Economic Integration: Customs Unions and Free Trade Areas
Learning Goals
Understand trade creation, trade diversion, and dynamic benefits of economic integration.
Describe the importance and effects of the European Union (EU) and NAFTA.
Describe attempts at economic integration among developing countries and countries in Central and Eastern Europe.
Introduction
Economic integration: Commercial policy of discriminatively reducing or eliminating trade barriers only among nations joining together.
Degree of economic integration:
Preferential trade arrangements: Lower barriers on trade among participating nations than on trade with nonmember nations.
Example: British Commonwealth Preference Scheme (1932).
Free trade area: All barriers removed on trade among members; each nation retains its own barriers to trade with nonmembers.
Examples: European Free Trade Association (EFTA, 1960), North American Free Trade Agreement (NAFTA, 1993), Southern Common Market (Mercosur, 1991).
Customs union: No tariffs or other barriers on trade among members; harmonizes trade policies toward the rest of the world.
Examples: European Union (EU, 1957), Zollverein (1834).
Common market: Customs union that also allows free movement of labor and capital among member nations.
Example: EU (achieved in 1993).
Economic union: Harmonizes or unifies monetary and fiscal policies of member states.
Examples: Benelux, United States.
Duty-free zones or free economic zones: Areas set up to attract foreign investments by allowing duty-free raw materials and intermediate products.
Trade-Creating Customs Union
Static, partial equilibrium effects are measured by trade creation and trade diversion.
Trade creation: Domestic production in a member nation is replaced by lower-cost imports from another member nation.
Increases welfare of member nations through greater specialization based on comparative advantage.
Increases welfare of nonmembers because increased real income spills over into increased imports from the rest of the world.
Illustration of a Trade-Creating Customs Union
Figure 10.1 illustrates the effects of a trade-creating customs union.
DX and SX represent Nation 2’s domestic demand and supply curves of commodity X.
Free trade price: PX = $1 in Nation 1 and PX = $1.50 in Nation 3.
Nation 2 initially imposes a 100% ad valorem tariff on all imports of commodity X, imports from Nation 1 at P_X = $2.
At P_X = $2, Nation 2 consumes 50X, with 20X produced domestically and 30X imported from Nation 1.
Nation 2 collects $30 in tariff revenues.
If Nation 2 forms a customs union with Nation 1, P_X = $1 in Nation 2.
At this price, Nation 2 consumes 70X, with 10X produced domestically and 60X imported from Nation 1.
Nation 2 collects no tariff revenue.
Consumer benefit equals area AGHB (increase in consumer surplus).
Net gain for Nation 2: Sum of shaded triangles CJM and BHN, or $15.
Triangle CJM: Production component of welfare gain from trade creation.
Triangle BHN: Consumption component of welfare gain from trade creation.
Viner (1950) focused on the production effect, Meade (1955) considered consumption effect, and Johnson combined both.
CJM is the production component of the welfare gain from trade creation and results from shifting the production of 10X (CM) from less efficient domestic producers in Nation 2 to more efficient producers in Nation 1.
BHN is the consumption component of the welfare gain from trade creation and results from the increase in consumption of 20X (NB) in Nation 2
Trade-Diverting Customs Unions
Trade diversion: Lower-cost imports from outside the customs union are replaced by higher cost imports from a union member.
Reduces welfare by shifting production from more efficient producers outside the union to less efficient producers inside.
Worsens international allocation of resources and shifts production away from comparative advantage.
A trade-diverting customs union results in both trade creation and trade diversion.
Can increase or reduce welfare of union members.
Welfare of nonmembers declines.
Illustration of a Trade-Diverting Customs Union
Figure 10.2 illustrates the effects of a trade-diverting customs union.
DX and SX are Nation 2’s domestic demand and supply curves of commodity X, while S1 and S3 are the free trade perfectly elastic supply curves of Nation 1 and Nation 3, respectively.
With a 100% tariff, Nation 2 imports from Nation 1 at P_X = $2.
If Nation 2 forms a customs union with Nation 3, it imports commodity X from Nation 3 at P_X = $1.50.
Imports are diverted from more efficient producers in Nation 1 to less efficient producers in Nation 3.
This leads to some trade creation.
The welfare gain in Nation 2 from pure trade creation is $3.75 (given by the sum of the areas of the two shaded triangles).
The welfare loss from trade diversion proper is $15 (the area of the shaded rectangle).
Thus, this trade-diverting customs union leads to a net welfare loss of $11.25 for Nation 2.
Flatter DX and SX curves and closer S3 to S1 make it more likely that even a trade-diverting customs union will lead to a net welfare gain.
Attempts to measure the static welfare effects resulting from the formation of the European Union all came up with surprisingly small net static welfare gains (in the range of 1 to 2 percent of GDP).
The Theory of the Second Best and Other Static Welfare Effects of Customs Unions
The theory of customs unions is a special case of the theory of the second best.
The Theory of the Second Best
Free trade leads to efficient utilization of world resources and maximizes world output and welfare.
Viner showed that forming a customs union can increase or reduce welfare.
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 lead to the second-best position.
Developed by Meade (1955) and generalized by Lipsey and Lancaster (1956).
Conditions More Likely to Lead to Increased Welfare
Higher pre-union trade barriers of member countries.
Lower customs union’s barriers on trade with the rest of the world.
Greater number of countries forming the customs union and the larger their size.
More competitive rather than complementary economies of member nations.
Closer geographic proximity of the members of the customs union.
Greater pre-union trade and economic relationship among potential members of the customs union.
The European Union (EU) has had greater success than the European Free Trade Association (EPTA) because the nations forming the EU were much more competitive than complementary, were closer geographically, and had greater preunion trade than the EFTA nations
Other Static Welfare Effects of Customs Unions
Administration savings from the elimination of customs officers, border patrols, and so on, for trade among member nations.
A trade-diverting customs union is likely to lead to an improvement in the collective terms of trade of the customs union.
Any customs union is likely to have much more bargaining power than all of its members separately.
Dynamic Benefits from Customs Unions
Increased competition.
Economies of scale.
Stimulus to investment.
Better utilization of economic resources.
Increased competition: Producers become more efficient to meet competition, merge, or go out of business.
Stimulates the development and utilization of new technology.
Cuts costs of production.
Careful by passing and enforcing antitrust legislation.
Economies of scale: Enlarged market results in economies of scale.
Significant economies were achieved after the formation of the EU by reducing the range of differentiated products manufactured in each plant and increasing “production runs”.
Stimulus to investment: Investment increase to take advantage of the enlarged market and to meet the increased competition.
Outsiders set up production facilities within the customs union to avoid trade barriers.
Tariff factories
Better utilization of economic resources: Free community-wide movement of labor and capital results in better utilization of economic resources.
These dynamic gains are presumed to be much greater than the static gains.
Recent empirical studies seem to indicate that these dynamic gains are about five to six times larger than the static gains.
Joining a customs union because of the static and dynamic benefits that it provides is only a second-best solution.
The best policy may be for a nation to unilaterally eliminate all trade barriers.
Whether regional blocs are building blocks or stumbling blocks to free multilateral trade.
History of Attempts at Economic Integration
European Union (EU).
European Free Trade Association (EFTA).
North American Free Trade Area (NAFTA).
Southern (American) Common Market.
Other attempts at economic integration among developing countries and among the Republics of the former Soviet Union.
The European Union
Founded by the Treaty of Rome (March 1957).
Members: West Germany, France, Italy, Belgium, the Netherlands, and Luxembourg.
Came into being on January 1, 1958.
Common external tariff was set at the average of the 1957 tariffs of the six nations.
Free trade in industrial goods within the EU and a common price for agricultural products were achieved in 1968.
Restrictions on the free movement of labor and capital were reduced by 1970.
Membership increased to 15 after the United Kingdom, Denmark, and Ireland joined in 1973, Greece in 1981, Spain and Portugal in 1986, and Austria, Finland, and Sweden in 1995.
On January 1, 1993, the EU removed all remaining restrictions on the free flow of goods, services, and resources (including labor) among its members, thus becoming a single unified market.
By 2008, the EU had expanded to 27 members and represented the largest trading bloc in the world.
Intra-EU trade has been estimated to be double what it would have been in the absence of integration.
More than half of this trade expansion has been in intra-industry trade.
Formation of the EU significantly expanded trade in industrial goods with nonmembers.
Due to very rapid growth of the EU and the reduction to very low levels of the average tariff on imports of industrial products..*
Formation of the EU resulted in trade diversion in agricultural commodities.
Development of a common agricultural policy (CAP).
Variable import levies: EU determines common farm prices and imposes tariffs to make the price of imported agricultural products equal to the high established EU prices.
At the Lome Convention in 1975, the EU eliminated most trade barriers on imports from ´ 46 developing nations in Africa, the Caribbean, and the Pacific region that were former colonies of EU countries.
In February 2000, Lom´e IV expired and was replaced by a new agreement, the Cotonou Agreement, signed in Cotonou, Benin, in June 2000.
The EU ´ replaced the Cotonou Agreement in January 2008 with “new partnership agreements (NPAs) based on reciprocity” with the 79 countries involved, broken into six regional groups.
The static welfare benefits resulting from the formation of the EU are estimated to be 1 to 2 percent of GDP, while the dynamic benefits are estimated to be much larger.
Perhaps the greatest benefit has been political, resulting from unifying into a single economic community nations, such as Germany and France, that were once bitter enemies.
United States has been of two minds on European unity, supportive yet wary of losing influence.
In 1986, the EU amended the Treaty of Rome with the Single European Act, which provided for the removal of all remaining barriers to the free flow of goods, services, and resources among members.
This led to the pouring in of foreign direct investments into the EU out of fear of increased protectionism against outsiders.
Member nations have adopted a common value-added tax system.
Plans have also been drawn for full monetary union, including harmonization of monetary and fiscal policies, and eventual full political union.
In May 2004, ten countries, mostly from the former communist bloc in Central and Eastern Europe, became members of the European Union.
With the admission of the 12 new members, the European Union is now comparable in size to NAFTA.
The European Free Trade Association
Formed in 1960 by the “outer seven” nations: the United Kingdom, Austria, Denmark, Norway, Portugal, Sweden, and Switzerland, with Finland becoming an associate member in 1961.
Achieved free trade in industrial goods in 1967.
The maintenance by each nation of its own trade barriers against nonmembers can lead to the problem of trade deflection.
Iceland acceded the EFTA in 1970, Finland became a full member in 1986, and Liech- tenstein, a part of the Swiss customs area, in 1991.
In 1973, the United Kingdom and Denmark left the EFTA and, together with Ireland, joined the EU, as did Portugal in 1986.
On January 1, 1994, the EFTA joined the EU to form the European Economic Area (EEA), a customs union that will eventually allow the free movement of most goods, services, capital, and people among the 17 member nations
In 1995, Austria, Finland, and Sweden left the EFTA and joined the EU, leaving the EFTA with only four members (Switzerland, Norway, Iceland, and Liechtenstein).
The North American and Other Free Trade Agreements
In September 1985, the United States negotiated a free trade agreement with Israel.
Provided for bilateral reductions in tariff and nontariff barriers to trade in goods between the two countries.
In 1988, a free trade agreement was finally negotiated between the united states and canada
By the time the pact went into effect in January 1, 1989, Canada was already by far the largest trading partner of the United States.
The pact called for the elimination of most of the remaining tariff and nontariff trade barriers between the two countries by 1998.
In September 1993, the United States, Canada, and Mexico signed the North American Free Trade Agreement (NAFTA), which took effect on January 1, 1994.
Eventually lead to free trade in goods and services over the entire North American area.
NAFTA will also phase out many other barriers to trade and reduce barriers to cross-border investment among the three countries.
The main impact of NAFTA was on trade between the United States and Mexico.
The implementation of NAFTA benefits the United States by increasing competition in product and resource markets, as well as by lowering the prices of many commodities to U.S. consumers.
Free trade access to Mexico allows U.S. industries to import labor-intensive components from Mexico and keep other operations in the United States rather than possibly losing all jobs in the industry to low-wage countries.
As a condition for congressional approval of NAFTA, the United States also negotiated a series of supplemental agreements with Mexico governing workplace and environmental standards.
The implementation of NAFTA benefited Mexico by leading to greater export-led growth resulting from increased access to the huge U.S. market and by increasing inward foreign direct investments.
Mexico’s ability to benefit from NAFTA has been limited, however, by weak economic institutions and inadequate structural reforms of the economy
In 1993, the United States launched the Enterprise for the American Initiative (EAI), which led to the formation of the Free Trade Area of the Americas (FTAA) in 1998, whose ultimate goal is hemispheric free trade among the 34 democratic countries of North and South America.
Since 2001, the United States also signed free trade agreements (FTAs) with Australia, Bahrain, Chile, Jordan, Morocco, Oman, Peru, and Singapore.
Also operational is the United States-Dominican Republic-Central American Free Trade Agreement (US-DR-CAFTA) with Costa Rica, El Salvador, Guatemala, Honduras, and Nicaragua, besides the Dominican Republic.
Ratified in 2001 was the U.S. FTA with Korea, Panama, and Colombia.
Japan has FTAs with ASEAN, India, Mexico, and Switzerland and is negotiating with still other countries.
Canada has FTAs with the United States and Mexico (NAFTA) and the European Free Trade Association (EFA), as well as with Israel, Colombia, Costa Rica, Honduras, and Peru; and it is negotiating with other countries as well.
This spaghetti-bowl proliferation of bilateral and regional FTAs is regarded by some as a stumbling block to a freer multilateral trading system.
Attempts at Economic Integration among Developing Countries
The success of the EU encouraged many attempts at economic integration among groups of developing nations as a means of stimulating the rate of economic development.
Most of these attempts, however, met with only limited success or failed.
The Central American Common Market (CACM).
The Latin American Free Trade Association (LAFTA).
The Southern Common Market (Mercosur).
The Free Trade Area of the Americas (FTAA).
The Caribbean Free Trade Association (CARIFTA).
The East African Community (EAC).
The West African Economic and Monetary Union (WAEMU).
The 14-member Southern Africa Development Community (SADC).
The Association of South East Asian Nations (ASEAN).
These customs unions are (or were) to a large extent explicitly trade diverting to encour- age industrial development.
Perhaps the greatest stumbling block to successful economic integration among groups of developing nations is the uneven distribution of benefits among members.
Another difficulty is that many developing nations are not willing to relinquish part of their newly acquired sovereignty to a supranational community body, as is required for successful economic integration.
Other difficulties arise from lack of good transportation and communication among member nations, the great distance that often separates members, and the basically complementary nature of their economies and competition for the same world markets for their agricultural exports.
For these reasons, economic integration among developing countries cannot be said to have been very successful in most cases.
Economic Integration in Central and Eastern Europe and in the Former Soviet Republics
In 1949, the Soviet Union formed the Council of Mutual Economic Assistance (CMEA or COMECON) with the communist bloc nations in Eastern Europe
The purpose of this agreement was to divert trade from Western nations and achieve a greater degree of self-sufficiency among communist nations.
Under this arrangement, most CMEA members imported oil and natural gas from the Soviet Union in exchange for industrial and farm products.
In CMEA member countries, the state decided and controlled all international transactions through a number of state trading companies, each handling some product line.
Under such a system, the types and amounts of goods imported were determined by the requirements of the national plan over and above domestically available products.
Political considerations played at least as important a role as economic considerations in such a trade, while comparative advantage and relative commodity prices did not have any direct role.
Trade among CMEA economies was generally conducted on the basis of bilateral agreements and bulk purchasing.
Since 1989, communist regimes collapsed all over Eastern Europe and in the Soviet Union.
All 12 Central and Eastern European Countries (CEEC) and the 15 Newly Independent States (NIS) of the former Soviet Union have and are continuing to restructure their economies and their foreign trade along market lines.
The establishment of a market economy requires
freeing prices and wages from government control
transferring productive resources from government to private ownership (i.e., privatizing the economy)
opening the economy to competition and liberalizing international trade (i.e., replacing state trading with trade based on market principles)
establishing the legal and institutional framework necessary for the functioning of a market economy
In the majority of countries, severe economic dislocations in the form of increasing unemployment, high inflation, huge budget deficits, unsustainable international debts, and disrupted trade relations accompanied the collapse of traditional central planning.
Since 1989 there has been a shift in the direction of CEEC and NIS trade.
Most CEEC countries have had and most NIS countries are having difficulties expanding trade with the West because of the generally low quality of their manufactured products and protectionism in industrial countries.
At the end of 1991, the Soviet Union was formally dissolved, and, under the leadership of Russia, most former Soviet Republics (now called the Newly Independent States or NIS) formed the Commonwealth of Independent States (CIS).
In 1991, the EU signed association agreements with Poland, Hungary, and Czechoslovakia, giving those countries free trade access to the EU, except in some important products, such as steel, textile, and agricultural products.
In 1992, Poland, Hungary, the Czech Republic, and Slovakia formed the Central European Free Trade Association (CEFTA) and the Baltic States of Estonia, Latvia, and Lithuania formed the Baltic Free Trade Agreement (BAFTA), but they are now all members of the EU.
In 2004, ten Central and Eastern European countries (Poland, Hungary, the Czech Republic, Slovakia, Slovenia, Estonia, Lithuania, Latvia, Malta, and Cyprus) became EU members in 2004, and Bulgaria and Romania joined in 2008.
Albania, the countries of former Yugoslavia (Bosnia-Herzegovina, Croatia, Serbia, Montenegro, and Macedonia, with the exception of Slovenia), as well as Turkey have started negotiation for admission into the EU.
The former Soviet Republics (Russia, Armenia, Azerbaijan, Belarus, Georgia, Kazakhstan, the Kyrgyz Republic, Moldova, Tajikistan, Turkmenistan, Ukraine, and Uzbekistan—with the exception of the Baltic States of Estonia, Latvia, and Lithuania) are further behind in their restructuring process and are not in line to join the EU.