INTERNATIONAL ECONOMICS

Session 5: Regional Integration and Developing Countries

1. 1.1 Post-Work

Forms of Economic Integration When countries form economic coalition, barriers to free trade are reduced between members. But, these barriers continue to exist between member countries and non-members. The type and depth of the trade barriers that the member countries institute against the non-members depends on the degree/stage of economic integration. In Preferential Trade Agreements (PTAs), lower trade barriers (primarily tariffs) are accorded only to members. For example, the British Commonwealth Preference Scheme established in 1932 imposed lower import tariffs on trade with former members of British Empire. This is the loosest form of economic integration. In FTAs, there are no tariffs on most of the traded commodities between members. And the members can also negotiate for withdrawal reduction of NTBs. However, each member maintains different commercial policies with non-members. In a custom union, tariffs and other barrier to trade among members is not allowed. In addition, trade policies of members are harmonized i.e. setting a common tariff towards the rest of the world. The advanced from of custom union is the common market wherein besides free trade of goods & services between members, there is also free movement of labour and capital among members static.

1.2

Static Economic Effects of RTAs The economic effects of customs union and FTAs (on home, partner countries and rest of the world) are discussed in terms of Trade Creation and Trade Diversion effects. By definition, Trade Creation occurs when the high cost domestic production is substituted by low cost imports of member countries. This is assessed assuming that all economic resources are fully employed before and after formation of the custom union. Only under these conditions, the welfare of the member countries increases due to greater specialization in production. In a larger context, the welfare of non members is also increased. This is because as the welfare of the members of the trade creating custom union rises, this also leads to an increase in imports from the rest of the world. Against this, trade diversion leads to a fall in welfare. This is because lower cost imports from the rest of the world are substituted by the high cost imports from the member countries. This reduces welfare as it shifts production from more efficient producers outside the custom union to less efficient producers inside the union. The static welfare effects of forming a customs union can be assessed by the relative importance of trade creation effects vis--vis trade diversion effects. If the trade creation effects are relatively more then the custom union is welfare increasing; otherwise, it is welfare decreasing.

1.3

Welfare Effects of CU under varying The basic theory analyses the effects of customs union on resource allocation, specialization and welfare for the member, the group as a whole and

RoW. For a custom union to have allocation effects it is necessary that the tariff rates of members should differ fro at least some products. The resulting harmonization of tariffs gives rose to allocational effects. Harmonization may take the form of averaging or other intermediate position between the highest and lowest rate. For analyzing the effects of customs union, two differing cases of pre and post tariffs are considered:

a. No imports due to high domestic tariff World price (Pw) is low. Domestic tariff in both countries leads to no imports, i.e. domestic demand entirely supplied by domestic production. Pw + t = Domestic price D = S Under customs union, with tariff averaging, a new common external tariff (CET) is fixed. The CET is lower than the initial tariff in Home Country and higher in Partner Country. For the Home Country, there is a trade creation effect. For the Partner Country, as price increases, Producer surplus will increase and consumer surplus will decrease. Exports will be from Partner to Home Country. The RoW will be unaffected by the formation of custom union as the trade with RoW is Zero before and after formation of CU. Thus, the welfare effects are confined only to the union members.

b. Higher tariff in Home and Lower Tariff in Partner The tariff in Home Country leads to no imports. The tariff in Partner Country results in exports. With tariff averaging and a CET, the effect on country H would be: Trade creation

Trade diversion Trade diversion more than trade creation The effect on Country P would be: Loss in consumer surplus Gain in producer surplus Producer surplus gain more than loss in consumer surplus In this case, custom union leads to overall gains by Partner Country and loss to Home Country

1.4

Welfare Effects of FTA on Home, Partner and RoW Two basic features distinguished FTA from customs union. These are: i. The member countries retain the power to fix their own separate tariff rates on imports from RoW. ii. Rules of Origin are designed to confine intra-area trade to the producers of the member countries. This is to avoid or limit trade deflection. We analyse the effects of FTA on a single country when both countries, Home (H) and Partner (P) produce identical product with differing tariff rateslower tariff (Tp) in country P and higher tariff (TH) in country H (prohibitive). Between H and P, the product enjoys tariff free movement. As long as FTA is a net importer, the price in country H will not fall below that of country P, i.e. TP and the price will not be higher than TH. Between the two countries, country H is an inefficient producer compared to country P. In the FTA, the amount the country P will supply will depend on the price in country H and the price, in turn, is dependent on the demand curve of country H. As the FTA Price (i.e TP) is lower than the price TH, the excess demand in country H will be met by the exports of country P. However, if the demand increases in country H, all the excess demand will be supplied by country P at a

higher price and the domestic requirement of country P will be imported from the RoW. In this sense, there will be indirect trade deflection.

1.5

Theory of Second Best The basic premise of trade based on comparative advantage is that free trade leads to most efficient utilization of world resources and thus maximizes world output and welfare. Therefore, it was widely believed (prior to Viners work on custom union in 1950) that any movement toward free trade would increase welfare. If a custom union does not increase trade barriers against the RoW, then elimination of trade barriers among the members represents a move towards free trade. However, viva showed that that custom union could increase or decrease welfare depending on the conditions under which the formation takes place. Thus, the Theory of Second Best proposes that if all the conditions necessary for maximizing welfare under trade are not met, then satisfying as many conditions as possible does not necessarily mean second-best solution. Thus, forming a custom union and removing trade barriers only among the members does not necessarily produce second-best welfare position.

1.6

Dynamic Effects The dynamic effects of forming a customs union are realized due to increased competition, economies of scale and better utilization of resources. Custom union leads to an increase in competition as the trade barriers are eliminated, producers in each member country will have to compete with the producers of other member countries. This, in turn, will lead to cut in costs of production and thereby lead to an increase in consumer surplus.

Under custom union, the market is enlarged. This can result in reaping economies of scale even by a member country which has limited domestic market. Another benefit of a larger market is a stimulus to investment, both by member and non-member countries. Self-Learning Exercises a) b) c) Under what conditions is the formation of a customs union likely to lead to trade creation and increase welfare. What are the effects of formation of EU? Discuss the static and dynamic benefits to the members of EU. Discuss the trade effects of NAFTA for US, Canada and Mexico.

Readings Chapter 6 & 7