CH 10

CHAPTER T E N
10 International Economics
Tenth Edition
Economic Integration: Customs

Unions and Free Trade Areas
Dominick Salvatore
John Wiley & Sons, Inc.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
Learning Goals:
 Understand the meaning of trade creation,
trade diversion, and the dynamic benefits of
economic integration
 Describe the importance and effects of the
European Union (EU) and NAFTA.
 Describe attempts at economic integration
among developing countries and countries in
Central and South America and in Eastern
Europe.
Introduction
 Economic integration refers to the commercial

policy of discriminatively reducing or
eliminating barriers only among the nations
joining together.
Introduction
 Preferential trade arrangements

 Provide lower barriers to trade among
participating nations than on trade with non-
member nations.
 The loosest form of economic integration.
 Example: British Commonwealth Preference
Scheme, established in 1932 between the United
Kingdom and members of the British Empire.
Introduction
 Free trade areas

 Removes all barriers to trade among members,
but each nation retains its own barriers to
trade with non-members.
 Examples:
 European Free Trade Association (EFTA), 1960,
between United Kingdom, Austria, Denmark,
Norway, Portugal, Sweden and Switzerland
 North American Free Trade Agreement (NAFTA),
1993, between the United States, Canada and
Mexico
Introduction
 Customs union
 Removes all barriers to trade among members
and harmonizes trade policies toward the rest
of the world.
 Examples:
 European Union (EU), or European Common
Market, 1957, between West Germany, France,
Italy, Belgium, the Netherlands, and
Luxembourg.
 Zollverein, 1834, between large number of
sovereign German states
Introduction
 Common market
harmonizes trade policies toward the rest of
the world, and allows free movement of labor
and capital among member nations.
 Example:
 European Union (EU) achieved common market
status in 1993.
Introduction
 Economic union
harmonizes trade policies towards the rest of
the world, allows free movement of labor and
capital among member nations, and unifies
monetary and fiscal policies of members.
 Most advanced type of economic integration.
 Examples:
 Benelux, formed after World War II between
Belgium, the Netherlands and Luxembourg
Introduction
 Duty free zones (free economic zones)

 Areas established to attract foreign
investments by allowing raw materials and
intermediate products duty free.
Trade-Creating Customs Unions
 Trade creation occurs when domestic

production in a member nation is replaced by
lower-cost imports from another member
nation.
 Leads to increased welfare for members as nations
specialize in comparative advantages.
 Leads to increased welfare for non-members as
increased real income spills over into
increased imports from rest of the world.
FIGURE 10-1 A Trade-Creating Customs Union.
Trade-Diverting Customs Unions
 Trade diversion occurs when lower-cost

imports from non-members are replaced by
higher cost imports from members.
 By itself, trade diversion lowers welfare as it
shifts resources away from comparative
advantages.
 Trade diverting customs union also results in
trade creation. Change in welfare depends on
relative magnitude of creation and diversion.
FIGURE 10-2 A Trade-Diverting Customs Union.
The Theory of the Second Best and Other
Static Welfare Effects of Customs Unions
 It was once believed that any movement toward

freer trade would increase welfare, so formation
of a customs union would necessarily result in
increased welfare for members and non-
members.
 In 1950, Viner showed that formation of a
customs union could increase or reduce welfare,
depending on the circumstances under which it
takes place.
 Theory of the Second Best

If all conditions required to maximize welfare
cannot be satisfied, trying to satisfy as many
conditions as possible does not necessarily or
usually lead to the second-best position.
 Conditions More Likely to Lead to Increased

Welfare
1. Higher pre-union trade barriers of member
nations.
2. Lower customs union’s trade barriers with
non-members.
3. Greater number of nations forming customs
union, and the larger their size.
 Conditions More Likely to Lead to Increased

Welfare
4. More competitive rather than complementary
economies of member nations.
5. Closer geographical proximity of member
nations.
6. Greater pre-union trade and economic
relationship among potential member nations.
 Other Static Effects of Customs Unions

1. Administration savings from elimination of
customs officers, border patrols, and others.
2. Reduction in demand for imports from and
supply of exports to rest of the world will
likely lead to improvement in collective terms
of trade of member nations.
3. By acting as a single unit, customs union will
likely have more bargaining power than
members separately.
Dynamic Benefits from Customs Unions
 Dynamic Benefits of Customs Unions

1. Increased competition, leading to greater
efficiencies and technological improvements.
2. Economies of scale from the enlarged market.
3. Stimulus of investment to take advantage of
enlarged market, and to meet increased
competition.
4. Better utilization of community resources as labor
and capital move freely (assumes common
market).
History of Attempts at Economic Integration
 The European Union (EU)

 1958 – established common external tariff
 1968 – Achieved free trade in industrial goods
within EU, and common price for agricultural
goods
 1970 – Reduced restrictions on movement of
labor and capital
 1993 – Removed all remaining restrictions on
flow of goods, services and resources, becoming
largest trade bloc in the world
 The European Free Trade Association (EFTA)

 1960 – formed by “outer seven” nations: United
Kingdom, Austria, Denmark, Norway, Portugal,
Sweden and Switzerland
 1967 – Achieved free trade in industrial goods
 1991 – Membership evolved to include Austria,
Finland, Iceland, Liechtenstein, Norway, Sweden,
and Switzerland
 1994 – Joined EU to form European Economic
Area (EEA)
 The North American Free Trade Agreement

(NAFTA)
 1994 – formed by United States, Canada and
Mexico, to eventually lead to free trade in
goods and services over entire North
American area.
 Also phased out many other barriers to trade and
reduced barriers to cross-border investments
among the three member nations.
Attempts at Economic Integration in
Developing Countries
 The Central American Common Market

(CACM)
 Costa Rica, El Salvador, Guatemala,
Honduras, and Nicaragua
 Established in 1960, dissolved in 1969, and
reestablished in 1990
 The Latin American Free Trade Association

(LAFTA)
 Established in 1960 by Mexico and most South
American countries.
 Superceded by the Latin American Integration
Association (LAIA) in 1980.
 The Southern Common Market (Mercosur)

 Argentina, Paraguay, Brazil, and Uruguay in
1991.
 Associate members Bolivia and Chile (1996),
Peru (2003), Columbia, Ecuador, and
Venezuela (2004).
 Venezuela is scheduled to become a full
member in 2012.
 The Free Trade Area of the Americas (FTAA)

 1998
 Goal of establishing free trade among the 34
democratic nations of North and South
America
 Caribbean Free Trade Association

(CARIFTA)
 Formed in 1968, became a common market in
1973 (CARICOM)
 Antigua and Barbuda, Bahamas, Barbados,
Belize, Dominica, Grenada, Guyana, Haiti,
Jamaica, Montserrat, St. Kitts-Nevis, St. Lucia,
St. Vincent, and the Grenadines, Suriname,
Trinidad and Tobago
 Southern African Development Community

 Angola, Botswana, Democratic Republic of
Congo, Lesotho, Madagascar, Malawi,
Mauritius, Mozambique, Namibia, South
Africa, Swaziland, Tanzania, Zambia,
Zimbabwe
 Association of South East Asian Nations

(ASEAN)
 Brunei, Darussalam, Cambodia, Indonesia,
Laos, Malaysia, the Philippines, Singapore,
Thailand, Vietnam
 Primarily a political association, but began in
1977 to move toward a common market
 East African Community (EAC)

 1967, Kenya, Tanzania, and Uganda
 West African Economic and Monetary Union
(WAEMU)
 Benin, Burkina Faso, Cote d’Ivoire, Guinea
Bissau, Mali, Niger, Senegal, Togo
Economic Integration in Central and Eastern
Europe
 Council of Mutual Economic Assistance

(CMEA)
 During Soviet period
 Since dissolution of the Soviet Union, many
central European countries have moved
toward EU membership
 Many of the former Soviet states lag behind in
this process
Case Study 10-1 Economic Profile of the EU,
NAFTA, and Japan
Case Study 10-2 Gains from the Single EU Market
Case Study 10-3 Mexico’s Gains from NAFTA—
Expectations and Outcome
Case Study 10-4 Economic Profile of Mercosur
Case Study 10-5 Changes in Trade Patterns with
Economic Integration
Appendix to Chapter 10
 General Equilibrium Analysis of a Trade-

Diverting Customs Union
FIGURE 10-3 General Equilibrium Analysis of a Trade-Diverting
Customs Union.
Regional Trade Agreements around the world
in 2012
Regional Trade Agreements around the world
in 2012
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CHAPTER T E N

Economic Integration: Customs

 Economic integration refers to the commercial

 Preferential trade arrangements

 Free trade areas

 Duty free zones (free economic zones)

 Trade creation occurs when domestic

 Trade diversion occurs when lower-cost

 It was once believed that any movement toward

 Theory of the Second Best

 Conditions More Likely to Lead to Increased

 Conditions More Likely to Lead to Increased

 Other Static Effects of Customs Unions

 Dynamic Benefits of Customs Unions

 The European Union (EU)

 The European Free Trade Association (EFTA)

 The North American Free Trade Agreement

 The Central American Common Market

 The Latin American Free Trade Association

 The Southern Common Market (Mercosur)

 The Free Trade Area of the Americas (FTAA)

 Caribbean Free Trade Association

 Southern African Development Community

 Association of South East Asian Nations

 East African Community (EAC)

 Council of Mutual Economic Assistance

 General Equilibrium Analysis of a Trade-

 All rights reserved. Reproduction or translation of this work beyond

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