and unequivocably increases the welfare of members and nonmembers, 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).
ANHUI UNIVERSITY OF FINANCE & ECONOMICS 16/36

4.2 Illustration of TradeDiverting Customs Union

ANHUI UNIVERSITY OF FINANCE & ECONOMICS

17/36

4.3 General Equilibrium Analysis of a Trade Diverting Customs Union

ANHUI UNIVERSITY OF FINANCE & ECONOMICS

18/36

5 Conditions More Likely to Increase Welfare

1.The higher the preunion trade barriers of member countries are, the greater probability it is that formation of the customs union will create trade among members rather than divert trade from nonmembers to members. 2.The lower the customs unions barriers are on trade with the rest of the world, the less likely it is that formation of the customs union will lead to costly trade diversion, because they have already traded each other before. 3.The greater the number of countries in the union and the larger their size are, the greater probability it is that low-cost producers fall within the union.

ANHUI UNIVERSITY OF FINANCE & ECONOMICS

19/36

5 Conditions More Likely to Increase Welfare

4.The more competitive the member nations are, the greater opportunities there are for specialization in production and trade creation with the formation of the customs union. 5.The closer geographically the members of the customs union are, the less likely it is that the transportation costs become an obstacle to trade creation among members. 6.The greater the preunion trade and economic relationship among potential members of the customs union is, the greater the opportunities are for significant welfare gains as a result of the formation of the customs union.

ANHUI UNIVERSITY OF FINANCE & ECONOMICS

20/36

5.1 Other Static Welfare Effects of Customs Unions

One is the administration savings from the elimination of customs officers, border patrols, and so on. This benefit arises whether the customs union is trade creating or trade diverting. Second, a trade-diverting customs union is likely to improve the collective terms of trade of the customs union. For a trade-creating customs union, the opposite is true. Finally, any customs union is likely to have much more bargaining power, such as EU.

ANHUI UNIVERSITY OF FINANCE & ECONOMICS

21/36

5.2 Dynamic Benefits of Customs Union

The sourses of dynamic benefits:
Increased competition Economies of scale Stimulus to investment Better use of economic

resources

ANHUI UNIVERSITY OF FINANCE & ECONOMICS

22/36

5.2 Static & Dynamic Benefits

Comparison of the static and dynamic benefits: These dynamic gains of a customs union are presumed to be much greater than the static gains and to be very significant. Recent empirical studies indicate that these dynamic gains are about five to six times larger than the static gains.

ANHUI UNIVERSITY OF FINANCE & ECONOMICS

23/36

6 Economic Integrations
The larger economic integrations
European Union European Free Trade Association North American Free Trade Agreement (NAFTA) Asian-Pacific Economic Cooperation (APEC)
ANHUI UNIVERSITY OF FINANCE & ECONOMICS 24/36

6.1 Economic Integrations---EU

The European Union was founded by the Treaty of Rome, signed in March 1957 by West Germany, France, Italy, Belgium, the Netherlands, and Luxembourg, and came into being on January 1, 1958. The common external tariff was set at the average of the 1957 tariffs of the six nations. Free trade in industrial goods within the EU and a common price for agricultural products were achieved in 1968; restrictions on the free movement of labor and capital were reduced by 1970. Membership increased to 15 after the United Kingdom, Denmark, and Ireland joined in 1973, Greece in 1981, Spain and Portugal in 1986, and Austria, Finland, and Sweden in 1995. It became 25 when Malta, Cyprus, Poland, Hungary, Czech, Slovakia, Slovenia, Estonia, Latvia, Lithuania joined the EU on May 1, 2004.
ANHUI UNIVERSITY OF FINANCE & ECONOMICS 25/36

6.1 Economic Integrations---EU

ANHUI UNIVERSITY OF FINANCE & ECONOMICS

26/36

6.2 Economic Integrations---EFTA

The European Free Trade Association was formed by the United Kingdom, Austria, Denmark, Norway, Portugal, Sweden, and Switzerland, with Finland becoming an associate member in 1961. The 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. Iceland joined the EFTA in 1970, Finland became a full member in 1986, and Liechtensteinin 1991. However, in 1973, the UK and Denmark left EFTA, as did Portugal in 1986. Thus, in 1991, the EFTA had seven members (Austria, Finland, Iceland, Liechtenstein, Norway, Sweden, and Switzerland) with headquarters in Geneva. On January 1, 1994, the EFTA joined the EU to form the European Economic Area (EEA). In 1995, Austria, Finland, and Sweden left the EFTA and joined the EU.
ANHUI UNIVERSITY OF FINANCE & ECONOMICS 27/36

6.2 Economic Integrations---EFTA

ANHUI UNIVERSITY OF FINANCE & ECONOMICS

28/36

6.3 Economic Integrations---NAFTA

In September 1993, the United States, Canada, and Mexico signed the NAFTA, which took effect on January 1, 1994. This agreement will eventually lead to free trade in goods and services over the entire North American area.

ANHUI UNIVERSITY OF FINANCE & ECONOMICS

29/36

6.3 Economic Integrations---NAFTA

NAFTA benefits the United States by increasing competition in product and resource markets, and by lowering the prices of many commodities to U.S. consumers. NAFTA benefited Mexico by (1) Leading to greater export-led growth resulting from increased access to the huge U.S. market (2) Encouraging the return of flight capital (3) Fostering more rapid structural reforms domestically. Mexico suffered a net loss of jobs and incomes in agriculture, but these losses were more than matched by net increases in industry.
ANHUI UNIVERSITY OF FINANCE & ECONOMICS 30/36

6.4 Economic Integrations---APEC

APEC's 21 Member Economies are Australia; Brunei Darussalam; Canada; Chile; People's Republic of China; Hong Kong, China; Indonesia; Japan; Republic of Korea; Malaysia; Mexico; New Zealand; Papua New Guinea; Peru; The Republic of the Philippines; The Russian Federation; Singapore; Chinese Taipei; Thailand; United States of America; Viet Nam. APEC has 21 members - referred to as "Member Economies" - which account for more than a third of the world's population (2.6 bill. people), approximately 60% of world GDP (US$19, 254 bill.) and about 47% of world trade. It also represents the most economically dynamic region in the world having generated nearly 70% of global economic growth in its first 10 years.
ANHUI UNIVERSITY OF FINANCE & ECONOMICS 31/36

6.4 Economic Integrations---APEC

ANHUI UNIVERSITY OF FINANCE & ECONOMICS

32/36

6.4 Economic Integrations---APEC

ANHUI UNIVERSITY OF FINANCE & ECONOMICS

33/36

6.4 Economic Integrations---APEC

Purpose and Goals: to further enhance economic growth and prosperity for the region and to strengthen the Asia-Pacific community. Since its beginning, APEC has worked to reduce tariffs and other trade barriers, creating efficient domestic economies and dramatically increasing exports. Key to achieving APECs vision are referred to as the Bogor Goals) of free and open trade and investment in the Asia-Pacific by 2010 for industrialised economies and 2020 for developing economies. These goals were adopted by Leaders at their 1994 meeting in Bogor, Indonesia.

ANHUI UNIVERSITY OF FINANCE & ECONOMICS

34/36

7 Discussion Questions
What is economic integration? What are the different forms? What is meant by trade creation and trade diversion? What are the static welfare effects of a trade-creating and trade-diversting customs union? What dynamic benefits are the nations forming a customs union likely to receive? How do they arise? How large are they? What are the leading economic integrations in the world?
ANHUI UNIVERSITY OF FINANCE & ECONOMICS 35/36

THANK YOU!

ANHUI UNIVERSITY OF FINANCE & ECONOMICS

36/36