Ch.10 Economic Integration

CHAPTERTEN
10
International
Economics
Tenth Edition
Economic Integration: Customs

Unions and Free Trade Areas
Dominick Salvatore
John Wiley & Sons, Inc.
Salvatore:InternationalEconomics,10thEdition2010JohnWiley&Sons,Inc.
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
Introduction
Economic integration refers to the commercial
policy of discriminatively reducing or

eliminating barriers only among the nations
joining together.
Introduction
Preferential trade arrangements
Provide lower barriers to trade among

participating nations than on trade with nonmember 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.
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
Introduction
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
Introduction
Common market

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.
Introduction
Economic union

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
Introduction
Duty free zones (free economic zones)
Areas established to attract foreign

investments by allowing raw materials and
intermediate products duty free.
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.
FIGURE101ATradeCreatingCustomsUnion.
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.
FIGURE102ATradeDivertingCustomsUnion.

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 nonmembers.
In 1950, Viner showed that formation of a
customs union could increase or reduce welfare,

depending on the circumstances under which it
takes place.

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.

Conditions More Likely to Lead to Increased
Welfare
1.
Higher pre-union trade barriers of member

nations.
2.
Lower customs unions trade barriers with

non-members.
3.
Greater number of nations forming customs

union, and the larger their size.

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.

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.
Dynamic Benefits from Customs Unions

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).

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

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)

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.

Ch.10 Economic Integration

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CHAPTERTEN

Economic Integration: Customs

Static Welfare Effects of Customs Unions

policy of discriminatively reducing or

Provide lower barriers to trade among

Example: British Commonwealth Preference

Removes all barriers to trade among members,

European Free Trade Association (EFTA), 1960,

Removes all barriers to trade among members

European Union (EU), or European Common

Removes all barriers to trade among members,

European Union (EU) achieved common market

Removes all barriers to trade among members,

Benelux, formed after World War II between

Areas established to attract foreign

Trade-Creating Customs Unions

production in a member nation is replaced by

Leads to increased welfare for members as nations

Leads to increased welfare for non-members as

Trade-Diverting Customs Unions

imports from non-members are replaced by

By itself, trade diversion lowers welfare as it

Trade diverting customs union also results in

The Theory of the Second Best and Other

freer trade would increase welfare, so formation

In 1950, Viner showed that formation of a

customs union could increase or reduce welfare,

The Theory of the Second Best and Other

If all conditions required to maximize welfare

The Theory of the Second Best and Other

Higher pre-union trade barriers of member

Lower customs unions trade barriers with

Greater number of nations forming customs

The Theory of the Second Best and Other

More competitive rather than complementary

Closer geographical proximity of member

Greater pre-union trade and economic

The Theory of the Second Best and Other

Administration savings from elimination of

Reduction in demand for imports from and

By acting as a single unit, customs union will

Dynamic Benefits from Customs Unions

Increased competition, leading to greater

Economies of scale from the enlarged market.

Stimulus of investment to take advantage of

Better utilization of community resources as labor

History of Attempts at Economic Integration

1958 established common external tariff

1968 Achieved free trade in industrial goods

1970 Reduced restrictions on movement of labor

1993 Removed all remaining restrictions on flow

History of Attempts at Economic Integration

1960 formed by outer seven nations: United

1967 Achieved free trade in industrial goods

1991 Membership evolved to include Austria,

1994 Joined EU to form European Economic

History of Attempts at Economic Integration

1994 formed by United States, Canada and

Also phased out many other barriers to trade and

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