Various levels n Free trade area (FTA) - NAFTA n Customs union (cu) - 1 CET n Common market - 4 freedoms n Economic union - common policies n Total integration

INTERNATIONAL ECONOMIC INTEGRATION REF:CU1A OCT 08 Note: You will have a copy of these slides with spaces for you to complete during the lecture

Customs Unions n Trade creation / trade diversion n Dynamic effects n Terms of trade

Trade creation(TC) & Trade diversion(TD) n CU initially regarded as move to free trade n Viner (1950) : TC & TD n Numerical example

Numerical example HomePartnerRoW n Price/cost (£) n Case1: trade creation tariff= 30 n Pre cu n Post cu

Numerical example HomePartnerRoW n Price/cost (£) n Case1: trade creation tariff= 30 n Pre cu n Post cu

Numerical example HomePartnerRoW n Price/cost (£) n Case1: trade creation tariff= 30 n Pre cu n Post cu504060

HomePartnerRoW n Price/cost (£) n Case2: trade diversion tariff= 15 n Pre cu n Post cu

HomePartnerRoW n Price/cost (£) n Case2: trade diversion tariff= 15 n Pre cu n Post cu

HomePartnerRoW n Price/cost (£) n Case2: trade diversion tariff= 15 n Pre cu n Post cu504045

n Assumptions (partial equilibrium analysis) –Partners (Sp) S/curve & world S/curve (Sw) infinitely elastic. Sw (efficient) below Sp –Domestic supply & demand (SH & DH) –Consumers dont differentiate - origin of good –Home & partner small, CU small

CU theory note: model will differ if change assumptions Q good X Price SH DH Sw Sp

CU theory Q good X Price SH DH Sw Sp Sw+tariff P1 P2 Sp+tariff Phome

Pre CU Q good X Price SH DH Sw Sp Sw+tariff P1 P2 Sp+tariff Phome Q1 Q2 a b c d Area abcd =?

Post CU Q good X Price SH DH Sw Sp Sw+tariff P1 P2 Sp+tariff Phome Q1 Q2 a b c d P3 Q3Q4 xy

Post CU Q good X Price SH DH Sw Sp Sw+tariff P1 P2 Sp+tariff Phome Q1 Q2 a b c d P3 Q3Q4 xy Z W +ve specialisation effect +ve substitution effect

pre-cupost-cu PRICEP2P3 CONSUMPTION Q1Q3 PROD(home)Q2Q4 IMPORTSQ1-Q2Q3-Q4

n Net gain = TC-TD x + y-z –production gain = x –consumer gain = y –cost of trade diversion = z n W = ?

Deductions n Higher original tariff - greater potential benefits n Smaller cost difference partner & RoW - likely TD losses lower n Greater price elasticity DH & SH - TC likely n Greater overlap of goods - bigger gains n Bigger CU - TD less likely n Low CET - TD less likely

Higher original tariff (compared to earlier diagram) - greater potential benefits Q good X Price SH DH Sw Sp Sw+tariff P1 P2 Q1Q2 P3 Q3Q4 x y Z TC > TD in this example

Remember: Previous diagram, showing TC<TD Q good X Price SH DH Sw Sp Sw+tariff P1 P2 Sp+tariff Phome Q1 Q2 a b c d P3 Q3Q4 xy Z W +ve specialisation effect +ve substitution effect

Empirical evidence n Net result cant be found from theory –empirical evidence (Nielsen) n Balassa - 3 studies –TC > TD n Others agree –Truman (1968), Kreinin (1970), Aitkin (1970) n But: welfare = trade flows??

n Measurement –counterfactual analysis »project trends »control country »trade flow models n Second best theory

Public goods argument for cu: Cooper & Massell (1965) & Johnson (1965) n Industrialisation n Bargaining strength n Pragmatic argument for free trade n Link with potential allies n Skilled labour pool n Reduce dependence on imports

Dynamic effects n Ignored in previous (static) analysis n Dynamic effects likely to result in major benefits –difficult to assess –orthodox CU theory concentrates on static benefits –can show welfare gains –consider redistribution to compensate losers

n Dynamic effects –rise productivity –technological advances –concentration and market structures –economies of scale –economies of experience n Above limited to dynamic sectors; regional variations!!

Terms of Trade (ToT) effect n Important for a large CU n Improvement in ToT increases welfare n ToT - secondary objective n Any ToT gain transferred from rest of world - not wealth creating effect

Further developments n Common market theory n New trade theories –based on industrial organisation theory –Includes consideration of »market structures »competition effects n More recent research considers this –eg. Gasiorek, Smith, Venables, (JCMS 2002) consider the Uks entry into the EEC

Conclusion n CU theory only deals with the relatively small static effects of integration, but it is a starting point n Empirical evidence from the formation of the EC6 seems to generally support CU theory –TC>TD