1. 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

2. 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

3. 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

4. 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

5. 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”

6. 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?

7. 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.

8. Trade creation

9. Trade diversion

10. 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

11. 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

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