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Global Economics Eco 6367 Dr. Vera Adamchik


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Title: Global Economics Eco 6367 Dr. Vera Adamchik

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

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

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

  • Types of
  • economic integration

Levels of economic integration
1. Free-trade area (FTA)
  • All members of a free trade area remove tariffs
    on each others products, while each member
    retains its independence in establishing trading
    policies with non-members.
  • Example the North American Free Trade Agreement

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

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

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

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

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

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

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

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

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

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

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

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

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

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

  • Trade blocs
  • The static and dynamic effects of economic

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

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

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

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

  • Static effects of
  • economic integration

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

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

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

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

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

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

Static Effects of Trade Arrangements
With Free Trade red triangle consumer
surplus green triangle producer surplus
Static Effects of Trade Arrangements
With Tariff (before customs union) red triangle
consumer surplus green triangle producer
surplus black rectangle tariff revenue 2
orange triangles deadweight loss (DWL)
Static Effects of Trade Arrangements
With Customs Union agreement with Germany will
lower the price to SG trade-creation effect
(welfare gain) a production effect b
consumption effect trade-diversion
effect (welfare loss) area c
  • Because both trade creation and trade diversion
    are clearly possible with economic integration,
    economic integration represents only a partial
    movement to free trade.
  • Whether or not it produces a net benefit to
    participating countries is an empirical issue.

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

  • Dynamic effects of
  • economic integration

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

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

  • Regional economic integration in Europe

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

  • Member states of the European Union in 2007

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

In-class exercise
  • Read Postwar Trade Integration in Europe (a

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

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

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

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

EU Agricultural Policy
  • No restrictions on agricultural products traded
  • A common agricultural policy replaced the
    agricultural stabilization policies of individual
    member states
  • The support of prices through a system of
    variable levies and export subsidies.

Variable levies
  • Variable levies to protect EU farmers from
    low-cost foreign competition
  • Falling world prices ? automatic increases in the
    EUs import tariff
  • Variable levies are more restrictive than a fixed

Export subsidies
  • EU producers sell abroad for low price but
    receive higher price
  • EU purchases any surplus. Surplus then sold on
    world market for lower price

Government Procurement Policies
  • Government procurement has been used to support
    national and regional firms for several reasons
  • (1) national security
  • (2) compensation for local communities near
    environmentally damaging public industries (such
    as nuclear fuels)
  • (3) support for emerging high-tech industries
  • (4) politics (as in assistance to highly visible

  • Government purchases previously limited primarily
    to domestic producers
  • 1992 EU required bidding process from EU firms.
  • (1) governments purchase from the cheapest
    foreign supplier (static effect)
  • (2) increased competition (dynamic effect)
  • (3) surviving firms produce with economies of
    scale (restructuring effect).

  • A liberalized procurement policy permits the UK
    gvt to buy computers from the cheapest EU
    supplier, Germany.

Evolution of the EU
  • The Maastricht Treaty (1991) established a
    monetary union and committed the member-countries
    to adopting a common currency (the Euro) by
    January 1, 1999.
  • Establishing of the euro required participating
    national governments not only to give up their
    own currencies but also to give up control over
    monetary policy.

Evolution of the EU
  • The Maastricht Treaty mandated the specific
    convergence criteria
  • Price stability inflation 1.5 above average
    inflation of three countries with lowest
  • Low long term interest rates 2.0 above
    average of same three countries
  • Stable exchange rate within target bands of
    monetary union for 2 years
  • Sound public finances budget deficit 3.0 of
    GDP government debt 60.0 of a years GDP

Evolution of the EU
  • A common currency also implied the need for a
    single European Central Bank (ECB) responsible
    for all monetary and exchange rate policies of
    the EMU.
  • The ECB is based in Frankfurt, Germany.
  • The ECB sets interest rates and determines
    monetary policy across the euro zone.
  • The ECB is meant to be independent from political
    pressure, although critics question this.

Evolution of the EU
  • The 13 countries (the euro zone) of the 27 member
    states adopted the euro by January 1, 1999.
  • Three long-term EU members the United Kingdom,
    Denmark and Sweden did not adopt the euro.
  • Euro notes and coins were not actually issued
    until January 1, 2002.

Evolution of the EU
  • One of the drawbacks of the euro is that the EU
    is not what economists would call an optimal
    currency area.
  • In the optimal currency area, similarities in the
    underlying structure of economic activity make it
    feasible to adopt a single currency and use a
    single exchange rate as an instrument of
    macroeconomic policy.

Evolution of the EU
  • Success of common currency area
  • similar business cycles
  • similar economic structures
  • single monetary policy affecting all members in
    same manner
  • absence of legal or cultural barriers that would
    limit labor mobility
  • wage flexibility
  • stabilizing transfer system

Evolution of the EU
  • Many of the European economies in the euro zone,
    however, are very dissimilar wages, tax regimes,
    business cycles, limited labor mobility tied to
    cultural factors, etc.
  • Under the circumstances, a common monetary policy
    may mean that interest rates are too high for
    depressed regions and too low for booming regions.

Political structure of the EU
  • There are five main institutions of the EU
  • The European Council
  • The Council of the EU (Council of Ministers)
  • The European Commission
  • The European Parliament
  • The Court of Justice of the EU
  • http//
  • http//
  • choose the institutions tab.

  • The European Council is a summit of the Heads of
    State or Government of the Member States of the
    European Union and the President of the
    Commission. The Council meets at least twice a
    year (in practice, four times a year special
  • It is not the legislature. The Council
    provides broad guidance and impetus to action
    general political direction for the EU,
    fundamental questions related to the constitution
    and construction of the EU, and decisions on the
    most contentious issues.
  • http//

  • 2. The Council of the EU (Council of Ministers)
    is the main policy-making body. This is the
    legislature of the Community and makes policy
    largely on the basis of proposals made by the
    European Commission, which is the executive. The
    council has many committees and working groups.
    Representatives are usually senior ministers of
    national government. The Presidency of the
    Council rotates every six months.
  • http//

  • The Council (in some cases in cooperation with
    the European Parliament) can make three main
    types of legislation
  • Regulations have direct effect and are binding
    throughout the EU.
  • Directives provide framework legislation which,
    though equally binding, is implemented by
    national legislation.
  • Decisions which are binding on the member state,
    organization, firm, or individual to whom they
    are addressed.
  • Finally there are recommendations and
    opinions which have no binding force.

  • 3. The European Commission is the executive body.
    It is responsible for implementing aspects of EU
    law and monitoring member states to ensure they
    are complying with EU laws. It has the primary
    right to initiate legislations it prepares
    proposals for decision by the Council.
  • http//

  • 4. The European Parliament is elected by voters
    in the member countries (with a specified number
    of seats allocated to each country). It is a
    political driving force, supervising and
    questioning the Council and Commission (debates
    legislation proposed by the Commission and
    forwarded to it by the Council). Joint power to
    adopt legislation with Council. Supervises
    appointment of the Commission.
  • http//

  • 5. The Court of Justice is the supreme appeals
    court for EU law. It interprets the constitution
    and settles disputes.
  • http//

  • Regional economic integration in the Americas

Trade blocs in the Americas
  • The North American Free Trade Agreement (NAFTA)
    took effect on January 1, 1994.
  • The U.S., Canada, and Mexico are the member
  • http//
  • NAFTA eliminates tariffs among the three member
    countries over a 15-year period and at the same
    time substantially reduces non-tariff barriers.

  • With respect to foreign investments, all barriers
    to the movement of capital were immediately
  • At the same time, customs officials must enforce
    rules of origin to guard against a firms ruse of
    doing minimal processing within the area and then
    claiming that the product is locally produced.
  • The NAFTA rules of origin are incredibly complex,
    covering over 200 pages with thousands of
    different rules for different products.

  • Recall the domestic content / rules of
    origin provision
  • Under the NAFTA, members do not permit duty-free
    entry of automobiles from other members unless
    62.5 of the value of the automobile originates
    in the NAFTA countries.
  • To receive NAFTA tariff preferences, apparel must
    be manufactured in North America from the
    yarn-spinning stage forward.
  • http//

The impact of NAFTA
  • Trying to estimate the effects of NAFTA almost
    became a new industry in itself.
  • Consulting firms, government economists, and
    academics produced a variety of studies comparing
    the NAFTA world with a non-NAFTA world.
  • The impact of NAFTA on the three participating
    economies has been hotly debated, and there have
    been widely varying estimates of the potential

The Andean Community
  • The Andean Pact was formed in 1969 by Bolivia,
    Chile, Colombia, Ecuador, and Peru.
  • The trade bloc more or less failed by the
    mid-1980s. It was was re-launched in 1990 by
    Bolivia, Colombia, Ecuador, Peru, and Venezuela,
    re-named the Andean Community of Nations in 1997
    and now operates as a customs union.

  • The goal of establishing a common market by 1995
    has not been reached.
  • In 2003, the Andean Community signed an agreement
    with MERCOSUR to restart negotiations on the
    creation of a FTA between the two trading blocs.
  • In 2006, Venezuela withdrew from the Andean
    Community as part of that countrys attempts to
    join MERCOSUR.

  • The Southern Cone Common Market (formed in 1991,
    Argentina, Brazil, Paraguay, and Uruguay) is a
    customs union.
  • Venezuela became a full member in 2006.
  • Bolivia, Chile, Colombia, Ecuador, and Peru
    (i.e., the Andean Community) have associate
    member status.
  • By 1995, the MERCOSUR countries established
    internal free trade and common external tariff
    (averaging 12) for most products.

  • One highly protected sector is automobiles, with
    an external tariff of about 34 (and an ERP of
    over 100).
  • Trade within MERCOSUR has increased most rapidly
    in protected capital-intensive products like
    automobiles, machinery, and electronic goods
    products that are not consistent with the member
    countries global comparative advantage.

  • It is likely that MERCOSUR is diverting trade
    rather than creating trade, and local firms are
    investing in industries that are not competitive
    on a worldwide basis.
  • MERCOSUR is a success in terms of survival, but
    its net effects on the well-being of its member
    countries are not yet clear.

  • The Central American Common Market was formed in
    the early 1960s by Costa Rica, El Salvador,
    Guatemala, Honduras, and Nicaragua.
  • It collapsed in 1969 (a war between El Salvador
    and Honduras).
  • It was revived in 2003 when the U.S. signaled its
    intention to enter into bilateral free trade
    negotiations with the group.

  • The U.S. Central America Free Trade Agreement
    Dominican Republic (CAFTA-DR), established in
    2004, is a historic agreement that creates the
    second-largest free-trade zone in Latin America
    between the six countries and the U.S.
  • http//
  • Upon entry into force, the CAFTA-DR agreement
    will eliminate 80 of the tariffs immediately,
    with the remaining tariffs phased out over 10

  • The Caribbean Community and Common Market
    (CARICOM) was established in 1973 by the
    English-speaking Caribbean countries.
  • It repeatedly failed to progress toward a customs
    union, leave alone economic and monetary union
    proclaimed in 1984.
  • Despite this, CARICOM expanded to 15 members by

  • In early 2006, six CARICOM members established
    the Caribbean Single Market and Economy (CSME).
  • The goal of CSME is to lower trade barriers and
    harmonize macroeconomic and monetary policy
    between member states.

  • In 1994-1998, work was initiated at the meetings
    of 34 of the Western hemispheres trade ministers
    (Cuba did not participate) to create a Free Trade
    Area for the Americas (FTAA).
  • The purpose of the meetings was to establish a
    hemispheric free-trade agreement by January 1,
    2005 something that did not occur.

  • Now support for the FTAA from the U.S. and Brazil
    (the largest economies in North and South
    America) is mixed.
  • Furthermore, rising political tensions between
    Venezuela and the U.S. have impeded progress
    toward the completion of FTAA.
  • http//
  • http//

  • Regional economic integration in Asia

ASEAN countries
  • The Association of Southeast Asian Nations
    (ASEAN) was formed in 1967 and wants to foster
    freer trade between member countries and to
    achieve some cooperation in their industrial
  • http//
  • An ASEAN Free Trade Area (AFTA) between the six
    original members of ASEAN came into effect in
  • http//

APEC members
  • The Asia-Pacific Economic Cooperation (APEC)
    forum was initiated in 1989 by Australia, with
    representatives from 12 countries.
  • The association now has 21 members, including the
    U.S., Japan, China, and Russia.
  • The goal is to achieve free trade and investment
    in the Asia-Pacific area by 2020.
  • http//

  • Regional economic
  • integration in Africa

  • Progress toward the establishment of meaningful
    trade blocs in Africa has been slow.
  • Many countries are members of more than one of
    the nine dormant blocs in the region.
  • Kenya, Uganda, and Tanzania committed to
    re-launching the East African Community (EAC) in
    2001, however so far, the effort appears futile.

  • Significant political turmoil in several African
    nations has persistently impeded any meaningful
  • Also, deep suspicion of free trade exists in
    several African countries. The argument most
    frequently heard is that because these countries
    have less developed and less diversified
    economies, they need to be protected by tariff
    barriers from unfair foreign competition. Given
    the prevalence of this argument, it has been hard
    to establish free trade areas or customs unions.

  • The various trade blocs in Africa have
    overlapping memberships with internal
    inconsistencies, conflicting regulations and
    rules, and different strategies and objectives
    which work to impede the expansion of domestic
    markets and discourage both domestic and foreign
  • These integration issues may also tend to
    intensify political problems and issues in the

In-class exercise
  • Discuss the trend toward regional economic
    integration in the world. Then focus on the role
    of regional trade initiatives in U.S. trade
    strategy. Go to the home page of the Office of
    the United States Trade Representative,
    http// , then click on Trade
    Agreements on the horizontal dark-blue menu bar.
    Review different regional trade agreements and
    initiatives and comment on one of them (that is,
    describe the member countries, goals, rules,
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