International Economics Tenth Edition CHAPTER T E N 10 International Economics Tenth Edition Economic Integration: Customs Unions and Free Trade Areas Dominick Salvatore John Wiley & Sons, Inc. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Learning Goals: 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 South America and in Eastern Europe. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Introduction Economic integration refers to the commercial policy of discriminatively reducing or eliminating barriers only among the nations joining together. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Preferential trade arrangements Introduction Preferential trade arrangements Provide lower barriers to trade among participating nations than on trade with non-member nations. The loosest form of economic integration. Example: British Commonwealth Preference Scheme, established in 1932 between the United Kingdom and members of the British Empire. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Introduction Free trade areas Removes all barriers to trade among members, but each nation retains its own barriers to trade with non-members. Examples: European Free Trade Association (EFTA), 1960, between United Kingdom, Austria, Denmark, Norway, Portugal, Sweden and Switzerland North American Free Trade Agreement (NAFTA), 1993, between the United States, Canada and Mexico Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Introduction Customs union Removes all barriers to trade among members and harmonizes trade policies toward the rest of the world. Examples: European Union (EU), or European Common Market, 1957, between West Germany, France, Italy, Belgium, the Netherlands, and Luxembourg. Zollverein, 1834, between large number of sovereign German states Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Introduction 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. Example: European Union (EU) achieved common market status in 1993. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Introduction 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 and fiscal policies of members. Most advanced type of economic integration. Examples: Benelux, formed after World War II between Belgium, the Netherlands and Luxembourg Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Duty free zones (free economic zones) Introduction Duty free zones (free economic zones) Areas established to attract foreign investments by allowing raw materials and intermediate products duty free. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Trade-Creating Customs Unions Trade creation occurs when domestic production in a member nation is replaced by lower-cost imports from another member nation. Leads to increased welfare for members as nations specialize in comparative advantages. Leads to increased welfare for non-members as increased real income spills over into increased imports from rest of the world. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

FIGURE 10-1 A Trade-Creating Customs Union. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Trade-Diverting Customs Unions Trade diversion occurs when lower-cost imports from non-members are replaced by higher cost imports from members. By itself, trade diversion lowers welfare as it shifts resources away from comparative advantages. Trade diverting customs union also results in trade creation. Change in welfare depends on relative magnitude of creation and diversion. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

FIGURE 10-2 A Trade-Diverting Customs Union. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

The Theory of the Second Best and Other Static Welfare Effects of Customs Unions It was once believed that any movement toward freer trade would increase welfare, so formation of a customs union would necessarily result in increased welfare for members and non- members. In 1950, Viner showed that formation of a customs union could increase or reduce welfare, depending on the circumstances under which it takes place. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Theory of the Second Best The Theory of the Second Best and Other Static Welfare Effects of Customs Unions Theory of the Second Best If all conditions required to maximize welfare cannot be satisfied, trying to satisfy as many conditions as possible does not necessarily or usually lead to the second-best position. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Conditions More Likely to Lead to Increased Welfare The Theory of the Second Best and Other Static Welfare Effects of Customs Unions Conditions More Likely to Lead to Increased Welfare Higher pre-union trade barriers of member nations. Lower customs union’s trade barriers with non-members. Greater number of nations forming customs union, and the larger their size. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Conditions More Likely to Lead to Increased Welfare The Theory of the Second Best and Other Static Welfare Effects of Customs Unions Conditions More Likely to Lead to Increased Welfare More competitive rather than complementary economies of member nations. Closer geographical proximity of member nations. Greater pre-union trade and economic relationship among potential member nations. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Other Static Effects of Customs Unions The Theory of the Second Best and Other Static Welfare Effects of Customs Unions Other Static Effects of Customs Unions Administration savings from elimination of customs officers, border patrols, and others. Reduction in demand for imports from and supply of exports to rest of the world will likely lead to improvement in collective terms of trade of member nations. By acting as a single unit, customs union will likely have more bargaining power than members separately. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Dynamic Benefits from Customs Unions Dynamic Benefits of Customs Unions Increased competition, leading to greater efficiencies and technological improvements. Economies of scale from the enlarged market. Stimulus of investment to take advantage of enlarged market, and to meet increased competition. Better utilization of community resources as labor and capital move freely (assumes common market). Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

History of Attempts at Economic Integration The European Union (EU) 1958 – established common external tariff 1968 – Achieved free trade in industrial goods within EU, and common price for agricultural goods 1970 – Reduced restrictions on movement of labor and capital 1993 – Removed all remaining restrictions on flow of goods, services and resources, becoming largest trade bloc in the world Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

History of Attempts at Economic Integration The European Free Trade Association (EFTA) 1960 – formed by “outer seven” nations: United Kingdom, Austria, Denmark, Norway, Portugal, Sweden and Switzerland 1967 – Achieved free trade in industrial goods 1991 – Membership evolved to include Austria, Finland, Iceland, Liechtenstein, Norway, Sweden, and Switzerland 1994 – Joined EU to form European Economic Area (EEA) Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

History of Attempts at Economic Integration The North American Free Trade Agreement (NAFTA) 1994 – formed by United States, Canada and Mexico, to eventually lead to free trade in goods and services over entire North American area. Also phased out many other barriers to trade and reduced barriers to cross-border investments among the three member nations. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Attempts at Economic Integration in Developing Countries The Central American Common Market (CACM) Costa Rica, El Salvador, Guatemala, Honduras, and Nicaragua Established in 1960, dissolved in 1969, and reestablished in 1990 Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Attempts at Economic Integration in Developing Countries The Latin American Free Trade Association (LAFTA) Established in 1960 by Mexico and most South American countries. Superceded by the Latin American Integration Association (LAIA) in 1980. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Attempts at Economic Integration in Developing Countries The Southern Common Market (Mercosur) Argentina, Paraguay, Brazil, and Uruguay in 1991. Associate members Bolivia and Chile (1996), Peru (2003), Columbia, Ecuador, and Venezuela (2004). Venezuela is scheduled to become a full member in 2012. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Attempts at Economic Integration in Developing Countries The Free Trade Area of the Americas (FTAA) 1998 Goal of establishing free trade among the 34 democratic nations of North and South America Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Attempts at Economic Integration in Developing Countries Caribbean Free Trade Association (CARIFTA) Formed in 1968, became a common market in 1973 (CARICOM) Antigua and Barbuda, Bahamas, Barbados, Belize, Dominica, Grenada, Guyana, Haiti, Jamaica, Montserrat, St. Kitts-Nevis, St. Lucia, St. Vincent, and the Grenadines, Suriname, Trinidad and Tobago Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Attempts at Economic Integration in Developing Countries Southern African Development Community Angola, Botswana, Democratic Republic of Congo, Lesotho, Madagascar, Malawi, Mauritius, Mozambique, Namibia, South Africa, Swaziland, Tanzania, Zambia, Zimbabwe Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Attempts at Economic Integration in Developing Countries Association of South East Asian Nations (ASEAN) Brunei, Darussalam, Cambodia, Indonesia, Laos, Malaysia, the Philippines, Singapore, Thailand, Vietnam Primarily a political association, but began in 1977 to move toward a common market Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Attempts at Economic Integration in Developing Countries East African Community (EAC) 1967, Kenya, Tanzania, and Uganda West African Economic and Monetary Union (WAEMU) Benin, Burkina Faso, Cote d’Ivoire, Guinea Bissau, Mali, Niger, Senegal, Togo Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Economic Integration in Central and Eastern Europe Council of Mutual Economic Assistance (CMEA) During Soviet period Since dissolution of the Soviet Union, many central European countries have moved toward EU membership Many of the former Soviet states lag behind in this process Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Case Study 10-1 Economic Profile of the EU, NAFTA, and Japan Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Case Study 10-2 Gains from the Single EU Market Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Case Study 10-3 Mexico’s Gains from NAFTA—Expectations and Outcome Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Case Study 10-4 Economic Profile of Mercosur Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Case Study 10-5 Changes in Trade Patterns with Economic Integration Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

General Equilibrium Analysis of a Trade-Diverting Customs Union Appendix to Chapter 10 General Equilibrium Analysis of a Trade-Diverting Customs Union Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

FIGURE 10-3 General Equilibrium Analysis of a Trade-Diverting Customs Union. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Regional Trade Agreements around the world in 2012 Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Regional Trade Agreements around the world in 2012 Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

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