Chapter 10: Economic Integration Topics in chapter 10: What is meant by economic integration? Trade creation and trade diversion Trade integration in practice Trade integration in the EU There is a great deal of overlap between ch. 10 in Salvatore and ch. 5 in Baldwin. Salvatore discusses the small country case, which is covered in appendix A to ch. 5 in Baldwin. Generally, Baldwin uses the large country approach

Economic Integration What do we mean by economic integration? A group of countries removes trade restrictions among each other, but maintains restrictions on imports from non member countries Violates WTOs MFN principle, but accepted under WTO trade rules Whether bilateralism as opposed to multilateralism is a good thing is highly controversial

Different Blocs Free Trade Area (FTA) Customs Union (CU) Trade barriers are removed among member countries, and each member maintains an individual trade policy towards non member countries Customs Union (CU) As FTA, but a common trade policy towards non member countries

Different Blocs Common Market (CM) Economic Union (EU) AS CU, but free movement of factors of production in addition Economic Union (EU) As CM, but members harmonise economic policy too

The great debate – is trade discrimination good or bad ? Accepted ”truth”: economic integration increases welfare. Free trade is optimal, and FTAs/CUs in fact means that trade is liberalised In the 1950s, Jacob Viner showed that this is not necessarily correct – later known as ”the theory of the second best”

Viner`s example Country A B C Cost of production 35 26 20 Assume that country A has had a 100 % tariff rate on imports from abroad, and now a CU is formed with A and B. Will this increase welfare in country A ? Assume that country A has had a 50 % tariff rate on imports, and now a CU is formed between A and B. Does this increase welfare in country A?

Trade creation/trade diversion Question 1: A will import the good from B. An inefficient producer at home is replaced by an efficient producer in a member country. This is trade creation and increases welfare. Question 2: A will no longer import from the cheapest source (country C cost = 20), but will now import from B for 26. An efficient producer in 3rd country is replaced by an inefficient producer in a member country. This is trade diversion, and reduces welfare. Trade is diverted from C to B.

Trade creation

Trade diversion

How do we avoid trade diversion ? As many countries as possible should participate. If all countries participate, there will be no trade diversion Tariff rates and other protectionist barriers should be as low as possible towards non members Countries should have a fairly similar economic structure. Countries which are highly dissimilar may already have exploited their trade opportunities

What about dynamic effects ? Dynamic effects are usually divided into 2 1. Increased competition – increases investments, increased efficiency and increased innovation 2. Scale effects – a larger market may increase economies of scale Dynamic effects are not necessarily positive Economies of scale behind high tariff walls – imports can be squeezed out (trade suppression) all imports Different regional development

Trade agreements in practice Canada - U.S. free trade area NAFTA – North American Free Trade Area FTAs among developing countries