Exhaustive Notes on Economic Integration: Customs Unions and Free Trade Areas

10.1 Introduction to Economic Integration

• Theory of Economic Integration: Defined as the commercial policy of discriminatively reducing or eliminating trade barriers only among nations that join together.
• Preferential Trade Arrangements: The loosest form of integration. Barriers of trade among participating nations are lower than barriers on trade with nonmember nations.
  • Example: The British Commonwealth Preference Scheme, established in $1932$ by the United Kingdom with members and former members of the British Empire.
• Free Trade Area (FTA): All barriers to trade are removed among member nations, but each nation retains its own specific barriers against non-members.
  • Examples:
    • European Free Trade Association (EFTA): Formed in $1960$ by the United Kingdom, Austria, Denmark, Norway, Portugal, Sweden, and Switzerland.
    • North American Free Trade Agreement (NAFTA): Formed by the United States, Canada, and Mexico in $1993$.
    • Southern Common Market (Mercosur): Formed by Argentina, Brazil, Paraguay, and Uruguay in $1991$.
• Customs Union: Removes all internal barriers (like an FTA) and harmonizes trade policies toward the rest of the world (e.g., setting common external tariff rates).
  • Examples:
    • European Union (EU): Initially the European Common Market, formed in $1957$ by West Germany, France, Italy, Belgium, the Netherlands, and Luxembourg.
    • Zollverein: Formed in $1834$ by sovereign German states; significantly aided the unification of Germany in $1870$.
• Common Market: Builds on a customs union by also allowing the free movement of labor and capital among member nations. The EU achieved this status at the start of $1993$.
• Economic Union: The most advanced stage, involving the harmonization or unification of monetary and fiscal policies.
  • Example: Benelux (Belgium, Netherlands, Luxembourg), formed after World War II.
  • Example of complete union: The United States.
• Duty-Free Zones (Free Economic Zones): Specialized areas designed to attract foreign investment by allowing raw materials and intermediate products to enter duty-free.

10.2 Trade-Creating Customs Union

• Definition of Trade Creation: Occurs when domestic production in a member nation is replaced by lower-cost imports from another member nation.
• Welfare Effects: Trade creation increases the welfare of members by fostering specialization based on comparative advantage. It also benefits nonmembers as increased real income in the union spills over into higher demand for imports from the rest of the world.
• Static Welfare Gain Illustration (Figure 10.1):
  • Nation 2 settings: Domestic demand $D_x$, domestic supply $S_x$.
  • Free trade prices: Nation 1 ($P_x = \$1$), Nation 3 ($P_x = \$1.50$).
  • Initial state: Nation 2 imposes a $100\,\text{percent}$ nondiscriminatory ad valorem tariff. It imports from Nation 1 at $P_x = \$2$. Consumption is $50X$ ($GH$), domestic production is $20X$ ($GJ$), and imports are $30X$ ($JH$). Tariff revenue collected is $\$30$ ($MJHN$).
  • Customs Union with Nation 1: Tariffs are removed for Nation 1. Price drops to $P_x = \$1$. Consumption rises to $70X$ ($AB$), domestic production falls to $10X$ ($AC$), and imports from Nation 1 rise to $60X$ ($CB$).
  • Net Static Welfare Gain: The sum of shaded triangles $CJM$ and $BHN$, totaling $\$15$.
    • Triangle CJM (Production Component): Gain from shifting $10X$ of production from inefficient domestic producers to more efficient producers in Nation 1.
    • Triangle BHN (Consumption Component): Gain from increased consumption of $20X$ resulting from the lower price.
• Theoretical Contributions:
  • Viner (1950): Pioneer of customs union theory; originally focused only on the production effect.
  • Meade (1955): First to incorporate the consumption effect.
  • Johnson: Combined the two triangles to calculate total welfare gain.

10.3 Trade-Diverting Customs Unions

• Definition of Trade Diversion: Occurs when lower-cost imports from outside the union are replaced by higher-cost imports from a union member due to preferential treatment.
• Welfare Effects: Generally reduces welfare by shifting production away from comparative advantage. However, because it often accompanies some trade creation, the net effect can be positive or negative for the union. Welfare for the rest of the world unequivocally declines.
• Illustration of Trade Diversion (Figure 10.2):
  • Nation 2 initial state: $100\,\text{percent}$ tariff, price $P_x = \$2$, imports $30X$ from Nation 1.
  • Customs Union with Nation 3 only: Nation 2 removes tariffs on Nation 3 but keeps them for Nation 1. Nation 3 price is $P_x = \$1.50$ (cheaper than Nation 1's tariff-inclusive price of $\$2$). Imports are diverted from Nation 1 (most efficient) to Nation 3 (less efficient).
  • Net Welfare Calculation:
    • Gain from Trade Creation: Triangles $C'JJ' + B'HH' = \$3.75$.
    • Loss from Trade Diversion: Rectangle $MNH'J' = \$15$ (the cost of importing the original $30X$ at a higher price).
    • Net Loss: $\$11.25$.
• Conditions for Net Gain/Loss: A gain is more likely if domestic demand/supply curves are elastic and if the member nation's price ($S_3$) is close to the non-member's price ($S_1$).

10.4 The Theory of the Second Best and Welfare Conditions

• Theory of the Second Best: Formulated by Viner, Meade (1955), and generalized by Lipsey and Lancaster (1956). It states that if all conditions for maximum welfare (Pareto optimum) cannot be met, satisfying the remaining conditions doesn't necessarily lead to the next best outcome. Removing some barriers (as in a customs union) can either increase or decrease welfare.
• Conditions Favoring Increased Welfare:
  1. High pre-union trade barriers among members.
  2. Low barriers on trade with nonmembers after union formation.
  3. A large number of member countries and large economic size.
  4. Competitive rather than complementary economies (more room for specialization).
  5. Geographical proximity (lower transportation costs).
  6. Strong pre-union trade and economic relations.
• Other Static Welfare Effects:
  • Administrative Savings: Eliminating customs officers and border patrols for member trade.
  • Terms of Trade: A trade-diverting union may improve its terms of trade by reducing demand for non-member imports. A trade-creating union might see a deterioration as it demands more imports due to higher real income.
  • Bargaining Power: Acting as a single unit increases power in international negotiations (e.g., the EU).

10.5 Dynamic Benefits from Customs Unions

• Dynamic Gains: Estimated to be $5$ to $6$ times larger than static gains. They include:
  1. Increased Competition: Forces producers to be efficient, innovate, and utilize new technology. The EU uses antitrust legislation to prevent union-wide collusion.
  2. Economies of Scale: Enlarged markets allow for longer production runs. Even small nations like Belgium/Netherlands enjoyed this within the EU.
  3. Stimulus to Investment: Firms invest to meet higher demand and increased competition.
  4. Tariff Factories: External firms (e.g., U.S. firms post-$1955$ and post-$1986$) building production facilities inside the union to bypass discriminatory barriers.
  5. Resource Utilization: In a common market, the free movement of labor and capital optimizes resource use.
• Policy Perspective: Unilateral free trade is often the ‑