International Economics 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. CHAPTER T E N 10

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.

10.1. 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.

10.1 Introduction We examine economic integration in general and customs unions in particular. ► Preferential trade arrangements: barriers are lowered on trade among members than on trade with nonmenber nations. ► Free trade area: all barriers are removed on trade among members, but each nation retains its own barriers to trade with nonmembers. Eg. EFTA (1960), NAFTA (1993), Japan- Singapore FTA (2004) ► Customs union: FTA + trade policies are harmonized among members toward nonmembers. EC (1993) ► Common market: CU + labor and capital are allowed to move freely among members. EU (before 2002) ► Economic union: CM + monetary and fiscal policies are harmonized. EU (after 2002)

10.1. Introduction Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc. 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.

10.1. 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 Korea’s FTAs with many countries including the U.S.

Introduction Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc. 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

10.1. Introduction Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc. 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.

10.1. Introduction Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc. 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

10.1. Introduction Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc. Cf: Duty free zones (free economic zones) Areas established to attract foreign investments by allowing raw materials and intermediate products duty free.

10.2. 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. (1) Before CU (Home country =N2) -Price of X (Px1 = $1, Px2 = $3, Px3 = $1.50) - Price of X in N2 with 100% tariff = $2 - demand : 50X - supply : 20X - import : 30X from Nation 1 (2) After CU (N2 & N1) - Price of X in N2 = $1 - demand : 70X - supply : 10X -import : 60X -Net welfare gain = CJM+BHN

10.3. 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. (1) Before CU (Home country =N2) -Price of X (Px1 = $1, Px2 = $3, Px3 = $1.50) - Price of X in N2 with 100% tariff = $2 - demand : 50X - supply : 20X - import : 30X from Nation 1 (2) After CU (N2 & N3) - Price of X in N2 = $ demand : 60X - supply : 15X -import : 45X -welfare gain = CJ’M’+B’HH’ -welfare loss = J’H’MN -Net welfare = ?

10.4. 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, 10th Edition © 2010 John Wiley & Sons, Inc.

10.4. 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.

10.4. 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.

10.4. 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.

10.4. 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.

10.5. Dynamic Benefits from Customs Unions Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc. 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).

10.6. 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.

10.6. 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.

10.6. 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.

10.6. History of Attempts at Economic Integration Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.

10.6. History of Attempts at Economic Integration Regionalism in Asia and the Pacific region To be discussed with various references. Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.