SCHOOL OF BUSINESS AND ECONOMICS

DEPARTMENT OF ECONOMICS
BED 4236: REGIONAL INTEGRATION AND ECONOMICS

Economic Integration

Introduction

The importance and influence of international economic integration is well recognised. The
existence of various preferential trade agreements and their proliferation shape the form, nature and
often the direction of the world trading system. Integration has affected most of the countries in the
world. It has also become an unavoidable and powerful element in most national and international
economic policy decisions.
In fact, most of the countries throughout the world have either attempted to enter or entered into a
trade liberalisation or integration agreement with others.Therefore, the character of and relation
between regional integration and a multilateral trading system continues to be at the heart of the
trade and investment policy debate. Some of the biggest achievements in integration, however, have
been among the developed countries, in particular the European Union (EU). Integration both
deepened and widened in Europe.

Meaning of Regional Integration

Regional integration is a process in which neighboring states enter into an agreement in order to
upgrade cooperation through common institutions and rules. Regional Integration is also known as
the process by which two or more nation-states agree to cooperate and work closely together to
achieve peace, stability and wealth. There are some examples of regional integration that has been
established for years.

Based on The Logic of Regional Integration’s book written by Walter Mattli, the first major
voluntary regional integration initiatives appeared in the nineteenth century. In 1828, for example,
Prussia established a customs union with Hesse-Darmstadt. This was followed successively by the
Bavaria Wuttemberg customs Union, and etc.

Half a century later, the idea of European integration was re-invented and the process of merging
European nation-states into one prosperous economy and stable polity began. The first step was
taken with the creation of the European Coal and Steel Coummunity (ECSC) in 1952. In 1957,
Germany, France, Italy, Belgium, Luxemburg, and the Netherlands signed the Treaty of Rome
establishing the European Community (EC). Then, the enlargement of the EC occurred in 1973,
with the accession of the United Kingdom, Denmark, and Ireland. Greece joined in 1981, Spaun
and Portugal in 1986. Nine years later, Austria, Finland, and Sweden became the community’s
newest members. In the meantime, European integration has moved beyond trade. In 1979, the
European Monetary System was established. By November 1993, the community had changed its
name to the European Union (EU) to mark the deep level of integration attained.

The integration is not an exclusively just European phenomenon, of course. In the 1960s the Latin
American Free Trade Association, the Andean Pact, and the Central American Common Market
were launched. In the early 1990s, more than half a dozen new integration projects were started in
Latin America.

In North America, a Free Trade Agreement between the United States and Canada was signed in
1989. This agreement grew into the North American Free Trade Agreement (NAFTA). In Asia
itself, the most notable regional grouping is the Association of Southeast Asian Nations (ASEAN),
formed on 8 August 1967 in Bangkok by the five original member countries: Indonesia, Malaysia,
Philipines, Singapore, and Thailand.

Brunei Darussalam joined on 8 January 1984, Vietnam on 28 July 1995, Laos and Myanmar on 23
July 1997, and Cambodia on 30 April 1999. In 1992, members agreed to establish gradually an
ASEAN Free Trade Area. One of the most rapidly expanding groups is the Asia Pasific Economic
Cooperation forum (APEC). ASEAN organization (Association of Souteast Asian Nations
(ASEAN) concists 10 states: Brunei Darussalam, Cambodia, Laos, Malaysia, Myambar, Philipines,
Singapore, Thailand, Vietnam, and including Indonesia. This organization was created by the
member states to aim or purpose, (1) accelerating the economic growth, social progress and cultural
development in the region through joint endeavors in the spirit of equality and partnership in order
to strengthen the foundation for a prosperous and peaceful community of Southeast Asian Nations,
and (2) promoting regional peace and stability through abiding or everlasting respect for justice and
the rule of law in the relationship among countries in the region. In the political cooperation,
ASEAN does political and security dialogue which having the aim to promote regional peace and
stability by enhancing regional resilience. Regional resilience shall be achieved by cooperating in
all fields based on the principles of self-confident, self-reliance, mutual respect, cooperation, and
solidarity, which shall constitute foundation for a strong and viable community of nations in
Southeast Asia.

Sovereignty

In the Age of Globalization, the sovereignty of the modern state was constituted in mutually
exclusive territories and the concentration of sovereignty in nations. In the developing globalization,
it is important to know about the impact of Regional Integration Agreement (Regional integration)
for the countries’ autonomy in order to maintain their existence and authority (sovereignty). By
using their power or utilizing resources they have, to compete with other countries.
Reasons for economic integration

It is stated in Maurice W. Schiff’s book about Regional Integration and Development there are
some reasons why a country making agreement with other country in a region.

1. Governments’ wish to bind themselves to better policies, including democracy and to signal such
bindings to domestic and foreign investors.

2. A desire to obtain more secure access to major markets.

3. The pressures of globalization, forcing firms and countries to seek efficiency through larger
markets, increased competition, and access to foreign technologies and investment.

4. Governments’ desire to maintain sovereignty by pooling it with others in areas of economic

management where most nation-states are too small to act alone.

5. A desire to jog the multilateral system into faster and deeper action in selected areas.

6. A desire to help neighboring countries stabilize and prosper.

Joining a Regional Integration Agreement (RIA) necessarily requires surrendering some immediate
control over policymaking and losing some political autonomy. Some regional cooperation,
however, go deeper than that and create institutions for joint decisionmaking. For example, as the
EU’s integration has deepened, decisionmaking has increasingly moved away from national capitals
to Brussels, and much of the current debate is shaped by the belief that some form of political
unification must eventually follow the creation of an integrated economic unit. By pooling
sovereignty, members of a Regional Integration Agreement may able to preserve and enlarge it and
thus strengthen themselves by creating a united front against external pressures or by joining forces
in international negotiation. Besides that, regional cooperation can strengthen the voices of all small
nations. These countries often face severe disadvantages in dealing with the rest of the world
because of their low bargaining power and high negotiation costs.

The regional integration also can affect the economic development or economic growth. A country
with a highest economic rate will have more power and authority than other country members.
Moreover, it can increase competition in tradeable goods sector. That increased competition may
induce improvements in efficiency, lower markups, and a larger demand for inputs in those sectors,
further increasing the relative demand for capital. Integration may also can affect the prices of
capital goods. Lower tariffs and trading costs on imports of capital equipment may reduce the price
of investment goods, raising the rates of return and accumulation. Increased competition from
capital goods could also stimulate the domestic capital goods industry to greater efficiency.

As what has been stated before that the regional integration can affect the territorial authority,
sovereignty of the nations, and also the economics development of the members. The cooperation in
a region can give both positive impact and negative impact, indeed. As we know that the members
of the regional integration are not only the country who having a good power of economic growth
but also a country which still underdeveloped and need to be supported by the other members. One
side, the cooperation among the countries can lead competition power so that each countries will
give their forces being a greatest one, they will utilize all natural resources by making a better
product than others to evidence their existence, authority and sovereignty of the nations. But, on the
other hand, this condition also can make negative impact for poor country as a member.
Eventhough they have natural resources sufficiently to be utilized, sometimes they are not ready
and can not compete the richer country.
This is the problem, the poor one can be ignored and less power, hence they unable to compete
other countries then became increasingly backward. But, the other impact is there will be trade
globalization (free trade area) among the members. So that, by creating agreement and commitment
between the countries in regional integration, it can create the supranational activities such as in
Asia (ASEAN), when we want to go to other countries which still in one region (Southeast Asia)
we do not need visa as requirements. This would mean there is no longer borders among the
members of the association.

Forms of integration

Essentially, the term “economic integration” is used to refer to the formation of an inter-
governmental organisation (IGO) by three or more countries to create a larger and more open
economy expected to benefit member countries. Theoretically, the process of economic integration
may take any of the following forms, each of which may represent a different stage of integration if
member countries have a desire to pursue the integration of their national economies to its logical
conclusion:

1) Preferential trade arrangements, which represent the form of loose economic integration
whereby participating sovereign states scale down trade barriers to the movement of goods in their
trade with each other;

2) A free trade area, which basically entails the complete removal of trade barriers among member
countries, while each member country maintains separate trade policies with non-members;

3) A customs union, whereby member countries venture beyond the removal of trade barriers
among them and adopt a common external trade policy with all non-members;

4) A common market, whose nature involves the removal of all barriers to the movement of
factors of production (particularly labour and capital) among member countries in addition to the
requirements of a customs union cited above;

5) An economic union, which essentially requires member countries to go beyond the requirements
of a common market by unifying the economic institutions of the member countries, and the
coordination of their economic policies;

6) A monetary union, whereby the member countries, in addition to satisfying the requirements of
an economic union, adopt a common currency, as well as create and use a common, supranational
central bank; and

7) A political union, whereby cooperating countries in a monetary union eventually create a

regional bloc that is akin to a nation-state or federal government by creating centralised political
institutions, including a regional parliament.

The first four stages or forms of integration represent what Gerber (1999, 210-211 and 223-231) has
referred to as “shallow integration,” while the last three represent what he has designated as “deep
integration.” Essentially, the term “shallow integration” refers to any form or stage of economic
integration whose scope is limited to border-related issues—that is, tariffs and non-tariff trade
barriers (NTBs).

“Deep integration,” on the other hand, goes beyond border-related issues; among other things, it
entails harmonisation of member countries’ important economic institutions, as well as legal,
product-safety, labelling, environmental, and technical standards.
 CUSTOM UNION
A customs union is an agreement between two or more neighboring countries to remove trade barriers,
reduce or abolish customs duty, and eliminate quotas. The union was defined by the General Agreement on
Tariffs and Trade (GATT) and is the third stage of economic integration.

Unlike in free trade agreements, a common external tariff is imposed on non-members of the
trading agreement. When countries outside the union trade with countries in the customs union, they
need to make a single payment (duty fee) for the goods that have crossed the border. Once inside
the union, they can trade freely with no added tariffs.

Purpose of Customs Unions

The purpose of a customs union is to make it easier for member countries to trade freely with each
other. The union reduces the administrative and financial burden of barrier trading and fosters
economic cooperation among nations.

However, member countries do not enjoy the liberty to form their own trade deals. The countries in
the customs union usually restructure their domestic economy and economic policies in order to
maximize their gain from membership in the union. The European Union is the largest customs
union in the world in terms of the economic output of its members.

Although a customs union does not include free movement of goods and people, it generates trade
creation and diversion that helps with economic integration. Below are the advantages and
disadvantages of customs unions.

Advantages of Custom Unions

Customs unions offer the following benefits:

1. Increase in trade flows and economic integration

The main effect of a free-trade agreement is that it increases trade between member countries. It
helps improve the allocation of scarce resources that satisfy the wants and needs of consumers and
boosts foreign direct investment (FDI).

Customs unions lead to better economic integration and political cooperation between nations and
the creation of a common market, monetary union, and fiscal union.

2. Trade creation and trade diversion

The effectiveness of a customs union is measured in terms of trade creation and trade diversion.
Trade creation occurs when the more efficient members of the union sell to less efficient members,
leading to a better allocation of resources.

Trade diversion occurs when efficient non-member countries sell fewer goods to member countries
because of external tariffs. It gives less efficient countries in the union the opportunity to capitalize
on their position and sell more goods within the union.

If the gains from trade creation exceed the losses from trade diversion, it leads to increased
economic welfare among member countries.
3. Reduces trade deflection

One of the main reasons a customs union is favored over a free trade agreement is because the
former solves the problem of trade deflection. It occurs when a non-member country sells their
goods to low-tariff FTA (free trade agreement) country and then resells to high-tariff FTA country,
leading to trade distortions. The presence of a common external tariff in customs unions helps avoid
problems that arise from tariff differentials.

Disadvantages of Customs Unions

Along with the advantages, customs unions also come with a few drawbacks:

1. Loss of economic sovereignty

Members of a customs union are required to negotiate with non-member countries and
organizations such as the WTO. It is necessary to maintain a customs union; however, it also means
that individual member countries are not free to negotiate their own deals.

If a country wants to protect an infant industry in its market, it is unable to do so by imposing tariffs
or other protective barriers due to the liberal trading policies. Similarly, if a country wants to
liberalize its trade outside the union, it is unable to do this due to the common external tariff.

2. Distribution of tariff revenues

Some countries in the union do not receive a fair share of tariff revenues. It is common among
countries like the UK that trade relatively more with countries outside the union. Around 20%-25%
of the tariff revenue is retained by the member who collects the revenue. It is estimated that the cost
of collecting this revenue exceeds the actual revenue collected.

3. Complexity of setting the tariff rate

A common problem faced by customs unions is the complexity of setting the applicable tariff rate.
The process is very costly and time-consuming. Member countries often find it hard to forgo the
trade of certain good or service because another country in the union is producing it more
efficiently. The problem is usually faced by developing countries and is a major issue that the UK is
dealing with during Brexit.
The Theory of Customs Union
Before J. Viner developed the theory of customs union, there was a general belief that customs
union raises the level of welfare as customs union is a movement towards freer trade at least within
a specific area. Viner pointed out that the conclusion concerning increase in welfare due to customs
union is not necessarily true.
A custom union is an organisation that includes two or more countries. They abolish tariff and other
trade restrictions among themselves and adopt a common external tariff against the non-member
countries.

The static effects of a customs union in a partial equilibrium system, on the lines suggested by
Viner, Meade, Lipsey and Johnson, can be studied on the basis of the assumptions given below:

(i) The customs union includes two countries—the home country A and the partner country B.

(ii) The rest of the world is denoted by a third country, say country C.

(iii) The customs union imposes a common external tariff.

(iv) There is an absence of any other type of trade restriction.

(v) The customs union imposes only a specific tariff.

(vi) The three countries produce only one commodity says, X.

(vii) The home country A was the highest cost country and the country C was the least cost country
before the formation of the customs union.

(viii) The supply curves are perfectly elastic in countries A and C.

(ix) The production is governed by constant returns to scale.

(x) There is perfect competition in both product and factor markets.

(xi) The supply of productive inputs is fixed.

(xii) There is a state of full employment of resources.

(xiii) The techniques of production are given and constant.

(xiv) The transport costs are absent.

(xv) The home country is originally having balance of trade equilibrium, i.e., exports equal imports.
The effects of customs union on production, consumption and trade, given the above assumptions,
can be explained in terms of trade creation and trade diversion due to customs union.

(a) Trade Creation:

The formation of customs union involves the abolition of tariff among the member countries and
imposition of common tariff against the rest of the world. It is supposed that the home country A is
the least efficient country and its unit cost of producing a watch is Rs. 1000.

In the partner country B, which is more efficient, the unit cost of production of that watch is Rs.
800. The rest-of-the world is represented by non-member country C, which is the most efficient and
the average cost of producing the same watch is Rs. 700 in that country.

If, before the formation of custom union, the home country A imposes 100 percent tariff on all
imports, the unit costs in B and C become Rs. 1600 and Rs. 1400 respectively. In these
circumstances, it is desirable for the home country A to produce the commodity domestically. If the
customs union is formed and duty is removed on imports from B but it remains in the case of
country C, the partner country B becomes the least cost country. Now the home country will prefer
to import watches from B rather than produce it domestically. So the formation of customs union
has resulted in the creation of trade.

(b) Trade Diversion:

It is possible that before the formation of the customs union, a given commodity (watches) was
being imported from the most efficient and the least cost country C. After the formation of the
customs union, as duty is removed from import from the partner country B, while it remains
enforced on imports from C, the former becomes the least cost country.

In such a situation, the home country A will start importing watches from the partner country B
rather than non-member country C. Thus there is diversion of trade from outside country C to the
partner country B after the formation of the customs union. It may be explained through the Table
18.2.
Table 18.2 shows that the unit costs of watch in the home country (A), partner country (B) and non-
member country (C) before the formation of the customs union were Rs. 1000, Rs. 800 and Rs. 600
respectively. Thus country C was the least cost or the most efficient country and the home country
A was the highest cost country.

As the home country imposes 50 percent duty on all imports, the unit costs in A, B and C become
Rs. 1000, Rs. 1200 and Rs. 900 respectively. Since C is the least cost country, watches will be
imported by A from this country.

After the formation of the customs union, the import duty is abolished on imports from B, while it
remains in case of non-member country C. The unit costs, in this situation, are Rs. 1000, Rs. 800
and Rs. 900 in case of A, B and C respectively. As a consequence, country A will prefer to import
watches from country B (partner country) rather than the outside country C. Thus the formation of
customs union results in the diversion of trade from an outside country to the partner country. This
is called as the trade diversion.

The partial equilibrium effects of the formation of the customs union can be analysed with the help
of Fig. 18.1.
In Fig. 18.1., quantity of the commodity (watches) is measured along the horizontal scale and price
along the vertical scale. DA and SA are the demand and supply curves respectively of the home
country A. SB and SC are the perfectly elastic supply curves of countries B and C respectively. The
selling price of country A is OP1 whereas the selling prices of countries B and C are respectively
OP3 and OP2. Thus country C is the most efficient and the home country A is the least efficient.

Before the formation of the customs union, country A imposes P2P4 per unit tariff on all imports.
Now the tariff-ridden price for country C is OP2 + P2P4 = OP4. It is still lower than A’s selling
price OP1. Country B is out of picture because its selling price inclusive of tariff is even higher than
A’s selling price. Country A will enter into trade with country C.

At the tariff-ridden price OP4, the domestic production by country A is OQ1 and the demand is
OQ2 so that the quantity imported from country C is Q1Q2. The consumer’s surplus in this trade
equilibrium is D0FP4 and producer’s surplus is S0EP4. The revenue receipts of the government in
country A are EFLK. The measure of welfare before the formation of the customs union is D0FP4 +
S0EP4 + EFLK = D0FLKE S0.

If customs union is formed and the tariffs are removed in case of partner country B, while these
continue to exist in case of the non-member country C. As the selling price OP3 of country B is
lower than that of country C, the home country will import watches from the partner country B and
country C gets eliminated from trade.

The main effects after the formation of customs union are as follows:

a. Price Effect:

As compared to the tariff-ridden price OP4, there is a fall in the selling price to OP3 after the
customs union is formed.

b. Production Effect:

Before the formation of the custom union, the domestic production in country A was OQ1. After the
customs union is formed, the domestic production falls from OQ1 to OQ3. This fall in output is met
through imports. The overall import is Q3Q4 which is more than the earlier imports Q1Q2. The
increase in imports Q1Q3 that offsets the fall in domestic production is termed as Trade Creation
Effect I.

c. Consumption Effect:

Before the formation of customs union, the quantity demanded was OQ2 and afterwards it is OQ4.
Thus the demand for watches rises by Q2Q4. This additional demand is met through imports from
the partner country B. Thus the increase in consumption Q2Q4 is the consumption effect. It is
referred as Trade Creation Effect II. Jacob Viner had over-looked it but the writers like Meade,
Gehrels, Lipsey and Johnson have recognised it.

d. Revenue Effect:

Before the formation of the customs union, the government in country A was obtaining revenues
from tariff to the tune of EFLK. After the formation of customs union, since imports are being made
from the partner country B, the government does not receive any revenues. Thus there is loss in
government revenues to the extent of EFLK.
Given the trade creation effects I and II the total trade creation effect is (Q1Q3 + Q2O4).

e. Welfare Effect:

The welfare effect due to trade creation can be assessed as below:

Gain in Consumer’s Surplus = P4FHP3

Loss in Producer’s Surplus = P4EGP3

Loss in Government Revenues = EFLK

Welfare Effect = P4FHP3 – P4EGP3 – EFLK = ΔEKG + ΔFLH

Trade Diversion and Reduction in Welfare:

While the trade creation results in a gain in welfare, the diversion of trade from a non-member
country (C) to the member country (B) after the formation of customs union, involves some loss in
welfare. The reason for it is that the trade gets diverted from a more efficient or low cost country C
to the less efficient or high cost country B.

Before the formation of customs union, the home country A was importing Q1Q2 quantity of the
commodity from the non-member country C. After the formation of customs union, the quantity
imported is Q3Q4 out of which Q3Q1 and Q2Q4 can be identified as trade creation effect and the
remaining quantity imported Q1Q2 is the trade diversion effect.

Before the formation of the customs union, the payment for importing Q1Q2 quantity was
Q1EFQ2. Out of it the revenue receipts to the government of the home country amounted to (P2P4
× Q1Q2 = EMNF). So the actual payment to country C for the import of Q1Q2 quantity of watches
was Q1MNQ2.

After the formation of the customs union, the same quantity Q1Q2 is being imported from the
partner country B on account of trade diversion. Since no tariff is applicable to B, the total payment
to it due to import amounts to OP3 × Q1Q2 = KQ1 × Q1Q2 = Q1KLQ2.

Thus there is a larger external payment for importing the same quantity after the formation of the
customs union to the extent of Q1KLQ2 – Q1MNQ2 = KMNL which is shown through shaded area
in Fig. 18.1.

This represents a loss or reduction in welfare. From this, it follows that trade diversion causes a
reduction in welfare. The simple reason for the decline in welfare is that the imports are made from
less efficient (high cost) partner country B rather than more efficient (low cost) non-member
country C.

f. Net Welfare Effect of Custom Union:

The trade creation results in an increase in welfare. It is depicted by areas ΔEKG and ΔFLH in Fig.
18.1. The trade diversion, on the contrary, causes a reduction in welfare. In Fig. 18.1, it has been
shown by the area KMNL. Therefore the formation of customs union may either cause a net
increase or reduction in welfare.

(i) If KMNL = (ΔEKG + ΔFLH), there is neither an increase nor a decrease in net welfare.
(ii) If KMNL < (ΔEKG + ΔFLH), the formation of customs union results in a net increase in
welfare of the home country A.

(iii) If KMNL > (ΔEKG + ΔFLH), the formation of customs union leads to a net loss in welfare in
country A.
He analysed the production effects of customs union through the concepts of trade creation and
trade diversion. The works of the writers like Meade, Lipsey, Lancaster and many others analysed
the consumption effects. H.G. Johnson followed a partial equilibrium approach to investigate fully
the effects of a customs union by incorporating both the production and consumption effects.

General Equilibrium Approach to Customs Union

Jacob Viner’s partial equilibrium analysis, based upon trade creation and trade diversion effects, is
undoubtedly useful but is only of elementary character. The writers like R.G. Lipsey and J. Vanek
have analysed the theory of customs union in the general equilibrium framework.
1. The Lipsey Model of Customs Union:

In the partial equilibrium approach, Jacob Viner pointed out that trade diversion causes a loss in
welfare. This assertion of Viner came to be criticised at the hands of J.E. Meade, F. Gehrels and
R.G Lipsey. In their opinion, Vinerian conclusion can be valid only if it is assumed that the
commodities are consumed in a fixed proportion and substitution effect is not present.

Assumptions:
Lipsey began by demonstrating that Viner’s assertion can be valid under the following assumptions:

(i) There are three countries—A, B and C. Country A is the home country, country B is the member
or partner country and country C is a non-union member country.

(ii) The home country A is a small country having the highest costs.

(iii) The non-union country C is the most efficient and has the lowest costs.
(iv) There are two commodities, X and Y.

(v) Country A and B specialise completely in the production of X-commodity.

(vi) Commodity Y is imported from some foreign country.

(vii) The two commodities are consumed in some fixed proportion irrespective of structure of
relative prices.

(viii) The supply of the commodities is perfectly elastic.

(ix) The production takes place under the conditions of constant returns to scale.

On the basis of these assumptions, Lipsey put Jacob Viner’s model into a general equilibrium
framework and proceeded to demonstrate that trade diversion can lead to a loss in welfare after the
formation of customs union. This has been explained through Fig. 18.5.
In Fig. 18.5, commodity X is measured along the vertical scale and commodity Y is measured along
the horizontal scale. The home country A specialises completely in the production of X commodity
and production of X takes places at D. Country A imports OE quantity of Y from C in exchange of
OD quantity of X.

The line DE represents the best possible terms of trade available to country A before the formation
of customs union. Consumption takes place at G in a fixed proportion measured by the slope of line
OR.

When customs union is formed with country B, the trade gets diverted from C to B, the member
country which is less efficient than country C. Now country A exports OD quantity of X
commodity in exchange of OF quantity of Y commodity from partner country B. The terms of trade
in this case are indicated by the slope of the line DF. It clearly, shows that the terms of trade have
got worsened for the home country A after the formation of customs union.

Consumption still takes place in the fixed proportion on the line OR at point H. It means no
substitution takes place despite relative changes in prices of two commodities. The point H is
clearly inferior to the point G because it represents smaller amounts of both the commodities
consumed. Thus Viner’s assertion becomes valid that trade diversion results in a loss in welfare.

Lipsey, however, pointed out that J. Viner’s assumption concerning consumption in fixed
proportion is unrealistic. If this assumption is dropped, the trade diversion due to the formation of
customs union can have two welfare effects opposite to each other. First, after the formation of
customs union, country A will have to pay a higher price for commodity Y than before because the
partner country B, from which import is being made, is less efficient than the non-member country
C.

Second, since no import duty is being paid on imports from country B, the domestic price of Y will
fall bringing about increased consumption of Y due to its substitution for X. This may result in an
increase in the welfare in country A. Given these two off-setting effects whether customs union and
consequent trade diversion will increase welfare or not, can be explained through Fig. 18.6.
In Fig. 18.6, it is supposed that the home country A specialises completely in the production of X
commodity and it originally imports OE quantity of Y from the most efficient country C in
exchange of the export of OD quantity of X. The line DE represents the terms of trade for country
A. These are the best possible terms of trade because country C is the cheapest source of supply of
the commodity Y. G is the point of consumption where the line DE is tangent to the community
indifference curve.

Before the formation of customs union, as tariff is imposed by country A on Y commodity, the
terms of trade line is now PP1. It is tangent to the community indifference curve I1 at K. Since K
lies on lower community indifference curve, there is loss in welfare after the imposition of tariff.
The TOT at K are exactly the same as at G because both G and K lie upon the same line DE.

If a customs union is formed by A and B, there will be trade diversion. Country A will import Y
commodity from the partner country B rather than the non-member country C. As OD quantity of X
is exchanged with OF quantity of Y, the terms of trade are measured by the slope of the line DF.
Since DF is tangent to the community indifference curve I1 at H, this is the point of consumption
after the customs union is formed. At H. the people in country A consume less quantity of X and
more quantity of Y.

It means there is substitution of Y in place of X. The level of satisfaction, however, remains the
same because points K and H lie upon the same community indifference curve I1. Thus Lipsey
arrived at the conclusion that there is no reduction in welfare due to the formation of customs union
and consequent trade diversion. Such a conclusion is quite contrary to what Jacob Viner had stated.
Criticism:

Lipsey’s general equilibrium model of customs union has been attacked by economists on the
following grounds:

(i) Lipsey’s refutation of the conclusion given by Jacob Viner rests upon the assumption that
Viner’s supposition of fixed proportion in consumption was invalid. According to Jagdish Bhagwati
the reduction in welfare is not necessarily because of the fixed proportions in consumption but it is
because of Vinerian implicit assumption of a constant level of imports.

When it is assumed that the volume of imports before and after the formation of customs union is
unchanged, it must lead to the conclusion that trade diversion results in loss in welfare. But if the
formation of customs union causes an increased volume of imports, there is likelihood that the net
welfare remains constant or it rises compared to the pre-union situation.

(ii) Whether trade diversion causes a loss or gain in welfare or leaves it unaffected is conditioned by
what happens to the terms of trade. If the deterioration in country A’s terms of trade is such that
there is a shift from DE to DF (as shown in Fig. 18.6), the consumption equilibrium remains on the
same community indifference curve I1, and the level of welfare after the formation of customs
union remains constant.

In case deterioration in A’s terms of trade is of a larger magnitude than indicated by the shift of line
DE to DF, the post-union consumption equilibrium will be determined at a community indifference
curve that lies to the left of I1. Consequently, the customs union will cause a reduction in welfare. If
the deterioration in the terms of trade causes the TOT line to lie between DE and DF, the
consumption equilibrium will get determined at a community indifference curve higher than I1. It
will signify a gain in welfare after the formation of customs union despite trade diversion.

2. The Vanek Model of Customs Union:

Jaroslav Vanek has employed the technique of offer curves to analyse the general equilibrium
theory of the customs union.

Assumptions:

Vanek’s model of customs union rests upon the following main assumptions:

(i) There are three countries—A, B and C. Country A is the home country. Country B is the partner
country in the customs union and country C is the non-member country. It represents rest-of-the
world.

(ii) Each of these countries consumes, produces and exchanges two commodities X and Y.

(iii) Commodity X is the exportable commodity of country A.

(iv) Commodity Y is the exportable commodity of the partner country B.

(v) Commodity Y is also the exportable commodity of the non-member country C.

(vi) Neither of the two commodities is inferior at any relative price or the level of income.
(vii) Before the formation of customs union, the home country A was trading with the non-member
country C.

The pre-customs union trade situation can be explained through the respective offer curves of the
two countries. Vanek has made use of the excess offer curve to analyse the trade between the union
and the rest of the world (country C). The excess offer curve can indicate various quantities of X-
commodity which country A is willing to exchange with the different quantities of Y offered by the
non-member country C. The trade situation between the union and the non-member country is
explained through Fig. 18.7.

In Fig. 18.7., OA and OB are the offer curves of Y countries A and B respectively before the
formation of the customs union. If OT1, is the TOT line, the trade between A and B is fully
balanced at the point P and the union countries can offer no quantity of X commodity to the non-
member country C. In other words, they do not wish to trade with C because their excess offer is
zero.

If the TOT line is OT2, the country A wishes to trade at P2 on its offer curve and country B wishes
to trade at P1 on its own offer curve. Now country A offers more quantity of X than the country B is
willing to import. Similarly A requires more quantity of Y than country B is willing to offer. The
distance P1P2 measures the excess offer of X commodity for Y by country A. By taking a distance
equal to P1P2 from origin along the line OT2, the point R can be specified (OR = P1P2).

Suppose now the TOT line is OT3. Country A wishes to trade at P4 and country B wishes to trade
at P3. Country A offers more quantity of X than what country B can absorb. Similarly country A
demands more quantity of Y that country B can offer. The distance P3P4, in this case, measures the
excess offer of X by country A that can be exported to the non-member country C.

Now taking a distance OS equal to P3P4 along OT3 from the point of origin, another point S can be
obtained (OS = P3P4). By joining points R and S with the origin, it is possible to derive union’s
excess offer curve OE.

Given the excess offer curve of the union and the offer curve of the non-member country, the
optimum welfare position from the view point of customs union can be determined. In Fig. 18.8,
OE is the excess offer curve of the customs union and OC is the offer curve of country C (rest-of-
the- world).

The trade equilibrium position is originally P. When customs union is formed between A and B and
common external tariff is raised against the non-member country C, the excess offer curve of the
union shifts to OE1 and the trade equilibrium occurs at P1. The TOT line which was originally
OT1, now becomes more-steep as OT2. It signifies an improvement in the TOT for the member
countries.

If the union goes on raising the common tariff against the rest-of-the world, the excess offer curve
of the customs union shifts further to the left to OE2. In this case the intersection between OE2 and
OC determines trade equilibrium position to P2. The TOT line OT3 becomes still steeper indicating
further improvement in the terms of trade for the customs union and worsening of the terms of trade
for the rest-of-the world.

The increase in external tariff not only improves the terms of trade but also raises the level of
welfare. The point of welfare maximisation is reached where the trade indifference curve of the
union becomes tangent to the offer curve of the rest-of-the-world (country C). If this tangency
occurs at the point P2, it indicates the optimum tariff that corresponds with the maximum welfare
for the member countries of the customs union.

Thus Vanek’s model establishes a relationship between the level of external tariff and the welfare
maximisation of the member countries. This approach makes a significant departure from Viner and
Lipsey’s approaches. It analyses the welfare effect of customs union without making reference to
trade-creation and trade-diversion effects.
Customs Union: Dynamic Effects and Theory

The static effects of customs union are- (i) trade- creation and (ii) trade-diversion. The static effects
are basically concerned with reallocation of production and consumption. In fact the formation of
the customs union initiates a process of structural and technical readjustments, on the one hand,
amongst the member countries and, on the other, among the non-member countries.

Such long-lasting dynamic effects of customs union have been greatly emphasised by the writers
like T. Scitovsky, B. Belassa and W.M. Corden.

The dynamic effects of customs union are as follows:

1. Increased Competition:

The most significant dynamic effect of customs union is the increase in intensity of competition
within the union. Earlier in the sheltered markets, the monopolistic and oligopolistic industries had
become sluggish and complacent. After the formation of customs union, as they are exposed to
competition from rival firms within the union, they have to operate in the most efficient way or face
the risk of elimination.

All the firms, earlier operating below their optimum productive capacity, make efforts to expand
production in order to cater to the demand from an expanded market and to minimise their costs.
Competition also stimulates the managerial efficiency and induces the industries to utilize new
technology.

The customs union must take care that collusion and market-sharing arrangements, which had
earlier restricted competition at the national level, should not restrict competition at the union level.
In this direction, the member countries should enforce anti-trust legislation throughout the customs
union.

2. Economies of Scale:

When a customs union is formed, expansion in the size of market, increased competition, increased
specialisation and consequent enlargement of plant size lead to the emergence of internal and
external economies of scale. This is evident from the experience of the countries of European
Community (EC). The formation of EC resulted in economies of scale due to reduction in the range
of differentiated products, increase in production run, pooling of skilled labour, capital resources,
research and management.

3. Stimulus to Investment:

The expansion of market and more intensified competition stimulates investment activity. The need
for introducing new techniques and accelerated depreciation of the existing plants and equipment
step up greatly the rate of investment. In addition, there is also strong stimulus to foreign
investment. Many non-member countries set up their plants in the territory of union members so
that their products can evade the tariff barriers.

Such industrial units are called as tariff factories. The massive United States investments in Europe
after 1955 were probably on account of the American desire of not to be excluded from the rapidly
expanding market of EC.

4. Movement of Productive Factors:

After the formation of customs union, or more particularly, the common market, there is free
movement of labour, capital and enterprise within the entire region of the common market. This
ensures the optimal utilization of resources, increase in factor productivity and consequent rise in
the growth rate of the economies of all the countries in the union.

5. Technological Advance:

As a customs union is formed, expansion in the size of market, greater competition, need for
increasing the scale of production and achieving higher factor productivity, make the firms and
industries develop very strong urge to imitate, to innovate and to make commercial application of
technical, scientific and managerial innovations.

There is strong stimulus to research for making improvements in the production techniques,
processes of production and quality of products. The intense technological developments tend to
push up the rate of economic growth.

6. Improvements in the Terms of Trade:

The formation of the customs union results in raising of external tariffs against the outside world
and consequent reduction in imports from abroad. This tends to raise the bargaining power of the
union members against the rest-of-the-world. The improvement in the terms of trade brings about
also an improvement in the balance of payments position of the member countries.

7. Reduction of Risk and Uncertainty:

The foreign transactions often involve high degree of risk. The complexity of trade regulations,
unilateral changes by countries in the tariff and non-tariff trade restraints and foreign exchange
regulations create much uncertainty. The economic integration reduces to a significant extent, risk
and uncertainty particularly in respect of the inter-member transactions.

It is on account of these dynamic benefits that the West European countries and the countries of
certain other regions deemed it appropriate to organise themselves into some form of economic
integration. The recent empirical studies seem to indicate that the dynamic gains of customs unions
are five to six times larger than the static gains.

Theory of Customs Union as the Theory of Second Best:

The maximisation of welfare can be possible only under the conditions of free international trade.
The Pareto-optimality conditions can be valid only under perfect competition and unrestricted
international trade. If a customs union is formed, there is a violation of Pareto-optimality
conditions.

In a customs union, there is no doubt elimination of tariff restrictions and it is a movement towards
freer trade, yet there may be certain imperfections in the expanded market of customs union on
account of the existence of oligopolies and product differentiation.

The rigidities exist on account of diverse monetary and fiscal policies, unless integration assumes
the most advanced form of economic union. In addition, the maintenance of high external tariffs
amounts to sheltering of inefficient industries within the union. It means the process of production,
despite integration, is not likely to become ideal. The formation of the customs union does not
necessarily maximise welfare.
In certain situations, it may result in a net loss in welfare. Therefore, the customs union is not
consistent with Pareto-optimality. It is rather concerned with Pareto-non-optimal or sub-optimal
trade situation.

The theory of customs union is a half-way house between free trade and protection. From this
consideration, the theory of customs union can be treated as a theory of the second best.
Intra-Industry Trade and Customs Union:

A number of empirical studies, related to intra- industry trade have indicated that a considerable
part of trade among the members of European Community (EC) is of the nature of intra-industry
trade. No doubt, many models of intra-industry trade have been developed but a few attempts have
been made to relate it to the customs union.

However, a simple model, based on Neo-Chamberlinian model of intra-industry was developed by

W. Ethier and H. Horn in 1984. This model attempted to explain the possibility of trade creation
gains from intra- industry trade due to integration.

In this model, it is assumed that two countries A and B, before forming customs union produce
homogeneous commodity, food and a differentiated product, say machinery. The different variants
of manufactured product (machinery) are imperfect substitutes for one another. The production in
their case is governed by increasing returns to scale. Both countries A and B export their own
varieties of manufactured products to each other as well as to the rest-of-the-world (W).

The rest- of-the-world produces food only. The production of food is governed by constant returns
to scale. Countries A and B import food from rest of the world. The two countries before forming
the customs unions were having the same tariff on the import of food and manufactured products.
There was no restriction by the rest-of-the-world on the import of manufactures.

After the formation of customs union by A and B, the existing tariff on the import of food becomes
the common external tariff. Since member countries of customs union did not import manufactures
earlier from the rest-of-the-world and they exported varieties of manufactured product (machinery)
to each other, there would be no trade diversion after the formation of customs union.

The trade creation effect, however, would be present. The two countries will be able to secure gain
due to trade creation as consumers of each country will have duty free access to a greater variety of
goods. The consumption of larger variety of goods will definitely increase the level of welfare.

Conditions for a welfare custom union

Each of these conditions tends to make trade creation and welfare
improvements more likely:
● The lower the demand for country C’s exports and the greater the demand for goods produced by
partner countries in a customs union, the greater the likelihood of an improvement in welfare due to
trade creation.
● The higher the trade barriers in third countries, the higher the trade creation in the customs union.
● The level of tariffs (as well as other impediments to trade) typifies acountry’s lack of
competitiveness. In an extreme situation when country A has a prohibitive tariff and if domestic
production is impossible, then there will be no home consumption of the good in question. Any
reduction in this tariff has a potentially beneficial welfare effect on consumers in country A.
● The ‘flatter’ the demand and supply curves in relation to the quantity the greater the areas 2 and 4
which embody trade creation.
● The larger the number of countries that participate in a customs union, the smaller the probability
of trade diversion. An incentive to form and enlarge a customs union persists until the entire world
becomes a customs union, that is, until the introduction of universally accepted free trade. A
customs union among all countries of the
world would have only trade creation as a consequence.
● If integration takes place between neighbouring countries, the lower the transportation costs and
the greater the gains from integration.
● The more inelastic the supply from third countries, the more these countries lose, while the
customs union partner countries gain. Tradediversion is preferable to trade creation for the
preference-granting country, for it does not entail any sacrifice of domestic industrial production
● Goods of different countries are competitive if these countries have similar costs of production
for the same good. Integration of countries with such a production structure produces, potentially,
the greatest gains. If the same countries have different costs of production for the same good, they
have a complementary economic structure.
Integration in this case may also produce gains, but perhaps not as big as in the former instance.
● The larger the number of (small) firms in the same industry, the smaller the potential resistance of
vested interests that can oppose integration and a ‘painful’ adjustment to the new situation, with
more competition on an integrated market.
● The less developed the economies prior to integration, the higher the potential opportunities for
benefits from (planned) specialisation.

Intra industry trade

This type of trade between countries is likely to be strong if:
● they are both relatively highly developed;
● the difference in their level of development is small;
● they have large national markets;
● the barriers to trade are low;
● there is a high potential for product differentiation;
● entry in narrow product lines is obstructed by significant barriers (sunk costs); and
● transaction costs are low.
 COMMON MARKET
A common market is a formal agreement where a group is formed among several countries in which
each member country adopts a common external tariff. In a common market, countries also allow
free trade and free movement of labor and capital among the members in the group. The trade
arrangement is used to promote free trade and free movement of production factors.

Conditions required to be defined as a Common Market

To be defined as a common market, the following conditions must be satisfied:

1. Tariffs, quotas, and all barriers regarding importing and exporting goods and services among
members of the common market are eliminated.
2. Common trade restrictions such as tariffs on other countries are adopted by all members of
the common market.
3. Production factors such as labor and capital are able to move freely without restriction
among member countries.

If one of the conditions is not satisfied, the resulting market is not a common market. For example,
if production factors such as labor and capital are not able to move freely without restriction among
member countries, it would be defined as a customs union.

Benefits of a Common Market

1. Free movement of people, goods, services, and capital

In addition to the removal of tariffs among member countries, the key benefits of a common market
include the free movement of people, goods, services, and capital. Therefore, a common market is
often regarded as a “single market” as it allows the free movement of production factors without the
obstruction created by national borders.

2. Efficiency in production

For an economy, a common market facilitates efficiency among members – factors of production
become more efficiently allocated resulting in stronger economic growth. As the market becomes
more efficient, inefficiency companies will eventually shut down due to fiercer competition.

Companies that remain typically benefit from economies of scale and increased profitability, and
innovate more to compete in a more intense competitive landscape.
Costs of a Common Market

1. Decline in competitiveness

The transition to a common market comes with a few drawbacks. For one, companies that have
previously been protected and subsidized by the government may struggle to remain afloat in a
more competitive landscape. The migration of production factors to other countries may hinder the
economic growth of that country and lead to increased unemployment.

2. Trade diversion

Trade diversion occurs when efficient non-members are crowded out of the common market.
Furthermore, a country may exhibit depressed wages if it faces an influx in the migration of
production factors where supply exceeds demand.

Labour Mobility

Labor mobility refers to the ease with which laborers are able to move around within an economy
and between different economies. It is an important factor in the study of economics because it
looks at how labor, one of the major factors of production, affects growth and production.

There are two primary types of labor mobility: geographic and occupational. Geographic mobility
refers to a worker's ability to work in a particular physical location, while occupational mobility
refers to a worker's ability to change job types. For example, a worker moving from the United
States to France illustrates the concept of geographic mobility. An automobile mechanic who
changes jobs to become an airline pilot reflects the concept of occupational mobility. (For related
reading, see: Get a Finance Job Overseas.)

Why Does Geographic Mobility Matter?

From a policymaker's perspective, geographic mobility can have important implications on the
economy of a particular country. This is because easing immigration requirements can do several
things:

 Increase the supply of labor. As more workers enter the economy, the general labor supply
increases. An increase in labor supply accompanied by a static labor demand can decrease
wage rates.
 Increase unemployment. Unless employers demand more workers, an increase in labor
supply could lead to a glut in labor. This means more workers are available than jobs. (For
more on this, see: Surveying The Employment Report.)
 Increase productivity. Not all laborers added to the labor supply will be unskilled. An influx
in laborers can increase productivity if they bring specialized skills to the workplace,
and they might push out existing employees who are less productive. (For related reading,
see: Economic Indicators: Employee Cost Index (ECI))

Obtaining geographic mobility is not a purely economic matter. It can also be an issue of state
sovereignty and government control. After all, governments are also concerned with security, and
completely open borders mean governments are not sure who or what is coming into their countries.
While increased geographic mobility generally has a positive impact on the economy, it is also one
of the first targets to incur the wrath of both citizens and their representatives. Immigration is
already a hot-button topic, both in the United States and abroad.

A reduction in geographic restrictions can be reached in several different ways. Between countries,
it is accomplished through treaties or economic agreements. Countries can also increase the number
of worker visas available, or reduce the requirements of receiving one. For example, countries that
are part of the European Union have fewer restrictions on the movement of labor between members,
but can still place tight restrictions on labor movement from non-member countries.

The effectiveness of improved geographic mobility will ultimately depend on individual workers. If
economic opportunities are not available in a different country or in a different part of one's current
country, the likelihood of an employee wanting to make a change will be diminished.

Why Does Occupational Mobility Matter?

The ease with which employees can move from a job in one particular industry to a job in a
different industry determines how quickly an economy can develop. For example, if there was zero
occupational mobility, we would still be hunter-gatherers, because no one would have been able to
become farmers or specialists.

An easing of occupational mobility restrictions can do several things:

 Increase the supply of labor in particular industries. Lower restrictions cause laborers to
have an easier time entering a different industry, which can mean the demand for labor is
more readily met.
 Lower wage rates. If it is easier for laborers to enter a particular industry, the supply of labor
will increase for a given demand, which lowers the wage rate until equilibrium is reached.
(For more insight, see: Exploring the Minimum Wage.)
 Allow nascent industries to grow. If an economy is shifting toward new industries,
employees must be available to run that industry's businesses. A shortage of employees
means overall productivity can be negatively impacted because there aren't enough
employees to provide the service or work the machines used to make the product. (For
related reading, see: Employability, the Labor Force and the Economy.)

Occupational mobility can be restricted through regulations. Licensing, training or education

requirements prevent the free flow of labor from one industry to another. For example, restrictions
limit the supply of physicians, since specialized training and licensing is required to work in that
particular profession. This is why physicians can command higher wages because the demand for
physicians coupled with a restricted supply increases the equilibrium wage. This funnels
unqualified members of the labor force into industries with fewer restrictions, keeping the wage rate
lower through a higher labor supply compared to the amount of labor demanded.
Labor Mobility: Two Perspectives

Labor mobility affects workers on two levels: the aggregate level and the personal level.

On a personal level, increased labor mobility gives workers an opportunity to improve their
financial situations. If workers are permitted to train for new jobs, move locations or seek higher
wages, they are more likely to be happy working, which can have a positive impact on productivity.
Workers who do not feel indefinitely relegated to low wages or jobs with few benefits will
consistently seek better positions, which also makes it easier for new industries to attract the most
qualified applicants by offering better perks.

The aggregate level refers to the economy as a whole. The extent to which labor forces are mobile
can impact how quickly an economy can adapt to technological changes, how quickly competitive
advantages can be exploited and how innovative industries develop. Restrictions placed on how
workers move around, either geographically or occupationally, can slow growth by making it more
difficult for businesses to hire productive workers. At the same time, unrestricted labor can depress
wages in certain industries and create unemployment.

Ohlin's Factor Price Equalization Theorem

In International Trade, commodities move instead of factors. According to Bertil Ohlin,

"Commodity movement acts as a substitute for factor movement in bringing about factor price
equalization."

In a two country model with relatively large differences in their endowments (capital and labor),
prior to trade the prices of these factors will be different. With the opening of trade, each country
will export the product of its abundant cheap factor. When export demand is added to domestic
demand, prices of their abundant cheap factor will rise. The domestic demand for the products of
scarce factors tend to decline due to the availability of such products through imports. This in turns
lead to decline in the price of the scarce factor. In each country, due to the prices of the abundant
factor rising and scarce factor falling the prices of both factors of production tend to move towards
the same level.

Under the ideal condition of:

1. Perfect competition,
2. Free trade,
3. Identical production function,
4. No transport cost,
5. Constant returns to scale, and
6. Many other restrictive conditions.

International trade logically should result in factor price equalization.

Diagram of Factor Price Equalization

Country I produces commodity a on isoquant aa (isoquant is an equal product curve) and country II
produces commodity b on isoquant bb. AB and CD are their respective factor price lines. As it can
be understood from the above diagram, country I and II are capital and labour abundant
respectively, hence their prices are low in respective countries.

Country I exports capital intensive 'a' commodity and imports labour intensive 'b' commodity from
country II. Thus prices of capital tend to increase in country I and of labour in country II. At the
same time, prices of scarce factor in both the countries fall due to declining domestic demand. With
no restrictions to trade, the process continues till prices of both factors in both countries are
equalized.

In above figure, the factor price line AB gradually rotates counter clockwise sliding along with an
isoquant. CD factor price line slowly rotates clockwise, sliding along with bb isoquant, until the two
factor price lines (AB & CD) coincide at PL. PL is tangent to aa at T and bb at S, indicating that
factor prices in both the countries are the same.

Complete factor price equalization depends on the validity of all assumptions. The equality of
factors in both countries must be the same. Factor intensity of commodities, at all prices, must
remain the same (i.e. commodity a, which is capital intensive should remain the same at all set of
factor prices).

In the real world, in the absence of the required assumptions and conditions, what one could
experience is only the tendency towards factor price equalization.
Capital mobility and immobility

Definition of capital mobility – easy for physical assets and finance to move across geographical
boundaries.

Capital immobility – when capital faces restrictions on the free movement.

What is capital?

Capital principally refers to physical capital – durable goods used in the production process –
machines, factories. This physical capital is determined by levels of investment.

When people refer to capital, they also may mean ‘financial capital’ or ‘short-term capital’. This is
not physical machines, but money and liquid assets. This kind of capital can be much more mobile.
For example, a multinational may move some of its financial capital from Europe to Australia to
take advantage of higher interest rates in Australia.

Therefore capital flows can involve:

 Foreign Direct Investment (FDI) – e.g. Nissan building a factory in England.

 Portfolio Flows – short-term capital, e.g. taking advantage of different interest rates and
moving saving accounts to a different country
 Bank transfers.

What does capital mobility mean?

1. If capital is mobile, then it means it is easy and seamless to move capital from one country
to another.
2. Perfect capital mobility would imply no transaction or other costs in moving capital from
one country to another.
3. Capital immobility means it is difficult and expensive to move capital between countries.

What determines capital mobility?

1. Tariffs/taxes on capital flows. Capital flows may be taxed by the government. e.g. tax on
investment or capital gains tax on profitable capital flows. High levels of tax will discourage
capital flows.
2. Restrictions on capital flows. Some countries may impose restrictions on the amount of
capital that can be taken into and out of a country. (Foreign exchange controls) For example,
in the period of hyperinflation, Zimbabwe imposed capital controls on individuals taking
foreign currency out of the country.
3. Rules and Regulations. Governments can impose rules which increase the cost of moving
capital from one country to another.
4. Exchange Rate Volatility. If a country has a volatile exchange rate, this may discourage
capital inflows as investors are worried about a devaluation in the exchange rate which
reduces the profitability of investment. (this is an indirect factor)
Impact of Capital Mobility

 FDI. If capital is mobile, then it will be easier to attract Foreign Direct Investment into your
country. It will also increase investment opportunities abroad.
 Better rate of return. With improved capital mobility, it will be easier to move financial
capital around to gain higher yields and interest rates.
 Real exchange rates parity. If capital is mobile it should reduce differences in real exchange
rates. If goods are relatively cheaper in the US, it should encourage people to buy goods
there and transfer capital to low-cost countries. See: purchasing power parity
 It could help equalise incomes between different countries. E.g. with perfect capital
mobility, it may encourage European firms to invest in developing countries who have lower
wage rates. These capital inflows could help raise wages in developing economies.

Problems of Capital Mobility

 It could cause a sudden outflow of capital under times of uncertainty. These capital
outflows could lead to job losses and unemployment. For example, suppose Greece felt it
had to leave the Euro. This would mean the Greek currency would probably fall 25%. With
perfect capital mobility, there would be a rapid outflow of money from Greece to other
European countries. This could cause a run on Greek banks and cause significant disruption
to the financial and economic situation. In this case, temporary capital restrictions would be
helpful in making the transition from Euro to new Greek currency.

Globalisation

Liberalization in the national and international economy is a policy choice of governments,

primarily in the developed world. It is linked with privatization and downsizing of the
activities of the public sector and the expansion of the activities of the private sector.
Globalization of the economy and production is a fact. It is the outcome of the behaviour of
firms (TNCs), their organisation, changing technology in production and distribution,
control and finance, as well as economies of scale and takeovers

Weaknesses of Globalization process

four weaknesses of the globalization process:

● a lack of legitimacy,
● a lack of accountability,47
● a lack of organization and
● a lack of transparency.

Trans-border business activities

There are four main types of trans-border business activities that are conducted by TNCs:
market seeking, resource based, rationalized and strategic asset seeking (Dunning, 1999, pp.
3–4):
● Market-seeking (demand-oriented) investments search for new markets, but they replace
trade. They are influenced by the relative size and growth of the foreign market in which the
investment is made, the relative costs of supplying that market through imports or local
production, as well as the relative advantage of engaging in
direct local production or licensing.
 ● Resource-seeking (supply-oriented) FDI is motivated by the availability and cost of both
natural resources and labour in the target location. As the products of such investments are
often exported abroad, the economic climate in foreign markets, changes in technology,
transport costs and barriers to trade influence the attractiveness
of such investment to TNCs.
● Rationalized investments seek efficiency. Like resource-based investments, they are
complementary to trade. Their attractiveness is found in cost considerations. They are
influenced by the ease with which intermediate or final products (linked to economies of
scale and specialization) can be traded on the international market. A case in question is the
US loss of competitiveness as a site for labour-extensive production. The domestic US
enterprises from this area of manufacturing locate abroad (Mexico, China and elsewhere in
Asia).
● Strategic asset-seeking FDI is aimed at protecting and augmenting the existing ownership-
specific advantages of the investing firm. Alternatively, such FDI may be aimed at reducing
the advantages of competitors.

Advantages of Local firms

Local firms have several advantages over foreign ones, for example:

● they have a better knowledge of local consumer and supplier markets;

● they do not have the costs of operating at a distance;
● they often receive favors from the government;
● they do not operate in a different, often hostile, language, tax, legal, exchange rate, social
and political environment; and
● TNCs may have some disadvantages in the eyes of certain local
Politicians in target countries as they are foreign and, often, relatively large.

Therefore, TNCs bear these elements in mind when deciding on the location of their
affiliates. They weigh up whether they have enough advantages over other firms or whether
they can create the capacity to overcome these obstacles.

ECONOMIC UNION

An economic union is an agreement between two or more nations to allow goods, services, money
and workers to move over borders freely. The countries may also coordinate social and financial
policies to support this common market.

The European Union (EU) is an example of an economic union. The countries of the EU coordinate
their respective economic policies, laws and regulations so they can work together to address
economic and financial issues. The EU also has a common currency, the Euro, used by 19 EU
members.

An economic union is different from a customs union. The members of a customs union enjoy free
movement of goods

Requirements of an economic and monetary union

In theory, an economic and monetary union requires the following elements:
● Centralization of monetary policy;
● a single central bank or a system of central banks that control stabilization policies;
● convertibility (at least internal) of the participating countries’ currencies;
● unified performance on the international financial markets;
● capital market integration;
● identical rates of inflation;
● harmonisation of fiscal systems;
● replacement of balance of payments disequilibria with regionalimbalances;
● similar levels of economic development or a well-endowed fund fortransfers of real resources to
the less-developed regions and thoseunder external shocks; and
● continuous consultation about and coordination of economic policiesamong the participating
countries, as well as the adjustment ofwages on the union level.

The cost of a Monetary Union

First, the creation of a supranational body to conduct monetary policy(money supply, rate of interest
and rate of exchange) in an EMU may be perceived as a significant loss of the participating
countries’ national sovereignty.
Second, it was argued that floating rates of exchange permit unconstrained choices between
unemployment and inflation in a country. On these grounds, countries may seem to be free to
pursue their own stabilization policies.
Third, a serious problem in a monetary union may be traced in the inflow of capital into the
prosperous regions. The regions losing this capital expectation compensatory public action
including transfers from the prosperous ones.
Fourth is the loss of seigniorage. This comes from the national currency held abroad (also called the
inflation tax).6 Instead of selling debt, a government may print money and, hence, raise revenue in
order to cover its budget deficit
Fifth includes changeover costs from switching to a new currency. These are administrative,
technical printing and distribution costs of the new currency such as the adaptation of money
distribution and vending machines.

Benefits of a monetary union

The benefits of monetary integration are numerous, but generally intuitive in their nature. They are
barely quantifiable and non-economists have difficulty in comprehending their character and
significance. The principal
gains from monetary integration are the following:
● The most important benefit that an EMU brings to its participants is an improvement in
integration of markets for goods, services and factors.
● Prices are transparent and directly comparable. This boosts competition and specialisation in
tradable goods and services. Spatial and industrial location of resources is improved.
● In a situation of stable prices, interest and exchange rates, internal trade and investment flows are
not volatile, as there is no exchange rate risk and uncertainty.
● Transaction9 and hedging costs are significantly reduced.
● There are gains from additional trade.
● Investors may decide with a high degree of long-term confidence. There are no intra-union
controls for direct investment. For example, without a single currency, a German investor may
regard an investment
project in Belgium as riskier than the same project in Germany.
● By unifying monetary and coordinating fiscal policies, the participating countries are led to fewer
distortions while combating macroeconomic disequilibria. This introduces both a greater internal
monetary stability and an increase in influence in international monetary affairs. This contributes to
economic growth and dynamic gains.
● The pooling of national reserves of foreign currencies is also advantageous for the members of an
EMU. By internalizing their ‘foreign’ trade, these countries reduce their demand for foreign
currency reserves.
Role of government

Governments can play several roles in economic activity, including:

● setting up general economic, legal and political stability;
● initiation;
● supervision;
● ownership of assets; and
● arbitration.

Instruments
Tariffs (trade policy) have historically been the most important instrument of industrial policy.
After a number of rounds of multilateral reduction in tariffs under the auspices of GATT/WTO, the
use of this instrument has been restricted in scope and reduced in power. However, other methods
and instruments of intervention have developed. Some of these represent protectionist pressures
against adjustment, while others are adjustment oriented.
They include:
● subsidies for exports, production, R&D, education, employment and investment;
● NTBs;
● tax, exchange rate and credit policy;
● public purchases;
● price and exchange controls;
● regulation of the market (such as licensing);
● technical and other standards;
● direct production by the state;
● provision of infrastructure; and
● competition and concentration policy.

Reasons for Protectionism

some argued that protectionist policies were required for:
● the security of jobs, as was the case during the 1930s and ever since; or
● the safeguard of infant industries, as during the 1950s; or
● rent shifting in oligopolistic markets, as during the 1980s; or
● the safety of the environment and social (labour) standards, as is currently the case.

Why firms locate in areas where there are firms from the same or related industry

A firm locates in an area where there are firms from the same or related industry (in a cluster)
because:
● it has production links with other firms;
● it may benefit from the already existing pool of suppliers;
● there are services such as finance, information, consulting and maintenance;
● there may be a pool of trained and experienced labour;
● firms may reduce the cost of transport;
● there may be a concentration of consumers (proximity to the major growing markets is often the
most important reason for the selection of a particular location); and
● they may jointly negotiate contracts with transporters and organize export promotion boards and
the like.
Why it is beneficial for producers from the same industry to be located together

Marshall (1890) considered the issue of why it is beneficial for producers from the same industry to
be located together. He offered three basic reasons why producers concentrate (form a cluster):
● Knowledge spillovers: proximity eases exchange and spread of information.
● Advantages of thick markets for specialised skills: firms may easily find the necessary labour and
workers may get promotion or work if the current employer does poorly.
● Backward and forward linkages associated with large markets: links may clarify and explain a
part of the concentration story only if there are economies of scale.
Causes of regional disequilibria
There are many causes of regional disequilibria, including (Vanhove and Klaasen, 1987, pp. 2–7):
● market rigidities (such as relatively low mobility of factors);
● geographical factors;
● differences in the availability of resources;
● education of management and training of labour;
● regional economic structure (in some regions industries with ageing technologies, in others
industries with modern technologies);
● institutional factors such as the centralisation of public institutions (Paris is an obvious example);
and
● national wage setting in spite of differences in productivity and labour market conditions across
different regions.

Reasons why Governments intervene

Governments intervene in regional matters mainly for the following three reasons:
● Equity This is a strong social motive based on public pressure on the government to try to achieve
and maintain a ‘proper’ balance, as well as an ‘orderly’ and just geographical distribution, of
national wealth and access to the public in different regions.
● Efficiency This is a desire to employ, sustain and increase national economic potentials and
capabilities.
● Strategic behaviour This gives public authorities a chance to shape comparative advantages and
influence the output potential and capabilities of the country

Objective and justification

The objectives of a regional policy are various, but their common denominator is that they aim to
employ the regions’ unemployed or underemployed resources and potentials, to locate new ones, to
attract missing factors, as well as to increase output and incomes. With this in mind, a regional
policy can be justified on nine counts.

The first justification for a regional policy (intervention that is supposed to assist in the process of
economic adjustment), in contrast to free market adjustment, can be found in the structural
deficiencies of regions.

Regional imports consists of goods and services. In France, for example, most of the country’s
regions purchase financial, insurance, legal and other services from Paris. This is not easily
quantified. A reduction in a region’s exports, for instance, may be obvious from the outset.
Regional solutions to these disequilibria are inhibited by rules of competition and by the existence
of a single currency. Herein we find the second ‘justification’ for regional intervention in an
economic union.
The third reason may be found in the employment of factors. The neoclassical theory of
international trade usually assumes free and full international mobility of factors, which ensures full
employment.
The fourth rationale can be found in the ‘need’ for compensation. Two forces created by economic
integration affect regional development. The first one, specialisation, leads the backward regions to
specialise in labour intensive production according to their comparative advantage.

The second force includes economies of scale, externalities and path dependence. This can lead to a
divergence in regional incomes. As integration extends the size of the market, firms take advantage
of economies of scale and externalities.

The fifth reason is the improved allocation of resources. When the market is imperfect, free market
forces usually direct capital towards already developed regions in the short and medium terms.
Private investors tend to maximize the speed of the safe return of their invested funds and to
minimize investment in infrastructure.

The sixth reason lies in the improvement of stabilisation (macroeconomic) policy. Regional
differences in rates of unemployment may reduce the opportunities to control inflation and
introduce a stabilisation policy.

Seventh, a regional policy may reduce public expenditure in the assisted region in the long run.
Public support to firms to locate in certain regions may propel economic activity towards these
regions

Eighth, although regional policy is targeted at regions with some disadvantage (underdevelopment,
unemployment, obsolete technologies and output structure, congestion or pollution), the benefits of
a regional policy are not confined to the assisted area

Finally, in addition to the above arguments for regional policy, which mostly deal with ‘economic’
efficiency, there are political grounds which are at least as important as the economic ones.
Solidarity, tolerance and perception of a common future are the core of any social community

Impact of regional integration

Economic integration may increase the average welfare of consumers in the involved countries in
many different direct and indirect ways. The problem is that the benefits accrue to everyone in
relatively small instalments and only in the medium and long terms. Some of these gains include:
● secure access to the market of partner countries;
● increased investment opportunities as expectations may be established with an increased degree
of security;
● improved efficiency in the use of resources;
● elimination of trade barriers reduces cost of trade;
● increased competition on internal market puts a downward pressure on prices;
● facilitation of exchange of technical information;
● competition forces firms to apply new ideas and technologies;
● due to the enlarged market, producers may better exploit and benefit from economies of scale;
● potential for coordination of certain economic policies;
● improved bargaining position with external partners;
● research and innovation may be stimulated because of tougher competition on a larger market and
a possibility of sharing fixed costs in such a market environment;
● the market of the integrated group provides more opportunities for a wider range of goods and
services that can be offered to consumers, hence there is an improvement in individuals’ utility
function; and
● reduction in X-inefficiency which moves the production activities of firms closer to best-practice
business organisation.

Instruments of regional policy

Major instruments include:
● tax concessions;
● subsidies: regional allocation of capital, investment, infrastructure,output, social security and
income/wage;
● vocational training;
● public procurement and provision of goods, services and infrastructure;
● loan guarantees;
● reduction in interest rates;
● protection of intellectual property;
● decentralisation of government offices, education and health services;
● reductions in energy and public transportation costs;
● free locations;
● licences for the location of business; and
● trade protection.
As seen from this list, the choice of policy tools is rather limited. The secret of success in this
situation is not the wide range of instruments, but rather their astute combination and application.

STATIC MODEL

A static model of the theory of customs union considers the impact of the formation of a customs
union on trade flows and consumption in the integrated countries. The classical (orthodox or
static) theory of customs union rely on a number of explicit and implicit assumptions.

This model makes theoretical consideration easier, but it also simplifies reality to the extent that
the policy recommendations are to be considered with great care.

ASSUMPTIONS OF THE STATIC MODEL

Assume that there are only three countries. Country A, a relatively small country in relation to the
other two, forms a customs union with country C (which, ay represent all other countries in the
world), is discriminated against by the customs union by means of a common external tariff.

A relatively small number of nations provide the possibility of a relatively higher analytical power
in theoretical model. Tariffs are levied on an ad valorem basis in all the countries.

1. Rates of the tariffs are the same both for the final commodities and inputs, so that the rate
of nominal protection equals the rate of effective protection. The assumption of equal
rates of tariff prior to the integration removes the possible dispute about the initial level of
the common external tariff. Tariffs are the only instrument if trade where there are no
 NTBs.the price of imported goods for home consumers (pmt) is composed of the price of an
imported good (pm) and tariff (t).

Pmt= (1+t) pm

Where:

t≥0
State intervention exists only at the border and trade is balanced.

2. Free or perfect competition, exists both in markets for goods and services, as well as in the
markets for factors .perfect competition (or competition equality of opportunity) exists in
all economies, but for the existence of tariffs.
3. Production cost per unit of output are constant over all levels of output. Production
functions are homogeneous of degree one ,for example to produce one more unit of good
X ,inputs must be increased by constant proportion .costs of production determine the
retail prices of goods. Producers of an industry operate at the minimum efficient scale to
the production possibility frontier. Countries embark upon the production of certain goods
on the basis of the prices (relative abundance or scarcity) of home factors.
The theory of customs union refer to the manufacturing sector: a fixed unit of factors of
production is fully employed .There are no sector specific factors such as special human and
physical capital, entrepreneurship .in a dynamic model these specific factors can be transformed in
the medium and long run, but this would require adjustment costs which are ruled out in the static
model. Mobility of factors is perfect within their home country, while commodities re perfectly
mobile between integrated countries .this means that TNCs are ignored.

4. There are no transport costs, there are no insurance costs and also there are no banking
costs this model assumes that these costs are not incurred at any point in the theory of
customs union.
5. All countries have access to the same technology and differ only in their endowment of
factors.
 6. Economies are static with constant expectations .this means that the rates of growth,
technologies, and tastes, propensities to consume, save, import and invest are given and
unchangeable.
7. There are no new goods, no innovation and no depreciation of the capital stock.
8. All goods and services are homogeneous such that consumers do not have a preference for
the consumption of goods and services from any particular supplier. They decide upon
their purchases exclusively on the basis of differences in the price.
9. All goods and services have unit income elasticity’s of demand that is every income
increase or decrease in income has a proportional change in demand for all goods and
services in the same direction. This means that demand is well behaved.
10. Non-tradable commodities do not exist. There are no intra- industry trade or ‘cross hauling’
that is s country cannot both export and import identical goods or close substitutes
11. There are no inventories. All markets clear simultaneously. Such equilibrium must be both
sustainable and feasible that is firms can either profitably undercut market price or make
losses.
12. In this model there is no uncertainty .Firms and resource owners are perfectly informed
about all markets while consumers are fully familiar with goods and services. This
assumption was relevant in the past but the existence of the internet put the economies
close to a position of full, timely and perfect information.
13. Fiscal (taxes and subsidies) and monetary (rates of exchange, interest inflation and balance
of payments) operations are ruled out.
14. Country which is not included in the customs union is assumed not to retaliate against the
integrated countries.
The above assumptions are highly restrictive, but greatly simplify the analysis so that the essential
properties of the model can be highlighted .the objective of the analysis is to make a point, rather
than to be realistic.
Due to the formation of a customs union there are some that come along as before the formation
the home country may be originally having a balance of trade equilibrium. The static model of
theory of customs union which considers the impact of formation of a customs union on trade
flows in the integrated countries results in some static effects which come along as a result of the
formation of the customs union. The static effects are basically concerned with reallocation and
consumption of goods among the integrated countries.

These static effects are: trade creation and trade diversion.

TRADE CREATION

The formation of a customs union involve the abolition of the tariff barriers among member
countries and the imposition of tariff against the rest of the world. Trade creation occurs when the
domestic production of a good in a member country is replaced with imports of the same good
from another member country within the customs union because of lower production cost.

It is supposed that home country A is less efficient country and its unit cost of producing a phone
is RS 5000.in the partner country B which is the more efficient the cost of producing the same
which is RS 4000and the cost of producing the same phone in the rest of the world(the most
efficient country) is RS 3000.before the formation of a customs union country A impose a 100%
tariff on all imports then the unit cost of B and C become RS 8000 and 6000 effectively.in this
circumstance it is desirable for country A to produce domestically other than going for exports
thus reduces consumption of the imported goods and allowing consumption of domestically
produced goods which makes the consumption static as people will only consume what is
produced domestically.

Example of a static effect under trade creation

Assuming that prior joining the European common market in 1973 United Kingdom could produce
butter at 130p per kilogram on average.at the same time New Zealand could produce the same
quantity at 100p and Denmark could produce at 120p.therefore prior to the formation of a
customs union, New Zealand has a comparative advantage in butter and is the most efficient.
Denmark is the second most efficient and united kingdom the least efficient.

In order to protect its inefficiency United Kingdom imposes differential tariffs on New Zealand and
demark in order to raise the price of importation for both. This raises the prices of butter in other
countries thus the formation of a customs union between them will lower the tariffs to zero .this
will lead to trade creation among the countries as there are no trade barriers thus the impact of
production and consumption will be felt.

TRDE DIVERSION

This occurs when the imports of a member country are replaced by the imports of a non-member
country because of removal of trade barriers and application of a common tariff to non-member
countries.

It is possible that before creation of a customs union a given commodity was being imported from
the most efficient country C to the least efficient country A, after the formation of the customs
union, as duty is removed from imports from the partner country B ,while it remains enforced on
imports from country C the former becomes the least cost efficient country.in such a situation
the home country A will start importing commodities from country B rather non-member country
C .thus, there is diversion of trade from outside country C to the member country B.

Explain the types of trans-border business activities that are conducted by TNCs or
MNCs and their effects on the local firms.

Transnational corporations (TNCS) can be variably interchanged with multinational

corporations. MNCs generally, these are seen as counties with headquarters in one country
while its whole or partial operations subsidized in other countries. Subsidiaries report to the
headquarters but are allowed to operate as their own entities.

With time, they have come to grow in size thus gaining power both at home and in the
subsidiary countries. As a result, they are criticized to act in their self-interest due to their
economic and political power.

Definitions:
Transnational Corporation is commercial enterprise that operates substantial facilities,
does business in more than one country and does not consider any particular country as its
national home. The United Nations Commission on Transnational Corporations and
Investments has defined TNC as investors that own or control production or service facilities
outside the country in which they are based.

Multinational Corporation, this is an organization that owns or control production of goods

and services in one or more countries other than their home country. MNC is considered as
the older term and still a generic label to firms with features of both TNC and MNC,
nonetheless a significant emphasis is placed on TNC.

Difference:
The difference between the two is that the MNCs have investments in other countries where
they don’t have coordinated product offering in those countries. They have a higher focus on
adapting their products and services to each individual local market. While in other hand the
TNCs are quite complex, they have foreign investments, as well it have a central corporate
facility but give decision making research and development and marketing powers to each
individuals foreign market. They don’t have a centralized management system, therefore can
be said to own many companies instead of subsidiaries due to their massive budgets. TNCs
and MNCs are highly influential to globalization.

Activities undertaken by the TNCs and MNCs:

Due to the above mention differences, TNCs and MNCs can be seen to engage in difference
activities. As noted before their significant market power enables them to have impact on the
government policies through withdrawal threats. They initiate lobbying directed at variety of
the business concerns such as tariff structures, aiming to restrict competition of the foreign
industries as well as tax concerns.

MNCs mostly deal with consumer goods. They include manufacturers and quick-service
restaurants such as proctor and gamble, unlevel, MC Donald and seven cleven.

TNCs engage in a wider range of business actives including petroleum, pharmaceutical

industries, T.T consulting among others. They include firms such as Peloitte, shell, Accentore,
Roche and Glaxo-smith klein.

TNCs and MNCs Outstanding features:

 Both have huge economic power

 Can boast of sophisticated technology
 Enjoy easy access to professional management.
 Operate through a network of branches and subsidiaries.
  They have a huge asset turnover.

Effects on the local firms:

The presence of TNCs and MNCs in any given country can have both positive and negative
effects to the local industries.

 The local industry is able to enjoy the latest technology from their foreign
counterparts.
 Businesses can also get management expertise from TNCs and MNCs.
 There is a general increase of business operations which not only benefit local firms
but also increases the employment levels, investment levels as well as income stream
which is a plus-side for the developing country.
 TNCs and MNCs are able to counter local monopolies thus counting fair competition
and giving others a chance to join in.
 Local firms are able to borrow from Research and Development outcomes from TNCs
and MNCs.
 There is a general increase and growth of both industrial sector and economic sector.
This goes a long way to mobilize the Balance of Payment (BOP). Economic growth
benefits the business in a country and improves living standard for the people.

There is another side of every coin. In the same way, there is also a negative aspect of hosting
TNCs and MNCs especially for developing regions.

 The corporations may transfer outdated technology to the home country thus always
having the competitive edge on local firms.
 Since both TNCs and MNCs don’t operate with the national autonomy, they may pose a
major threat to the political and economic sovereignty of host countries.
 TNCs and MNCs may kill the emerging domestic industry by coming up as the
monopolies.
 TNCs and MNCs may overuse a country’s resources causing depletion of the resources
in that particular country.
 At times, the greater amount of money is that which flows out of TNCs and MNCs to
their home countries to make payments towards profits, dividends and royalty. These
injury the host country as the benefits to hosting them are minimal.
  Disregard national interests of the host country by undermining the government
policies to favor them. Meanwhile the local industries may end up getting.

DISCUSS THE BENEFITS OF FOREIGN DIRECT INVESTMENTS IN DEVELOPING

NATIONS.

Foreign Direct Investment [FDI] is an investment in the form of a controlling ownership in a

business in one country by an entity based in another country.

BENEFITS

a) Economic development stimulation

Foreign direct investment can stimulate the target country’s economic development, creating a
more conducive environment for you as an investor and benefits for the local industry

b) Easy international trade

Commonly a country has its own import tariff, and this is one of the reasons why trading with it is
quite difficult. Also there are industries that usually require their presence in the international
markets to ensure their sales and goals will be completely met. With FDI, all these will be made
easier.

c) Employment and economic boost

Foreign direct investment creates new jobs, investors build new companies in the target country,
create new opportunities. This leads to an economic boost.

d) Development of human capital resources

Human capital is the competence of those able to perform labor more known to us as workforce.
The attribute gained by training and sharing experience would increase the education and overall
human capital of a country. Its resource is not a tangible asset that is owned by companies, but
instead something that is on loan. With this in mind, a country with FDI can benefit greatly by
developing its human resource while maintaining ownership.

e) Tax incentives

Parent enterprise would also provide foreign direct investment to get additional expertise,
technology and products. As the foreign investor, you can receive tax incentives that will be highly
useful in your selected field of business.

f) Resource transfer
Foreign direct investment will allow resource transfer and other exchange of knowledge, where
various countries are given access to new technologies and skills.

g) Reduced disparity between revenues and costs

Foreign direct investment can reduce the disparity between revenues and costs. With such,
countries will be able to make sure that production costs will be the same and can be sold easily.

h) Increased productivity
The facilities and equipment provided by foreign investors can increase a workforce’s productivity
in the target country.

i) Increment in country’s income

With more jobs and higher wages, the national income normally increases. As a result, economic
growth is spurred. Larger corporations would usually offer high salary levels than what you would
normally find in the target country, which can lead to increment in income.
World Trade Organization

The World Trade Organization (WTO) is an intergovernmental organization that is concerned

with the regulation of international trade between nations. The WTO officially commenced on 1
January 1995 under the Marrakesh Agreement, signed by 123 nations on 15 April 1994, replacing
the General Agreement on Tariffs and Trade (GATT), which commenced in 1948. It is the largest
international economic organization in the world.
The WTO deals with regulation of trade in goods, services and intellectual property between
participating countries by providing a framework for negotiating trade agreements and a dispute
resolution process aimed at enforcing participants' adherence to WTO agreements, which are signed
by representatives of member governments and ratified by their parliaments. The WTO prohibits
discrimination between trading partners, but provides exceptions for environmental protection,
national security, and other important goals. Trade-related disputes are resolved by independent
judges at the WTO through a dispute resolution process.
The WTO's current Director-General is Roberto Azevêdo, who leads a staff of over 600 people in
Geneva, Switzerland.
A trade facilitation agreement, part of the Bali Package of decisions, was agreed by all members on
7 December 2013, the first comprehensive agreement in the organization's history. On 23 January
2017, the amendment to the WTO Trade Related Aspects of Intellectual Property Rights (TRIPS)
Agreement marks the first time since the organization opened in 1995 that WTO accords have been
amended, and this change should secure for developing countries a legal pathway to access
affordable remedies under WTO rules.
Studies show that the WTO boosted trade, and that barriers to trade would be higher in the absence
of the WTO. The WTO has highly influenced the text of trade agreements, as "nearly all recent
[preferential trade agreements (PTAs)] reference the WTO explicitly, often dozens of times across
multiple chapters... in many of these same PTAs we find that substantial portions of treaty
language—sometime the majority of a chapter—is copied verbatim from a WTO agreement."
The WTO's predecessor, the General Agreement on Tariffs and Trade (GATT), was established by a
multilateral treaty of 23 countries in 1947 after World War II in the wake of other new multilateral
institutions dedicated to international economic cooperation—such as the World Bank (founded
1944) and the International Monetary Fund (founded 1944 or 1945). A comparable international
institution for trade, named the International Trade Organization never started as the U.S. and other
signatories did not ratify the establishment treaty, and so GATT slowly became a de facto
international organization.
GATT Negotiations before Uruguay
Seven rounds of negotiations occurred under GATT. The first real GATT trade rounds concentrated
on further reducing tariffs. Then the Kennedy Round in the mid-sixties brought about a GATT anti-
dumping Agreement and a section on development.
The Tokyo Round during the seventies represented the first major attempt to tackle trade barriers
that do not take the form of tariffs, and to improve the system, adopting a series of agreements on
non-tariff barriers, which in some cases interpreted existing GATT rules, and in others broke
entirely new ground. Because not all GATT members accepted these plurilateral agreements, they
were often informally called "codes".
Several of these codes were amended in the Uruguay Round and turned into multilateral
commitments accepted by all WTO members. Only four remained plurilateral (those on government
procurement, bovine meat, civil aircraft and dairy products), but in 1997 WTO members agreed to
terminate the bovine meat and dairy agreements, leaving only two. Despite attempts in the mid-
1950s and 1960s to establish some form of institutional mechanism for international trade, the
GATT continued to operate for almost half a century as a semi-institutionalized multilateral treaty
regime on a provisional basis.

During the Doha Round, the US government blamed Brazil and India for being inflexible and the
EU for impeding agricultural imports.
Well before GATT's 40th anniversary, its members concluded that the GATT system was straining
to adapt to a new globalizing world economy. In response to the problems identified in the 1982
Ministerial Declaration (structural deficiencies, spill-over impacts of certain countries' policies on
world trade GATT could not manage, etc.), the eighth GATT round—known as the Uruguay
Round—was launched in September 1986, in Punta del Este, Uruguay.
It was the biggest negotiating mandate on trade ever agreed: the talks aimed to extend the trading
system into several new areas, notably trade in services and intellectual property, and to reform
trade in the sensitive sectors of agriculture and textiles; all the original GATT articles were up for
review. The Final Act concluding the Uruguay Round and officially establishing the WTO regime
was signed 15 April 1994, during the ministerial meeting at Marrakesh, Morocco, and hence is
known as the Marrakesh Agreement.
The GATT still exists as the WTO's umbrella treaty for trade in goods, updated as a result of the
Uruguay Round negotiations (a distinction is made between GATT 1994, the updated parts of
GATT, and GATT 1947, the original agreement which is still the heart of GATT 1994).
GATT 1994 is not, however, the only legally binding agreement included via the Final Act at
Marrakesh; a long list of about 60 agreements, annexes, decisions and understandings was adopted.
The agreements fall into six main parts:
 the Agreement Establishing the WTO
 the Multilateral Agreements on Trade in Goods
 the General Agreement on Trade in Services
 the Agreement on Trade-Related Aspects of Intellectual Property Rights
 dispute settlement
 reviews of governments' trade policies
In terms of the WTO's principle relating to tariff "ceiling-binding" (No. 3), the Uruguay Round has
been successful in increasing binding commitments by both developed and developing countries, as
may be seen in the percentages of tariffs bound before and after the 1986–1994 talks.

Ministerial conferences

The highest decision-making body of the WTO, the Ministerial Conference, usually meets every
two years. It brings together all members of the WTO, all of which are countries or customs unions.
The Ministerial Conference can take decisions on all matters under any of the multilateral trade
agreements. Some meetings, such as the inaugural ministerial conference in Singapore and the
Cancun conference in 2003 involved arguments between developed and developing economies
referred to as the "Singapore issues" such as agricultural subsidies; while others such as the Seattle
conference in 1999 provoked large demonstrations. The fourth ministerial conference in Doha in
2001 approved China's entry to the WTO and launched the Doha Development Round which was
supplemented by the sixth WTO ministerial conference (in Hong Kong) which agreed to phase out
agricultural export subsidies and to adopt the European Union's Everything but Arms initiative to
phase out tariffs for goods from the Least Developed Countries.
The Twelfth Ministerial Conference (MC12) is set to be held in Astana, Kazakhstan, in 2020. The
decision was taken by consensus at the General Council meeting on 26 July 2018 and marks the
first time a Ministerial Conference is to be organized in Central Asia.

Doha Round (Doha Agenda): 2001–

The WTO launched the current round of negotiations, the Doha Development Round, at the fourth
ministerial conference in Doha, Qatar in November 2001. This was to be an ambitious effort to
make globalization more inclusive and help the world's poor, particularly by slashing barriers and
subsidies in farming. The initial agenda comprised both further trade liberalization and new rule-
making, underpinned by commitments to strengthen substantial assistance to developing countries.

Progress stalled over differences between developed nations and the major developing countries on
issues such as industrial tariffs and non-tariff barriers to trade particularly against and between the
EU and the US over their maintenance of agricultural subsidies—seen to operate effectively as trade
barriers. Repeated attempts to revive the talks proved unsuccessful, though the adoption of the Bali
Ministerial Declaration in 2013 addressed bureaucratic barriers to commerce.
As of June 2012, the future of the Doha Round remained uncertain: the work programme lists 21
subjects in which the original deadline of 1 January 2005 was missed, and the round remains
incomplete.
The conflict between free trade on industrial goods and services but retention of protectionism on
farm subsidies to domestic agricultural sectors (requested by developed countries) and the
substantiation[jargon] of fair trade on agricultural products (requested by developing countries)
remain the major obstacles. This impasse has made it impossible to launch new WTO negotiations
beyond the Doha Development Round. As a result, there have been an increasing number of
bilateral free trade agreements between governments. As of July 2012 there were various
negotiation groups in the WTO system for the current stalemated agricultural trade negotiation.

Functions
Among the various functions of the WTO, these are regarded by analysts as the most important:
 It oversees the implementation, administration and operation of the covered agreements.
 It provides a forum for negotiations and for settling disputes.
Additionally, it is WTO's duty to review and propagate the national trade policies, and to ensure the
coherence and transparency of trade policies through surveillance in global economic policy-
making.
Another priority of the WTO is the assistance of developing, least-developed and low-income
countries in transition to adjust to WTO rules and disciplines through technical cooperation and
training.
1. The WTO shall facilitate the implementation, administration and operation and further the
objectives of this Agreement and of the Multilateral Trade Agreements, and shall also
provide the framework for the implementation, administration and operation of the
multilateral Trade Agreements.
2. The WTO shall provide the forum for negotiations among its members concerning their
multilateral trade relations in matters dealt with under the Agreement in the Annexes to this
Agreement.
3. The WTO shall administer the Understanding on Rules and Procedures Governing the
Settlement of Disputes.
4. The WTO shall administer Trade Policy Review Mechanism.
5. With a view to achieving greater coherence in global economic policy making, the WTO
shall cooperate, as appropriate, with the international Monetary Fund (IMF) and with the
International Bank for Reconstruction and Development (IBRD) and its affiliated agencies.
The above five listings are the additional functions of the World Trade Organization. As
globalization proceeds in today's society, the necessity of an International Organization to manage
the trading systems has been of vital importance. As the trade volume increases, issues such as
protectionism, trade barriers, subsidies, violation of intellectual property arise due to the differences
in the trading rules of every nation. The World Trade Organization serves as the mediator between
the nations when such problems arise. WTO could be referred to as the product of globalization and
also as one of the most important organizations in today's globalized society.
The WTO is also a centre of economic research and analysis: regular assessments of the global
trade picture in its annual publications and research reports on specific topics are produced by the
organization. Finally, the WTO cooperates closely with the two other components of the Bretton
Woods system, the IMF and the World Bank.

Principles of the trading system

The WTO establishes a framework for trade policies; it does not define or specify outcomes. That
is, it is concerned with setting the rules of the trade policy games.[55] Five principles are of
particular importance in understanding both the pre-1994 GATT and the WTO:
1. Non-discrimination. It has two major components: the most favoured nation (MFN) rule,
and the national treatment policy. Both are embedded in the main WTO rules on goods,
services, and intellectual property, but their precise scope and nature differ across these
areas.
The MFN rule requires that a WTO member must apply the same conditions on all trade
with other WTO members, i.e. a WTO member has to grant the most favourable conditions
under which it allows trade in a certain product type to all other WTO members. "Grant
someone a special favour and you have to do the same for all other WTO members."
National treatment means that imported goods should be treated no less favourably than
domestically produced goods (at least after the foreign goods have entered the market) and
was introduced to tackle non-tariff barriers to trade (e.g. technical standards, security
standards et al. discriminating against imported goods).
2. Reciprocity. It reflects both a desire to limit the scope of free-riding that may arise because
of the MFN rule, and a desire to obtain better access to foreign markets. A related point is
that for a nation to negotiate, it is necessary that the gain from doing so be greater than the
gain available from unilateral liberalization; reciprocal concessions intend to ensure that
such gains will materialise.
3. Binding and enforceable commitments. The tariff commitments made by WTO members
in a multilateral trade negotiation and on accession are enumerated in a schedule (list) of
concessions. These schedules establish "ceiling bindings": a country can change its bindings,
but only after negotiating with its trading partners, which could mean compensating them
for loss of trade. If satisfaction is not obtained, the complaining country may invoke the
WTO dispute settlement procedures.
4. Transparency. The WTO members are required to publish their trade regulations, to
maintain institutions allowing for the review of administrative decisions affecting trade, to
respond to requests for information by other members, and to notify changes in trade
policies to the WTO. These internal transparency requirements are supplemented and
facilitated by periodic country-specific reports (trade policy reviews) through the Trade
Policy Review Mechanism (TPRM). The WTO system tries also to improve predictability
 and stability, discouraging the use of quotas and other measures used to set limits on
quantities of imports.
5. Safety values. In specific circumstances, governments are able to restrict trade. The WTO's
agreements permit members to take measures to protect not only the environment but also
public health, animal health and plant health.
There are three types of provision in this direction:
1. articles allowing for the use of trade measures to attain non-economic objectives;
2. articles aimed at ensuring "fair competition"; members must not use environmental
protection measures as a means of disguising protectionist policies.
3. provisions permitting intervention in trade for economic reasons.
Exceptions to the MFN principle also allow for preferential treatment of developing countries,
regional free trade areas and customs unions.

Organizational structure
The General Council has the following subsidiary bodies which oversee committees in different
areas:
Council for Trade in Goods
There are 11 committees under the jurisdiction of the Goods Council each with a specific task.
All members of the WTO participate in the committees. The Textiles Monitoring Body is
separate from the other committees but still under the jurisdiction of Goods Council. The
body has its own chairman and only 10 members. The body also has several groups relating to
textiles.

Council for Trade-Related Aspects of Intellectual Property Rights

Information on intellectual property in the WTO, news and official records of the activities of
the TRIPS Council, and details of the WTO's work with other international organizations in
the field.

Council for Trade in Services

The Council for Trade in Services operates under the guidance of the General Council and is
responsible for overseeing the functioning of the General Agreement on Trade in Services
(GATS). It is open to all WTO members, and can create subsidiary bodies as required.

Trade Negotiations Committee

The Trade Negotiations Committee (TNC) is the committee that deals with the current trade
talks round. The chair is WTO's director-general. As of June 2012 the committee was tasked
with the Doha Development Round.

The Service Council has three subsidiary bodies: financial services, domestic regulations, GATS
rules and specific commitments.[60] The council has several different committees, working groups,
and working parties. There are committees on the following: Trade and Environment; Trade and
Development (Subcommittee on Least-Developed Countries); Regional Trade Agreements; Balance
of Payments Restrictions; and Budget, Finance and Administration. There are working parties on
the following: Accession. There are working groups on the following: Trade, debt and finance; and
Trade and technology transfer.

Decision-making
The WTO describes itself as "a rules-based, member-driven organization—all decisions are made
by the member governments, and the rules are the outcome of negotiations among members".
The WTO Agreement foresees votes where consensus cannot be reached, but the practice of
consensus dominates the process of decision-making.
Richard Harold Steinberg (2002) argues that although the WTO's consensus governance model
provides law-based initial bargaining, trading rounds close through power-based bargaining
favouring Europe and the U.S., and may not lead to Pareto improvement.

Dispute settlement
Main article: Dispute settlement in the WTO
The WTO's dispute-settlement system "is the result of the evolution of rules, procedures and
practices developed over almost half a century under the GATT 1947". In 1994, the WTO members
agreed on the Understanding on Rules and Procedures Governing the Settlement of Disputes (DSU)
annexed to the "Final Act" signed in Marrakesh in 1994. Dispute settlement is regarded by the WTO
as the central pillar of the multilateral trading system, and as a "unique contribution to the stability
of the global economy". WTO members have agreed that, if they believe fellow-members are
violating trade rules, they will use the multilateral system of settling disputes instead of taking
action unilaterally.
The operation of the WTO dispute settlement process involves case-specific panels appointed by the
Dispute Settlement Body (DSB), the Appellate Body,[74] The Director-General and the WTO
Secretariat, arbitrators, and advisory experts.
The priority is to settle disputes, preferably through a mutually agreed solution, and provision has
been made for the process to be conducted in an efficient and timely manner so that "If a case is
adjudicated, it should normally take no more than one year for a panel ruling and no more than 16
months if the case is appealed... If the complainant deems the case urgent, consideration of the case
should take even less time. WTO member nations are obliged to accept the process as exclusive and
compulsory.
According to a 2018 study in the Journal of Politics, states are less likely and slower to enforce
WTO violations when the violations affect states in a diffuse manner. This is because states face
collective action problems with pursuing litigation: they all expect other states to carry the costs of
litigation. A 2016 study in International Studies Quarterly challenges that the WTO dispute
settlement system leads to greater increases in trade.
However, the dispute settlement system cannot be used to resolve trade disputes that arise from
political disagreements. When Qatar requested the establishment of a dispute panel concerning
measures imposed by the UAE, other GCC countries and the US were quick to dismiss its request
as a political matter, stating that national security issues were political and not appropriate for the
WTO dispute system.

Accession and membership

Main article: World Trade Organization accession and membership
The process of becoming a WTO member is unique to each applicant country, and the terms of
accession are dependent upon the country's stage of economic development and current trade
regime.
The process takes about five years, on average, but it can last longer if the country is less than fully
committed to the process or if political issues interfere. The shortest accession negotiation was that
of the Kyrgyz Republic, while the longest was that of Russia, which, having first applied to join
GATT in 1993, was approved for membership in December 2011 and became a WTO member on
22 August 2012.
Kazakhstan also had a long accession negotiation process. The Working Party on the Accession of
Kazakhstan was established in 1996 and was approved for membership in 2015. The second longest
was that of Vanuatu, whose Working Party on the Accession of Vanuatu was established on 11 July
1995. After a final meeting of the Working Party in October 2001, Vanuatu requested more time to
consider its accession terms.
In 2008, it indicated its interest to resume and conclude its WTO accession. The Working Party on
the Accession of Vanuatu was reconvened informally on 4 April 2011 to discuss Vanuatu's future
WTO membership. The re-convened Working Party completed its mandate on 2 May 2011. The
General Council formally approved the Accession Package of Vanuatu on 26 October 2011. On 24
August 2012, the WTO welcomed Vanuatu as its 157th member. An offer of accession is only given
once consensus is reached among interested parties.
A 2017 study argues that "political ties rather than issue-area functional gains determine who joins"
and shows "how geopolitical alignment shapes the demand and supply sides of membership".[88]
The "findings challenge the view that states first liberalize trade to join the GATT/WTO. Instead,
democracy and foreign policy similarity encourage states to join."

Accession process

WTO accession progress:[89]

Draft Working Party Report or Factual Summary adopted
Goods or Services offers submitted
Working party meetings
Memorandum on Foreign Trade Regime submitted
Working party established
A country wishing to accede to the WTO submits an application to the General Council, and has to
describe all aspects of its trade and economic policies that have a bearing on WTO agreements. The
application is submitted to the WTO in a memorandum which is examined by a working party open
to all interested WTO Members.
After all necessary background information has been acquired, the working party focuses on issues
of discrepancy between the WTO rules and the applicant's international and domestic trade policies
and laws. The working party determines the terms and conditions of entry into the WTO for the
applicant nation, and may consider transitional periods to allow countries some leeway in
complying with the WTO rules.
The final phase of accession involves bilateral negotiations between the applicant nation and other
working party members regarding the concessions and commitments on tariff levels and market
access for goods and services. The new member's commitments are to apply equally to all WTO
members under normal non-discrimination rules, even though they are negotiated bilaterally.
For instance, as a result of joining the WTO, Armenia offered a 15 per cent ceiling bound tariff rate
on accessing its market for goods. Together with the tariff bindings being ad valorem there are no
specific or compound rates. Moreover, there are no tariff-rate quotas on both industrial and
agricultural products.
Armenia's economic and trade performance growth was noted since its first review in 2010,
especially its revival from the 2008 global financial crisis, with an average annual 4% GDP growth
rate, despite of some fluctuations. Armenia's economy was marked by low inflation, diminishing
poverty and essential progress in enhancing its macroeconomic steadiness in which trade in goods
and services, which is the equivalent of 87% of GDP, played a growing role.
When the bilateral talks conclude, the working party sends to the general council or ministerial
conference an accession package, which includes a summary of all the working party meetings, the
Protocol of Accession (a draft membership treaty), and lists ("schedules") of the member-to-be's
commitments. Once the general council or ministerial conference approves of the terms of
accession, the applicant's parliament must ratify the Protocol of Accession before it can become a
member. Some countries may have faced tougher and a much longer accession process due to
challenges during negotiations with other WTO members, such as Vietnam, whose negotiations
took more than 11 years before it became official member in January 2007.

Members and observers

The WTO has 164 members and 23 observer governments. Liberia became the 163rd member on 14
July 2016, and Afghanistan became the 164th member on 29 July 2016. In addition to states, the
European Union, and each EU country in its own right, is a member. WTO members do not have to
be fully independent states; they need only be a customs territory with full autonomy in the conduct
of their external commercial relations.
Thus Hong Kong has been a member since 1995 (as "Hong Kong, China" since 1997) predating the
People's Republic of China, which joined in 2001 after 15 years of negotiations. The Republic of
China (Taiwan) acceded to the WTO in 2002 as "Separate Customs Territory of Taiwan, Penghu,
Kinmen and Matsu" (Chinese Taipei) despite its disputed status.
The WTO Secretariat omits the official titles (such as Counsellor, First Secretary, Second Secretary
and Third Secretary) of the members of Chinese Taipei's Permanent Mission to the WTO, except for
the titles of the Permanent Representative and the Deputy Permanent Representative.
As of 2007, WTO member states represented 96.4% of global trade and 96.7% of global GDP. Iran,
followed by Algeria, are the economies with the largest GDP and trade outside the WTO, using
2005 data. With the exception of the Holy See, observers must start accession negotiations within
five years of becoming observers. A number of international intergovernmental organizations have
also been granted observer status to WTO bodies. 12 UN member states have no official affiliation
with the WTO[citation needed].

Agreements
The WTO oversees about 60 different agreements which have the status of international legal texts.
Member countries must sign and ratify all WTO agreements on accession. A discussion of some of
the most important agreements follows.
The Agreement on Agriculture came into effect with the establishment of the WTO at the beginning
of 1995. The AoA has three central concepts, or "pillars": domestic support, market access and
export subsidies.
The General Agreement on Trade in Services was created to extend the multilateral trading system
to service sector, in the same way as the General Agreement on Tariffs and Trade (GATT) provided
such a system for merchandise trade. The agreement entered into force in January 1995.
The Agreement on Trade-Related Aspects of Intellectual Property Rights sets down minimum
standards for many forms of intellectual property (IP) regulation. It was negotiated at the end of the
Uruguay Round of the General Agreement on Tariffs and Trade (GATT) in 1994.
The Agreement on the Application of Sanitary and Phytosanitary Measures—also known as the SPS
Agreement—was negotiated during the Uruguay Round of GATT, and entered into force with the
establishment of the WTO at the beginning of 1995. Under the SPS agreement, the WTO sets
constraints on members' policies relating to food safety (bacterial contaminants, pesticides,
inspection and labelling) as well as animal and plant health (imported pests and diseases).
The Agreement on Technical Barriers to Trade is an international treaty of the World Trade
Organization. It was negotiated during the Uruguay Round of the General Agreement on Tariffs and
Trade, and entered into force with the establishment of the WTO at the end of 1994. The object
ensures that technical negotiations and standards, as well as testing and certification procedures, do
not create unnecessary obstacles to trade".
The Agreement on Customs Valuation, formally known as the Agreement on Implementation of
Article VII of GATT, prescribes methods of customs valuation that Members are to follow. Chiefly,
it adopts the "transaction value" approach.
In December 2013, the biggest agreement within the WTO was signed and known as the Bali
Package.
Impact
Studies show that the WTO boosted trade. Research shows that in the absence of the WTO, the
average country would face an increase in tariffs on their exports by 32 percentage points.
According to a 2017 study in the Journal of International Economic Law, "nearly all recent
[preferential trade agreements (PTAs) reference the WTO explicitly, often dozens of times across
multiple chapters. Likewise, in many of these same PTAs we find that substantial portions of treaty
language—sometime the majority of a chapter—is copied verbatim from a WTO agreement... the
presence of the WTO in PTAs has increased over time."

Criticism

Criticism of the World Trade Organization

Martin Khor argues that the WTO does not manage the global economy impartially, but in its operation has
a systematic bias toward rich countries and multinational corporations, harming smaller countries which
have less negotiation power. Some suggested examples of this bias are:

 Rich countries are able to maintain high import duties and quotas in certain products, blocking
imports from developing countries (e.g., clothing);
 According to statements made at United Nations Conference on Trade and Development (UNCTAD,
2005), the use of NTBs (non-tariff barriers), based on the amount and control of price levels has
decreased significantly from 45% in 1994 to 15% in 2004, while use of other NTBs increased from
55% in 1994 to 85% in 2004, such as anti-dumping measures allowed against developing countries;
 The maintenance of high protection of agriculture in developed countries, while developing ones
are pressed to open their markets;
 Many developing countries do not have the capacity to follow the negotiations and participate
actively in the Doha Round; and
 The Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPs) agreement, which
limits developing countries from utilizing some technology that originates from abroad in their local
systems (including medicines and agricultural products).
 Khor argues that developing countries have not benefited from the WTO Agreements of the
Uruguay
 Round and, therefore, the credibility of the WTO trade system could be eroded. According to Khor,
"one
 of the major categories of 'problems of implementation of the Uruguay Round' is the way the
Northern countries have not lived up to the spirit of their commitments in implementing (or not
implementing) their obligations agreed to in the various Agreements."
 Khor also believes that the Doha Round negotiations "have veered from their proclaimed direction
oriented to a development-friendly outcome, towards a 'market access' direction in which
developing countries are pressurized to open up their agricultural, industrial and services sectors.
 Jagdish Bhagwati asserts, however, that there is greater tariff protection on manufacturers in the
poor countries, which are also overtaking the rich nations in the number of anti-dumping filings
 UNIVERSITY EXAMINATION 2018/2019

SCHOOL OF BUSINESS AND ECONOMICS

DEPARTMENT OF ECONOMICS

BECF/BECS/BCOM/BBM

UNIT CODE: BED 4236 UNIT TITLE: REGIONAL INTEGRATION

ECONOMICS

DATE: AUGUST 2019 REGULAR TIME: 2 HOURS

INSTRUCTIONS: ANSWER QUESTION ONE AND ANY OTHER TWO QUESTIONS

Question One
a) Explain the basic principle of GATT (4marks)
b) Give reasons why countries integrate (6marks)
c) What are the national differences that cause international trade to occur? (6 Marks)
d) Explain three concepts related to competitiveness (6marks)
e) State the four phases of innovation process.(8Marks)

Question two

a). Give the condition for a welfare improving nation.(8Marks)

b) What are the factors that drive the process of technological change (12marks)
Question Three
a) Explain the major types of integration (8marks)

b) Economic integration is popularly criticized on the grounds that it reduces a country;s

national sovereignty. Discuss (12marks)

Question Four
 a) Explain the static model in the theory of custom union (8marks)
.b). Give reasons with relevant examples why innovation is so concentrated in Europe and not in
Africa (12marks)

Question Five

a) Explain the effect of Taxation and Fiscal policy in shaping the basic economic variables
(10Marks)
b) Give the obstacles of migration of labour both in receiving countries and in countries of
origin (10 marks)
 UNIVERSITY EXAMINATION 2018/2019

SCHOOL OF BUSINESS AND ECONOMICS

DEPARTMENT OF ECONOMICS

BECF/BECS/BCOM/BBM

UNIT CODE: BED 4236 UNIT TITLE: REGIONAL INTEGRATION

ECONOMICS

DATE: AUGUST 2019 REGULAR TIME: 2 HOURS

INSTRUCTIONS: ANSWER QUESTION ONE AND ANY OTHER TWO QUESTIONS

Question One
f) State the obstacles of integration (4marks)
g) Give advantages a local firm has over a foreign firm in operating business (6marks)
h) explained the difference between trade creation and trade diversion due to customs union.
(6 Marks)
i) Give the weaknesses of globalization process. (6marks)
j) Explain the four main types of trans-border business activities that are conducted by
TNCs (8Marks)

Question two

a). Give the requirement of monetary and economic union. (8Marks)

b) Explain the causes of regional disequilibrium across the member countries (12marks)
Question Three
c) Demonstrate how trade diversion can lead to a loss in welfare after the formation of
customs union (8marks)
 d) Discuss the cost and benefit of a monetary union for a member country (12marks)

Question Four
b) Explain the main effects after the formation of customs union (8marks)
.b). Give reasons with relevant examples why innovation is so concentrated in Europe and not in
Africa (12marks)

Question Five

c) With the help of an illustration, Discuss the static effects of a customs union in a partial
equilibrium system
(10Marks)
d) Discuss the instruments of regional policy (10 marks)