CHAPTER

1 0
ECONOMIC
INTEGRATION:
CUSTOMS UNIONS
AND FREE TRADE
 LEARNING
GOALS:
After reading this chapter, you should be able
to:
Understand the meaning of trade
creation, trade diversion, and the dynamic
benefits of economic integration

Describe the importance and effects of

the European Union (EU) and NAFTA

Describe attempts at economic

integration among developing countries
and countries in Central and Eastern
Europe.
Introductio
• Economicnintegration involves reducing trade barriers among
participating nations.
• Forms range from preferential trade arrangements to free trade areas,
customs unions, common markets, and economic unions.
• Customs unions eliminate internal trade barriers and harmonize external
trade policies.
• Examples include the EU and the Zollverein.
• Other forms include free trade areas (NAFTA, EFTA) and common
markets.
• The chapter focuses on customs unions, analyzing trade-creating and
trade-diverting effects, the theory of the second best, dynamic effects,
and historical attempts at integration.
Trade-Creating Customs
Union
In this section, we first explain the process of trade
creation, and then we illustrate the effects of a trade-
creating customs union.
Trade Creation
Domestic production shifts to lower-cost imports from other
union members. Increases welfare due to:

• Greater specialization based on comparative advantage.

• Benefits for both union members and non-members.
• Increased real income and imports for all.
Illustration of a Trade-Creating
Customs Union
Before the customs union: Nation 2 imposes a 100% tariff on imports, leading to higher
domestic prices and imports from the lower-cost Nation 1.

After the customs union: Tariffs on imports from Nation 1 are eliminated. This reduces
prices in Nation 2, increases consumption, and shifts production towards the more efficient
Nation 1.

Benefits: Consumers in Nation 2 gain from lower prices (AGHB). However, domestic
producers lose (AGJC) and tariff revenue is lost (MJHN).

Net gain: The net welfare gain for Nation 2 is the sum of the shaded triangles CJM and
BHN ($15), representing the overall increase in efficiency due to trade creation.
 Trade-Diverting Customs
Unions

In this section, we first explain the meaning of trade

diversion, and then we illustrate the effects of a trade-
diverting customs union.
 Trade Add Title

Diversion
Trade Diversion:
• Imports from cheaper non-member countries are replaced by
more expensive imports from within the union.
• Reduces welfare by:
⚬ Shifting production to less efficient union producers.
⚬ Worsening the international allocation of resources.
⚬ Moving away from comparative advantage.
Trade-Diverting Customs Union:
• Results in both trade creation and trade diversion.
• Net welfare effect for members is uncertain (depends on the
balance of trade creation and diversion).
• Always reduces the welfare of non-members.
Illustration of a Trade-Diverting
Customs Union
Figure 10.2 illustrates a trade-diverting customs union where
Nation 2 shifts imports from the more efficient Nation 1 to the
less efficient Nation 3. This leads to a welfare loss due to
trade diversion (shaded rectangle) that outweighs the welfare
gain from trade creation (shaded triangles). While trade
creation increases efficiency, the loss from shifting production
to a less efficient producer within the union dominates. This
results in a net welfare loss for Nation 2.
The Theory of the Second Best and
Other Static Welfare Effects of
Customs
Theory of the Unions
Second Best:
• The theory of customs unions is a special case of this broader
principle.
Conditions for Trade Creation and Increased Welfare:
• The chapter will explore the factors that make trade creation more
likely and increase the welfare of union members.
Other Static Welfare Effects:
• The chapter will investigate other static welfare effects of customs
unions beyond trade creation and diversion.
The Theory of the Second
Bestto Viner:
Prior
• Free trade was believed to maximize global welfare.
• Any move towards freer trade, like a customs union, was expected to
increase welfare for all.
Viner's Contribution:
• Showed that customs unions can increase or decrease welfare.
• Introduced the "theory of the second best."
Theory of the Second Best:
• If all conditions for optimal welfare cannot be met, trying to satisfy some of
them may not lead to the best possible outcome.
• Customs unions are an example of this principle.
Significance:
• The theory of the second best has broad implications in economics beyond
international trade.
• It was further developed by Meade and generalized by Lipsey and
Lancaster.
Conditions More Likely to Lead to
Increased Welfare
A customs union is more likely to lead to trade creation and increased welfare
under the following conditions:
1.High pre-union trade barriers: Greater potential for trade creation within the
union.
2.Low barriers with the rest of the world: Reduces the likelihood of trade diversion.
3.Large number of large members: Increases the probability of finding low-cost
producers within the union.
4.Competitive economies: Greater opportunity for specialization and trade
creation.
5.Close geographic proximity: Reduces transportation costs and facilitates trade.
6.Strong pre-union trade and economic ties: Higher potential for significant welfare
gains.
Other Static Welfare Effects of Customs
Unions
Administration Savings:
• Elimination of customs officers, border patrols, etc., for trade within the
union.
• Occurs regardless of whether the union is trade-creating or trade-diverting.
Terms of Trade Effects:
• Trade-diverting unions may improve the union's terms of trade.
• Trade-creating unions may worsen the union's terms of trade.
• Individual member's terms of trade depend on specific circumstances.
Increased Bargaining Power:
• Customs unions have greater bargaining power in international trade
negotiations compared to individual members.
• The EU is a prime example.
 Dynamic Benefits from Customs
UnionsCompetition:
Increased
• Stimulates efficiency, innovation, and lower prices for consumers.
• Requires antitrust measures to prevent collusion within the union.
Economies of Scale:
• Enlarged market allows for increased production runs and reduced costs.
• While important, even small nations can achieve economies of scale
through exports.
Stimulus to Investment:
• Attracts investment to take advantage of the larger market and avoid
trade barriers.
• Examples: US investments in Europe after 1955 and 1986.
Dynamic Gains:
• Estimated to be significantly larger than static gains.
Dynamic Benefits from Customs
Unions
Unilateral Trade Liberalization:
• The most efficient solution, but may worsen terms of trade for large
nations.
• Faces political challenges due to opposition from affected groups.
Regional Blocs and Multilateral Trade:
• Debate exists on whether blocs facilitate or hinder global free trade.
• Ideal scenario: Blocs reduce internal and external barriers and readily
admit new members.
History of Attempts at Economic
Integration
In this section, we briefly survey the history of attempts at economic
integration, starting with the formation of the European Union, the
European Free Trade Association, the North American Free Trade Area, and
the Southern (American) Common Market, and then examining other
attempts at economic integration among developing countries and among
the Republics of the former Soviet Union.
 The European Free Trade
• Association
Formation: EFTA established in 1960 by "outer seven"
nations.
• Focus: Free trade in industrial goods, limited agricultural
trade.
• Trade Deflection: Risk of imports entering through low-tariff
members.
• Membership Changes: UK, Denmark, Ireland, and Portugal
joined the EU. Iceland, Finland, and Liechtenstein joined EFTA.
• EEA: EFTA and EU formed the EEA in 1994, aiming for free
movement.
• Current Status: EFTA now has four members: Switzerland,
Norway, Iceland, and Liechtenstein.
The North American and Other Free Trade
Agreements
• US-Israel Free Trade Agreement: First bilateral trade agreement for the
US, focusing on goods, services, and intellectual property.
• US-Canada Free Trade Agreement: Eliminated most trade barriers,
boosting economic growth on both sides.
• NAFTA: Established free trade between the US, Canada, and Mexico.
Increased trade significantly, but also led to job losses in some US sectors.
• Benefits of NAFTA: Increased competition, lower prices, and job creation
in some sectors for the US. Increased exports and FDI for Mexico.
• FTAA: Initiative for hemispheric free trade, facing challenges in
negotiations.
• Other US FTAs: Signed with various countries, including Australia,
Bahrain, Chile, and many others.
Attempts at Economic Integration among Developing
Countries
1.Central American Common Market (CACM): Formed in 1960, dissolved in
1969, and revived in 1990.
2.Latin American Free Trade Association (LAFTA): Established in 1960,
superseded by the Latin American Integration Association (LAIA) in 1980.
3.Southern Common Market (Mercosur): Formed in 1991 by Argentina, Brazil,
Paraguay, and Uruguay. Expanded to include Bolivia, Chile, Peru, Colombia,
Ecuador, and Venezuela.
4.Free Trade Area of the Americas (FTAA): Established in 1998, aiming for free
trade among 34 countries.
5.Caribbean Free Trade Association (CARIFTA): Transformed into CARICOM in
1973.
Attempts at Economic Integration among Developing
Countries
6. East African Community (EAC): Established in 1967 by Kenya, Tanzania, and
Uganda.
7. West African Economic and Monetary Union (WAEMU): Includes Benin, Burkina Faso,
Cote d’Ivoire, Guinea Bissau, Mali, Niger, Senegal, and Togo.
8. Southern Africa Development Community (SADC): Includes 14 member countries in
Southern Africa.
9. ASEAN: Formed in 1967, primarily as a political association. In 1977, ASEAN decided
to pursue economic integration, aiming towards the creation of a common market.
thank
you!