Various levels

1

• Various levels
• Free trade area (FTA) - NAFTA
• Customs union (cu) - 1 CET
• Common market - 4 freedoms
• Economic union - common policies
• Total integration

2
INTERNATIONAL ECONOMIC INTEGRATIONREFCU1A OCT
08

• Note You will have a copy of these slides with
  spaces for you to complete during the lecture

3
Customs Unions

• Trade creation / trade diversion
• Dynamic effects
• Terms of trade

4
Trade creation(TC) Trade diversion(TD)

• CU initially regarded as move to free trade
• Viner (1950) TC TD
• Numerical example

5
Numerical example

• Home Partner RoW
• Price/cost () 50 40 30
• Case1
• trade creation
• tariff 30
• Pre cu
• Post cu

6
Numerical example

• Home Partner RoW
• Price/cost () 50 40 30
• Case1
• trade creation
• tariff 30
• Pre cu 50 70 60
• Post cu

7
Numerical example

• Home Partner RoW
• Price/cost () 50 40 30
• Case1
• trade creation
• tariff 30
• Pre cu 50 70 60
• Post cu 50 40 60

8

• Home Partner RoW
• Price/cost () 50 40 30
• Case2
• trade diversion
• tariff 15
• Pre cu
• Post cu

9

• Home Partner RoW
• Price/cost () 50 40 30
• Case2
• trade diversion
• tariff 15
• Pre cu 50 55 45
• Post cu

10

• Home Partner RoW
• Price/cost () 50 40 30
• Case2
• trade diversion
• tariff 15
• Pre cu 50 55 45
• Post cu 50 40 45

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• Assumptions (partial equilibrium analysis)
• Partners (Sp) S/curve world S/curve (Sw)
  infinitely elastic. Sw (efficient) below Sp
• Domestic supply demand (SH DH)
• Consumers dont differentiate - origin of good
• Home partner small, CU small

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CU theory note model will differ if change
assumptions
Price
Sp
Sw
DH
SH
Q good X
13
CU theory
Price
Phome
Sptariff
P2
Swtariff
Sp
P1
Sw
DH
SH
Q good X
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Pre CU
Price
Area abcd ?
Phome
Sptariff
c
b
P2
Swtariff
Sp
P1
Sw
d
a
DH
SH
Q1
Q2
Q good X
15
Post CU
Price
Phome
Sptariff
c
b
P2
Swtariff
x
y
Sp
P3
P1
Sw
d
a
DH
SH
Q1
Q2
Q3
Q4
Q good X
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Post CU
Price

Phome
Sptariff
c
b
P2
Swtariff
x
y
W
Sp
P3
Z
P1
Sw
d
a
DH
SH
Q1
Q2
Q3
Q4
Q good X
ve specialisation effect
ve substitution effect
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• pre-cu post-cu
• PRICE P2 P3
• CONSUMPTION Q1 Q3
• PROD(home) Q2 Q4
• IMPORTS Q1-Q2 Q3-Q4

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• Net gain TC - TD
• x y - z
• production gain x
• consumer gain y
• cost of trade diversion z
• W ?

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Deductions

• Higher original tariff - greater potential
  benefits
• Smaller cost difference partner RoW - likely TD
  losses lower
• Greater price elasticity DH SH - TC likely
• Greater overlap of goods - bigger gains
• Bigger CU - TD less likely
• Low CET - TD less likely

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Higher original tariff (compared to earlier
diagram) - greater potential benefits
Price
TC gt TD in this example

Swtariff
P2
x
y
Sp
P3
Z
P1
Sw
DH
SH
Q3
Q4
Q1
Q2
Q good X
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Remember Previous diagram, showing TCltTD
Price

Phome
Sptariff
c
b
P2
Swtariff
x
y
W
Sp
P3
Z
P1
Sw
d
a
DH
SH
Q1
Q2
Q3
Q4
Q good X
ve specialisation effect
ve substitution effect
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Empirical evidence

• Net result cant be found from theory
• empirical evidence (Nielsen)
• Balassa - 3 studies 1953-1970
• TC gt TD
• Others agree
• Truman (1968), Kreinin (1970), Aitkin (1970)
• But welfare trade flows??

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• Measurement
• counterfactual analysis
• project trends
• control country
• trade flow models
• Second best theory

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Public goods argument for cu Cooper Massell
(1965) Johnson (1965)

• Industrialisation
• Bargaining strength
• Pragmatic argument for free trade
• Link with potential allies
• Skilled labour pool
• Reduce dependence on imports

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Dynamic effects

• Ignored in previous (static) analysis
• Dynamic effects likely to result in major
  benefits
• difficult to assess
• orthodox CU theory concentrates on static
  benefits
• can show welfare gains
• consider redistribution to compensate losers

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• Dynamic effects
• rise productivity
• technological advances
• concentration and market structures
• economies of scale
• economies of experience
• Above limited to dynamic sectors regional
  variations!!

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Terms of Trade (ToT) effect

• Important for a large CU
• Improvement in ToT increases welfare
• ToT - secondary objective
• Any ToT gain transferred from rest of world - not
  wealth creating effect

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Further developments

• Common market theory
• New trade theories
• based on industrial organisation theory
• Includes consideration of
• market structures
• competition effects
• More recent research considers this
• eg. Gasiorek, Smith, Venables, (JCMS 2002)
  consider the Uks entry into the EEC

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Conclusion

• CU theory only deals with the relatively small
  static effects of integration, but it is a
  starting point
• Empirical evidence from the formation of the EC6
  seems to generally support CU theory
• TCgtTD