1. International Economics
Li Yumei
Economics & Management School
of Southwest University

2. International Economics
Chapter 10
Economic Integration: Customs Unions and Free Trade Areas

3. Organization 10.1 Introduction 10.2 Trade-Creating Customs Unions
10.3 Trade-Diverting Customs Unions
10.4 The Theory of the Second Best and Other Static Welfare Effects of Customs Unions
10.5 Dynamic Benefits from Customs Unions
10.6 History of Attempts at Economic Integration
Chapter Summary
Exercises

4. 10.1 Introduction
This chapter analyzes the economic impact of the formation of regional economic associations (economic integration) on the member nations and on the rest of world
Regional economic associations eliminate tariff and other trade barriers among members but keep them against the outside world
The Theory of Economic Integration

5. The Theory of Economic Integration
The Theory refers to the commercial policy of
discriminatively reducing or eliminating trade
barriers only among the nations joining together. It
includes the preferential trade arrangements to free
trade areas, customs unions, common markets, and
economic unions.
Preferential trade agreements
They provide lower barriers on trade among participating
nations than on trade with non-member nations. It is the loosest
form of economic integration. Such as British Commonwealth
Preference Scheme established in 1932.

6. The Theory of Economic Integration
A Free Trade Area
It is the form of economic integration wherein all barriers are
removed on trade among members, but each nation retains its
own barriers to trade with non-members.
Such as European Free Trade Association (EFTA) formed in
1960 (U.K, Austria, Denmark, Norway, Portugal, Sweden, and
Switzerland); North American Free Trade Agreement (NAFTA)
formed in 1993 ( U.S., Canada, Mexico); Southern Common
Market (Mercosur) formed in 1991 ( Argentina, Brazil, Paraguay
and Uguguay)

7. The Theory of Economic Integration
A Customs Union
It allows no tariffs or other barriers on trade among members,
and in addition it harmonizes trade policies toward the rest of
the world.
Such as European Union (EU) or European Common Market
formed in 1957 (West Germany, France, Italy, Belgium,
Netherlands and Luxembourg)
A Common Market
It goes beyond a customs union by allowing the free movement
of labor and capital among member nations.
Such as EU in 1993

8. The Theory of Economic Integration
An Economic Union
It goes further by harmonizing or even unifying the monetary
and fiscal policies of member states. It is the most advanced
type of economic integration. Such as EU.
Recent Tendency—Duty-Free Zones or Free Economic Zones
These zones are areas set up to attract foreign investment by
allowing raw materials and intermediate products duty-free.
In this chapter, the main discussion is generally in
terms of customs unions.

9. 10.2 Trade-Creating Customs Unions
Trade Creation
Illustration of a Trade-Creating Customs Union
Conclusion

10. Take the customs union as the example to analyze
Trade Creation
Take the customs union as the example to analyze
the effects of the economic integration. It has two
kinds of effects: trade creation and trade diversion.
Trade Creation
It occurs when some domestic production in a nation that is a
member of the customs union is replaced by lower-cost imports
from another member nation (assuming that all economic
resources are fully employed before and after formation of the
customs union);
It increases the welfare of member nations because it leads to
greater specialization in production based on comparative
advantage.

11. Illustration of a Trade-Creating Customs Union
Figure 10.1
FIGURE 10-1 A Trade-Creating Customs Union.

12. Illustration of a Trade-Creating Customs Union
Explanation of Figure 10.1
With Tariff, the nation’s production surplus increases while the consumer surplus decreases, the deadweight loss is the total of protection effect and consumption effect. And it reduces the national welfare;
The formation of a customs union, no tariff, it can increase the national welfare, it is the total of protection effect and consumption effect.

13. Illustration of a Trade-Creating Customs Union
Theory of A Customs Union
Viner, who pioneered the development of the theory of customs unions in 1950, concentrated on the production effect of trade creation and ignored the consumption effect;
Meade extended the theory of customs unions in 1955 and was the first consider the consumption effect;
Johnson added the two triangles to obtain the total welfare gain of a customs union.

14. Conclusion
A trade-creating customs union can increase the national welfare— the trade creation: production welfare and consumption welfare from the comparative advantages
A trade-creating customs union also increases the welfare of non-members because some of the increase in its real income spills over into increased imports from the rest of world

15. 10.3 Trade-Diverting Customs Unions
Trade Diversion
Illustration of a Trade-Diverting Customs Union
Conclusion

16. Trade Diversion and Welfare
It occurs when lower-cost imports from outside the customs union are replaced by higher cost imports from a union member
Trade Diversion and Welfare
Trade diversion reduces welfare because it shifts production from more efficient producers outside the customs union to less efficient producers inside the union
Trade Diversion and Resource Allocation
Trade diversion worsens the international allocation of resources and shifts production away from comparative advantage

17. The Effects of a Trade-diverting Customs Union
Trade Diversion
The Effects of a Trade-diverting Customs Union
In the end, a trade-diverting customs union results in both trade creation and trade diversion
Conclusion
Whether a trade-diverting customs union can increase or
reduce the welfare of union members, depending on the
relative strength of these two opposing forces
While the non-members can be expected to decline because their economic resources can only be utilized less efficiently than before trade was diverted away from them

18. Illustration of a Trade-Diverting Customs Union
Figure 10.2
FIGURE 10-2 A Trade-Diverting Customs Union.

19. Illustration of a Trade-Diverting Customs Union
Explanation of Figure 10.2
With free trade, domestic consumption of X is 70 (domestic supply 10X while the imports 60X);
With tariff, domestic consumption of X is 50 (domestic supply 20X while the imports 30X);
Form of a trade-diverting customs union, domestic consumption of X is 60 (domestic supply 15X while the imports from the member 45X)
Static Welfare Effects
Within the trade-diverting customs union, the imports are less than free trade , leading to trade diversion (the loss)
Within the trade-diverting customs union, the imports from members are more than tariff, leading to trade creation (benefit)

20. Conclusion
A trade-creating customs union leads only to trade creation and un-equivocably increases the welfare of members and non-members
A trade-diverting customs union leads to both trade creation and trade diversion, and can increase or reduce the welfare of members (and will reduce the welfare of the rest of the world)

21. 10.4 The Theory of the Second Best and Other Static Welfare Effects of Customs Unions
Conditions More Likely to Lead to Increased Welfare
Other Static Welfare Effects of Customs Unions
Conclusion

22. The Theory of the Second Best
Take the customs union as the special case of the theory of the second best
It postulate that when all conditions required to reach maximum social welfare or Pareto optimum cannot be satisfied, trying to satisfy as many of these conditions as possible does not necessarily or usually lead to the second best welfare position
Theory: beginning by Viner in 1950, developing by Meade in 1955, generalizing by Lipsey and Lancaster in 1956

23. Conditions More Likely to Lead to Increased Welfare
The higher of the pre-union trade barriers of member countries, it is more probable that the greater trade creation rather than trade diversion
The lower of the customs union’s barriers on trade with the rest of world, the less likely to costly trade diversion
The more competitive rather than complementary are the economies of member nations, the greater opportunities for specialization in production and trade creation
The closer geographically are the members of the customs union, less transportation costs barriers to trade creation among members
The greater of pre-union trade economic relationship , the greater opportunities for significant gains

24. Other Static Welfare Effects of Customs Unions
Administrative Savings
It means the elimination of customs officials, border patrols.
The Improvement in Collective Terms of Trade
This is because a trade-diverting customs leads to the reduction
of its demand for imports and its supply of exports to the rest of
world . It is likely to improve the collective terms of trade
Much More Bargaining Power
Several countries act as a single unit in international trade
negotiations. It is more powerful than a single country

25. Conclusion
Customs Union as a second best to maximize the economic welfare
Customs Union is more likely to lead to the increased welfare: trade creation and trade diversion
Other static effects

26. 10.5 Dynamic Benefits from Customs Unions
Increased Competition
Economies of Scale
Stimulus to Investment
Better Utilization of Economic Resources

27. Increased Competition
In the absence of a customs union
Producers are likely (especially those in monopolistic and
oligopolistic market ) to sluggish and complacent behind trade
barriers
With the customs union
Producers in each nation must become more efficient to meet the competition of other producers within the union, merge, or go out of business, reducing the cost of production to the benefit of consumers
The increased level of competition is also likely to stimulate the development and utilization of new technology, reducing the cost of production to the benefit of consumers

28. Economies of Scale The Enlarged Market
The formation of a customs union leads to the enlarged
market . It is likely to benefit from the economies of scale.
Such as EU, before the formation of the customs union, some
of several small countries have obtained the economies of
scale through the scale production for domestic consumption
and exports, after the formation EU achieved significant
economies of scale.

29. Stimulus to Investment
The stimulus to investment to take the advantage of the enlarged market and to meet the increased competition
The formation is likely to spur outsiders to set up production facilities within the customs union to avoid trade barriers imposed on non-union products (called as tariff factories)
Examples for U.S. Investment in EU after 1955 and after 1986

30. Better Utilization of Economic Resources
A customs union is also a common market, it
means that the free community wide movement
of labor and capital is likely to result in better
utilization of the economic resources of the
entire community
﹡These dynamic gains from the formation of a
customs union are presumed to be much greater
than the static gains
﹡ The static and dynamic benefits from the formation of a customs union is the second best solution

31. 10.6 History of Attempts at Economic Integration
The European Union
The European Free Trade Association
U.S. Free Trade Agreements and the North American Free Trade
Attempts at Economic Integration among Developing Countries
Economic Integration in Central and Eastern Europe and in the Former Soviet Republics

32. The European Union ( European Community)
History of EU (up to now 27 members)
European Common Market : founded in 1957 under the Treaty of Rome by West Germany, France, Italy, Belgium, the Netherlands and Luxembourg came into being on January 1, 1958;
Enlargement of EU
till 1995 altogether 15 members including UK, Denmark and Ireland in 1973; Greece in 1981; Spain and Portugal in 1986; Austria, Finland and Sweden in 1995;
New 10 EU members May 2004: Cyprus,Czech Republic ,Estonia,Hungary,Latvia,Lithuania,Malta,Poland,Slovak Republic,Slovenia
New 2 EU members January 2007: Bulgaria, Romania

33. The European Union ( European Community)
Economic Community
Single European Act in 1992 provided for the removal of all
remaining barriers to the free flow of goods, services, and
resources among members and, in fact, became a single
unified market at the beginning of 1993.
The Operation of EU
Common value-added tax system;
Commission
Council of Ministers
European Parliament
Court of Justice
Full Monetary Union

34. The European Union Main Provisions Common Commercial Policy
Since the historic enlargement that took place on 1 May 2004,
the 25 Member States of the EU constitute one single market with a
Common Commercial Policy which includes the uniform EU-wide
application of Trade Policy Instruments( dispute settlement, trade
barriers regulation, anti-dumping, anti-subsidy, safeguard, injurious
pricing instrument, trade defense instruments-enlargement, trade
defense instruments-small & medium-sized enterprises (SMEs),
monitoring of third country commercial defense actions) On 1
January 2007, the same legislation and measures will be
automatically applied also to Bulgaria and Romania, the new EU
Member States.

35. The European Union Common Agricultural Policy (CAP)
It was formed in EU determines common farm prices, and
then it imposes tariffs so as always to make the imported
agricultural products equal to the high established EU prices. There
are two measures to reach the purpose.
Variable Import levies (差价税)
Deficiency Payments (差额补贴)
Negative effect: huge agricultural surplus, high storage costs and
subsidized exports
Case Study 9-3 (section 9.3E) and Uruguay Round (section 9.7)

36. The European Free Trade Association
EFTA
It was formed in 1960 by UK, Austria, Denmark, Norway,
Portugal, Sweden, and Switzerland, Finland becoming an
associate member in 1961(full member in 1986). EFTA achieved free trade in industrial goods in 1967, but only a few special provisions were made to reduce barriers on trade in agricultural products
On January 1, 1994, the EFTA joined the EU to form the European Economic Areas (EEA)

37. U.S. Free Trade Agreements and the North American Free Trade
In September 1985, US negotiated a free trade agreement with Israel. It was the first bilateral trade agreement signed by US
In 1988 a free trade reached with Canada
In 1993, North American Free trade Agreement (NAFTA) agreed among US, Canada and Mexico, which took effect on January 1, 1994
Case Study 10-3 page 336

38. Attempts at Economic Integration among Developing Countries
Economic Integration in Developing Countries
Central American Common Market
Latin American Free Trade Association
Southern Common Market ( Mercosur)
Free Trade Area of Americas (FTAA)
Caribbean Free Trade Association
East African Economic Community
West African Economic Community
19-member Preferential Trade Area of Eastern and Southern Africa
Association of Southeast Asian Nations (ASEAN)
Case Study 10-4 and 10-5 page

39. Council of Mutual Economic Assistance (CMEA or COMECON)
Economic Integration in Central and Eastern Europe and in the Former Soviet Republics
Council of Mutual Economic Assistance (CMEA or COMECON)
It was formed in 1949 in Soviet Union with the communist bloc
nations in eastern Europe (Bulgaria, Czechoslovakia, East
Germany, Hungary, Poland, and Romania) plus Mongolia
(Cuba, North Korea, and Vietnam jointed later).
Main Purpose
It was to divert trade from Western nations and achieve a
greater degree of self-sufficiency among communist nations

40. Economic Integration in Central and Eastern Europe and in the Former Soviet Republics
Commercial Policy
Among the member countries, the state decided and
controlled all International transactions through a number of state trading companies
Trade among the member countries conducted on the basis of bilateral agreements (barter trade and counter trade in which one good was exchanged for another) and bulk purchasing (the agreement of a state trading company to purchase a specified quantity of a commodity of a year or for number of years from a state trading company of another nation )
The End of CMEA
After the end of 1989, it collapsed all over due to the political
changes (Case Study 10-6 page 342)

41. The static and dynamic effects of Economic Integration
Chapter Summary
The static and dynamic effects of Economic Integration
trade-creation
trade-diversion
Economic Integration Organizations
Among developed countries
Among developing countries
Trade Blocs

42. Exercises
Discussion Problems:
Page 345 to 336 from 1 to 14 questions

43. Exercises Additional Reading
The classic works on the theory of customs unions are:
J.Viner, The Customs Union Issue (New York: The Carnegie Endowment for International Peace, 1953)
J.Meade, The Theory of Customs Unions (Amsterdam: North-Holland, 1955)
R.G.Lipsey, “ The Theory of Customs Unions: A general Survey,” Economic Journal, September 1961, pp , Reprinted in R.E.Caves and H.G.Johnson, Readings in International Economics (Homewood, Ⅲ.: Irwin, 1968), pp

44. Internet Materials http://mkaccdb.edu.int