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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, 10th Edition © 2010 John Wiley & Sons, Inc.
In this chapter:
 Introduction
 Trade-Creating Customs Unions
 Trade-Diverting Customs Unions
 The Theory of the Second Best and Other
Static Welfare Effects of Customs Unions
 Dynamic Benefits from Customs Unions
 History of Attempts at Economic Integration
Salvatore: International Economics, 10th Edition © 2010 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, 10th Edition © 2010 John Wiley & Sons, Inc.
Introduction
 Preferential trade arrangements


Provide lower barriers to trade among
participating nations than on trade with nonmember 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, 10th Edition © 2010 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, 10th Edition © 2010 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, 10th Edition © 2010 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, 10th Edition © 2010 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, 10th Edition © 2010 John Wiley & Sons, Inc.
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, 10th Edition © 2010 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, 10th Edition © 2010 John Wiley & Sons, Inc.
FIGURE 10-1 A Trade-Creating Customs Union.
Salvatore: International Economics, 10th Edition © 2010 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, 10th Edition © 2010 John Wiley & Sons, Inc.
FIGURE 10-2 A Trade-Diverting Customs Union.
Salvatore: International Economics, 10th Edition © 2010 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 nonmembers.
 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, 10th Edition © 2010 John Wiley & Sons, Inc.
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, 10th Edition © 2010 John Wiley & Sons, Inc.
The Theory of the Second Best and Other
Static Welfare Effects of Customs Unions
 Conditions More Likely to Lead to Increased
Welfare
1.
Higher pre-union trade barriers of member
nations.
2.
Lower customs union’s trade barriers with
non-members.
3.
Greater number of nations forming customs
union, and the larger their size.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
The Theory of the Second Best and Other
Static Welfare Effects of Customs Unions
 Conditions More Likely to Lead to Increased
Welfare
4.
More competitive rather than complementary
economies of member nations.
5.
Closer geographical proximity of member
nations.
6.
Greater pre-union trade and economic
relationship among potential member nations.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
The Theory of the Second Best and Other
Static Welfare Effects of Customs Unions
 Other Static Effects of Customs Unions
1.
Administration savings from elimination of
customs officers, border patrols, and others.
2.
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.
3.
By acting as a single unit, customs union will
likely have more bargaining power than
members separately.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
Dynamic Benefits from Customs Unions
 Dynamic Benefits of Customs Unions
1.
Increased competition, leading to greater
efficiencies and technological improvements.
2.
Economies of scale from the enlarged market.
3.
Stimulus of investment to take advantage of
enlarged market, and to meet increased
competition.
4.
Better utilization of community resources as labor
and capital move freely (assumes common
market).
Salvatore: International Economics, 10th Edition © 2010 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, 10th Edition © 2010 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, 10th Edition © 2010 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, 10th Edition © 2010 John Wiley & Sons, Inc.