Global Economics Eco 6367 Dr. Vera Adamchik

1. Global EconomicsEco 6367Dr. Vera Adamchik Regional Trading Arrangements

2. Chapter outline • To understand the differences between the basic levels of economic integration. • To identify the effects of economic integration. • To grasp the real-world progress of economic integration in Europe, the Americas, Asia, and Africa.

3. Economic integration: countries join together to create a larger economic unit with special relationship among the members. • Regional economic integration refers to agreements between countries in a geographic region. • Economic integration often takes place in stages. Five basic types of formal regional economic arrangements are usually distinguished.

4. Types of economic integration

5. Levels of economic integration

6. 1. Free-trade area (FTA) All members of a free trade area remove tariffs on each other’s products, while each member retains its independence in establishing trading policies with non-members. Example: the North American Free Trade Agreement (NAFTA).

7. The ‘no-tariff’ scheme is usually assumed to apply to all products between member countries, but it can clearly involve a mix of free trade in some products and preferential, but still protected, treatment in others.

8. Potential concerns: Non-member countries may export a product to the member country with the lowest level of outside protection and then through it to other member countries with higher levels of protection (the transshipmentstrategy). • In this case, member countries must use rules of origin and maintain customs administration on the borders between themselves.

9. 2. Customs union • All tariffs are removed between members of a customs union and the group adopts a common external commercial policy toward non-members. Furthermore, the group acts as one body in the negotiation of all trade agreements with non-members. • Example: Southern Cone Common Market (MERCOSUR).

10. The existence of the common external tariff takes away the possibility of transshipment by non-members. • Potential concerns: member nations give up independence in setting tariff rates.

11. 3. Common market • All tariffs are removed between the members of a common market; a common external trade policy is adopted for non-members; and all barriers to factor movements among the member countries are removed. • Examples: European Union is a true common market since 1992; MERCOSUR is aiming for common market status.

12. Potential concerns: • A further reduction in national control of the individual economy; • Members give up sovereignty in immigration and capital flows; • Factor integration has proven to be very difficult.

13. 4. Economic union • Economic union includes all features of a common market but also implies the unification of economic institutions and the coordination of economic policy (i.e., a harmonized monetary and fiscal policy) throughout all member countries. • While separate political entities are still present, an economic union generally establishes several supranational institutions whose decisions are binding upon all members.

14. When an economic union adopts a common currency, it becomes a monetary union as well. • Potential concerns: It is extraordinarily difficult to give up the domestic sovereignty and autonomy in monetary policy.

15. Example: The EU is an imperfect economic union since not all members of the EU have adopted the euro, and differences in tax rates across countries still remain.

16. 5. Political union • If the policies are not just harmonized by separate governments, but actually decided by a unified government with binding commitments on all members, then an economic bloc amounts to full economic nationhood. Some authors call this full economic integration or political union.

17. Examples: • Most nations are full economic/political unions. • The EU is on a path toward full economic unity/at least partial political union. • Belgium and Luxembourg have had a political union since 1921.

19. The economic case for regional integration • Regional economic integration is an attempt by each participating country to exploit the gains from free trade and investment.

20. The political case for regional integration Linking countries together • makes them more dependent on each other; • creates incentives for political cooperation and reduces the likelihood of violent conflict; • gives countries greater political clout when dealing with other nations.

21. Impediments to integration Economic integration can be difficult because: • the net impact of economic integration on a participating country may be negative; • even when a nation as a whole benefits from a regional free trade agreement, certain groups may lose; • it may imply a loss of national sovereignty.

22. Trade blocs & The static and dynamic effects of economic integration

23. The first two types of economic integration -- FTA and customs union – are simply trade blocs. • Trade blocs remove trade barriers within the bloc but keep their national barriers to the flow of labor and capital and their fiscal and monetary autonomy. • Trade blocs have proved easier to form than common markets or full unions among sovereign nations.

24. Currently, there are about 130 separate preferential trade agreements in force in the world, and nearly half of them had begun operating since 2000. • Only a few countries, including Mongolia and Taiwan, were not members of some trade bloc.

25. Regional trade agreements are designed to promote free trade, but instead many regional groupings discriminate (in trade alone or on all fronts) between insiders and outsiders. • Hence, a trade bloc is often considered as a trade barrier that is designed to discriminate. [As opposed to an equal-opportunity trade barriers, ones that tax or restrict all imports regardless of country of origin.]

26. Trade discrimination can be either good or bad. • Because differential treatment for member and non-member countries can lead to shifts in the pattern of trade among countries, the net impact on a participating country is, in general, ambiguous and must be judged on the basis of each individual country.

27. Static effects of economic integration

28. Static effects of economic integration, occur directly on the formation of the integration project. • The two static effects of economic integration are called trade creation and trade diversion. These terms were coined by Jacob Viner (1950).

29. Trade creation • Integration represents a movement to free trade on the part of member countries. • Integration facilitates new trade within the trade bloc through displacement of high-cost domestic producers by lower-cost partner suppliers. • The net volume of new trade resulting from forming or joining a trade blocis called trade creation.

30. Trade diversion • At the same time, integration can lead to the diversion of trade from a lower-cost non-member source (which still faces the external tariff of the group) to a higher-cost member-country source (which no longer faces any tariffs). • The volume of trade shifted from low-cost outside exporters to higher-cost bloc-partner exporters is called trade diversion.

31. The gains from a trade bloc are tied to trade creation, and the losses are tied to trade diversion. • The net effect (that is, gains minus losses) could be positive or negative. • Any conclusions on whether the net effect of joining a trade bloc will be positive or negative must be based on an analysis of each particular coalition formation.

32. In-class exercise • Trade creation and trade diversion (a numerical example from the textbook). • Assume a world is composed of three countries: Luxembourg, Germany, and the US. • Suppose that Luxemburg and Germany decide to form a customs union, and that the US is a non-member.

33. Assume that Luxemburg is very small relative to Germany and to the US (that is, cannot influence foreign prices). • The US is assumed to be the most efficient supplier of grain ($3 per bushel). • Germany’s supply price is $3.25 per bushel.

34. Static Effects of Trade Arrangements With Free Trade: red triangle = consumer surplus green triangle = producer surplus

35. With Tariff: (before customs union) red triangle = consumer surplus green triangle = producer surplus black rectangle = tariff revenue 2 orange triangles = deadweight loss (DWL) Static Effects of Trade Arrangements

36. With Customs Union: agreement with Germany will lower the price to SG trade-creation effect (welfare gain): a = production effect b = consumption effect trade-diversion effect (welfare loss): area c Static Effects of Trade Arrangements

37. Because both trade creation and trade diversion are clearly possible with economic integration, economic integration represents only a partial movement to free trade. • Whether or not it produces a net benefit to participating countries is an empirical issue.

38. Note of caution • There is considerable feeling among economists that economic coalitions among regional groupings of countries may not be as economically desirable as an alternative – nondiscriminatory decreases in trade barriers worldwide. • In other words, the world may be moving toward blocs of countries and away from global integration. • Political tensions and frictions can also result from the current discriminatory policy actions.

39. Dynamic effects of economic integration

40. Additional gains from forming the trade bloc: (1) An increase in competition can reduce prices. (2) An increase in competition can lower costs of production. Reasons: Monopolies in national markets  competition in the trade bloc  innovation, R&D, investment. (3) Firms can lower costs by expanding their scale of production. Reasons: Before the bloc is formed, the size of a firm is largely limited by the size of its own market. In the trade bloc  a larger market to serve  economies of scale.

41. Static and dynamic effects When dynamic effects are considered, the presumption is more likely that the partners will benefit from the union, and the outside world may also gain.

42. Regional economic integration in Europe

43. Europe has two trade blocs: • The European Union (EU) with 27 members. • The European Free Trade Association (EFTA) with 4 members – Iceland, Liechtenstein, Norway, and Switzerland.

44. Member states of the European Union in 2007

45. Evolution of the EU The EU was formed as a result of • the devastation of two world wars in Western Europe and the desire for a lasting peace, and • the desire by the European nations to hold their own on the world’s political and economic stage. Some thought that the continued existence of internal barriers was an important retardant to better European performance.

46. In-class exercise • Read “Postwar Trade Integration in Europe” (a handout).

47. Evolution of the EU The Treaty of Rome (1957) established the European Community – precursor to the European Union (the name was changed in 1994) 1957: Belgium, France, Italy, Luxembourg, Netherlands, West Germany 1973: United Kingdom, Ireland, Denmark 1981: Greece 1986: Spain, Portugal 1995: Austria, Finland, Sweden 2004: Cyprus, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia, Slovenia 2007: Bulgaria, Romania

48. Evolution of the EU • Article 3 of the Treaty of Rome(1957)called for the creation of a common market. • 1958-1968 import duties among the member-nations are dismantled (FTA) and their external barriers are unified in stages (customs union). • By the early 1980, it was clear that the EC had fallen short of its objectives. The EC responded by creating the Delors Commission.

49. Evolution of the EU • The Delors Commission proposed that all impediments to the formation of a single market be eliminated by December 31, 1992. • The result was the Single European Act, which was independently ratified by the parliaments of each member country and became EC law in 1987.

50. Evolution of the EU The Single European Act proposed: • Remove all frontier controls; • Mutual recognition of product standards; • Open public procurement to nonnational suppliers; • Lift barriers to competition in the retail banking and insurance business; • Remove all restrictions on foreign exchange transactions.