1. Economic Integration
Chapter 3

2. Background of the development of economic integration
The development of productivity and international division after World War II
To fight with external forces
European countries after World War II
USA after 1980s
Asian countries
The positive effect of economic integration

3. Types of economic integration
Regional Trade Agreement
A regional trade agreement means there are two or more countries reduce or abolish tariffs on a limited number of products.
The British imperial preference system (1932)

4. Types of economic integration
Free Trade Area
All members of the group remove tariffs on each other’s products, while at the same time each member retains its independence in establishing trading policies with nonmembers.
EFTA (1960)
This scheme is usually assumed to apply to all products between member countries, but it can clearly involve a mix of free trade in some products and preferential, but still protected, treatment in others.

5. Types of economic integration
Customs Union
All tariffs are removed between members and the group adopts a common external commercial policy toward nonmembers. Further more, the group acts as one body in the negotiation of all trade agreements with nonmembers. The existence of the common external tariff takes away the possibility of transshipment by nonmembers.

6. Types of economic integration
Common Market
All tariffs are removed between members, a common external trade policy is adopted for nonmembers, and all barriers to factor movements among the member countries are removed. The free movement of labor and capital between members represents a higher level of economic integration and, at the same time, a further reduction in national control of the individual economy.
EEC single market begun on Jan 1, 1993

7. Types of economic integration
Economic Union
Includes all features of a common markets but also implies the unification of economic institutions and the coordination of economic policy through out all member countries. While separate political entities are still present, an economic policy union generally establishes several supranational institutions whose decisions are binding upon all members. When an economic union adopts a common currency, it has become a monetary union as well.

8. Rules of Origin in International Trade
The determination of what country actually produced the good is known as the rules of origin.
It is common for the rules of origin to be more restrictive for preferential trade agreements than it is for imports from countries not being granted some form of preferential status.
For example, the U.S. has relied on the substantial transformation test to determine the “nationality” of a good in the past. And, under NAFTA, the rules of origin became even more complicated.

9. The Static Effects of a Customs Union
The reduction of tariffs and non-tariff barriers to trade in a regional trade agreement has both benefits and costs.
The favorable effect on trade is known as trade creation (TC).
Trade Creation takes place whenever economic integration leads to a shift in product origin from a domestic producer whose resource costs are higher to a member producer whose resource costs are lower.

10. Suppose country A, B, C produce cars respectively at different costs
Suppose country A, B, C produce cars respectively at different costs. According to the following table, country A does not import cars before customs union is established. But if country A and B signs an Agreement of customs union, country will begin to import cars from country B, and stop producing cars itself—the effect of Trade Creation.
A B C
Domestic price
Domestic price plus tariff of
country A (tariff of 20%)
Domestic price plus common tariff of
the customs union (tariff of 20%)

11. The losses for countries that are not members of the trade agreement are known as trade diversion (TD).
Trade Diversion takes place whenever there is a shift in product origin from a non-member producer whose resource costs are lower to a member-country producer whose resource costs are higher. This shift represents a movement away from the free-trade allocation of resources and could reduce welfare.

12. Suppose country A, B, C can produce wheat at different costs
Suppose country A, B, C can produce wheat at different costs. According to the following table, country A import wheat from country C before customs union is established. But after country A and B form a customs union, country A will turn to country B to get the wheat it needs—the effect of Trade Diversion.
A B C
Domestic price
Domestic price plus tariff of
country A (import duty of 25%)
Domestic price plus common tariff of
the customs union (tariff of 25%)

13. The Static Effects of a Customs Union
Whether or not a trade agreement between two countries increases world welfare depends on whether trade creation is larger than trade diversion.
Using the supply and demand model, we can illustrate the static welfare effects of lowering trade barriers among member countries of a custom union. Assume that the world composed of three countries: Mexico, the U.S., and Japan.

14. The Static Effects of a Customs Union
Price of Cars Sm P4
Sus+tarriff P3
Sj+tarriff e a f b P2
Sus c P1 Sj Dm Q1 Q2 Q3 Q4
Quantity of Cars

15. The Static Effects of a Customs Union
Mexico is a “small” country.
The formation of a customs union leads to changes in consumers’ surplus, producers’ surplus, and the tariff income of the government.
The consumers’ surplus increase: e+a+f+b
The producers’ surplus decrease: e
The tariff income of the government decrease: f+c
The total effect depends on the size of the positive effect and the negative effect.

16. General Conclusions on Trade Creation/Diversion
The more closely the price in the partner country approaches the low-cost world price, the more likely the effect of integration on the market in question will be positive.
The effect of the integration is more likely to be positive if the initial tariff rate is higher.
The more elastic the supply and demand curves, the greater the quantity response by both consumers and producers.
Integration is more likely to be beneficial when there is a greater number of participating countries.

17. The Dynamic Effects of a Customs Union
More competitive environment and lower degree of monopoly power
Economies of scale
Greater investment in the member countries
Structural changes
Internal and external economies
Expected increases in income and demand
Reduced risk and uncertainty

18. Summary of Economic Integration
The conditions under which economic integration is more likely to have overall beneficial effects:
The higher the level of pre-union tariffs and the lower the common external tariff, the more likely the net effects will be positive.
The more elastic supply and demand in the member countries are, the more likely the net results will be positive.
The net positive effects will likely be larger the greater the number of participating members and the larger the economic size of the group.

19. Summary of Economic Integration
The greater the ease of switching from a higher-cost domestic source to a lower-cost member source, the greater the pre-union per-unit cost differences between the two sources, and the greater the scope for experiencing economies of scale and attracting foreign investment, the larger the potential gains from integration.
If transportation costs are considered, the closer the member countries are geographically, the more likely there will be static and dynamic gains from integration.

20. The European Union
The world’s largest and most successful regional trade agreement (also regional economic integration) is the European Union (EU).
The EU currently contains 27 countries with a combined population of 372 million and a combined GDP larger than the U.S.A..
The agreement includes the removal of trade barriers, the mobility of capital and labor, the harmonization of regulations, and a common currency.

21. → European Economics Community (EEC) in 1958 with 6 members
History of EU:
→ European Economics Community (EEC) in 1958 with 6 members
→ European Community (EC) in 1979 with 9 members
→ European Union (EU) in 1993 with 12menbers
→ EU with 27 members now

22. The size of the European market
The largest integrated market in the world.
It is likely to have a major role in determining future international political arrangements, trade patterns and rules, and international economic relations in general.
EU market is similar to NAFTA market on population and GDP.

23. NAFTA
North American Free Trade Agreement (NAFTA) is an agreement to establish a free-trade area consisting of the U.S., Canada, and Mexico.
For the U.S. and Canada, the agreement was useful in the sense that it eliminated some of the last vestiges of protectionism in a large trading relationship.
For Mexico, access to two of the world’s largest markets seemed to be an excellent way to advance export-led growth and attract the investment capital the country needed.

24. The North American Free Trade Agreement (NAFTA)
One of the largest trade agreement areas in the world today.
Three feature of the NAFTA:
most forms of trade barriers came down;
it specifies North American content requirements for goods that are subject to free trade;
it establishes a system of dispute resolution.

25. Criticism of Economic Integration
Sovereignty covers the rights of nations to be free from unwanted foreign interference in their affairs.
Complaints: International institutions violate national sovereignty by imposing unwanted domestic economic policies.

26. Criticism of Economic Integration
Ideology issue
Complaints: The advices and technical assistance provided to developing countries are a reflection of the biases and wishes of developed country interests.

27. Criticism of Economic Integration
Implementation and Adjustment Costs
Complaints: When agreements combine developing and developed countries, the negotiating skills and the ability to absorb the costs of implementation and adjustment are asymmetry.