ECONOMIC INTEGRATION THEORY

1. Types of economic integration

2. Effects of economic integration - Gains from trade - Static effects - Dynamic effects

3. Effects on outside countries

4. Empirics - European Integration

1.

Economic integration

The process of removing trade impediments between two or more countries. Requires certain elements of cooperation and coordination

Global integration (GI) Negotiations within GATT / WTO large reductions in tariffs Uruguay-round:
- non-tariff barriers - trade in services - intellectual property rights - environment

Regional integration (RI) Number of regional integration agreements grown rapidly since 1980s

Regional integration a step towards or an obstacle to global integration? a building bloc or a stumbling bloc

Principles of World Trade governed by the World trade Organization (WTO):

Article I: Most-Favored-Nation (MFN) principle: a principle of non-discrimination. Rules out any preferential treatment among nations
If a country gives preferential tariff-access to any other country that concession must be extended (immediately) to all other countries

Exceptions

Article XXIV: Preferential Trading Areas (PTAs) allowed if 1) trade barriers removed on substantially all trade and

2) the agreement does not on the whole result in more restrictive trade barriers to outsiders than those that existed before

Levels of Integration:
1) Free Trade Area (FTA)
Trade barriers eliminated against the members and each country has its own trade barriers against outside countries. EFTA, EU/EFTA, NAFTA

2)

Customs Union (CU)

Free trade within the union and common external trade barriers EU

3)

Common market
Free factor mobility factor price-equalization

4)

Economic Union
Fixed exchange rates and coordination of fiscal and monetary policies

5)

Political Union
A sovereign parliament Germany

2.

Effects of Economic Integration

a) Gains from Trade

Adam Smith: absolute advantages, gains from specialization

David Ricardo: comparative advantages Trade enhanced efficiency in production increase consumption possibilities

Even unilateral reductions in trade barriers welfare enhancing Implication: regional integration a step towards free trade

b) Regional Integration

I. Static effects

Viner (1950) The Customs Union Issue

Trade creating viz. Trade-diverting effects

Trade creation: free-trade effect imports from a lower-cost producer in another country instead of domestic production

Trade diversion: protectionistic effect imports from a higher-cost producer within the CU instead of importing from the lowest-cost producer in the international market

No CU, tariff rate = 200%

Sweden Cost of Production Tariff in Sweden Price in Sweden 2.00 Germany 1.50 Thailand 1.00

CU with Germany, tariff rate = 200%

Sweden 2.00 Germany 1.50 Thailand 1.00

3.00

2.00

2.00

2.00

4.50

3.00

2.00

1.50

3.00

Trade-creating customs union

imports from a lower-cost producer in another country instead of domestic production

No CU, tariff rate = 90%

Sweden Cost of Production Tariff in Sweden Price in Sweden 2.00 Germany 1.50 Thailand 1.00

CU with Germany, tariff rate = 90%

Sweden 2.00 Germany 1.50 Thailand 1.00

1.35

0.90

0.90

2.00

2.85

1.90

2.00

1.50

1.90

Trade-diverting customs union

imports from a higher-cost producer within the CU instead of importing from the lowest-cost producer in the international market (no tariff revenue)

Trade creation: 1) members produce similar goods 2) demand and supply should be as flexible as possible

Trade-diversion: 1) smaller the larger the CU 2) the larger the differences in production costs between members. 3) initially low level of trade relative to production 4) high proportion of pre-union trade with future partners Countries that are currently competitive but potentially complementary should form a CU!

Importance of the level of economic development: Welfare-enhancing CU where the trade-creating effect dominates is more likely if the integrating countries are richer, produce similar (industrial) goods and have a large volume of trade before the CU is formed. Typically involves intra-industry trade.

II. Dynamic Effects

i)

Increased efficiency and economic growth by:

- increased competition - exploitation of scale economies

the importance of market size integration lower production costs and lower prices

ii)

Polarization

Concentration of production to certain regions need for redistributing policies (EU)

Could attract industries from outside countries

3. Effects on Outside Countries /Trade Policy Aspects

- Terms-of-trade effect: outside countries may face lower demand for their products

- The Common External Tariff (CET) under a CU?

(GATT article XXIV states that PTAs allowed if: 1) trade barriers removed on substantially all trade and 2) agreement must not on the whole result in more restrictive trade barriers to outsiders than those that existed before (weighted average of the trade barriers applied by the individual members before the CU))

Risk of trade blocs (Europe, the US and South-East Asia). A few strong trade blocs probably the most trade-diverting outcome

Globalization viz. Regionalisation?

4.

The European Union: Gains and Losses

Trade creation and trade diversion: Trade creation: Manufacturing competitive production Exports as a share of total exports increased from 35% in 1960 to 60% IIT around 60%. Trade diversion: Agriculture, textiles due to heavy protection

The Single Market administrative costs/bureaucracy and transport costs (boarder crossing simplification) mutual recognition of health and safety standards public procurement services labor mobility fiscal harmonization etc

Gains - one-time effects 2-4 % - potential long-run effects from e.g. increased competition and agglomeration effects Losses - risk of higher protection

Fortress Europe Small open country: risk of external trade barriers rise when adapting to the CET of the union

Other arguments: compensation for increased competition from other member countries protect certain industries in order to obtain monopoly power voting rules tend to favor protectionistic countries the economic development in the early 1990s

Macro-economic effects from the Monetary Union may increases integration and stability by - elimination of transaction costs - elimination of exchange risks - reduced investment risk - lower interest rates - lower inflation - more efficient taxation etc

Other Arrangements:

South South: common market not big enough, small industry sector, low competition and inefficient production behind a high CET a more industrialized partner tend to reap most of the gains through trade diversion polarization and unequal distribution South North: often a colonial pattern, e.g. between the EU and former colonies or bilateral agreements with East-European countries, the US and countries in South-America and the Caribbean increased specialization based on differences in endowment risk of large trade-diverting effects