ECONOMIC INTEGRATION

INDEX

CERTIFICATE

INTRODUCTION
Before 1947 countries were free to impose any tariffs on
their imports. However, when one country increased its tariffs, this action often
triggered retaliatory actions by its trading partners. The end result of
protectionism was lowered efficiency, less and no increase in employment. Thus
in the post-war era efforts were made to reduce tariff barriers, that is, to
liberalize international trade.
Integration between countries is an important feature of
trade liberalization. International integration may be either political or
economic. Political integration involves pooling of countries sovereignty to
some degree. Economic integration involves links between the economics of a
group of countries. These are often called regional economic groups. In
practice, economic integration tends to produce some degree of political
integration, though not necessarily full political union.
The benefits of free trade and stable exchange rates are
available only if the countries are welling to give up some measure of
independence and autonomy. This has resulted in increased economic
integration around the world with agreements among countries to establish links
through movement of goods, services, capital and labor across the borders.
However, according to some writers the regional trading blocs of the new
economic world order may divide the world into a handful of protectionist
super-states that, although liberalizing trade among members, may raise barriers
to external trade.
Economic Integration is the unification of economic
policies between different states through the partial or full abolition of tariff and
non-tariff restrictions on trade taking place among them prior to their
integration. This is meant in turn to lead to lower prices for distributors and

consumers with the goal of increasing the combined economic productivity of

the states.
Economic Integration is process in which two or more
states in a broadly defined geographic area reduce a range of trade barriers to
advance or protect a set of economic goals.
The level of integration involved in an economic
regionalist project can very enormously from loose association to a
sophisticated, deeply integrated, transnational zed economic space. It is in its
political dimension that economic integration differs from the broader idea of
regionalism in genera. Although economic decision go directly to the
intrinsically political question of resource allocation, an economic region can be
deployed as a technocratic tool by the participating government advance a
clearly defined and limited economic agenda without requiring more than
minimal political alignment or erosion of formal state sovereignty. The unifying
factor in the different forms of economic regionalism is thus the desire by the
participating states to use a wider, transnationalized sense of space to advance
national economic interests.

MEANING OF ECONOMIC INTEGRATION

The term Economic Integration has been interpreted in different
ways. Tinbergen defines economic integration as the creation of most desirable
structure of international economy, removing artificial hindrances to the
optimum operation and introducing deliberately all desirable elements of
coordination or unification. Negative integration relates to those aspects of
economic integration which involve the removal of discrimination and
restriction on the movement of goods among the member countries. On the
other hand, positive integration involves the modification of existing institutions
and policy instruments and adoption of new ones in order to remove market
distortions within the economic region. In short, economic integration aims at
removal of discrimination among the nations to bring about free movement of
goods and factors of productions.
Economic integration, therefore, refers to a process whereby two or
more countries combine into a larger economic group by removing
discriminations existing a long frontiers.
Economic integration can thus be viewed as a spectrum. At one
extreme we can envision a truly global economy in which all countries share a
common currency and agree to a free flow of goods, services, and factors of
production. At the other extreme there would be a number of closed economies,
each independent and self-sufficient. The various integrative agreements in
effect today lie along the middle of this spectrum.

DEFINITION OF ECONOMIC INTEGRATION

An economic arrangement between different regions
marked by the reduction or elimination of trade barriers and the coordination of
monetary and fiscal policies. The aim of economic integration is to reduce costs
for both consumers and producers, as well as to increase trade between the
countries taking part in the agreement.
Economic integration can thus be viewed as a spectrum. At
one extreme we can envision a truly global economy in which all countries
share a common currency and agree to a free flow of goods, services, and
factors of production. At the other extreme there would be a number of closed
economies, each independent and self-sufficient. The various integrative
agreements in effect today lie along the middle of this spectrum.

TYPES OR FORMS OF ECONOMIC INTEGRATION

There are five important types of economic integration. They are:
1.

Preferential Trading Agreement

2.

Free Trade Area

3.

Customs Union

4.

Common Market

5.

Economic Union
The above types of economic integration start at the lowest degree of

economic integration, that is, preferential trading club, and go through

progressively higher stages to the most complete degree of economic
integration, that is, economic union. A brief analysis of the above forms of
economic integration is undertaken below:
1.

Preferential Trading Agreement :

A preferential trading agreement is the loosest form of economic
integration. Under it a group of countries have a formal agreement to
allow each others goods to be traded on preferential terms. These
countries usually reduce their respective duties on imports of all goods
from each other. However, the member countries retain their original
tariffs against the outside world. A good example of preferential trading
agreement is the commonwealth preference system. In 1932, great Britain
and its commonwealth associates established a system of trade known as
the commonwealth preference system.

2.

Free Trade Area :

It is usually a permanent arrangement a group of countries. It
allows for tariff-free trade among the member countries. There is
complete removal of tariffs goods traded between the members of the free
trade area. The member countries are free to levy their own tariffs on
imports of goods from other countries outside the free trade area. Each
member country thus retains autonomy over trade with other countries.
An important problem faced by the countries under the free trade
area is that goods from outside the area may enter a high-duty member
country through a low-duty member country, and thus avoid the high
import duty. This practice will distort the patterns of trade between the
member countries and will, in effect, circumvent the external tariff
sovereignty of the member countries with higher tariffs.

3.

Customs Union :
A customs union is a free-trade area plus an agreement to establish
common barriers to trade with the rest of the world. Since they have a
common tariff against the outside world, the members need neither
customs controls on goods moving among themselves nor rules of origin.
Agreement is needed on the level of the common external tariff and on
the administration of the tariff revenues.
A good example of customs union is the European community
which was formed by the treaty of Rome in 1957. The European

community originally included six countries: Belgium, France, West

Germany, Italy, Luxembourg and the Netherlands.

4. Common Market :
Common Market is a customs union that also has free
movement of all factors of production among the common market
countries. The common market countries abolish all trade restrictions on
their mutual trade and also establish a common external tariff, as a
customs union. The existence of a common market implies that the
internal market comprising all the member countries, is common to all
firms trading within it. The removal of all internal barriers, both tariff and
non-tariff, allows all firms access to the entire internal market. Trade in
goods may be obstructed by non-tariff barriers such as differences in
product standers or testing procedures, customs formalities, transport
restrictions and so on. Non-tariff barriers are often much more of an
obstructions to trade than tariff barriers because they are less visible and
more difficult to overcome. Removal of such barriers will facilitate trade
in goods.
The central American Market is working towards becoming a
common market. However, it is yet to achieve this goal. The EU has
achieved this to some extent. The goal of EU was to create a true
common market.
5. Economic Union :

An economic union is the most complete form of economic

integration between countries. It involves a common market and also the
harmonization of economic policies, in particular monetary union and
coordination of fiscal policies. Monetary union implies there is a fixed
exchange rate system between the member countries, a common or single
currency, and central control over interest rates and other instruments of
monetary policy. Coordination of fiscal policy implies harmonization of
tax rates and taxes, and some degree of control over government budgets
and budget deficits. There may also be coordination of other economic
policies such as regional, industrial and agricultural policies. The member
countries in the economic union function as a single economy.
An economic union is the ultimate form of economic
integration. The European Union provide the best example.
Thus, the degree of economic integration ranges from preferential trade
arrangements to free trade areas, customs unions, common markets and
economic unions.

ARGUMENTS SURROUNDING ECONOMIC INTEGRATION

The important arguments surrounding economic integration are discussed
in this section.
1.

Trade Creation and Trade Diversion :

Jacob Viner, by his pioneering study of the customs union, had
brought out the economic costs and benefits of economic integration.
He argued that customs union gives rise to two opposing tendencies.
On the one hand, a customs union tends to increasing competition
among the member countries and this represents a movement towards
free trade. On the other hand, a customs union tends to provide
relatively more protection against trade and competition from the rest
of the world and this represents a movement towards greater
protection. Thus, according to Viners an economic integration
combines elements of freer trade with elements of greater protection,
and may either improve or worsen resource allocation and welfare,
depending upon the respective strengths of trade creation and trade
diversion.

(a)

Production Effects :
The formation of a customs unions causes some
products that were formerly produced domestically to be imported
from other member country due to the elimination of tariffs. In this
case, the shift in production is from a higher-cost domestic
producer to a lower-cost producer of a member country. This
results in trade creation. Thus, trade creation increase welfare by
reducing costs or, alternatively by increasing world income.

(b)

Consumption Effects :
Formation of customs union leads to increase it
consumption. This can be observed from the above examples of
credit creation and credit diversion. In both the cases, after the
formation of customs union the price of X in country A falls.
Unless As demand for X is perfectly inelastic, As consumption of
X will increase. This is bound to expand trade and improve
welfare.
2. Increased Competition :
Economic integration is likely to result in increased
competition. As trade barriers are eliminated the market expands
and the number of potential competitors increases. Oligopolistic
and monopolistic market structures become exposed to outside
competition. Inefficient firms must either become efficient or close
down. The increased level of competition is also likely to stimulate
the development and utilization of new technology. This creates a
stimulus conducive to managerial efficiency and technological
improvements. This creates an environment for faster economic
growth. All these efforts will lead to reduction in the costs of
production and thus benefit the consumers.
3. Economies of Scale :
Formation of customs union leads to expansion of the
size of the market, increase in competition and greater degree of
specialization. Firms will be able to exploit internal and external
economies. The firms will be able to utilize fully their plant capacity and
reach their optimum size.

4. Technical Change :
Increased competition and expansion of the market encourage
research and development, innovation and technical change.
Economic integration will be conductive to technological
improvement since large scale economies can be reaped. This tends
to promote faster technical change and economic growth.
5. Investment :
The formation of customs union may stimulate investment. The
increase in competition and technical change leads to additional
investment, which is necessary to take advantage of the newly created
opportunities. At the same time, some important-competing industries
may be hit by the increase in competition coming from more efficient
producer located in other union countries. This may result in some
disinvestment. This disinvestment must be subtracted from the positive
investment activity to determine the net effect on investment.
Some countries of the customs union may experience increase in
investment from the rest of the world. The foreign firms already operating
in the union may expand their activities to take advantage of the newly
created opportunities. Apart from this, some foreign firms that in the past
used to export to the union country may decide to invest by building
plants in the union countries. According to some writers, the massive US
investment in Europe after 1955 was due to the formation of European
Economic Community.

6. Economic Growth :
Increased competition, technical changes, economies of scale and
increased investment may lead to increase in income and employment
among the member countries of the union. This may lead to higher
economic growth which could be sustained with continuing changes in
business expectations, higher investment and new production technique
in the union countries.
7. Better Utilisation of Resources :
In a common market, the free movement of labor and capital is
likely to result in better utilisation of the economic resources of the entire
community.
INVESTOPEDIA EXPLAINS 'ECONOMIC INTEGRATION'
There are varying levels of economic integration, including
preferential trade agreements (PTA), free trade areas (FTA), customs unions,
common markets and economic and monetary unions. The more integrated the
economies become, the fewer trade barriers exist and the more economic and
political

coordination

there

is

between

the

member

countries.

By integrating the economies of more than one country, the shortterm benefits from the use of tariffs and other trade barriers is diminished. At
the same time, the more integrated the economies become, the less power the
governments of the member nations have to make adjustments that would
benefit themselves. In periods of economic growth, being integrated can lead to
greater long-term economic benefits; however, in periods of poor growth being
integrated can actually make things worse.

Stages of Economic Integration

There are several stages in the process of economic integration, from a very
loose association of countries in a preferential trade area, to complete economic
integration, where the economies of member countries are completely
integrated.
A regional trading bloc is a group of countries within a geographical region that
protect themselves from imports from non-members in other geographical
regions, and who look to trade more with each other. Regional trading blocs
increasingly shape the pattern of world trade - a phenomenon often referred to
as regionalism.
Stages of Integration

Preferential Trade Area

Preferential Trade Areas (PTAs) exist when countries within a geographical
region agree to reduce or eliminate tariff barriers on selected goods imported
from other members of the area. This is often the first small step towards the
creation of a trading bloc. Agreements may be made between two countries (bilateral), or several countries (multi-lateral).
Free Trade Area
Free Trade Areas (FTAs) are created when two or more countries in a region
agree to reduce or eliminate barriers to trade on all goods coming from other
members. The North atlantic free Trade Agreement (NAFTA) is an example of
such a free trade area, and includes the USA, Canada, and Mexico.
Customs Union
A customs union involves the removal of tariff barriers between members, plus
the acceptance of a common (unified) external tariff against non-members. This
means that members may negotiate as a single bloc with 3 rd parties, such as with
other trading blocs, or with the WTO.
Common Market
A common market is the first significant step towards full economic integration,
and occurs when member countries trade freely in all economic resources not
just tangible goods. This means that all barriers to trade in goods, services,
capital, and labour are removed. In addition, as well as removing tariffs, nontariff barriers are also reduced and eliminated. For a common market to be
successful there must also be a significant level of harmonisation of microeconomic policies, and common rules regarding monopoly power and other
anti-competitive practices. There may also be common policies affecting key

industries, such as the Common Agriculture Policy. (CAP) and Common

Fisheries Policy (CFP) of the European Single Market (ESM).
Economic Union
Economic Union is a term applied to a trading bloc that has both a common
market between members, and a common trade policy towards non-members,
but where members are free to pursue independent macro-economic policies.
Monetary Union
Monetary union is the first major step towards macro-economic integration, and
enables economies to converge even more closely. Monetary union involves
scrapping individual currencies, and adopting a single, shared currency, such as
the Euro for the Euro-16 countries, and the East Caribbean Dollar for 11 islands
in the East Caribbean. This means that there is a common exchange rate, a
common monitory policy, including interest rates and the regulation of
the quantity of money and a single central bank, such as the European Central
Bank or the East Caribbean Central Bank.

Fiscal Union
A fiscal union is an agreement to harmonise tax rates, to establish common
levels of public sector spending and borrowing, and jointly agree national
budget deficits or surpluses. The majority of EU states agreed a fiscal compact
in early 2012, which is a less binding version of a full fiscal union.
Economic and Monetary Union
Economic and Monetary Union (EMU) is a key stage towards compete
integration, and involves a single economic market, a common trade policy, a
single currency and a common monetary policy.

Obstacles to economic integration

Obstacles standing as barriers for the development of economic integration
include the desire for preservation of the control of tax revenues and licensing
by local powers, sometimes requiring decades to pass under the control of
supranational bodies. The experience of 1990-2009 has shown radical change in
this pattern, as the world has observed the economic success of the European
Union. So now no state disputes the benefits of economic integration: the only
question is when and how it happens, what exact benefits it may bring to a state,
and what kind of negative effects may take place.
Theory of Economic Integration
The theory of economic integration is the branch of economics concerned with
analysing the effects of different forms of integration on the economies of
member states and the rest of the world. Its relevance for Europe is the progress
made since the foundation of the European Community and European Free
Trade Area in 1958 and 1960 in dismantling trade barriers, adopting a common
external tariff (in the case of the EC), establishing a single market and, more
recently, creating a common currency. The basic theory of customs union, first
expounded by Viner in 1950 and later extended by Meade and Lipsey, provides
the theoretical foundation on which the theory of integration rests. While Viner's
work was important in showing that customs unions and free trade areas are not
always welfare-enhancing and may even lower global economic welfare, in its
simple form the theory was incomplete. It focused mainly on the short-run
effects of regional integration and failed to provide a convincing rationale for
why countries enter into such arrangements. Subsequently, Viner's analysis was
modified and added to by relaxing some of the more limiting assumptions on
which it rested, preparing the way for a deeper understanding of the integration
process. In particular, our understanding of how integration affects countries

was strengthened by the incorporation of economies of scale and terms of trade

effects, which Viner had largely ignored.
Beginning in the 1980s, important advances were made by extending the
analysis to incorporate the effects of increasing returns and imperfect
competition. An important role in this respect was played by the emergence of
the new trade theories. The launching of the Single Market programme in 1987
led to greater attention being given to the effects of deep integration on markets
in which intra-industry trade was the predominant form of competition. On top
of the normal gains from lower prices and improved resource allocation,
potentially much greater gains could be reaped from intra-industry
specialisation. At the same time, integration theory became much more
interested in the effects of integration on economic growth. The application of
endogenous growth theories to integration theory appeared to show that much
the largest gain from integration results from a permanent increase in the
regional growth rate. More recently, integration theory has become concerned
about the location effects of integration, reflecting the growing interest of trade
theorists in the importance of geography. New models of trade, incorporating
the effects of factor mobility, external economies of scale and product
competition, have established the importance of location in the analysis of the
effects of integration. In short, integration theory has come a long way from
where it started out fifty years or more ago, leaving us with a much more
comprehensive picture of how it impacts on countries both inside and outside
the region.

The Aims and Mechanics of Economic Integration

Aims and Objectives
Economic integration schemes share the common aim and objective of
expanding net benefits available for international distribution through fiscal
compensation and net distribution mechanisms. Peter Robson notes:
A primary economic objective of integration is to raise the real output and
income of the participants and their rates of growth by increasing specialization
and competition by facilitating desirable structural (linkages) changes. This
objective may be pursued with reference to trade in products only, as in a free
trade area or a customs union, or it may extend to factor mobilitythe free
movement of labour, capital and enterprises as in a common market, or an
economic union
The expected rise in output and income are essentially due to a combination
of several factors. First, specialization based on comparative advantage in
production tends to enlarge the output of products that can be shared by
participating states. Second, economies of scale associated with increased
production tends to lead to the obtaining of more output from a given quantity
of inputs and a given state of industrial technology. Third, this induced
widening of economic activity frequently contributes to an increase in outputs
arising from the augmented availability of factor inputs and improvements in
industrial technology. And fourth, enhanced intraregional competition could
cause structural and technological changes that would reduce the power of local
monopolies and lead to a more
efficient allocation of resources as well as to an expansion of output
availability. In addition, joint action facilitates bargaining with countries outside
the area of coordinated action.

There are economic as well as political reasons why nations pursue economic
integration. The economic rationale for the increase of trade between member
states of economic unions that it is meant to lead to higher productivity. This is
one of the reasons for the global scale development of economic integration, a
phenomenon

now

realized

in

continental economic

blocks such

as ASEAN, NAFTA, SACN, the European Union, and the Eurasian Economic
Community and proposed for intercontinental economic blocks, such as
the Comprehensive Economic Partnership for East Asia and the Transatlantic
Free Trade Area.
Comparative advantage refers to the ability of a person or a country to produce
a particular good or service at a lower marginal and opportunity cost over
another. Comparative advantage was first described by David Ricardo who
explained it in his 1817 book On the Principles of Political Economy and
Taxation in an example involving England and Portugal.[3] In Portugal it is
possible to produce both wine and cloth with less labor than it would take to
produce the same quantities in England. However the relative costs of
producing those two goods are different in the two countries. In England it is
very hard to produce wine, and only moderately difficult to produce cloth. In
Portugal both are easy to produce. Therefore while it is cheaper to produce cloth
in Portugal than England, it is cheaper still for Portugal to produce excess wine,
and trade that for English cloth. Conversely England benefits from this trade
because its cost for producing cloth has not changed but it can now get wine at a
lower price, closer to the cost of cloth. The conclusion drawn is that each
country can gain by specializing in the good where it has comparative
advantage, and trading that good for the other.
Economies of scale refers to the cost advantages that an enterprise obtains due
to expansion. There are factors that cause a producers average cost per unit to
fall as the scale of output is increased. Economies of scale is a long run concept

and refers to reductions in unit cost as the size of a facility and the usage levels
of other inputs increase. Economies of scale is also a justification for economic
integration, since some economies of scale may require a larger market than is
possible within a particular country for example, it would not be efficient
for Liechtenstein to have its own car maker, if they would only sell to their local
market. A lone car maker may be profitable, however, if they export cars to
global markets in addition to selling to the local market.
Besides these economic reasons, the primary reasons why economic integration
has been pursued in practice are largely political. The Zollverein or German
Customs Union of 1867 paved the way for German (partial) unification under
Prussian leadership in 1871. "Imperial free trade" was (unsuccessfully)
proposed in the late 19th century to strengthen the loosening ties within British
Empire. The Econopean Economic Community was created to integrate France
and Germany's economies to the point that they would find it impossible to go
to war with each other.