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Smith proposed in 1776 why unrestricted free trade is beneficial to a country. Free trade
is the absence of govt barriers to the free flow of goods and services between countries.
Smith claimed that the invisible hand of the market mechanism (instead of a govt
control) should determine what a country imports and exports; laissez-faire is the best for
a country. Two more theories that build upon Smiths were theories of Ricardos
comparative advantage (intellectual basis of the modern argument for unrestricted free
trade) and Hecksher-Ohlin theory (improvement of Ricardos theory). All of these theories
make strong cases for unrestricted free trade.

The 3 theories tell us that a countrys economy may gain if its citizens buy certain
products from other nations that could be produced at home. The gains rise because
international trade allows a country to specialize in the manufacture and export of
products that can be produced most efficiently in their


Chapter objective: to examine the economic and political debate surrounding regional
economic integration; to review the progress towards regional economic integration in
Europe, America, etc.; to distinguish the important implications of regional economic
integration for the practice of international business
Regional economic integration (REI): Agreements between countries in a geographic
region to reduce, and ultimately remove tariff and nontariff barriers to the free flow of
goods, services, and factors of production between each other. Total number of regional
trade agreements currently in force is about 400.
EU formally removed barriers on January 1, 1993. EU moved towards a closer political
union by launching a single currency (euro). EU today has 28 members and a gross
domestic product of 11 trillion (larger than US, in economic terms).
Canada, Mexico, and the US implemented the North American Free Trade Agreement
(NAFTA). While implementing NAFTA has resulted in job losses in some areas of the
American economy, in aggregate and consistent with the predictions of international
trade theory, most economists argue that the benefits of greater regional trade outweigh
any costs.

Mercosur: 1991 Argentina, Brazil, Paraguay, and Uruguay implemented an agreement

to reduce barriers to trade between each other. However, progress within Mercosur has
been halting, the institution is still in place. There are also active attempts at regional
economic integration in Central America, the Andean region of SA, SE Asia, and parts of
Africa. While the REI is seen as a good thing, some claim that this can create competition


Free trade area: an area in which all barriers to
the trade of goods and services among member
countries are removed. Theoretically ideal free trade
area, no discriminatory tariffs, quotas, subsidies, or
administrative impediments are allowed to distort
trade between members. However, each country is
allowed to determine its own trade policies with
regard to non-members. Ex: tariffs placed on
products of non-member countries may vary from
member to member. Free trade agreements are the
most popular form of REI, accounting for almost
90% of regional agreements. The most enduring
free trade area in the world is the European Free
Trade Association (EFTA) (established in Jan 1960, Norway, Iceland, Liechtenstein, and
Switzerland are current members Austria, Finland, and Sweden used to be in it, but
they joined EU in 1996). Emphasis of EFTA is on free trade in industrial goods (agriculture
was left out) Members are allowed to determine its own level of support and can
determine the level of protection applied to goods coming from outside the EFTA.
Customs union (a group of countries committed to eliminating trade barriers and
adopting a common external trade policy) is another step to achieving full economic and
political integration. Establishing a common external trade policy necessitates significant
administrative machinery to oversee trade relations with members and non-members.
Most countries that enter into a customs union desire even greater economic integration
down the road (EU began as a customs union but it moved to more than that).
An economic union (a group of countries committed to removing trade barriers,
adopting a common currency, harmonizing tax rates, and pursuing a common external
trade policy) entails even closer economic integration and cooperation than a common
market. EU is an economic union, although an imperfect one as not all members of the
EU have adopted the euro, and differences in tax rates and regulations across countries
still remain.
Moving toward an economic union raises the issue of how to make a coordinating
bureaucracy accountable to the citizens of member nations through political union
(a central political apparatus coordinating the economic, social, and foreign policy of its
member states). EU is on its way to achieving partial political union and can become one
through harmonizing its fiscal policy. US is even a closer political union as independent
states are effectively combined into a single country.



REI can be seen as an attempt to achieve additional gains from the free flow of trade and
investment between countries beyond those attainable under international agreements
like WTO. It is easier to establish a free trade and investment regime among a limited
number of adjacent countries than among the world community. The greater the number
of countries involved, the more perspectives that must be reconciled, and the harder it
will be to reach agreement. Thus, attempts at regional economic integration are
motivated by a desire to exploit the gains from free trade and investment.
Linking neighboring economies and making them increasingly dependent on each other
creates incentives for political cooperation between the neighboring states and reduces
the potential for violent conflict. In addition, by grouping their economies, the nations
can enhance their political weight in the world.
Integration has never been easy to achieve or sustain because 1. Economic integration
aids the majority, it has its costs. While a nation as a whole may benefit significantly from
a regional free trade agreement, certain groups may lose. Moving to a free trade regime
involves painful adjustments. 2. Integration arises from concerns over national
sovereignty. Ex. Mexicos concerns about maintaining control of its oil interests results in
an agreement with Canada and US to exempt the Mexican oil industry from any
liberalization of foreign investment regulations achieved under NAFTA.


Benefits of regional integration are determined by the extent of trade creation as
opposed to trade diversion. Trade creation occurs when high-cost domestic producers
are replaced by low-cost producers within the free trade area; may also occur when
higher-cost external producers are replaced by lower-cost external producers within the
free trade area. Trade diversion occurs when lower-cost external suppliers are replaced
by higher-cost suppliers within the free trade area. A regional free trade agreement will
benefit the world only if the amount of trade it creates exceeds the amount it diverts.


Evolution of the EU
EU is the product of 2 political factors: 1. Devastation of WE during 2 WWs and the desire
for a lasting peace 2. European nations desire to hold their own on the worlds political
and economic stage. Many nations were also aware of the political economic benefits of
closer economic integration of the countries.
Forerunners of EU: European Coal and Steel Community (goal: remove barriers to
intragroup shipments of coal, iron, steel, and scrap metal). Treaty of Rome (1957):
European Community was established. 1994: European Community became European
Political structure of the EU
4 main institutions of EU: 1. European Commission (responsible for proposing,
implementing, and monitoring compliance with EU legislation; run by a group of
commissioners appointed by each member country) 2. Council of EU (Ultimate decision
making body of the EU, passes legislation from the commission into law and is made of

one representative form each member states government). 3. European Parliament

(made up of 732 members directly elected by member states populations, it serves as a
consultative body to debate and propose amendments to the legislation forwarded from
the council) 4. Court of Justice (comprised of one judge from each member state, this
is the supreme appeals court for EU law).
Single European Act
Two revolutions occurred in Europe in the late 1980s. 1. Collapse of communism in
Eastern Europe. 2. Adoption of the Single European Act (adopted by members of the
EC in 1987; committed member countries to establish a single market by the end of

Objectives of the act

o Remove all frontier controls between EC countries (thus removing delays
and reducing the resources required for complying with trade bureaucracy)
o Apply the principle of mutual recognition to product standards. A
standard develop in one EC country should be accepted in another,
provided it meets basic requirements in such matters as health and safety.
o Open public procurement to non-national suppliers, reducing costs directly
by allowing lower-cost suppliers into national economies and indirectly by
forcing national suppliers to compete.