Regional Economic Integration

Regional Economic Integration
8 chapter Regional Economic Integration McGraw-Hill/Irwin Global Business Today, 5e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

Chapter 8: Regional Economic Integration
INTRODUCTION Regional economic integration refers to agreements between countries in a geographic region to reduce tariff and nontariff barriers to the free flow of goods, services, and factors of production between each other. While regional trade agreements are designed to promote free trade, there is some concern that the world is moving toward a situation in which a number of regional trade blocks compete against each other.

LEVELS OF ECONOMIC INTEGRATION There are five levels of economic integration. In a free trade area all barriers to the trade of goods and services among member countries are removed, but members determine their own trade policies with regard to nonmembers Examples of free trade areas include the European Free Trade Association (between Norway, Iceland, Liechtenstein, and Switzerland), and the North American Free Trade Agreement (between the U.S., Canada, and Mexico)

The different levels of economic integration are shown in Figure 8.1.

The customs union is one step further along the road to full economic and political integration, and eliminates trade barriers between member countries and adopts a common external trade policy The Andean Pact (between Bolivia, Columbia, Ecuador and Peru) is an example of a customs union

The common market has no barriers to trade between member countries, a common external trade policy, and the free movement of the factors of production MERCOSUR (between Brazil, Argentina, Paraguay, and Uruguay) is aiming for common market status

An economic union involves the free flow of products and factors of production between members, the adoption of a common external trade policy, and in addition, a common currency, harmonization of the member countries’ tax rates, and a common monetary and fiscal policy The European Union (EU) is an economic union, although an imperfect one since not all members of the EU have adopted the euro, and differences in tax rates across countries still remain

In a political union, independent states are combined into a single union The EU is headed toward at least partial political union, and the United States is an example of even closer political union

Classroom Performance System In a _______, all barriers to the free flow of goods and services between member countries are removed, and a common policy toward nonmembers is established. Free trade area Customs union Common market Economic union Classroom Performance System Answer: b

Classroom Performance System The European Union is an example of a(n) Free trade area Customs union Common market Economic union Classroom Performance System Answer: d

THE CASE FOR REGIONAL INTEGRATION The Economic Case for Integration Regional economic integration is an attempt to achieve additional gains from the free flow of trade and investment between countries beyond those attainable under international agreements such as the WTO

The Political Case for Integration The political case for integration has two main points: by linking countries together, making them more dependent on each other, and forming a structure where they regularly have to interact, the likelihood of violent conflict and war will decrease by linking countries together, they have greater clout and are politically much stronger in dealing with other nations

Impediments to Integration There are two main impediments to integration: while a nation as a whole may benefit from a regional free trade agreement, certain groups may lose concerns over the loss of national sovereignty

THE CASE AGAINST REGIONAL INTEGRATION Regional economic integration only makes sense when the amount of trade it creates exceeds the amount it diverts Trade creation occurs when low cost producers within the free trade area replace high cost domestic producers Trade diversion occurs when higher cost suppliers within the free trade area replace lower cost external suppliers

REGIONAL ECONOMIC INTEGRATION IN EUROPE Evolution of the European Union The EU is the result of: the devastation of two world wars on Western Europe and the desire for a lasting peace the desire by the European nations to hold their own on the world’s political and economic stage

The evolution of the European Union is shown in Map 8.1.

The forerunner of the EU was the European Coal and Steel Community, which had the goal of removing barriers to trade in coal, iron, steel, and scrap metal formed in 1951 The European Economic Community was formed in 1957 at the Treaty of Rome with the goal of becoming a common market

Political Structure of the European Union The five main institutions of the EU are: the European Council (resolves major policy issues and sets policy directions) the European Commission (responsible for implementing aspects of EU law and monitoring member states to ensure they are complying with EU laws) the Council of the European Parliament (the ultimate controlling authority within the EU) the European Parliament (debates legislation proposed by the commission and forwarded to it by the council) the Court of Justice (the supreme appeals court for EU law) Management Focus: The European Commission and Media Industry Mergers Summary This feature explores the efforts of the European Commission to influence the strategies of media companies as they joined forces in Europe. The European Commission, concerned that proposed joint ventures and mergers between companies would negatively affect competition within the industry, demanded that some companies alter their plans to work together, and indeed abandon relationships all together. Discussion of the feature can begin with the following questions. 1. Why did Timer-Warner and EMI agree to drop their proposed joint venture? How did the European Commission convince AOL and Time Warner to change their strategy? 2. In your opinion, were the actions of the European Commission reasonable? Why or why not? Do you feel that the governing bodies of one nation should have the power to restrict the actions of foreign companies?

The Single European Act The Single European Act, adopted by the EU member nations in 1987, committed the EC countries to work toward establishment of a single market by December 31, 1992 The Stimulus for the Single European Act The Single European Act was born out of frustration among EC members that the community was not living up to its promise

The Objectives of the Act frontier controls to remove all frontier controls between EC countries mutual recognition of standards to apply the principle of “mutual recognition,” which is that a standard developed in one EC country should be accepted in another, provided it meets basic requirements in such matters as health and safety public procurement to open procurement to non-national suppliers

financial services to lift barriers to competition in the retail banking and insurance businesses exchange controls to remove all restrictions on foreign exchange transactions between members by the end of 1992 freight transport to abolish restrictions on sabotage, the right of foreign truckers to pick up and deliver goods within another member’s borders, by the end of 1992 supply-side effects should lower the costs of doing business in the EC, but the single-market program is also expected to have more complicated supply-side effects

Impact The Single European Act provided the impetus for the restructuring of substantial sections of European industry allowing for faster economic growth than would otherwise have been the case

The Establishment of the Euro The Treaty of Maastricht, signed in 1991, committed the EU to adopt a single currency, the euro, by January 1, 1999 The euro is used by 12 of the 25 member states By adopting the euro, the EU has created the second largest currency zone in the world after that of the U.S. dollar For now, three EU countries, Britain, Denmark and Sweden, are opting out of the euro-zone Euro notes and coins were issued on January 1st, 2002 (in the interim, national currencies circulated, and were worth a defined amount of euros) Country Focus: Creating a Single European Market in Financial Services Summary This feature explores the European Union’s progress towards creating a single financial market. The quest, started in 1999, was to have been completed by 2005, however, progress has been slowed by various factors related to the member countries’ tradition of operating autonomously. So, while 41 measures designed to create a single market are in place, how to enforce the rules is still to be determined. In fact, some experts believe that it will be at least another decade before the benefits of the new rules become apparent. Discussion of this feature can begin with the following questions. 1. What are the benefits of creating a single financial market in the European Union for companies? Does it make sense for consumers? 2. What are the impediments to creating a single financial market in the European Union? What does the potential for this type of market mean for countries like Great Britain that have not joined the euro-zone?

Benefits of Euro Businesses and individuals should realize significant savings from having to handle one currency, rather than many The adoption of a common currency will make it easier to compare prices across Europe

Faced with lower prices European producers will be forced to look for ways to reduce their production costs in order to maintain their profit margins The introduction of a common currency should give a strong boost to the development of highly liquid pan-European capital market The development of a pan-European euro denominated capital market will increase the range of investment options open both to individuals and institutions

Costs of Euro A drawback of a single currency is that national authorities lose control over the monetary policy The Maastricht treaty called for the establishment of an independent European central bank (ECB) with a clear mandate to manage monetary policy so as to ensure price stability Internet Extra: More information about the euro is available at the European Union site { Go to the site and click on Frequently Asked Questions to see numerous topics about the euro. Then click on Benefits of the euro to see why member countries have made the transition to the euro. Finally click on Use in the World to see which countries have adopted the euro and how it fits into the international monetary system.

The ECB sets interest rates and determines monetary policy across the euro-zone Another drawback of the Euro is that the EU is not an optimal currency area (an area where similarities in the underlying structure if economic activities make it feasible to adopt a single currency and use a single exchange rate as an instrument of macro-economic policy)

The Early Experience Since its establishment January 1, 1999, the euro has had a volatile trading history with the U.S. dollar Initially, the euro fell in value relative to the dollar, but strengthened to a five year high of $1.33 in March 2005

Enlargement of the European Union Many countries, particularly from Eastern Europe, have applied for membership in the EU Ten countries joined on May 1, 2004 expanding the EU to 25 states, with population of 450 million people, and a single continental economy with a GDP of €11 trillion Internet Extra: To extend the discussion of the European Union, and explore its historical role and current activities in the global economy, go to { Click on Activities and peruse the menu of options under What the European Union does by Subject to find topics pertaining to your discussion. To learn more about its political structure, click on Institutions and then on the individual parts of the EU’s governing systems.

Classroom Performance System The ultimate decision making body of the European Union is the Council of the European Union European Parliament Court of Justice European Commission Classroom Performance System Answer: a

REGIONAL ECONOMIC INTEGRATION IN THE AMERICAS Regional economic integration is on the rise in the Americas.

Regional economic integration in the Americas is shown in Map 8.2.

The North American Free Trade Agreement (NAFTA) NAFTA’s Contents The free trade agreement between the United States, Canada, and Mexico became law January 1, 1994 NAFTA abolished tariffs on 99 percent of the goods traded between Mexico, Canada, and the United States, removed most barriers on the cross-border flow of services, protects intellectual property rights, removes most restrictions on FDI between the three member countries, allows each country to apply its own environmental standards, provided such standards have a scientific base, establishes two commissions to impose fines and remove trade privileges when environmental standards or legislation involving health and safety, minimum wages, or child labor are ignored

The Case for NAFTA Proponents of NAFTA have argued that it will provide economic gains to all countries: Mexico will benefit from increased jobs as low cost production moves south, and will attain more rapid economic growth as a result The U.S. and Canada will benefit from the access to a large and increasingly prosperous market and from the lower prices for consumers from goods produced in Mexico In addition, U.S. and Canadian firms with production sites in Mexico will be more competitive on world markets

The Case against NAFTA Opponents of NAFTA argued: that jobs would be lost and wage levels would decline in the U.S. and Canada Mexican workers would emigrate north pollution would increase due to Mexico's more lax standards Mexico would lose its sovereignty

NAFTA: The Results so Far Studies of NAFTA’s early impact suggest that both advocates and detractors may have been guilty of exaggeration The agreement has helped to create the background for increased political stability in Mexico

Enlargement Several other Latin American countries have indicated their desire to eventually join NAFTA Currently both Canada and the U.S. are adopting a wait and see attitude with regard to most countries

Classroom Performance System Studies show that after its first decade, There was a small net gain of jobs in the U.S. Exports from the U.S. failed to grow NAFTA’s overall impact has been significant The U.S., Canada, and Mexico all experienced a decrease in productivity Classroom Performance System Answer: a

The Andean Community The Andean Pact, originally formed in 1969, was based on the EU model By the mid-1980s, the Andean Pact had more or less failed In the late 1980s, Latin American governments began to adopt free market economic policies In 1990, the Andean Pact was re-launched, and now operates as a customs union In 2003, it signed an agreement with MERCOSUR to restart negotiations towards the creation of a free trade area

MERCOSUR MERCOSUR originated in 1988 as a free trade pact between Brazil and Argentina In 1990, it was expanded to include Paraguay and Uruguay MERCOSUR has been making progress on reducing trade barriers between member states Given some fairly high tariffs for goods from other countries, it appears that in some industries, MERCOSUR is diverting trade rather than creating trade, and local firms are investing in industries that are not competitive on a worldwide basis

Central American Common Market and CARICOM There are two other trade pacts in the Americas: the Central American Trade Market CARICOM Neither has made much progress yet.

Free Trade of the Americas Talks began in April 1998 to establish a FTAA (Free Trade of The Americas) by 2005 If the FTAA is established, it will have major implications for cross-border trade and investment flows within the hemisphere The FTAA would create a free trade area of nearly 800 million people

REGIONAL ECONOMIC INTEGRATION ELSEWHERE Association of Southeast Asian Nations Formed in 1967, ASEAN currently includes Brunei, Indonesia, Malaysia, the Philippines, Singapore, Thailand, and, most recently, Vietnam, Myanmar, Laos, and Cambodia The basic objectives of ASEAN are to foster freer trade between member countries and to achieve some cooperation in their industrial policies In 2003, an ASEAN Free trade Area (AFTA) between the six original members of ASEAN came into full effect with a goal of reducing import tariffs among the older members to zero by 2010, and for newer members by 2015

Asian Pacific Economic Cooperation (APEC) APEC currently has 21 members including the United States, Japan, and China The stated aim of APEC is to increase multilateral cooperation in view of the economic rise of the Pacific nations and the growing interdependence within the region

Regional Trade Blocs in Africa There are nine trade blocs on the African continent, however progress toward the establishment of meaningful trade blocs has been slow

IMPLICATIONS FOR MANAGERS Opportunities Markets that were formerly protected from foreign competition are opened The free movement of goods across borders, the harmonization of product standards, and the simplification of tax regimes, makes it possible for firms to realize potentially enormous cost economies by centralizing production in those locations where the mix of factor costs and skills is optimal

Threats The business environment becomes competitive For non-EU and/or non-North American firms, challenges arise from the likely long-term improvements in the competitive position of many European and North American companies

There is a risk of being shut out of the single market by the creation of a “trade fortress” Firms may be limited in their ability to pursue the strategy of their choice in the EU as the EU continues to increase its role in competition policy and intervene and impose conditions on companies proposing mergers and acquisitions

CRITICAL THINKING AND DISCUSSION QUESTIONS 1. NAFTA has produced significant net benefits for the Canadian, Mexican, and U.S. economy. Discuss. Answer: The proponents argue that NAFTA should be viewed as an opportunity to create an enlarged and a more productive base for the U.S., Canada, and Mexico. As low-income jobs move from Canada and the United States to Mexico, the Mexican economy should be strengthened giving Mexico the ability to purchase higher-cost American products. The net effect of the lower income jobs moving to Mexico and Mexico increasing its imports of high quality American goods should be positive for the American economy. In addition, the international competitiveness of United States and Canadian firms that move production to Mexico to take advantage of lower labor costs will be enhanced, enabling them to better compete with Asian and European rivals.

CRITICAL THINKING AND DISCUSSION QUESTIONS 2. What are the economic and political arguments for regional economic integration? Given these arguments, why don’t we see more substantial examples of integration in the world economy? Answer: The economic case for regional integration is straightforward. As we saw in Chapter 5, unrestricted free trade allows countries to specialize in the production of goods and services that they can produce most efficiently. If this happens as the result of economic integration within a geographic region, the net effect is greater prosperity for the nations of the region. From a more philosophical perspective, regional economic integration can be seen as an attempt to achieve additional gains from the free flow of trade and investment between countries beyond those attainable under international agreements such as the WTO. The political case for integration is also compelling. Linking neighboring economies and making them increasingly dependent on each other creates incentives for political cooperation between neighboring states. Also, the potential for violent conflict between the states is reduced. In addition, by grouping their economies together, the countries can enhance their political weight in the world. Despite the strong economic and political arguments for integration, it has never been easy to achieve (on a meaningful level). There are two main reasons for this. First, although economic integration benefits the majority, it has its costs. While a set of nations as a whole may benefit significantly from a regional free trade agreement, certain groups may loose. The second impediment to integration arises from concerns over national sovereignty.

CRITICAL THINKING AND DISCUSSION QUESTIONS 3. What effect is creation of a single market and a single currency within the EU likely to have on competition within the EU? Why? Answer: If the EU is successful in establishing a single market and currency, member countries can expect significant gains from the free flow of trade and investment. This will result from the ability of the countries within the EU to specialize in the production of the product that they manufacture the most efficiently, and the freedom to trade those products with other EU countries without being encumbered by tariffs and other trade barriers. In terms of competition, the competition between European firms will increase. Some of the most inefficient firms may go out of business because they will no longer be protected from other European companies by high tariffs, quotas, or administrative trade barriers. Companies from those countries that have not adopted the euro may find that their costs are higher as they deal with currency exchanges.

CRITICAL THINKING AND DISCUSSION QUESTIONS 4. Do you think it is correct for the European Commission to restrict mergers between American companies that do business in Europe? (For example, the European Commission vetoed the proposed merger between WorldCom and Sprint, both U.S. companies, and it carefully reviewed the merger between AOL and TimeWarner, again both U.S. companies.) Answer: This question deals with the delicate issue of just how far a country can extend the reach of its law, and should set the stage for a good debate. While some students will argue that the European Commission is overstepping its boundaries by restricting mergers between American companies doing business in Europe, other students will recognize that the U.S. might act in a similar fashion if American firms were being threatened by foreign companies seeking to merge and operate in the U.S. market.

CRITICAL THINKING AND DISCUSSION QUESTIONS 5. How should a U.S. business firm that currently only exports to ASEAN countries respond to the creation of a single market in this regional grouping? Answer: A U.S. business firm that is currently only exporting to ASEAN markets should seriously consider opening a facility somewhere within the region, as the economics of a common market suggest that outsiders can be at a disadvantage to insiders. The opening of borders within a common market has the potential to increase the size of the market for the firm. Of course it is possible, after careful consideration, that exporting may still be the most appropriate means of serving the market in some situations.

CRITICAL THINKING AND DISCUSSION QUESTIONS 6. How should a firm that has self-sufficient production facilities to in several ASEAN countries respond to the creation of a single market? What are the constraints on its ability to respond in a manner that minimizes production costs? Answer: The creation of the single market means that it may no longer be efficient to operate separate duplicative production facilities in each country. Instead, the facilities should either be linked so that each specializes in the production of only certain items, or several sites should be closed down and production consolidated into the most efficient locations. Existing differences between countries as well as the need to be located near important customers may limit a firm’s ability to fully consolidate or relocate production facilities for production cost reasons. Minimizing production costs are only one of many objectives of firms, as location of production near R&D facilities can be critical for new product development and future economic success. Thus what is most important in location decisions is long run economic success, not just cost minimization.

CRITICAL THINKING AND DISCUSSION QUESTIONS 7. After a promising start, in the last few years, MERCOSUR, the major Latin American trade agreement, has faltered and made little progress since What problems are hurting MERCOSUR? What can be done to solve these problems? Answer: MERCOSUR originated in 1988 as a free trade pact between Brazil and Argentina. The pact was expanded in 1990 to include Paraguay and Uruguay with goal of becoming a full free trade area by 1994, and a common market sometime after. While initially considered a success, critics began to question whether the trade diversion effects of MERCOSUR outweighed it trade creation effects. Then, in 1998 member states slipped into a recession and in 1999, Brazil’s financial crisis led to a significant devaluation of its currency creating further turmoil. Finally, in 2001, Argentina beset by economic stresses asked that the customs union be temporarily suspended, effectively ending MERCOSUR’s quest to become a fully functioning customs union. However, in 2003, Brazil’s new president announced his support for a revitalized and expanded MERCOSUR that would be modeled after the EU. Students can check the current status of the agreement online { /}.

CRITICAL THINKING AND DISCUSSION QUESTIONS 8. Would the establishment of a Free Trade Area of the Americas (FTAA) in 2005 be good for the two most advanced economies of the hemisphere, the United States and Canada? How might the establishment of the FTAA impact the strategy of North American firms? Answer: In 1994, a Free Trade of the Americas (FTAA) was proposed. If the agreement comes about, it would effectively create a free trade area of nearly 800 million people responsible for more than $12 trillion in GDP in However, the U.S., while initially a strong advocate of the agreement, has lessened its support for the FTAA recently. The question of whether the agreement is good for the U.S. and Canada will likely produce a lively debate among students.

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