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CHAPTER 10
ECONOMIC INTEGRATION: CUSTOMS UNIONS AND FREE TRADE AREAS
OUTLINE
10.1 Introduction
10.2 Trade-Creating Customs Unions
10.2A Trade Creation
10.2B Illustration of a Trade-Creating Customs Union
10.3 Trade-Diverting Customs Unions
10.3a Trade Diversion
10.3b Illustration of a Trade-Diverting Customs Union
10.4 The Theory of the Second Best and Other Static Welfare Effects
10.4A The Theory of the Second Best
10.4B Conditions More Likely to Lead to Increased Welfare
10.4C Other Static Welfare Effects of Customs Unions
10.5 Dynamic Benefits of Customs Unions
*10.6 History of Attempts at Economic Integration
10.6A The European Union
Case Study 10-1: Economic Profile of the EU, NAFTA, and Japan
Case Study 10-2: Gains from the Single EU Market
10.6B The European Free Trade Association
10.6C The North American and Other Free Trade Agreements
Case Study 10-3: Mexico's Gains from NAFTA Expectations and Outcome
10.6D Attempts at Economic Integration Among Developing Nations
Case Study 10-4: Economic Profile of Mercosur
Case Study 10-5: Changes in Trade Patterns with Economic Integration 344
10.6E Economic Integration in Central, Eastern Europe & Former Soviet Republics
Appendix:
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Key Terms
Economic integration
Preferential trade arrangements
Free-trade area
Customs union
Common market
Economic union
Duty-free zones
Trade creation
Trade diversion
Trade-diverting customs union
Theory of the second best
Tariff factories
European Union (EU)
This is not a core chapter and I would skip it except for section 6. Section 6 is an
important section and can be regarded as an extension of Chapter 9, which is a core
chapter. Section 6 deals with a very important set of current events.
2.
Section 6 is a long section and may require two classes to be adequately presented.
I would cover subsections a-d in one class and subsection e as well as both case
studies in the second class. Case Studies 10-1 to 10-6 can be used for a very\
stimulating class discussion.
3.
While section 6 can be presented without covering the material in sections 1-5,
some terms discussed in sections 1-5 (such as trade creation and trade diversion)
need to be defined.
4.
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Answers to Problems:
1.
2. a)
b)
When Nation A forms a customs union with Nation B this would be a tradecreating customs union because it replaces domestic production of commodity
X at Px=$10 with tariff-free imports of commodity X from Nation B at Px=$8.
3.
4. a)
b) When Nation A forms a customs union with Nation B this would be a trade-diverting
customs union because it replaces lower-price imports of commodity X of $6 (from
the point of view of Nation A as a whole) with higher priced imports of commodity
X from Nation B at $8.
Specifically, Nation A's importers do not import commodity X from Nation C
because the tariff-inclusive price of commodity X from Nation C is $9 as compared
with the no-tariff price of $8 for imports of commodity X from Nation B. However,
since the government of Nation A collects the $3 tariff per unit on imports of
commodity X from Nation C, the net effective price for imports of commodity X
from Nation C is really $6 for Nation A as a whole.
5.
See Figure 10-1 in the text. Any figure similar to Figure 10-1 in the text would do.
6.
The welfare gains that Nation 2 receives from joining Nation 1 to form a customs
Union is given by the sum of the areas of triangles CJM and BHN in Figure 10-1 in
the text. Any similar figure and sum of corresponding triangles would, of course, be
adequate.
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7.
See Figure 10-2 in the text. Any figure similar to Figure 10-2 in the text would do.
8.
The welfare loss that Nation 2 receives from joining Nation 1 to form a customs union
is given by C'JJ'+B'HH'- MNH'J'=$11.25 in Figure 10-2 in the text.
Any similar figure and sum of corresponding triangles minus the area of corresponding
rectangle would, of course, be adequate.
9.
10.
The net gain from the trade-diverting customs union shown in Figure 1 is given by
C'JJ'+B'HH'-MJ'H'N. As contrasted with the case in Figure 10-2, however, the sum
of the areas of the two triangles (measuring gains) is greater than the area the rectangle
(measuring the loss). Thus, the nation would now gain from the formation of a custom
union. Had we drawn the figure on graph paper, we would have been able to measure
the net gain in monetary terms also.
11.
12.
13.
NAFTA created much more controversy because the very low wages in Mexico led to
great fears of large job losses in the U. S.
14.
The possible cost to the U.S. from EU92 arose from the increased efficiency and
competitiveness of the E.U. The benefit arose because a more rapid growth in the EU
spills into a greater demand for American products, which benefits the U. S.
App. Compare points B' and H' in Figure 10-3 with the corresponding points in
Figure 3.
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Multiple-choice Questions:
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6. The formation of a trade-creating customs union where all economic resources of member
nations are fully employed before and after the formation of the customs union leads to an:
*a. increase in the welfare of member and nonmember nations
b. increase in the welfare of member nations only
c. increase in the welfare of nonmember nations only
d. increase or decrease in the welfare of member and nonmember nations
7. A trade-diverting customs union:
a. increases the welfare of member and nonmember nations
b. reduces the welfare of member and nonmember nations
c. increases the welfare of member nations but reduces that of nonmembers
*d. reduces the welfare of nonmembers and may increase or reduce that of members
8. A trade-diverting customs union is more likely to lead to trade creation:
a. the lower are the pre-union trade barriers of the member countries
*b. the lower are the customs union's barriers on trade with the rest of the world
c. the smaller is the number of countries forming the customs union and the smaller their size
d. the more complementary rather than competitive are the economies of the nations forming the
customs union
9. The theory of customs union is a special case of the theory of:
a. effective protection
*b. the second best
c. the product cycle
d. comparative advantage
10. Which is not a dynamic benefit from the formation of a customs union?
a. increased competition
b. economies of scale
c. stimulus to investment
*d. trade creation
11. The formation of the EU resulted in:
a. trade creation in industrial and agricultural products
b. trade diversion in industrial and agricultural products
*c. trade creation in industrial products and trade diversion in agricultural products
d. trade diversion in industrial products and trade creation in agricultural products
12. The benefit that the United States is likely to receive from NAFTA:
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