Bela Balassa and Ardy Stoutjesdijk Economic Integration

World Bank Reprint Series: Number Thirty

Bela Balassa and Ardy Stoutjesdijk

Economic IntegrationamongDeveloping Countries

Reprinted from the Journal of Common Market Studies 14(September 1975)

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The World Bank Catalog lists all publications of the World Bank and is avail-able without charge to individuals and institutions having a serious interestin economic and social development. Address requests for the Catalog to:Publications Office, The World Bank, Washington, D.C. 20433, U.S.A., or tothe World Bank European Office, 66, avenue d'1ena, 75116 Paris, France.

WORLD BANK BOOKS ABOUT DEVELOPMENT

Research Publications

Housing for the Urban Poor: Economics and Policy in the Developing World byOrville F. Grimes, Jr., published by The Johns Hopkins University Press, 1976

Electricity Economics: Essays and Case Studies by Ralph Turvey and DennisAnderson, published by The Johns Hopkins University Press, 1976

Village Water Supply: Economics and Policy in the Developing World by RobertSaunders and Jeremy Warford, published by The Johns Hopkins UniversityPress, 1976

Economic Analysis of Projects by Lyn Squire and Herman G. van der Tak,published by The Johns Hopkins University Press, 1975

The Design of Rural Development: Lessons from Africa by Uma Lele, publishedby The Johns Hopkins University Press, 1975

Economy-Wide Models and Development Planning edited by Charles R. Blitzer,Peter B. Clark, and Lance Taylor, published by Oxford University Press, 1975

Patterns of Development, 1950-1970 by Hollis Chenery and Moises Syrquin withHazel Elkington, published by Oxford University Press, 1975

A System of International Comparisons of Gross Product and Purchasing Powerby Irving B. Kravis, Zoltan Kenessey, Alan Heston, and Robert Summers,published by The Johns Hopkins University Press, 1 975

Attacking Rural Poverty: How Nonformal Education Can Help by Philip H.Coombs with Manzoor Ahmed, published by The Johns Hopkins UniversityPress, 1974

Country Economic Reports

Chad: Development Potential and Contraints by Richard Westebbe and others,distributed by The Johns Hopkins University Press, 1 974

Economic Growth of Colombia: Problems and Prospects by DragoslavAvramovic and others, published by The Johns Hopkins University Press, 1972

The Current Economic Position and Prospects of Ecuador by Roberto Echeverriaand others, distributed by The Johns Hopkins University Press, 1973

Kenya, Into the Second Decade by John Burrows and others, published by TheJohns Hopkins Unive,sil; Press, 1975

Korea: Problems and Issues in a Rapidly Growing Economy by Parvez Hasan,published by The Jol ns Hopkins University Press, 1976

Lesotho: A Development Challenge by Willem Maane, distributed by The JohnsHopkins University Press, 1975

(continued on inside back cover)

ECONOMIC INTEGRATIONAMONG DEVELOPING COUNTRIES*

BY BELA BALASSA AND ARDY STOUTJESDIJK

International Bank for Reconstruction and Development

IN THE early postwar period, economic integration among developingcountries was considered primarily as a way of extending the policyof import substitution on a regional scale. This approach is subjectto serious limitations since even regional markets will often notpermit the establishment of efficient-size firms, much less competi-tion among several such firms. Thus, regional integration orientedtowards import substitution may lead to the establishment of in-efficient plants and of an ineflcient industrial structure, therebypostponing the time-and increasing the difficulties-of a reorienta-tion of policies once the limits of import substitution have beenreached.

A different approach is taken in this paper. Economic integrationwill be considered as one of the policy options available to develop-ing countries and as part of their overall strategy for economicdevelopment. Broadly speaking, there are four possible policy optionsthat may be adopted singly or in combination: development in anational framework, regional economic integration, increased tradewith developing countries in other regions, and participation in theinternational division of labour.

I. ECONOMIIC INTEGRATION THROUGH THE LIBERALIZATION OF TRADE

Import Substitution in National MarketsIn the postwar period, a number of developing countries adopted apolicy of import substitution in the framework of national markets.This choice reflected the view prevalent at the time that exportation,whether of primary goods or manufactured products, does notrepresent a viable alternative. It was assumed that thie prospects forprimary exports were unfavourable because of the slow growth of

* This paper was prepared for the International Bank for Reconstruction andDevelopment. It should not, however, be deemed to represent the Bank's views.

37

38 JOURNAL OF COIMON MARKET STUDIES

demand on the part of developed nations, and that high importbarriers as well as the inability of the developing countries to pro-duce ccmpetitively foreclosed the possibilities for exporting manu-factured products.

Views expressed as regards prospects for exporting manufacturedproducts have proved to be overly pessimistic. Exports of manu-factures from developing countries rose four-fold during the I96os,with exports reaching $io billion in I970 as against the $4 billionpredicted by the United Nations and their rapid expansion con-tinued in the I970s. Also, while demand is rising at a slow rate fortropical beverages and fruits of which developing countries are theonly suppliers, the growth of import demand for most other primaryproducts exceeds that of consurmiption in developed nations whichface limitations of domestic supply. In fact, the slow exr,ansion ofthe exports of these commodities from developing countries hasoften been due to their own policies, resulting in a loss in theirworld market shares.

At the same time, the opportunities for economical import substi-tution in the national framework are limited by the size of domesticmarkets. The smaller the market, the more restricted are the possi-bilities of establishing industries which cater exclusively to domesticdemand and the higher are the costs of production. In the manu-facturing of intermediate products and durable goods in particular,efficient operations require large-scale production, with unit costsrising substantially at lower output levels. The size of the domesticmarket also limits the extent of product specialization in, individualfirms and restricts the possibilities for process specialization throughmanufacturing parts, components and accessories on an efficientscale. Furthermore, the sheltering of national markets reduces theextent of competition and lessens the incentive for technologicalimprovements.

An often-used measure of the size of national markets is the valueof the gross national product. Among the non-European developingcountries listed in the World Bank Atlas, 62 had a GNP of less than$I billion, 4o between $I and $5 billion, i5 between $5 and $Iobillion, three between $io and $25 billion in 197I. But, from thepoint of view of the exploitation of economies of scale and domesticcompetition, the market for manufactured goods is relevant. Nodeveloping country has a domestic inarket for manufact& goodsas large as that of the Netherlands, Sweden, or Belgium a.. iotg thesmaller developed countries, which have entered into integrationschemes in order to escape the linmitatioris imposed by their nationalmarkets.

ECONOMIC INTEGRATION AMONG DEVELOPING COUNTRIES 39

Since possibilities for economic growth through import substitu-tion are limited by the extent of a country's domestic market,countries of different size will need to have recourse to exports atdifferent J vwls of indus.rial development in order to ensure thecontinued .pansion of their manufacturing industries. In somesmall African countries where the consumption of manufacturedgoods does not exceed $IOO million a year, the domestic market isnot sufficiently large even for the production of relatively simplemanufactured goods.

At the other end of the scale, India and Brazil established adiversified industrial structure serving dome6tic needs, but have en-countered market limitations in a number of their industries andare now attempting to expand their exports. The shift in strategy isthe most apparent in Brazil that has increasingly focused on thepromotion of agricultural and manufacturing exports. In this, Brazilis following the example of countries, such as Korea and Taiwan,which have attained high rates of economic growth applying astrategy of export promotion.

Exports and Economic IntegrationExports of manufactured goods may be oriented towards themarkets of countries in the same region, to developing countries inother regions, or to developed nations. Providing incentives to ex-ports would benefit sales in all foreign markets; regional integrationwould boost exports to countries in the same geographical area; andpreferential schemes extending to other regions would stimulateexports to developing countries in those regions. But, as with importsubstitution, export promotion can be carried too far; this will bethe case if excessive incentives are provided. Accordingly, an appro-priate objective of development strate,y may be seen in providingfor the establishment of efficient export and import-substitutingactivities. Participation in the international division of labourthrough similar incentives to exports and import substitution andavoiding overly high protection of manufacturing industries cancontribute to this goal.

While adopting such a policy would affect a country's overalltrade, the establishment of the European Common Market and theEuropean Free Trade Association indicates that even in(duistrialcountries with relatively large domestic markets derive advantagesfrom refgonal integraticn. There are various reasons for this, severalof which apply to developing countries as well.

First of all, a country participating in a regional integrationscheme benefits from the elimination ofbarriers to its exports on the

40 JOURNAL OF COMMON MARKET STUDIES

part of the partner countries. this is of special importance for de-veloping countries whose exports of manufactured goods often sufferdiscrimination in developed country markets. We observe that tariffsin developed nations tend to rise with the degree of fabrication,thereby discouraging the importation of foods and raw materials ina processed form. Also, tariffs are generally higher on simple manu-factures than on products requiring a high level of technical sophisti-cation developing countries do not possess. Finally, quantitativerestrictions tend to be applied mostly to products originating in thedeveloping nations, as in the case of textiles, clothing and sKoes.

Considerations of risk and uncertainty favour regional integra-tion schemes. There is more information on prices and costs inneighbouring countries than in faraway nations, thereby lesseninguncertainty as regards the effects of trade liberalization on domesticindustry. Uncertainty in intraregional trade is further reduced ifcommitments are taken to refrain from reimposing restrictions onimports or subsidies to exports. This is of special interest sincedeveloped countries have repeatedly imposed restrictions once theimports of manufactures from less developed areas have increasedsubstantially. Also, in a regional union, it will generally be easierto reach-and to police-agreements to forego the use of measureswhich provide indirect benefits to domestic industry at the expenseof their competitors in the partner countries.

In the EEC, an additional consideration has been to create largemarkets for highly sophisticated industries, such as aircraft, com-puters and electronics, where national markets of the membercountries are too small for efficient operations, while protectingthese industries from US competition. This argument applies afortiori to developing economies which need protection for theirinfant industries. In a regional union, the cost of infant protectionwill be lower than in individual countries, since a wider marketpermits the establishment of larger plants, greater specialization, aswell as more competition. At the same time, the markets of thepartner countries can serve as a training ground for exporting else-where. W~ may then speak of infant export activities that need tolearn quality control as well as marketing techniques.

But regional integration schemes have disadvantages of their own.Integration involves a cost in the form of higher prices paid forimports from the partncr countries. Also, the establishment of newindustries in a regional framework may give rise to monopoly posi-tions and inefficient, high-cost production. This will occur if ex-cessive protection is granted to regional industries that permitshigh-cost operations and provides little incentive for technological


improvements. At the same timne, the establishiment of firms orientedtowards the markets of the partner countries may draw away re-sources, such as capital and ent- reneurship, from exporting toworld markets, where they could se put to better uses. It may alsobe necessary to undertake costly investments in transportation topermit a substantial expansion of intraregional trade.

Furthermore, involved negotiations on economic integration im-pinge on scarce decision-making capacity in developing countriesand limit the attention given to other policy options. On a differentplane, economic integration will involve a cost through the diminu-tion of national sovereignty as agreements on the liberalization ofintra-area trade and on the policy coordination necessary for thesuccess of the integration schemes reduce the scope of action bynational authorities.

The balance of the benefits and costs of regional integration in aparticular case will depend on the circumstances of the situation,including market size, resource endowment, geographical locationand access to developed country markets, as well as on the policiesapplied. In the following, attention will be given to policies thatmay be used to increase the benefits of integration through theliberalization of intra-area trade and to contribute to the equitabledistribution of these benefits among the participating countries.Subsequently, the possibilities of preferential tariff reductions ontrade among developing countries located in different areas will beexamined.

The Scope of Integration SchemesThere is a case for extending the range of industries covered byintegration schemes that involve the liberalization of intraregionaltrade. In this way, one may allow for compensating changes invarious industries, lessen the power of special interests, increasecompetition, and reduce investment requirements. Compensatingchanges will smoothen the path of adjustment and it may be easierto surmount opposition from special interests than if trade liberaliza-tion was limited to a few industries. Also, apart from the case ofintegratiom, among countries at different levels of development to bediscussed below, the exposure of domestic firms to competition fromthe partner countries would have beneficial effects in the form ofimprovements in the distribution of incomes through lowveringexcess profits and incentives for technical progress. Finally, the ex-pansion of intra-area trade may lead to a higher degree of capacityutilization, thereby reducing the need for new investments.

Nevertheless, integration in existing induLstries has been opposed

42 JOURNAL OF COMMON MARK1-T STUDIES

on the grounds that it would create serious dislocations in the indi-vidual countries. The experience of the Central American CommonMarket does not lend support to this view. The creation of theCentral American Common Market led to a rapid expansion oftrade among the member countries, with the annual rate of increaseaveraging 22 per cent in the period I953-6I and 32 per cent ini96i-68. This increase took place largely in manufactured goods,whose share in the total reached 86 per cent in I968 and entailedintraindustry specializatior, through the greater exchange of pro-ducts, such as textiles and shoes, tus permitting the exploitation ofeconomies of scale without appreciable adverse effects on nationalindustries.

Possibilities for economies of scale are even greater for machinery,consumer durables, and intermediate goods industries where, fol-lowing the European Common Market, intraindustry specializationcould be accomplished through narrowing product variety and theexchange of parts and components i i developing countries at highierlevels of industrialization. On the other hand, integration ofcountries at different levels of development would require moreadjustment and it raises the problem of the distribution of benefitsand costs to be discussed below.

It should be added that the cost of dislocation can be reduced ifadequate time is provided for adjustment by the spacing of tariffreductions. This can be done by agreeing on a fixed timetable onreducing, and ultimately eliminating tariffs. This would have addi-tional benefits in lessening uncertainty for the firm and providinginducements for adaptation to the conditions of a larger market.Moreover, in adopting a fixed time schedule for tariff reductions,there is less of a chance that the progress of integration will beblocked. This has happened in LAFTA where after initial progressthe opposition of vested interests has practically blocked tariff reduc-tions in the framework of annual multilateral negotiations.

Tarifi Policy in an Integrated AreaThere is further a case for establishing common tariffs on extra-area imports. This is because the maintenance of national tariffsleads to distortions in intra-area trade and affects distribution of thebenefits and cost from integration. Countries with relatively lowtariffs on imported raw materials and intermediate products willenjoy artificial cost advantages in intra-area trade in finished goods,and the extent of preferences granted to partner country supplierswill be greater the higher are national tariffs. With continuingdifferences in national tariffs and the possibilities for unilateral

ECONOMIC INTEGRATION AMONG DEVELOPING COUNTRIES 43changes in these tariffs, then, the progress of integration may bejeopardized.

In the event of a common tariff being adopted, there will be needto ensure that its height and structure are conducivt to the establish-ment of efficient industries. There is a case for lowering duties ifthe level of national tariffs was excessive, and the creation of acommon external tariff provides an opportunity for reduction andrationalization. More generally, for regional integration to con-tribute to efficient import substitution and exporting, it would haveto be accompanied by a rationalization of the system of incentivesin the participating countries.

Adoption of a common tariff on imports from nonmembercountries and the harmonization of other measures affecting im-ports and exports will eliminate distortions in competitiveness amongthe partner countries provided that exchange rates are free to adjust.Distortions in competitiveness will occur, however, if the speed ofinflation differs among countries and devaluation takes place onlyintermittently. This is because under- or over-compensation in ex-change rates for price changes has the same effect as changes intariffs and subsidies. At the same time, uncertainty is created asregards future changes in the domestic currency value of foreignexchange and the sale price of competing producers.

Variations in competitiveness due to price changes uncompensatedby changes in exchange rates create obstacles to regonal integrationsince countries do not wish to expose their producers to sudden andunforeseen changes in trade flows. To avoid these adverse conse-quences, it would be advisable for member countries to devaluepari passu with inflation. Apart from avoiding distortions in com-petitiveness, agreement on rules concerning exchange rate changeswould also permit maintaining the independence of nationalmonetary policies.

Distribution of Benefits and Costs of IntegrationFurther consideration needs to be given to the distribution of benefitsand costs of integration among member countries. The presumedmaldistribution of benefits and costs appears to be the single majorreason for the limited success of integration efforts in less developedareas. In this connection, reference has often been made to im-balances in intra-area trade following regional integration and theunequal distribLItion of manufacturing industries.

Imbalances in intra-area trade may however be the result of in-fluences other than regional integration, including differentialtrends in economic growth and infTation. And shou[d integration


be responsible for the imbalance, it may have been accompanied byoffsetting changes in extra-area trade, so that one needs to considerthe global trade position of a country rather than trade with thepartner countries only. In turn, global trade imbalances may beoffset by a devaluation or revaluation of the currency. Imbalances inintra-area trade per se should not be regarded as an indication ofthe unequal distribution of benefits. But, there is reason for concernif the imbalance is concentrated in trade in manufactured goods,reflecting the acquired superiority of certain partner countries inmanufacturing thlat may foreclose the developrnent of industrieselsewhere. In sueh instances, action would have to be taken to offsetthe advantages of countries that would otherwise '1;enefit from theirearly start in industrialization through concessions to the lesser-developed countries. This would, in turn, require striking a balancebetween the interests of countries at higher and lower income levels.At the same time, the concessions nee[ to be temporary in nature toavoid the perpetuation of inefficient industries.

The experience of the European Common Market may be ofinterest in this connection. Upon entry, Ireland has received con-cessions in postponing the elimination of duties on intra-area im-ports while enjoyin gree entry for its own exports and will furtherbenefit from investments by the European Investment Fund. Similarconcessions have been provided by agreements with Greece, Turkeyand Portugal.

Trade Liberalization among Developing Countries Located inDiflerent Regions

Alternatively, one may suggest limiting the participants in aneconomic integration scheme to countries at similar levels of in-dustrial development. As this condition is often not fulfilled inregional integration schemes, consideration needs to be given to thepossibility of extending reciprocal reductions in trade barriers to alldeveloping countries at similar levels of industrialization, regardlessof their geographical location. While such a scheme would escapethe difficulties due to integration among countries at different levelsof industrial development, it has difficulties of its own. To beginwith, the potential benefits are limited by high transportation costswhile it would involve considerable risk and uncertainty. There isuncertainty as regards the balance of cost and benefits, because oflimited information on production costs and on governmentalpolicies in countries located on different continents. Also, in theabsence of agreements on policies extending to external tariffs,quotas, licenses, export subsidies and indirect incentives, the balance


of advantages can be easily upset and trade will be subject to arti-ficial distortions. At the same time, it is difficult to reach an agree-ment on policy coordination because the loss of sovereignty involvedmay not be compensated by the expected benefits. And not only dobenefits promise to be larger in intraregional trade, but countries ina particular region, having similar history, customs, and evenlanguage, may possess the greater solidarity and common interestsnecessary for policy coordination than nations separated by greatdistances.

ConclusionRegional economic integration should be regarded as one of thepolicy options available to developing countries in pursuing theirstrategy for ecoinomic development. Its potential benefits and costsshould be weighted against those of other policy options, and inparticular an export-oriented strategy. Regional integration benefitsthe member countries by ensuring access to the markets of theirpartners, lessening risk and uncertainty as regards the effects oftrade liberalization on domestic industry, easing the task of policycoordination, and reducing the cost of infant industry protection.But it may also involve paying higher prices for regional imports,establishing monopoly positions in particular industries, drawingaway resources from more productive uses, and neglecting otherpolicy options.

The balance of benefits and costs of regional integration in aparticular case will depend on market size, resource endowment,geographical location, and access to developed country markets, aswell as on policies followed. There is a case for extending the scopeof industries covered by integration schemes that involve liberaliz-ing inrtraregional trade, unifying tariffs on extra-area imports, andcoordinating trade and exchange rate policies. Also, one shouldavoid excessive protection against extra-area imports, and measureswould have to be taken to ensure the equitable distribution of thebenefits and costs of integration among thie member countries.

Agreements on measures to be taken in favour of membercountries at lower levels of development are, however, difficult toreach in part because of difficulties involved in evaluat,ng the effectsof these measures and because of their cost for the more developedcountries. And, the loss of sovereignty involved in the eliminationof barriers to intra-area trade and the coordination of trade andexchange rate policies represents a further obstacle to integrationefforts. Furthermore, the benefits of greater competition may not beenjoyed if the combined demand of the member countries can sup-


port only one plant in a particular industry or if their markets areundeveloped. In such instances, recourse may be had to the projectapproach to integration that involves reaching agreement on theestablishment and the operation of particular industries.

The project approach can be utilized in regard to new industriesin conjunction with the application of a general trade liberalizationscheme; its potential scope will be the greater the smaller theintegrated area and the lower its level of industrial development. Inthe event that the conditions for implementing a trade liberaliza-tion scheme are not fulfilled, the project approach may be appliedby itself, with provisions made for intraregional trade in the productsinvolved, This approach will be discussed in Part II.

II. THE PROJECT APPROACH TO ECONOMIC INTEGRATION

Definitions and ConceptsOne of the principal aims of integration schemes among developingcountries is the establishment of projects which serve a wider thannational market. Such projects may emerge either through the freeoperation of market forces in a region where trade barriers havebeen removed, or as a result of an explicit agreement between twoor more countries which may or may not be part of a regional tradeliberalization scheme. Projects of this nature will be referred to asintegration projects.

In discussing economic integration, it is useful to bear in mindthat different classes of goods and services are not equally mobile.A well-known distinction is that between internationally tradableand non-tradable goods and services; in turn, Mennes, Tinbergenand Waardenburg distinguish among local, regional, national,continental and international or world goods and services.' Bothclassification schemes are based on a variety of economic and techni-cal consideratiors, among which transportation costs are the mostimportant. In the following, a distinction will be made amongnational, regional (i.e. multi-country) and international goods andservices.

National goods and services, including perishables, construction,housing, retail trade, most government and private services, arenormally not traded among countries. They can, therefore, be ex-cluded from the discussion of integration projects. By contrast,regio,nal and internatonal goods and services both qualify as candi-dates for integration projects. -Regional goods and services may be1 L. B. M. Mennes, Jan Tinbergen and J. George Waardenburg, The Element of

Space in Development Planning, Amsterdam, I969.


provided on a national basis as well as jointly for a roup of con-tiguous countries; they can not as a rule be imported from worldmarkets. This class of goods and serviL..s may include electricity,railways, roads, irrigation, etc. International goods and services, inturn, may be procured on a national and regional basis as well asfrom world markets. They comprise most agricultural, mining andmanufactured products.

The Scope for Integration Projects: regional goods and servicesIntegration projects in this category may be found in transportationand communications, public utilities, education and research, and afew other fields that are specified below. They bring economic bene-fits if production on a regional scale leads to cost savings comparedto their production on a national scale, taking into account pro-duction as well as distribution costs. Cost savings may be achieveddirectly through large-scale operations, fuller utilization of existingcapacity, greater specialization in production, joint management,and the coordinated use of jointly-owned resources. Benefts mayalso be reaped indirectly, e.g. by investments in infrastructure thatare principally designed to promote trade within the region.

Transportation provides examples of direct and indirect benefitsfrom integration projects. First, cost savings may be achievedthrough coordinated planning, construction and/or operation oftransportation facilities (e.g. a joint airline, a regionally integratedrailway network with identical railway gauges, regional shippingcompanies, and an integrated highway system). Second, coordinatedinvestments in transportation may have beneficial effects of an in-direct nature in promoting trade among the partner countries.

Cost savings and, in particular, quality improvements may alsobe achieved by the coordinated planning and operation of regionalcommunications networks. This would require, among others, tariffagreements, as well as the rationalization of signalling systems inthe case of telecommunications. Arrong public utilities, electricpower production and the development and management of waterresources offer scope for integration projects. Both types of projectssupply output that is normally not internationally tradable unlessdistances are short. In such cases, integration projects may offerbenefits by exploiting economies of scale through regional co-operation. In some instances, gains can also be obtained throughutilizing those resources from within the region that lead to thelower production costs; the latter may occur if several possible sitesexist within a region for hydro-electric power generation, but onesite is more suitable than others.

48 JOURNAL OF COMMON MARKET STUDIESIn the category of water supply projects, the principal case for

coordinated action is with respect to the development of inter-national river basins. A number of schemes of this nature exist(e.g. the Lower Mekong Basin), with the major potential gains tobe derived from improved flood control, and more intensive use ofthe water resources for irrigation purposes. In turn, projects locatedon international waters may cause problems of cnvironmental pol-lution in other countries, making desirable the coordination ofaction.

Joint projects in the field of education and research can lead tocost savings due to the better utilization of indivisible factors suchas teaching and research staff and equipment, and may result inqualitative improvements in education and research as well. Regionaluniversities, and technical colleges, and research into area-specificproblems, jointly financed and managed by the participatingcountries, come into this category. Integration projects in the cate-gory of research are not necessarily restricted to regional arrange-ments, and successful global undertakings exist, e.g. the InternationalRice Research Institute.

The list of categories of integration projects among regional goodsand services given so far is by no means exhaustive, and a variety ofother fields should be mentioned where scope for such projects exists.These include projects aiming at regional computer facilities, thepromotion of tourism, the promotion of regional exports throughregional trade promotion centres, the development of mineral re-sources, and the provision of meteorological services.

The Scope for Integration Projects: international goods and servicesThis category of projects consists chiefly of agricultural, mining andindustrial activities; their principal characteristic is that they can beinternatonally traded so that their availability in the region is notcontingent upon production within the region; if produced withinthe region, tey can also be exported to overseas markets.

In agriculture, there are examples of countries agreeing to limitthe expansion of production in order to improve their terms of trade(e.g. coffee). Such agreements are usually of a global nature; theyare considered to be outside the scope of this study. There are alsopossibilities for agreements on specialization in agricultural pro-duction beVween countries with different resource endowments.However, since economies of scale in agricultural production canbe exploited in the national framrnMork, integration projects inagriculture are usually linked with processing.


If regional planning permits the identification and establishmentof efficient facilities, for example to process cocoa, cotton, rubber, aswell as forest products and livestock, such projects are properlyclassified as integration projects. To the extent such facilities aredependent on the supply of inputs from the region as a whole,agreements among the participating countries may be required toguarantee compatible agricultural produce. Often, a country canexploit its geographical location by processing the exports of a land-locked country, which are allowed duty-free into the country. If thelandlocked country were to process its own agricultural produce forexports, the transit country could impose import duties on the pro-cessed product. This issue has arisen a few times in practice, forexample in West Africa with respect to livestock produced in theinland states of Mali and Niger.

Many cooperative efforts among developing countries have astheir main objective the promotion of industrial growth, and mostexisting integration agreements devote special attention to industrialdevelopment. This is primarily due to the belief that the wideningof the domestic market through regional integration enables thecapturing of economies of scale that characterize most industrialactivities, leading to lower average costs of production.

Lower average costs of production can be the result of higherrates of capacity utilization in the case of already existing plants.In such instances, partner countries may be induced to forego in-vestments in similar activities. Secondly, cost savings may be achievedby exploitation of economies of scale. The simplest form is one thatleads to the establishment of production units of a larger scale thanwould have been possible on the basis of the domestic market alone.Moreover, the wider market may permit the exploitation of ad-vantages associated with specialization, most of which are alsorelated to economies of scale. Specialization can take place either atthe product or the process level. Petrochemicals, fertilizer andmachinery provide possibilities for product specialization, withcountries producing different varieties within a product category.Process specialization occurs if a group of countries agree to special-ize in different components for the manufacture of machinery ortransport equipment.

Finally, it may be useful to point out that the project approach inthe case of international goods need not be restricted to the marketsof contiguous countries, and that a wider approach is feasible giventhe possibility of international trade. The extreme case is that ofworld-wide sectoral investment planning; an example of an appli-


cation of this approach was recently discussed in the Board.2 Themajor problem facing this particular approach is its implementa-tion: if it is difficult to reach agreement among a few neighbouringcountries on one or more integration projects, it may be expected tobe even more so among a larger group of countries.

The Measurement of Costs and BenefitsIn the preceding sections, we have described the scope for integra-tion projects in the various sectors of the economy and the natureof the benefits that may be derived from such projects. In spite ofthe potential gains that can be associated with integration projects,few of such projects have in fact been established. In an attempt toidentify the reasons for the limited success of the integration projectapproach, it appears useful to draw a distinction between two setsof problems, one related to the evaluation of the costs and benefitsof integration projects, the other being associated with the establish-ment and operation of such projects. In this section, we shall discussthe evaluation problems.

The selection and appraisal of integration projects raises a num-ber of complex technical problems. One of the main arguments infavour of integration projects is the exploitation of economies ofscale that many activities exhibit. However, until recently, noefficient planning techniques were available to select optimal pro-jects in the presence of economies of scale. Such a technique is nowavailable in the form of mixed-integer programming, but its appli-cation requires technical expertise which is available in few de-veloping countries.3

In addition to technical problems associated with project plan-ning in the presence of economies of scale, complications areintroduced by the explicit recognition of risk and uncertainty inproject analysis. The latter tends to weaken the case for large pro-duction units, even under economies of scale. As a plant designedto meet reuirements for a regional market faces greater uncertaintythan one that caters for a national market only, since regional co-operation may be discontinued, the expected benefits of an integra-tion project are correspondingly lower.

2IBRD, IFC, IDA, Fertilizer Reqtuirements of Developing Countries, May I5,

1974.

3 A research project at the Development Research Center (RPO 224-Program-ming in the Manufacturing Sector) which is now in its final phase, has resulted inthe formulatior and solution of a number of mixed-integer programming modelsfor specific industrial activities. These models are formulated such that they vreeasily applicable elsewhere, either for one country or for a group of countries,Moreover, the project has resulted in imp roved solution procedures for such models,reducing the cost of thei: use considerably.


Besides methodological problems of integration project selectionand evaluation, a data problem exists. To make an adequate case forintegration projects, detailed estimates of net benefits associated withthem in comparison to alternative modes of production are required.To measure these net benefits, production cost data for various scalesof production are required, as well as detailed information on thegeographical dispersion of demand and transportation cost. Yet,statistical data are rarely collected on the basis of a group of countries,and most data collection efforts are geared toward the domesticeconomy. Differences in data coverage and classification often renderthe construction of regional data sets a difficult problem, furthercomplicating the task of accurately measuring the costs and benefitsof integration projects.

Measurement of costs and benefits of integration projects is morecomplicated in the case of projects in the category of internationalgoods and services than for regional goods and services. For thelatter, project analysis takes place in an environment which is fullycontrolled by the region itself, imports from outside the regionbeing excluded by definition. As a result, fairly firm estimates canbe made of the net gains or losses associated with any specific pro-duction structure. In contrast, for international goods, imports fromworld markets provide an alternative to production on national orregional scale; to estimate the gains and losses of an integrationproject in this category, a projection of import prices is required.Given the uncertainty associated with future world market prices,the assessment of potential costs and benefits of regional productionbecomes more complicated.

Reaching Agreement on Integration ProjectsPerhaps tle most important obstacle to agreements on integrationprojects is the bias prevalent in most countries in favour of nationalprojects. This is reflected first of all in the orientation of theeconomic plannrng mrachinery in most countries which focusesprimarily on the design and implementation of national investmentprogrammes. If a regional bureaucracy exists, it is most often in-adequately staffed, lacking both the political power and the financialresources to constitute an effective counterpart to nationally-orientedinstitutions.

Even if political will is there, integration project agreements aredifficult to reach because of disputes concerning the distributionamong countries of costs and benefits associated with a given pro-ject. Unless the location of a project is dictated by natural resourceconstraints, it is difficult to get countries to agree on the location of

5z JOURNAL OF COMMON MARKET STUDIESan integration project. The more important a project, the moredifficult such negotiations may be, and it may either be impossibleto achieve agreement, or the allocation agreeable to all is so in-efficient that the total net gain of integration projects is wiped out.Judging by the experience of the last decade, problems of this naturehave arisen most frequently in the case of the 'foot-loose' industries.

Apart from the problem of which country provides the locationfor a given integration project, it may be difficult -o reach agree-ment on what countries wish to distribute equitably, and in whatmanner. Like any other project, an integration project generatesvalue added, employment, requires foreign exchange outlays anddomestic capital, may generate foreign exchange earnings, and pro-vides opportunities for tax revenues; moreover, the project may haveimportant externalities. The distributional formula agreeable topartner countries, therefore, contains many elements.

Disputes may furthermore arise over regional transfer prices of theoutput of integration projects. This is closely related to the fact thatthe approach to economic integration based on integration projectsfrequently leads to the establishment of monopolies. If restrictionsare placed on competing imports, a privately managed integrationproject will follow pricing and output policies that may not beconsistent with economic policy objectives in partner countries.Without government interventions, therefore, there may be a trade-off between the exploitation of economies of scale by establishingrelatively few productive units and an organization of supply thatresults in the achievement of given policy objectives.

These difficulties are of especial importance in the case of inter-national goods. As was explained before, the assessment of net gainsor losses for a project in this category is more difficult than for aproject in the category of regional goods and services because of theuncertainty related to developments in the world market. Thisproblem may be particularly important if different countries havediSferent perceptions of the future.

Also, integration projects in the regional category may be morestable over time than projects in the international category. In thecase of an integration project relating to a regional good or service,the alternative of national production exists but can not be realizedinstantly. Lengthy gestation periods are usually required to attainfull operation of a new project. However, in the case of integrationprojects in the category of international goods and services, projectcooperation can be terminated at once, by activating the importalternative. The above factors have in particular hampered theestablishment of integration projects in the industrial sector. Import


prices for industrial goods often vary by source and over time, whilewide fluctuations in ocean shipping rates complicate c.i.f. importprice projections even further. Under such conditions, it is extremelydifficult tc, make plausible quantitative estimates of the potentialnet gains to be derived from integration projects in this sector, andcountries have understandably been reluctant to agree to a produc-tion structure that may prove to be inefficient in the medium andlong-term. If the latter occurs, one of two situations may obtain.First, the producing country may lose its regional market, and endup with an underutilized plant. Second, the regional market ismaintained, but all participating countries suffer net losses becauseof relatively high-cost regional production. The former alternativeis more likely to occur in practice and this dist.inguishes integrationprojects sharply from national projects. If a national project turnsout to be based on an erroneous projection of c.i.f. imports prices,and is relatively high-cost, domestic pressures to prevent the shut-down of the project will be severe, usually resulting in higher pro-tection from inports than originally envisaged. In the case of anintegration project, such pressures from the project's host countrycan be assumed to be less effective in the partner countries.

The Package ApproaclhSome of the difficulties associated with reaching agreements on theindividual integration project approach can be reduced by adoptingthe so-called package approach. This approach specifically and ex-plicitly aims at facilitating the negotiation and enhancing thestability of an integration agreement by assuring that each partici-pating cotntry obtains at least one integration project from amonga package of such projects. The condil- a that each country hostsat least one project aims at replacing complicated distributionalformulas associated with individual project allocations amongcountries. Moreover, greater stability is achieved once an allocationof projects has been agreed upon because unilateral withdrawalfrom the regional scheme inflicts losses on the withdrawing countryitself.

An important condition to be fulfilled for the successful applica-tion of the package approach is that the project planning exerciseresults in comprehensive information on the effects of alternativeallocative schemes on partner countries. Some projects in the'package' will usually be more efficient than others due to theregion's comparative advantage. CouLntries with efficient projects inthe category of international goods and services may be better off

54 JOURNAL OF COMMON MARKET STUDIESthan countries with projects in the category of regional goods andservices, as the latter can not, by definition, be exported outside theregion. In general, it may be stated that the package approach ismore likely to achieve its goal of stability in the regional marketarrangement if the projects included are relatively efficient com-pared to national projects, in the case of regional goods and services,and compared to imports, for international goods and services. Ifhigh protective barriers are necessary for some or all of the projectsincluded in the category of international goods and services, it isconceivable that the cost of trade diversion to a partner country isso high as to offset the loss associated with underutilization of thecapacity of its integration projects following withdrawal from thescheme.

Even though it appears that the package approach poses lessserious problems of distribution of costs and benefits than the indi-vidual project approach, several such problems remain. If an allo-cation of projects is decided upon, for example, it may not be themost efficient one from the point of view of the region as a whole.Special arrangements nmay need to be made to ensure that eachproject is implemented, to ensure that the ex ante allocation ofprojects materializes. This may be particularly important if a pro-ject is allocated in a relatively unattractive part of the regionalmarket, and it turns out to be difficult to find capital and managerialtalent to establish the project. However, basically, these problemsare not more severe than they are in the case of individual projects.

A number of dynamic problems can be identified that are relatedmore directly to the package approach. First, the original allocationof projects may have been agreeable to all partner countries, butwhile in operation some projects appear so inefficient that problemsarise relating to the distribution of costs and benefits. Similarly,although the initial allocation of projects appeared acceptable, anincorrect projection of import prices, or demand, renders some pro-jects less efficient than predicted. Finally, as demand for differentproducts is likely to increase at different rates, some of the projectsin the package may become independent of the regionial market forefficient operation at an earlier stage than others, leading to in-stability over time.

One way in which these particular problems may be overcome isto consider joint financing of projects in the package by partnercountries, in addition to outside financing. This would result inspreading the financial risk of the operation of integration projectsamong partner countries, which may result in greater solidarity


among them in the face of unforeseen adverse circumstances affect-ing one or more integration projects.4

ConclusionThe integration project approach may offer substantial benefits tocountries that are not vet able to compete in world markets, andwish to establish an efficient production structure in activities thatare subject to economies of scale. In spite of its apparent advantages.however, this strategy has met with limited success, and very fewintegration projects have in fact been established. A number ofreasons can be identified to explain this state of affairs.

First, there is a strong bias in favour of national projects andnational development objectives; even if regional bureaucracies exist,they are usually powerless and without adequate resources. To re-move this bias, one necessary condition to be fulfilled is that con-vincing quantitative estimates are made of the net benefits ofintegration projects to partner countries. Project planning techniqueshave now been developed for project selection and appraisal in thepresence of economies of scale' and fairly detailed estimates can bemade of the relative costs and benefits of alternative productionstructures.

Secondly, a major stumbling block during attempts at reachingan agreement on integration projects relates to the distribuition ofcosts and bencefits of such projects among partner countries. In thecase of an individual integration Droject, discuissions of this nattureare often very difficult, and only if the net benefits of a specificintegration project appear large to each participating country, mayagreement be possible.

To alleviate some of the problems associated with the negotiationof integration project agreements, the package aoproach appears anattractive alternative. Although this approach does not provide apanacea for all problems associated with integration projects, itwould appear that the fact that each participating country hosts atleast one project facilitates not onlv the process of reachinz anagreement on integration projects. but also increases its stability.Enhanced stability can be expected as anv country that decides towithdraw from the integration scheme inflicts losses upon itself bylosing access to the regional market for its integration project(s).For these reasons, the package aporoach-nerhaps combined withsome arrangement to Provide for the joint financing of projects-may be recommended.

4 For a specific proposal along these lines, see: I. M. D. Little, 'Regional inter-national companies as an approach to economic integration', Joturnal of CommonMarket Studies, Vol. 5, I966.

Nigeria: Options for Lonwj*Tatin Development by Wouter Tims and others,published by The Johns Hopkins lJniversity Press, 1974

The Current Economic Position and Prospects of Peru by Jos6 Guerra andothers, distributed by The Johns Hopkins University Press, 1973

Senegal: Tradition, Diversification, and Econornic Development by HeinzBachmann and others, distributed by The Johns Hopkins lJniversity Press,

1974Turkey: Prospects and Probletms of an Expanding E&onLrny by Edmond Asfour

and others, distributed by The Johns Hopkins University Press, 1975Yugoslavia: Development with Decenitralizatiorn by Vinod Dubey and others,

published by The Johns Hopkins University Press, 1975

World Bank Staff OccasiOiida Papers

Economic Evaluation of Vtf;cctio7ndl Training Progra,ns by Manuel Zymelman,published by The Johns 1-c,p,dnris Univ'ersit& Press, 1976

A Development Model for the Agricultwlal Sectoir of Portugal by Alvin C. Egbertand Hyung M. Kim, published by The Johns Hopkinis University Press, 1975

The Future for Hard Fibers and Com petition from Synthetics by Enzo R. Grilli, dis-tributed by The Johns FHopkinis Univ'ersity Press, 1975

Public Expenditur-es on Educdt ioni and licorme Di6tribution in Colombia by Jean-Pierre Jallade, distributed by Tthe ik,hls Hopkins University Press, 1974

Tropical Hardwood Trade in the Asia'PdoifiC, Region by Keniji Takeuchi, dis-tributed by The Johns Hopkins Uni;'erb.' Pieess, 1974

Methods of Project Analvsis: A ReAviatt by D~ep;lk Lal, distrit.,uied by The JohnsHopkins University Press, i914

Road User Charges in Centra! America !,y Anthony ChuLcHllli, distributed by TheJohns Hopkins University P.ess, 1972

Cost-BenefitAnalysis in Education A Case Study of Kenya by Hans H. Thias andMartin Carnoy, distributed by Thie Johns Hopkins Press, 1972

Other Publications

Size Distribution of incorne A Compilation of Data by Shail Jain, distributed byThe Johns Hopkins University Press, 1 975

India: The Energy Sector by P.D. Hendersorn, pLiblished by Oxford UniversityPress, 1975

The Assauilt on World Povetitv: Probleisb of Rural Developm-nent, Education, andHealth, puiblished by The Jolihns lHopkinis University Press, 1975

Redistribution with Growth by ollis Chenery, Montek S. Ahluwalia, C. L. G. Bell,John H. Duloy, and Richard Jolly, published by Oxford UJniversity Press, 1974

Population Policies and Economic Detielopment: A World Bank Staff Report byTimothy King and others, pLiblished by The Johns llopkins University Press,

1974Prospects for Partnerstipou. hIdustrialization andti rrade Policies in the 1970s

edited by Helen Huiljh(.-,s, [pblished by Tfhe Johns Hopkins lJniversity Press,1973

THE WORLD BANKHeadquartersU1818 H Street, N.W.Washington, D.C. 20433 U.S.A.European Office66, avenue d'l1na75116 Paris, FranceTokyo OfficeKokusai Building1-1 Marunouchi 3-chomeChiyoda-ku, Tokyo 1 00, Japan

World Bank reprintsNo. 16. Hollis B. Chenery, "Restructuring the World Economy," Foreign Affairs [also

available in Spanish as published in El Trimestre Econ6mico]No. 17. Helmut Schuster, "Transportation Planning Techniques: Problems and

Prospects," KyklosNo.18. V. V. Bhatt, "Pattern of Income Distribution in India" [with V^ D. OJhal,

Sankhya and "A Decade of Performance of Industrial Development Bankof India," Commerce

No. 19. Michael Sharpston, "International Sub-contracting," Oxford EconomicPapers

No. 20. Hollis B. Chenery, "The Structuralist Approach to Development Policy,"American Economic Review

No. 21. V. V. Bhatt, "Some Aspects of Financial Policies and Central Banking in De-veloping Countries," World Development

No. 22. Bela Balassa, "Reforming the System of Incentives in Developing Coun-tries," World Development

No. 23. John H. Duloy and Roger D. Norton, "Prices and Incomes in Linear Program-ming Models," American Journal of Agricultural Economics

No. 24. P.B.R. Hazell and P. L. Scandizzo, "Market Intervention Policies When Pro-duction Is Risky," American Journal of Agricultural Economics

No. 25. Martin Karcher, "Ur'employment and Underemployment in the People's Re-public of Cnina," China Report

No. 26. Luz Maria Bassoco and Roger D. Norton, "A Quantitative Approach to Agri-cultural Policy Planning," Annals of Economic and Social Measurement

No. 27. Efrain Friedmann, "Financing Energy In Developing Countries," EnergyPoliCy

No. 28. Norman L. Hicks, "A Model of Trade and Growth for the Developing World,"European Economic Review

No. 29. V. V. Bhatt, "On Technology Policy and its Institutional Frame," World Devel-opment

No. 30. Bela Balassa and Ardy Stoutjesdijk, "Economic Integration among Develop-ing Countries," Journal of Common Market Studies

No. 31. Constantino Lluch and Ross Williams, "Cross Country Demand and SavingsPatterns: An Application of the Extended Linear Expenditure System,"The Review of Economics and Statistics

Documents

Bela Balassa and Ardy Stoutjesdijk Economic Integration