KTEE 308

International Economics

Lectures 5:
Trade Integration

1
International Trade Liberalization:
Regional Approach
 EU, EFTA, NAFTA, Mercosur, ASEAN etc.
 free trade among small number of nations;
while maintaining some barriers with rest of
the world
 these are called preferential trading
arrangements
Next some definitions:
Preferential Trading Agreement
 Two or more countries when they reduce
their respective duties on imports of all
goods (except services and capital) from
each other, retaining their original tariffs
against the outside world
 A good historical example is Great Britain
and its former colonies -- Commonwealth
Preference System
 Free-trade area (FTA)

 Two or more countries when they abolish

all import duties and quantitative
restrictions in their mutual trade in all goods
(except services and capital); retaining
their original tariffs against rest of the
world
 Examples of free-trade areas:

the European Free Trade Area (EFTA),
1960

Free Trade Agreement between USA and
Canada, 1988

North American Free-Trade Agreement
(NAFTA), 1994

Association of Southeast Asian Nations
(ASEAN): AFTA (1992)
Customs union:
 Two or more countries when they abolish
all import duties on their mutual trade in all
goods (except services and capital) and, in
addition, adopt a common external tariff
schedule on all imports of goods (except
capital) from rest of the world
 A historical example: in 1834 a large
number of sovereign German states
formed the "Zollverein”
 A more recent example is the European
Economic Community (EEC, 1957)
Common market:
 Two or more countries when they form a
customs union and, in addition, allow
free movement of all factors of
production (labor and capital) among
them
 An example is European Community
(EC), 1967
Economic union:
 Two or more countries when they form a
common market and, in addition, proceed
to unify their fiscal, monetary, and
socioeconomic policies
 Examples are "Benelux", 1960 (was first a
customs union starting in 1948) and
European Union (EU), 1999
 Will preferential arrangements
foster free trade?
 There is also some concern among economists
that regional trade agreements may make it
more difficult, rather than easier, to achieve
the ultimate objective of global free trade
 The regional approach to trade liberalization
could lead to the formation of large "trade
blocs" which trade freely among members
but choke off trade with the rest of the world
Will preferential arrangements foster
free trade? continued
 For this reason some economists have
argued that the multilateral approach
(MFN)1 to trade liberalization, represented
by the trade liberalization agreements in
successive WTO rounds, is more likely to
achieve global free trade than the regional
or preferential approach
1 Most Favored Nations
Will preferential arrangements foster
free trade! continued
 Preferential trade arrangements are often
supported because they represent a
movement in the direction of free trade
 If free trade is economically the most
efficient policy, it would seem to follow that
any movement towards free trade should
be beneficial in terms of economic efficiency
 It turns out that this conclusion is wrong
Will preferential arrangements
foster free trade! continued
 Even if free trade is most efficient, it is not
true that a step in that direction
necessarily raises economic efficiency
 Whether a preferential trade arrangement
raises a country's welfare and economic
efficiency depends on the extent to which
the arrangement causes trade diversion
versus trade creation
 Trade Creation and Trade Diversion:
Regional Integration and Welfare

 The overall welfare effects of economic

integration are ambiguous and require case-
by-case judgment
 Reason: integration is both a policy of
protection and a move toward free trade
 The effect of the protectionist element of
integration is called trade diversion
and
 the effect of the trade liberalization
element is called trade creation
 The free-trade area's overall effect on
welfare is determined by comparing the
trade-creation and trade-diversion effects
 If trade creation dominates, the formation
of a free-trade area will enhance welfare...

Sdom
Figure 1 PX

PD
SM + t
G C
P0 SNM + t
a c b d H
P1 SM
J e
SNM
Ddom

Q3 Q1 Q0 Q2 QX
 Figure 1: Welfare Effects of Economic Integration:
Formation of a Free-Trade Area in Good X. SM
denotes the supply of good X by member countries
and SNM the supply by non-member countries
 Formation of a free-trade area causes a move from
point C to point H in consumption. Trade increases
as imports rise from Q0 - Q1 to Q2 - Q3, causing a
welfare gain c + d
 Trade also is diverted from non-member countries
toward member countries, causing an efficiency loss
represented by the area of rectangle e
 The net gain for the domestic country
depends which is larger (c + d) or e!

Note that if member countries are the low-cost
producers of the traded good, there will be no
trade diversion effect and integration will
unambiguously increase welfare

Note also that if tariff is low enough to make
the tariff-inclusive price of nonmember imports
lower than the price of member imports, the
free-trade area will have no trade-creating or
trade-diverting effects since no trade with
member countries will occur
Why would a country
create a FTA with a
country A if it could
improve its welfare
more by forming one
with country B?
Why would a country create a
FTA...
1. To answer that we need to go beyond
calculation of static gains and losses (i.e.
trade creation and trade diversion) to dynamic
gains:

there may be economies of scale in production in
various goods
• so market size expands for the manufacturers in these
two countries…

why not include country B as well?
• maybe the economies of scale have already been fully
exploited...
Why would a country create a FTA …
continued
2. Preferential trading arrangements are some
times formed for political (noneconomic)
reasons

maybe, for instance, EU was formed
because the European political leaders
wanted to integrate their economies so
completely that temptations to go on war
would be diminished substantially
 How efficient is EU in terms of trade
creation?

 Economists obtain estimates of the overall

impact of integration by calculating the effects
corresponding to areas a, b, c, d, and e (in our
figure) for each major good traded
 In the case of EU, most analysts agree that
trade creation outweighs trade diversion;
estimates suggest the EU's trade-creating
effect has been about four times that of its
trade-diverting impact
A step back- Background on
economic integration
 First golden age of internationalization
(1870-1914) replaced by protectionism
during interwar period (1920-1939)

- Did isolationism contribute to WW2?
 Need to establish more open
international environment after WW2

- Avoid mistakes from interwar period

- International trade needed for recovery after
the World War: Marshall plan not sufficient
Bretton-Woods solutions
 Four cornerstones of international
economy

– International Bank for Reconstruction
and Development

– International Monetary Fund

– International Trade Organization

– Price stabilization fund
General Agreement on Tariffs
and Trade
 GATT signed by 23 countries in 1947
 ITO established in Havana 1948.
Agreement signed by 53 members
 US Congress did not ratify ITO Charter.
ITO collapsed 1950
 GATT negotiations continued
 Predecessor of the WTO (since 1.1.1995)
 WTO
 The only international body dealing with
the rules of trade between nations
 The agreements have three main
objectives:

to help trade flow as freely as possible

to achieve further liberalization gradually
through negotiations

to set up an impartial system of settling
disputes
see for more http://www.wto.org
IMF and World Bank
 Many developing countries have
undertaken unilateral trade liberalization
after pressure from IMF / World Bank
 Credits for structural adjustment and
poverty reduction often conditional on
trade reform
THE WORLD BANK
 Founded in 1944 by 44 countries (now
184 member countries) to finance the
reconstruction of the war-ravaged
economies of Western Europe
 After Western Europe recovered and
achieved economic self-sufficiency, the
bank turned its attention to assisting
developing countries
“The World Bank Group’s mission is to
fight poverty and improve the living
standards of people in the developing
world. It is a development Bank which
provides loans, policy advice, technical
assistance and knowledge sharing
services to low and middle income
countries to reduce poverty.”
 See also: http://www.worldbank.org
THE INTERNATIONAL
MONETARY FUND (IMF)
 Was established in Bretton Woods, USA,
in 1944 and started operating in 1946
 “The IMF is an organization of 184
countries, working to foster global
monetary cooperation, secure financial
stability, facilitate international trade,
promote high employment and
sustainable economic growth, and
reduce poverty.”
 IMF also lends money to members
having trouble meeting their financial
obligations to other members, but only
on condition that they undertake
economic reforms to eliminate these
difficulties

 For more: http://www.imf.org/

 The IMF aims to promote international
monetary cooperation, to facilitate
expansion and balanced growth of trade,
to promote exchange rate stability, and
to decrease the intensity and duration of
balance of payments problems
 See also: http://www.imf.org
UNCTAD
 United Nations Conference on Trade
and Development, UNCTAD, set up in
Geneva 1964 to promote views of
developing countries
 No executive power, only
recommendations to United Nations
General Assembly
 Plenary sessions every 3-4 years
Results of UNCTAD operations
 1968 – Generalized System of Preferences –
preferential tariffs for developing countries
 1974 – New International Economic Order
 – reform of international monetary system
 – cancellation of developing country debt
 – code of conduct for technology transfer
 – regulation of MNC activities
 – Commodity arrangements and Common Fund
 Little impact on policy making since 1970s
 – except possibly regional integration among
developing countries
UN regional economic
commissions
 Economic Commission for Europe, ECE 1947
 Economic and Social Commission for Asia
and the Pacific, ESCAP 1947 (1974)
 Economic Commission for Latin America and
the Caribbean, ECLAC 1948 (1983)
 Economic Commission for Africa, ECA 1958
 Economic Commission for Western Asia,
ECWA 1973
 Objectives of regional economic
commissions
 Promotion of intra-regional trade

– ECE: support to East-West trade, development
of joint industrial standards\

– ECLAC: push to establish Latin American Free
Trade Association (LAFTA) and Central American
Common Market (CACM)
 Support for development planning and
training of government officials
 Information about economic trends in region
 Organization for Economic
Cooperation and Development
 OECD, Established by 20 countries in 1960
 Successor to Organization for European
Economic Cooperation (1948), which managed
post-war liberalization of trade in Europe
 Now 30 full members from the “developed”,
industrialized countries
• sharing the principles of the market economy,
pluralist democracy and respect for human rights
OECD
 forum for consultations on trade policy
issues
 increasing concern for competitiveness,
technology, and innovation policy
 coordination of development assistance
policy (Development Assistance
Committee, DAC)
 Commodity trade
 Organization of Petroleum Exporting
Countries, OPEC 1960

– 11 member countries: Algeria, Indonesia, Iran,
Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia,
the United Arab Emirates and Venezuela.

– initial objective to stabilize international oil
prices, subsequent attempts to raise price of oil
 Other commodity agreements not as
prominent