Economic Integration

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Economic Integration

• Applied International Trade Analysis
• Lecture 7

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Forms of economic integration
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Potential effects of economic integration

• higher efficiency in production due to a
  specialization in accordance with comparative
  advantages
• increases in production due to the exploitation
  (internal and external) scale economies driven by
  a larger common market
• better international negotiating position due to
  the combined economic/political importance of a
  Union, this can improve terms of trade of the
  affected country
• increases in productive efficiency due to
  increased competition and
• effect on the quality and quantity of products
  and factors of production as a consequence of
  technical improvements.

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• As economic integrations evolve from customs
  union to an economic union other economic
  benefits are possible
• mobility of production factors among member
  countries
• coordination of monetary and fiscal policies and
• the goals of full employment, higher rates of
  economic growth and a more even distribution of
  income become unified and common goals.

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Integrations are more likely to succeed if

• The degree of competitiveness among member
  countries is greater, i.e. the greater the number
  of similar goods they produce. In such a case, in
  fact, due to differences in productive
  efficiency, each country will expand its
  comparatively more efficient industries and
  contract the comparatively less efficient ones
  thus there will be more scope for trade creation
  without much trade diversion from other
  countries
• The higher are the initial tariffs between the
  countries forming the customs union in fact, the
  gain deriving from the elimination of these
  tariffs will be larger
• The lower the tariffs with the outside world
  trade diversion, in fact, will be less likely
• The wider is the union, as this increases the
  probability that trade creation effects will
  override trade diversion effects (in the extreme
  case, if the union includes the entire world, we
  have free trade and no trade diversion can
  occur).

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• Trade creation - refers to the fact, as a
  consequence of the elimination of tariffs within
  the union, a commodity-which before the union was
  produced by each partner country but not traded
  because of tariffs-is now traded and so is
  produced by that partner country which is most
  efficient in its production.
• Trade diversion occurs when the elimination of
  tariffs within the union induces a partner
  country to import a commodity from another
  partner country instead of from a country outside
  the union, as it did before. Because although the
  latter is the most efficient in producing, it is
  no longer competitive on account of the tariff,
  which has been maintained against it.

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Effects of a customs union
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• The union will be formed between countries 1 and
  2, while country 3 will remain outside

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ECONOMIC EFFECTS OF CUSTOMS UNIONS
price
price
quantity
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• gains are represented by an increase in
  consumer's surplus by CDFG
• costs are represented by a fall in producer
  surplus (CDEJ) due to a fall in domestic
  production and a decrease in tariff (fiscal)
  revenue (IEFH) due to a voluntary redirection of
  trade towards the partner country
• additional loss of tariff revenue LIHM
• the net gains are equal to the difference between
  gains JEIHFG (trade creation) and costs LIHM
  (trade diversion)
• net gains from tariff unions depend on the
  difference between world and domestic prices
  before integration and on the elasticity of
  demand and supply curves

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Cooper-Massells critique of customs unions
price
quantity
quantity
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A more optimal way of forming a customs union

• First step
• home country should non-discriminately lower its
  tariff rates to AC (level of prices in its
  trading partner)
• Second step
• establishing a customs union the starting point
  is OC
• no trade diversion occurs home country imports
  from the world q2q3
• increase in imports (q1q2 q3q4) the country can
  potentially gain tariff revenue JILK MHGN
• net gains equal the sum of gains JEIHFG and
  potential new tariff revenue JILK MHGN (trade
  creation)

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The general equilibrium theory of customs union

• three countries (home country H, partner
  country B and outside country A) and two goods
  (X,Y). The home country imposes a tariff on her
  imports from both A and B.
• assume Ricardian technology with constant cost.
  The home country is completely specialized in
  production of good X (country H therefore
  produces at point S).

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• SEGB gives the fixed terms of trade between the
  home country and country B (lower cost source of
  good Y). The slope of SFA gives the relative
  price of good Y in country A. If an import tariff
  is imposed on both countries, it is clear that
  country B will be the source of imports.
• The home country consumes at E when p is the
  tariff-inclusive domestic price of imports and UT
  is the utility they enjoy.
• Once the customs union between the home country
  and country A is established this ensures that
  the home country imports only from A as the
  imports from A enter freely into H.

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• The relatives slopes of SpEp and SFA show that
  imports from the CU partner are now relatively
  cheaper. The home countrys new equilibrium is
  given by F. As a consequence of this trade
  diversion country H is worse of and moves down to
  Uc level of welfare.
• This does not have to be true though, as the
  relative price p can pass through the striped
  area and can give the country higher welfare.
  This occurs although some trade has been diverted
  away from the optimal source. Although there is a
  primary terms-of-trade loss, there is also a
  secondary consumption gain from the lower
  tariff-free price. This gain can compensate for
  the loss.

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Kemp-Wan (1976) theorem

• Kemp and Wan stated that a formation of a customs
  union always leads to a welfare increase
• If the pre-union levels of trade are kept
  unchanged, then the welfare on non-members is not
  affected
• Union members eliminate all tariffs between them
  and employ lump-sum transfers to countries that
  have experienced losses
• Using the obtained equilibrium and the
  so-established prices in the union and the
  pre-union price vector, the external tariff
  schedule can be established
• Such a tariff schedule would not cause trade
  diversion.

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EMPIRICAL RESULTS

• As seen the economic desirability of a currency
  union depends on the extent of trade diversion.
  Measurement of the latter is therefore an
  important empirical question.
• Measuring the welfare effects of a CU is easily
  done for a single commodity. As shown, the area
  of pure trade diversion is given by the area LIHM
  and this can be estimated as
• LIMH (pC pA)(q3 q2)
• The positive effects, on the other hand, can be
  described by the areas of trade creation JEI
  HFG
• JEI

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• HFG
• where pD pA (1t), e is the price elasticity of
  supply and ? is the price elasticity of demand.
  Adding the three equations yields
• Net effect

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• Viaene (1982) estimated the following equation
  for Spains bilateral import flow from 7 EC
  countries and the rest of the world (ROW)
• Spain's real aggregate imports from country l
  at time t
• Spain's real aggregate imports from country i
  (i?l)
• AVt Spain's real gross value added in
  agriculture and industry (measure of aggregate
  activity)
• CUt rate of capacity utilization of the Spanish
  economy (preasure of demand variable)
• plt region l's export price (including tariffs)
  relative to Spain's domestic price
• ult disturbance term

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• The parameter a measures the dependency of
  Spain's bilateral import flow from country l with
  the sum of all bilateral import flows, ?mi . If
  the effect of a change of (?mi) on mi is positive
  a gt 0, the flows are complementary and if
  negative (a lt 0) the flows are substitutes.

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Table 1 Substitution and complementarity of
Spain's bilateral import flows, 1961-77
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The terms of trade argument(Bowen et al., 1998,
pp.511)

• Home (H), partner (P) and rest of the world (W)
  economies
• Two goods

p
MC
Xw
d
c
pcu
a
pw
ptw
b
mcu
m
mf
mt
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• In isolation either of the two countries (H and
  P) are considered to small to impact world prices
• Because the combined CU has an impact on the
  world price, world supply line is increasing.
  This renders the marginal costs of imports for
  the CU larger than pw.
• Cost of imports xwp(xw)
• Marginal cost of imports p(xw)xwdp(xw)/dxw
• MC p(xw)11/e
• If the CU imported one less unit of imports it
  would save both on the price of the marginal unit
  (pw) as well as all the inframarginal units.

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• Optimally, the CU would have to restrict its
  demand for imports, reducing the equilibrium
  relative price of imports until point c where the
  internal price in the union equals the marginal
  cost.
• One way of doing so would be to impose an ad
  valorem tariff t. The internal price of the union
  is then pcupw(1 t).
• Setting pcuMC yields the optimal tariff
  (11/e).