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

INTERNATIONAL ECONOMIC INTEGRATION

REF:CU1A OCT 08

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

Customs Unions

Trade creation / trade diversion Dynamic effects Terms of trade

Trade creation(TC) & Trade diversion(TD)

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

Numerical example

Home PartnerRoW

Price/cost (£) 50 40 30 Case1:

trade creation

tariff= 30 Pre cu Post cu

Numerical example

Home PartnerRoW

Price/cost (£) 50 40 30 Case1:

trade creation

tariff= 30 Pre cu 50 70 60 Post cu

Numerical example

Home PartnerRoW

Price/cost (£) 50 40 30 Case1:

trade creation

tariff= 30 Pre cu 50 70 60 Post cu 50 40 60

Home PartnerRoW

Price/cost (£) 50 40 30 Case2:

trade diversion

tariff= 15 Pre cu Post cu

Home PartnerRoW

Price/cost (£) 50 40 30 Case2:

trade diversion

tariff= 15 Pre cu 50 55 45 Post cu

Home PartnerRoW

Price/cost (£) 50 40 30 Case2:

trade diversion

tariff= 15 Pre cu 50 55 45 Post cu 50 40 45

Assumptions (partial equilibrium analysis)– Partners (Sp) S/curve & world S/curve (Sw)

infinitely elastic. Sw (efficient) below Sp– Domestic supply & demand (SH & DH)– Consumers don’t differentiate - origin of good– Home & partner small, CU small

CU theory note: model will differ if change assumptions

Q good X

Price

SH DH

Sw

Sp

CU theory

Q good X

Price

SH DH

Sw

Sp

Sw+tariff

P1

P2

Sp+tariff

Phome

Pre CU

Q good X

Price

SH DH

Sw

Sp

Sw+tariff

P1

P2

Sp+tariff

Phome

Q1Q2

a

b c

d

Area abcd =?

Post CU

Q good X

Price

SH DH

Sw

Sp

Sw+tariff

P1

P2

Sp+tariff

Phome

Q1Q2

a

b c

d

P3

Q3Q4

x y

Post CU

Q good X

Price

SH DH

Sw

Sp

Sw+tariff

P1

P2

Sp+tariff

Phome

Q1Q2

a

b c

d

P3

Q3Q4

x y

Z

W

+ve specialisation effect +ve substitution effect

pre-cu post-cu

PRICE P2 P3

CONSUMPTION Q1 Q3

PROD(home) Q2 Q4

IMPORTS Q1-Q2 Q3-Q4

Net gain = TC - TD

x + y - z

– production gain = x– consumer gain = y– cost of trade diversion = z

W = ?

Deductions

Higher original tariff - greater potential benefits

Smaller cost difference partner & RoW - likely TD losses lower

Greater price elasticity DH & SH - TC likely Greater overlap of goods - bigger gains Bigger CU - TD less likely Low CET - TD less likely

Higher original tariff (compared to earlier diagram)- greater potential benefits

Q good X

Price

SH DH

Sw

Sp

Sw+tariff

P1

P2

Q1Q2

P3

Q3Q4

x y

Z

TC > TD in this example

Remember: Previous diagram, showing TC<TD

Q good X

Price

SH DH

Sw

Sp

Sw+tariff

P1

P2

Sp+tariff

Phome

Q1Q2

a

b c

d

P3

Q3Q4

x y

Z

W

+ve specialisation effect +ve substitution effect

Empirical evidence

Net result can’t be found from theory– empirical evidence (Nielsen)

Balassa - 3 studies 1953-1970– TC > TD

Others agree – Truman (1968), Kreinin (1970), Aitkin (1970)

But: welfare = trade flows??

Measurement – counterfactual analysis

» project trends

» control country

» trade flow models

Second best theory

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

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

Dynamic effects

Ignored in previous (static) analysis Dynamic effects likely to result in major

benefits– difficult to assess– orthodox CU theory concentrates on static

benefits– can show welfare gains– consider redistribution to compensate losers

Dynamic effects– rise productivity– technological advances– concentration and market structures– economies of scale– economies of experience

Above limited to dynamic sectors; regional variations!!

Terms of Trade (ToT) effect

Important for a large CU Improvement in ToT increases welfare ToT - secondary objective Any ToT gain transferred from rest of

world - not wealth creating effect

Further developments

Common market theory New trade theories

– based on industrial organisation theory– Includes consideration of

» market structures» competition effects

More recent research considers this– eg. Gasiorek, Smith, Venables, (JCMS 2002)

consider the Uk’s entry into the EEC

Conclusion

CU theory only deals with the relatively small ‘static’ effects of integration, but it is a starting point

Empirical evidence from the formation of the EC6 seems to generally support CU theory– TC>TD