3.

5: Economic Integration
Definitions

1. Economic integration is a process where countries coordinate and link their economic
policies. This leads to a decrease in trade barriers between the countries, with their fiscal
and monetary policies becoming more closely harmonized.
2. Trading blocs is a group of countries that join together in some form of agreement in
order to increase trade between themselves and/or to gain economic benefits from
cooperation on some level. This coming together is economic integration..
3. Free Trade Area (FTA) is an agreement made between countries, where the countries
agree to trade freely among themselves, but are able to trade with countries outside the
free trade area in whatever way they wish.
4. Customs union is an agreement made between countries, where the countries agree to
trade freely among themselves, and they also agree to adopt common external barriers
against any country attempting to import into the customs union.
5. Common Market is a customs union (where countries agree to trade freely among
themselves, and they also agree to adopt common external barriers against any country
attempting to import into the customs union) with common policies on product
regulation, and free movement of goods, services, capital and labor.
6. Economic/monetary union is a common market (where countries agree to trade freely
among themselves, and they also agree to adopt common external barriers against any
country attempting to import into the customs union, adopt common policies on product
regulation, and free movement of goods, services, capital and labor) with a common
currency and a common central bank.
7. Trade creation is an advantage of greater economic integration, occurring when the
entry of a country into a customs union leads to the production of a good moving from a
high-cost producer to a low-cost producer.
8. Trade diversion is a disadvantage of greater economic integration, occurring when the
entry of a country into a customs union leads to the production of a good moving from a
low-cost producer to a high-cost producer.

Bilateral vs. Multilateral agreements

● Bilateral trade agreements relate to trade between two countries.
● Multilateral trade agreements relate to trade between multiple countries.
● Their aim is to reduce or remove tariffs and/or quotas that have been placed on items
traded between two or more countries.
Trading blocs
1. Preferential Trading Area
● Gives preferential access to certain products from certain countries.
● Usually carried out by reducing, but not eliminating, tariffs.
● Example include:
❖ PTA between the European Union and the African, Caribbean and Pacific Group of
States (ACP).

2. Free Trade Area

● Countries agree to trade freely among themselves.
● Able to trade with countries outside of the their free trade area.
● Examples include:
❖ NAFTA (North American Free Trade Agreement) between the United States, Canada and
Mexico.
❖ EFTA (European Free Trade Association) between Iceland, Norway, Switzerland and
Liechtenstein.
❖ SAFTA (South Asian Free Trade Agreement) between India, Pakistan, Nepal, Sri Lanka,
Bangladesh, Bhutan, Nepal and the Maldives.

3. Customs union
● Same as Free Trade Area, but countries adopt common external barriers against any
country attempting to import into customs union.
 ● Examples include all common markets and monetary unions, such as:
❖ European Union.
❖ Switzerland - Liechtenstein customs union.
❖ East African Community between Kenya, Uganda and Tanzania
❖ Mercosur between Brazil, Argentina, Paraguay, Uruguay and Venezuela.

4. Common Market
● Customs union with common policies on product regulation, and free movement of
goods, services, capital and labor.
● Examples include:
● European Union
● CARICOM Single Market and Economy (CSME) between countries in South America.

5. Economic and monetary union

● Common market + common currency + common central bank.
● Examples include:
❖ Eurozone: Includes members of the European Union, adopted Euro as their currency and
have European Central Bank (ECB) as their central bank.

● Advantages of economic and monetary union:

❖ Exchange rate fluctuations between countries will disappear → Eliminating exchange
rate uncertainty → Increase cross-border investment and trade.
❖ Currency with the enhanced credibility to be used as a large currency zone →
More stable than against speculation than other individual currencies.
 ❖ Business confidence in the member countries improve → Leads up to higher trade
growth and internal growth.
❖ Transactions costs are eliminated within the monetary union.
❖ Common currency makes price differences more obviou between countries →
Prices equalizing across borders.
● Disadvantages of economic and monetary union:
❖ Interest rates are decided by the central bank → Individual countries are no longer
free to set their own interest rates → No longer influence the unemployment rate,
inflation rate and rate of economic growth in individual countries.
❖ Without fiscal integration (harmonized tax rates, common treasury, common budget)
→ Monetary union in weak and vulnerable → Threatens stability of the union.
❖ Individual countries aren’t able to alter their own exchange rate in order to effect the
international competitiveness of their exports or the cost of the imports.
❖ Initial costs of converting individuals currencies into one currency is very high.

6. Complete economic integration

● Final stage of economic integration.
● Individuals countries have no control over economic policies, full monetary union and
complete harmonization of fiscal policies.
● Stage where Eurozone is moving towards.

Trade Creation vs. Trade Diversion

1. Trade Creation
● Advantage of greater economic integration.
 ● Occurs when entry of a country into a customs union leads to production of a good
or service transferring from a high-cost producer → low-cost producer.

S(US)

Price Regained Regained

of world efficiency consumer
Biscuits surplus
P(UK+tariff) S(UK)
($) +tariff
P(UK) Q1 Q2 Q3
Q4 S(UK)
Quantity of Biscuits (tons)
2. Trade Diversion
● Disadvantage of greater economic integration. D(US)
● Occurs when entry of a country into a customs union leads to production of a good
or service transferring from a low-cost producer → high-cost producer.

S(US)

Loss of Loss
Price of
of world efficiency consumer
Biscuits surplus
S(Thai)
P(Thai+tariff) +tariff
($)
P(UK)
Q1 Q2 Q3
S(UK)
P(Thai) Q4
Quantity of Biscuits (tons)
S(Thai)

D(US)