3.4 Economic Integration


Terms in this set (...)

Economic integration
Economic co-operation between countries and co-ordination of their economic policies.
Internal rules
Rules that members follow for behaviour among themselves.
External rules
Rules that members follow for behaviour with non-members.
Preferential trade agreement
o Where members lower, but do not eliminate, barriers among themselves.
o An agreement between two or more countries to lower trade barriers between each other on particular products. Trade barriers may remain on the rest of the products and on imports from non-member countries.
o Dealings with non-members are not addressed so member countries maintain policies of their own choosing with regard to non-member countries.
o Gives preferential access to certain products from certain countries by reducing or eliminating tariffs, or by other agreements relating to trade.
Free trade area
Consists of a group of countries that agree to gradually eliminate trade barriers between themselves.

In trade relations between members, there may be free trade in some products and some protection in other products.

This is the most common type of trading bloc.

Each member country retains the right to pursue its own trade policy towards other non-member countries.
Members have the freedom to choose how they wish to deal with non-member countries.

Example = NAFTA and ASEAN
Customs union
Occurs where member countries not only eliminate internal trade barriers, but they also adopt common policies for dealings with any non-members.

All the member countries of the customs union act as a group in all trade negotiations and agreements with non-members.

Each country in a customs union is no longer free to determine its own trade policy towards non-member countries, but must adopt the policy agreed upon by the customs union.
Common market
Members eliminate internal trade barriers, adopt common external trade barriers and allow free movement of resources among member countries.

Resources are factors of production such as labour, or capital.

Example = Mercosur
Economic union
o Members eliminate internal barriers.
o Members adopt common external barriers.
o Members allow free movement of resources among member countries.
o Members also adopt a uniform set of economic policies.

Example = European Union and the Euro
Bilateral trade agreement
An agreement between two countries.
Multilateral trade agreement
Involves an agreement between many countries.
Regional trade agreement
Involves agreements between a group of countries that are within a geographical region.
What is the main objective of trade agreements?
The main objective of bilateral, regional and multilateral trade agreements is to promote trade liberalization.
What is trade liberalization?
This is an increase in free trade achieved by the reduction or elimination of trade barriers between members.
Trade agreements reached under the WTO are regional, multilateral or bilateral?

Trade agreements reached under the World Trade Organization (WTO) are multilateral, because they include WTO member countries around the world.

They require all member countries to reduce trade barriers at the same time.
One of the fundamental principles of the WTO is non-discrimination.

What does this mean and what it its significance?
o This means that a country cannot discriminate between any WTO members.
o Countries cannot impose high barriers on imports from one member country and lower barriers on imports from another country.
o This is a fundamental principle for the development of free trade globally.
What is a trading bloc?
A trading bloc is a group of countries that have agreed to reduce tariffs and other barriers to trade amongst themselves for the purpose of encouraging free trade and co-operation between them.
From a lower to a higher level of economic integration there the following types of trading blocs:
• Free trade area
• Customs union
• Common market
Economic integration over the long term can be expected to bring about many of the benefits of free trade, including:
o Increased competition
o Expansion into larger markets
What is a big problem that happens with free trade areas?

Why does this problem arise?

How is this problem solved?
A product may be imported into the FTA by the country that has the lowest external trade barriers and then sold to countries within the FTA that have higher external barriers.

This creates difficulties for the countries with higher trade barriers because they may end up importing more goods from countries outside the trade bloc than they would like.

This problem arises because each country has its own individual barriers toward non-members.

Because of this, FTA's generally make rules that prevent goods from entering countries with lower external barriers.
These are sometimes known as country of origin rules.


In order for an FTA to function properly, member countries must establish rules of origin for all third-party goods entering the free trade area.
Goods produced within the free trade area may cross borders tariff-free, but rules of origin requirements must be met to prove that the good was in fact produced in the exporting country.
In the absence of rules of origin, third-party countries seeking trade access to the FTA area will choose the path of least resistance in order to gain effective entry to the entire FTA region.
This means that they will enter the FTA through the country where they face the lowest barriers to entry.
Why do customs unions have an advantage over free trade areas?
Members of a customs union avoid having to create complicated internal rules for imports.

This is because they all have the same common external barriers.
What is a problem with customs unions?
Customs unions must co-ordinate their policies toward non-members and this gives rise to the possibility of disagreements.

It might be difficult for all countries to agree on what are appropriate levels of trade barriers for non-members, especially if the level of development of the countries is different.
What are the main factors of production benefitted from being in a common market?
The factors of production of importance are labour and capital.

In a common market they are free to cross all borders so they can move, travel and find employment freely within the member countries.

Workers are free to move and work in any member country without restrictions. Capital can also flow from country to country without restrictions.
What are the advantages of a common market over a customs union?
Members enjoy free trade and all its advantages, such as:
o Lower prices
o Greater consumer choice = There is a greater variety of goods for consumers to choose from.

Factor mobility across countries promotes a better use of factors of production.
o There can be more specialization so there is an improved global allocation of resources.
o For example, there may be high unemployment in a particular industry in one country and a high demand for labour in another country. This encourages unemployed workers to seek work in the country facing labour shortages.
o If the profitability of investing is greater in one country than in another, capital gravitates to the more profitable country, making better use of capital resources.

The principal advantage of establishing a common market is the expected gains in economic efficiency.
o With unrestricted mobility, labour and capital can more easily respond to economic signals within the common market, resulting in a more efficient allocation of resources.
A common market requires the willingness of member governments to give up some of their policy-making authority to an organisation with powers over all the member governments.

Is this easy? What are the consequences of this?
This can be difficult to accomplish.

It may take a long time for all countries to make the necessary policy changes to achieve co-ordination.

For these reasons, there are far fewer common markets in the world than free trade areas and customs unions.
Economic integration will increase competition among producers within the trading bloc.
With low or no barriers to trade, imports increase.

This forces domestic producers to compete with lower cost producers from other countries.

Trade barriers would have protected inefficient domestic producers, which does not promote a good global allocation of resources.
Increased competition offers major advantages in terms of:
o Production by more efficient producers
o Lower prices for consumers
o Improved allocation of resources.
As the size of the market they supply expands, firms can achieve:
o Lower costs of production on average, known as economies of scale.
o Lower prices for consumers.
o Greater export competitiveness.
Advantages of trading blocs:
• Lower prices for consumers and greater consumer choice.
• Increased investment.
• Better use of factors of production/improved resource allocation.
• Improved efficiency in production and greater economic growth.
• Political advantages.
Disadvantages of trading blocs:
• Trading blocs may not be the best way to achieve trade liberalization.
• Trading blocs may create obstacles to the achievement of free trade on a global scale.
• Unequal distribution of gains and possible losses in terms of the member countries.
Countries forming a trading bloc are unlikely to gain equally from the operation of the trading bloc, creating the potential for conflicts between the member countries.
This makes it difficult for agreements to be reached and means that some countries may actually lose from being in a trading bloc.
The IB syllabus refers specifically to trade creation and trade diversion as arising in customs unions.

Is this necessarily true?

They can arise in any type of trading bloc.
Trade creation:
Trade creation refers to the situation where higher cost products (imported or domestically produced) are replaced by lower cost imports after the formation of a trading bloc.
Benefits of trade creation:
Since trade creation involves the removal of tariffs, its benefits include getting rid of the disadvantages that come with imposing tariffs.
Trade diversion:
Trade diversion refers to the situation where lower cost imports are replaced by higher cost imports from a member after the formation of a trading bloc.

Trade diversion occurs when an importing country is forced to import from a higher cost producer within a trading bloc, whereas before it joined the trading bloc it was importing from a lower cost producer elsewhere.
The possibility of trade diversion resulting from a trading bloc is an additional argument against trading blocs and in favour of multilateral (WTO) trade liberalization.

The reason is that trade diversion cannot occur with multilateral reduction or elimination of trade barriers.
Does trade creation increase or decrease social welfare?

What about trade diversion?

What does this mean in terms of resource allocation?
Trade creation has the effect of increasing social welfare, while trade diversion reduces it.

Therefore, whereas a trading bloc creates free trade for the members, it may or may not improve the allocation of resources.

Resource allocation will improve only if trade creation effects are larger than trade diversion effects.
Trade creation and trade diversion occur in the short-term or in the long-term?
Trade creation and trade diversion refer to short-term (static) benefits and costs of trading blocs.

This is because in the long-term the countries that are harmed by trade diversion can change their consumption patterns so that they will import less of the good in question.
Long-term benefits for the members of trading blocs are more important than short-term effects that may arise.
Therefore, even if a trading bloc leads to trade diversion over the short term, it is possible that the long-term positive effects will more than compensate countries for possible short-term losses.
Different forms of economic integration allow member countries to gain from economies of scale.
Economies of scale are one of the major benefits of free trade.

In a small market, a firm cannot take advantage of economies of scale since a firm cannot grow large enough so that its long-run average costs begin to fall substantially.

When an economy opens itself up to free trade with other countries, its exports are likely to increase, assuming that it is a relatively efficient producer.
Monetary union
A common market with a common currency and a common central bank.

Involves a far greater degree of integration than a common market.
What happens when countries decide to adopt a single common currency?
In adopting a common currency, countries give up a significant part of their economic sovereignty to a supranational body.

In terms of the European Union, the European Central Bank is responsible for the monetary policy for all the member countries.

Following the adoption of a common currency, member countries give up control of their monetary supply and their ability to carry out their own monetary policy.
These powers are transferred from each of their national central banks to a single institution (the European Central Bank in the case of the EU).
Advantages of a monetary union:
• A single currency eliminates exchange rate risk and uncertainty, brining benefits to importers, exporters, consumers and investors.
This encourages trade and investments across boundaries, contributing to achieving a more efficient allocation of resources.

• A single currency eliminates transaction costs.
Whenever there is a conversion of one currency into another, fees are charged for the conversion.
A single currency eliminates these transaction costs, resulting in significant savings that have the effect of encouraging trade and investments.

• A single currency encourages price transparency. This makes it easier for all economic decision-makers to see price differences quickly and accurately across countries, which has the effect of promoting competition and therefore of promoting more efficient production.

• A single currency promotes a higher level of inward investment.
This type of investment can be expected to rise because of the absence of currency risk, resulting in greater economic growth.

• Low rates of inflation give rise to low interest rates, more investment and increased output.
A single currency under the control of a single central bank committed to maintaining price stability results in low rates of inflation.
What is price transparency?
Price transparency refers to the ability of consumers and firms to compare prices in all the countries that have adopted a common currency without having to make exchange rate calculations and conversions.
What is inward investment?
Inward investment refers to investments from outsiders towards the member countries with a common currency.
What is the main problem with a monetary union?
It is a system in which there is no possibility of changing the value of one currency in relation to another. There is no possibility of revaluing or devaluing the currency.
Disadvantages of a monetary union:
• A single currency involves loss of exchange rates as a mechanism for adjustment.
• A single currency involves loss of monetary policy as an instrument of economic policy.
• Fiscal policy is constrained by the convergence requirements.
• Monetary policy pursued by the single central bank impacts differently on each member country, depending on its own particular circumstances.
Since countries are likely to differ from each other with respect to degrees of inflation and unemployment or their position in the business cycle, the single monetary policy pursued by the single central bank is unlikely to suit every country's needs.
It may even harm some of the member countries, as is the case with the ECB not wanting to lower interest rates two years ago. This would have favored Greece but could have caused inflation in Germany so the interest rates were left the same.
What does not being able to change its exchange rate do to a country?
If a member country has a trade deficit with another member country, it no longer has its own national currency that could depreciate (in a flexible exchange rate system) or devalue (in a fixed exchange rate system) to correct the imbalance.