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Subject Economics

Paper No and Title 13 – International Economics

Module No and Title 18- Economic Integration - Various Forms, Static and
Dynamic Effects of Custom Union
Module Tag ECO_P13_M18

ECONOMICS Paper 13 – International Economics

Module 18- Economic Integration - Various Forms, Static and Dynamic
Effects of Custom Union
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TABLE OF CONTENTS
1. Learning Outcomes
2. Introduction
3. Forms of Economic Integration
4. Static Effects of Customs Union
4.1 Trade Creation
4.2 Trade Diversion
4.3 Other Static Welfare Effects of Customs Union
5. Dynamic Effects of Customs Union
6. Summary

ECONOMICS Paper 13 – International Economics

Module 18- Economic Integration - Various Forms, Static and Dynamic
Effects of Custom Union
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1. Learning Outcomes
After studying this module, you shall be able to

 Know the various agreements followed in the world.

 Identify different forms of economic integration.
 Evaluate economic impact of formation of regional economic associations.
 Analyze the welfare gains and losses due to economic integration, customs union in
particular.

2. Introduction

Economic Integration

Economic Integration is an important feature of trade liberalisation. It is a process in which more

than two (or just two) countries come together into a larger economic group by removing existing
discriminations along national frontiers. This concept has been described in various ways.
According to Tinbergen, it is the creation of most desirable structure of international economy,
removing artificial hindrances to the best possible operation and introducing with intent all
desirable elements of synchronization or alliance. Balassa defines it as a process & a state of
affairs which encompasses measures designed to bring to end favoritism between national
economies.

According to a clause called MFN (Most Favored Nation) in GATT/WTO, all members should be
given equal treatment. Tariffs, quotas and other non-trade barriers are equally applicable to all
nations irrespective of their origin. Despite this, most countries had separate levels of protection
for different countries with preferences given to its partners in regional agreements and less
favorable treatment to others.

Economic Integration could be of two types:

1. Negative integration which means removal of discrimination and restrictions on

movement of goods among member countries.
2. Positive integration which means modifications of existing institutions and adoption of
new ones to remove market distortions within economic region.

3. Forms of Economic Integration

The degree of economic integration varies greatly in regional agreements depending upon their
economic and political unification. The major forms of economic integration are identified as
follows:
ECONOMICS Paper 13 – International Economics
Module 18- Economic Integration - Various Forms, Static and Dynamic
Effects of Custom Union
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1. Preferential Trade Agreements (PTAs) – PTAs are a form of trading union in which
participating nations reduces tariff and other trade barriers for each other. This is the first
and the loosest stage of economic integration. An example would be the British
Commonwealth Preference Scheme, established by U.K. with members of the British
Empire.
2. Free Trade Area (FTA) - A FTA consists of ways to reduce or eliminate both tariff and
nontariff barriers between member nations for trade, while still continuing barriers to
trade for the other nations. Barriers to trade between individual PTA members and
nonmember nations can be different and are determined by each member's policy makers.
The North American Free Trade Agreement (NAFTA) between United States, Canada
and Mexico is an example of a free trade area. Other examples could be European Free
Trade Area (EFTA) & Greater Arab Free Trade Area (GAFTA).
3. Customs Union – In a custom union, members are needed to remove trade barriers for
each other and takes economic integration a step further by applying similar barriers to
trade for the nonmember nations, generally in the form of a common external tariff. The
European Community (which is now called as the European Union (EU) was the world's
most well-known customs union for many years. The European Community created a
common agricultural policy (CAP) for all member states. The CAP was (and still is)
characterized by a variable levy system which limits most agricultural imports from
nonmember countries by applying a common import duty. South Africa, Botswana,
Lesotho and Swaziland established the Southern African Customs Union (SACU) in
1969 as a continuance of their custom union arrangements, which are in force since 1910.
4. Common Market - A common market includes all the aspects of a customs union, but
takes integration further by permitting the free movement of goods and services, labor,
and capital among member nations. In January, 1993, the EU moved closer to full
common-market status by implementing the Single European Act, which consists of
provisions to remove some or all tariff and nontariff barriers to trade in goods and
services, labor, and capital.
5. Economic Union - An economic union represents the most complete form of economic
integration. Member nation social, taxation, fiscal, and monetary policies are harmonized
or unified. Belgium and Luxembourg formed an economic union in the 1920's. The EU
has adopted regulations creating a full economic union with common banking laws,
coordinated macroeconomic policy, and a common EU currency by the year 2000.

So, there are different forms of economic integration with different degrees of integration
between countries. And it is to be noted that the reduction of tariff and non-tariff barriers to trade
in a regional trade agreement has both positive and negative consequences. These barriers have
benefits as & costs. The favorable effect on world trade is known as trade creation but there are
losses to the countries that are not member to the trade agreement. This loss is termed as trade
diversion.

ECONOMICS Paper 13 – International Economics

Module 18- Economic Integration - Various Forms, Static and Dynamic
Effects of Custom Union
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GATT/WTO allows for an exception to the most favored nation (MFN) status for regional trade
agreements. In order to receive the exemption, it was important to show that level of protection
after the implementation would not be higher (on average) for the member countries before the
implementation. So, this exemption implies the assumption that trade creation is generally larger
than trade diversion & this has been supported empirically as well. But this does not mean that
the trade diversion is insignificant. Both these concepts in the context of custom unions will be
studied in the next section.

4. Static Effects of Customs Union

Jacob Viner, The Customs Union Issue, 1950 presented the first formal analysis that tariff
preferences can either improve resource allocations or worsen them. Economic Integration do
both: Liberalise trade by lower or zero restrictions and distort trade by forcing inside consumers
to pay different prices for identical goods at the same market location depending on product
origin. Countries which are not a part of the trading bloc they generally have an argument
that due to the economic integration of such type, within the bloc the level of trade
increases where as it falls down for the non-member countries.

So there are two views on economic integration, some say that regional bloc increases efficiency,
some say that it decreases efficiency. These effects from forming a customs union could be better
understood in the terms of trade creation & trade diversion.

4.1 Trade Creation

Trade creation is said to happen when domestic production of one member nation is
replaced by lower-cost imports from another member nation. The trade creation effect
causes efficiency gains for member nations, because some countries shift from a higher-
cost domestic source of supply of an item to a lower-cost foreign source. Member
countries eventually specialize in producing those items, for which they have a
comparative advantage.

ECONOMICS Paper 13 – International Economics

Module 18- Economic Integration - Various Forms, Static and Dynamic
Effects of Custom Union
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Let us take three countries- country A, B and C. PB and PC represents the price of the
good in country B and C before trade. Also country A imposes specific tariff on both
countries, the amount of tariff represented by the dotted green lines.

The autarky price in country A is PA. With tariffs, the price of importing the good from
country B and C rises and hence country A decides to supply itself the whole domestic
demand and S1=D1.

Suppose now country A decides to form a customs union with country B. then tariff from
country B will be eliminated. So the price of importing the good from country B is now
PB but from country C is PCT. Since PB < PA country A would now import the product
from country B. At the lower domestic price PB, imports would rise to the blue line
distance, or D2 - S2. Since trade now occurs with the customs union and it did not occur
before, trade is said to be created.

Welfare Effetcs : Consumer Surplus = + (a + b + c)

Producer Surplus = - a
Govt. Revenue = 0
National Welfare = + (b + c)

Trade Creation (imports) from “0” to D2 - S2 with formation of customs union.

ECONOMICS Paper 13 – International Economics

Module 18- Economic Integration - Various Forms, Static and Dynamic
Effects of Custom Union
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4.2 Trade Diversion

Trade diversion is said to happen when lower-cost imports from a nonmember nation are
prevented from entering the regional bloc by introducing tariff or nontariff barriers, and are
replaced by higher-cost imports from a member nation. Trade diversion brings down world
economic well-being since it shifts production from more efficient producers outside the trading
bloc to less efficient producers of the countries in the bloc. The international distribution of
resources becomes less efficient, & production moves away from the pattern suggested by theory
of comparative advantage.

We again take the case of 3 countries- country A, B & C. The graph depicts the demand & supply
curves for country A. PB & PC represent the free trade supply prices of the good from country's B
and C, respectively. Note that country C is assumed competent enough of supplying the product
at a lower price than country B.

Country A imposes specific tariff on both countries, the amount of tariff represented by the dotted
green lines. The tariff raises prices of domestic supplies to PBT & PCT, respectively.

Since, with the tariff, the product is cheaper from country C, country A will import the product
from country C and will not trade with country B initially. Imports are depicted on the graph by

ECONOMICS Paper 13 – International Economics

Module 18- Economic Integration - Various Forms, Static and Dynamic
Effects of Custom Union
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the red line, or by the distance D1 - S1. Initial tariff revenue is given by area (c + e), the tariff rate
times the quantity imported.

If we now assume the countries A & B form a custom union and A eliminates the tariff on
imports from country B. The domestic prices on goods from countries B and C are now PB and
PCT, respectively. Since PB < PCT country A would import all of the product from country B and
would import nothing from country C. Imports would rise to D2 - S2, denoted by the blue line.
Also since the non-distorted (i.e., free trade) price in country C is less than the price in country B,
trade is said to be diverted from a more efficient supplier to a less efficient supplier.

4.3 Other Static Welfare Effects of Customs Union

There are other welfare effects which are static in nature arising from the formation of a custom
union:

1. Custom union, a move towards free trade will eliminate the role of custom officers and
other leading to administration savings.
2. Customs union acting as a single unit in international trade negotiations will likely
possess much more bargaining power than the total of its members acting separately.

5. Dynamic Effects of Customs Union

Besides the static welfare effects, the countries forming a custom union are expected to gain over
long run in terms of the following benefits:

1. Increased Competition. Possibly the most important single gain from a custom union is the
potential for increased competition. Businesses, especially those in monopolistic and oligopolistic
markets, may become sluggish and complacent when protected by barriers to trade. With the
formation of a custom union, trade barriers among members are greatly reduced or eliminated,
and producers must become more efficient to effectively compete with foreign firms. Some may
succeed; some may merge with other firms; others will go out of business. The higher level of
competition is also likely to stimulate the development and adoption of new technology and new
products. The end result will be lower costs of production and, therefore, lower consumer prices
for goods and services, new products, and improvements in product quality. It is important that
member country governments enforce the new trade rules if these competitive forces are to
operate effectively.

2. Economies of Scale. Another benefit of custom union is that substantial economies of scale
may become possible in the enlarged market area. If firms were previously serving only the
domestic market, the expanded market with the custom union may create export opportunities. If
the production process possesses economies of scale, the increase in output lowers per unit costs

ECONOMICS Paper 13 – International Economics

Module 18- Economic Integration - Various Forms, Static and Dynamic
Effects of Custom Union
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and the price charged to consumers. For instance, it has been determined that many firms in small
nations, such as Belgium and the Netherlands before joining the EC, enjoyed economies of scale
by producing both for the domestic market and for export. However, after becoming members of
the EC, significant additional economies of scale were gained by individual firms reducing the
range of products manufactured and increasing the output of the remaining products.

3. Stimulus to Investment. The formation of a custom union is likely to stimulate outside

investment in production and marketing facilities to avoid the discriminatory barriers imposed on
nonmember products. In order for firms to meet the increased competition and take advantage of
the enlarged market, investment is likely to increase. In most cases, investment in a custom union
area is an alternative to the export of products from nonmember countries. The large investments
made by U.S. firms in Europe after the mid-1950s, and in the years and months giving way to the
Single European Act, were fostered by their desire not to be excluded from this large potential
market: investing ensured that their products would not be restricted by tariff & nontariff barriers.

4. Efficient Resource Use. Finally, if the custom union is a regular market, the free movement of
labor and capital is likely to stimulate more efficient use of the economic resources of the
complete bloc. On the whole effectiveness of industries and individual firms would most likely
increase with increased access to lower-cost capital and additional labor. This will imply that the
costs for consumer will lower down and real incomes would be high.

6. Summary

 Economic Integration is the policy of reducing or simply putting an end to trade barriers
among various nations in order to form a regional bloc.
 Many forms of economic integration have been realized: preferential trade agreement,
free trade area, common market, custom union & economic union.
 History has provided us with various examples of economic integration, with prominent
one being the NAFTA and EU.
 The short run or the static effects of a custom union are summarized in the concept of
trade creation and trade diversion.
 Trade creation is said to happen when domestic production of one member nation is
replaced by lower-cost imports from another member nation.
 Trade diversion is said to happen when lower-cost imports from a nonmember nation are
prevented from entering the regional bloc by tariff or nontariff barriers, and are replaced
by higher-cost imports from a member nation.
 The dynamic or the long run effects of custom union are increased competition, stimulus
to investment, technical change, economic growth, etc.

ECONOMICS Paper 13 – International Economics

Module 18- Economic Integration - Various Forms, Static and Dynamic
Effects of Custom Union