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  1. ECONOMIC INTEGRATION ECN4182

  2. Trade Blocs: 1960s

  3. Trade Blocs: 1970s

  4. Trade Blocs: 1990s

  5. Composition of Trade • Increased trade as share of GDP • Largest increase in trade among OECD countries • Increased trade in intermediate inputs • Import content of exports increased • International segmentation of production • Increased trade in new products • Trends challenge standard trade theory and analysis of gains from trade

  6. The rise, and fall, and rise of regionalism? • Post-war first phase of regional integration involved the creation of the EEC (1957) and EFTA (1961). • Success of these integration schemes led to a variety of other attempts at regional integration schemes in the 1970’s, and 80’s (the “old phase” of regionalism). • Many of these versions of import-substitution / inward looking but on the regional level. Therefore also tended to be south-south • Most of these proved unsuccessful and unsustainable • More recently another surge in regionalism (NAFTA, FTAA, Mercosur, SADC, ASEAN, CAFTA, GAFTA, EU Association Agreements…. • but this time the motivation much more towards using regional integration as a means of insertion into the world economy • agreements tend to be both South-South, and North South

  7. RTA formation Source: World Trade Organization

  8. The consequences (and therefore possibly motives) for regional integration are derived from trade theory ie • improved allocation of resources through exploitation of comparative advantage (Ricardo, HOS) • gains from trade arising from imperfectly competitive models (scale, variety, pro-competitive) • possible impact on economic growth… • Moving from restricted to free trade is welfare increasing, natural to assume that a move from restricted trade to regional integration will also be welfare increasing. • However, this is not necessarily the case. Restricted trade is a distorted equilibrium, and so is regional integration: • if all the optimal conditions cannot be met than it may not be welfare improving to satisfy just some of them, ie in the presence of distortions eliminating only some of the distortions may not increase welfare (theory of second best)

  9. Regional Trade Agreements • RTA: a group of countries liberalize trade among themselves, but not with the rest of the world. • Stages of regional integration agreements: • preference areas (PTA) • Free Trade Areas (FTA) • Customs Unions (CU) • Common Market • Monetary Union • Economic Union

  10. Preferential Trade Agreement (PTA) • the weakest form of economic integration. • countries would offer tariff reductions, though perhaps not eliminations, to a set of partner countries in some product categories. • Higher tariffs, perhaps non-discriminatory tariffs, would remain in all remaining product categories. • This type of trade agreement is not allowed among WTO members who are obligated to grant most-favored nation status to all other WTO members. • Under the most-favored nation (MFN) rule countries agree not to discriminate against other WTO member countries. • Thus, if a country's low tariff on bicycle imports, for example, is 5%, then it must charge 5% on imports from all other WTO members. • Discrimination or preferential treatment for some countries is not allowed.

  11. Free Trade Area (FTA) • occurs when a group of countries agree to eliminate tariffs between themselves, but maintain their own external tariff on imports from the rest of the world. • The North American Free Trade Area is an example of a FTA. • When the NAFTA is fully implemented, tariffs of automobile imports between the US and Mexico will be zero. • However, Mexico may continue to set a different tariff than the US on auto imports from non-NAFTA countries. • Because of the different external tariffs, FTAs generally develop elaborate "rules of origin". • These rules are designed to prevent goods from being imported into the FTA member country with the lowest tariff and then transshipped to the country with higher tariffs. • Other example: AFTA (ASEAN FREE TRADE AREA); SAFTA (SOUTH ASIA FREE TRADE AREA); LAFTA (LATIN AMERICA FREE TRADE AREA)

  12. Customs Union • A customs union occurs when a group of countries agree to eliminate tariffs between themselves and set a common external tariff on imports from the rest of the world. • The European Union represents such an arrangement. • A customs union avoids the problem of developing complicated rules of origin, but introduces the problem of policy coordination. • With a customs union, all member countries must be able to agree on tariff rates across many different import industries.

  13. Common Market • A common market establishes free trade in goods and services, sets common external tariffs among members and also allows for the free mobility of capital and labor across countries. • The European Union was established as a common market by the Treaty of Rome in 1957, although it took a long time for the transition to take place. • Today, EU citizens have a common passport, can work in any EU member country and can invest throughout the union without restriction.

  14. Monetary Union • Monetary union establishes a common currency among a group of countries. • This involves the formation of a central monetary authority which will determine monetary policy for the entire group. • The Maastricht treaty signed by EU members in 1991 proposed the implementation of a single European currency (the Euro) by 1999. • The degree of monetary union that will arise remains uncertain in 1998.

  15. Economic Union • An economic union typically will maintain free trade in goods and services, set common external tariffs among members, allow the free mobility of capital and labor, and will also relegate some fiscal spending responsibilities to a supra-national agency. • The European Union's Common Agriculture Policy (CAP) is an example of a type of fiscal coordination indicative of an economic union.

  16. Conditions for a “successful” union: • The greater the degree of complementarity in the range of goods produced (greater overlap), therefore more possibilities for Trade Creation • For a given overlap in production bundles the greater the differences in costs • the higher the proportion of trade with the union partner as opposed to the rest of the world • the larger the size of the union  world free trade • the higher are the tariffs prior to the union (implies greater distortion) • the lower the post-union external tariff (reduces scope for trade diversion

  17. motives for a regional integration? • Classical theory does not offer us an a priori reason why countries should choose to integrate • difficulties of pursuing multilateral liberalization successfully • Scale economies • Trade and imperfect competition • Terms of trade effects: • if a CU impacts negatively on demand for rest of world products (trade diversion), than it may be that the price of these goods goes down, and the terms of trade for the union countries  • Public Goods (Cooper-Massell, Johnson) • if there is a collective preference for eg. industrial production, or if there are positive externalities associated with certain sectors then there may be grounds for government intervention • 1st best policy - subsidise the industry, but suppose this is not a viable option • an alternative is tariffs which will expand industrial production • However tariffs not allowed under GATT/WTO rules, but CUs and PTAs are

  18. Efficiency gains: • a) if production was initially inefficient (eg. X-inefficiency) the increase in competition may force firms to produce more efficiently  “cold shower of competition” • b) take advantage of scale economies in a large “home market”. • Increase in FDI as firms perceive that setting up production gives them access to a larger market • “Dynamic” effect - strictly speaking impact on growth. Effects here are as in the trade and growth literature. • Impact of removal of non-tariff barriers (physical barriers, technical barriers, fiscal barrier, public procurement… • reallocation of resources as above • release of real resources as the non-tariff barriers use real resources • Political motives

  19. “drawbacks” of integration • Note there have been many unsuccessful attempt at regional integration schemes therefore need to perhaps think about why • uneven distribution of benefits of integration • competitive “strategic” trade policies • economic geography • political factors • inward looking

  20. Trade Diversion and Trade Creation • The analysis uses a partial equilibrium framework which means that we consider the effects of preferential trade liberalization with respect to a representative industry.

  21. Trade Diversion and Trade Creation • assume in each case that there are three countries in the world, countries A, B and C. • Each country has supply and demand for a homogeneous good in the representative industry. • Countries A and B will form a free trade area. • Note: trade diversion and creation can occur regardless of whether a preferential trade agreement, a free trade area or a customs union is formed. • refer to the arrangement as a free trade area (FTA)) • assume that country A is a small country in international markets which means that it takes international prices as given. • Countries B and C are assumed to be large countries (or regions). • Thus country A can export or import as much of a product as desired with countries B and C at whatever price prevails in those markets.

  22. Trade Diversion and Trade Creation • country A initially is assumed NOT to be trading freely. • Instead the country will have a MFN (i.e., the same tariff against both countries) specific tariff applied on imports from both countries B and C. • In each case below we will first describe an initial tariff-ridden equilibrium. • To calculate: the price and welfare effects that would occur in this market if Country A and B form a free trade area. • When the FTA is formed, country A maintains the sametariff against country C, the non-FTA country.

  23. Trade Diversion • In general, trade diversion means that a free trade area diverts trade, away from a more efficient supplier outside the FTA, towards a less efficient supplier within the FTA. • In some cases, trade diversion will reduce a country's national welfarebut in some cases national welfare could improve despite the trade diversion.

  24. Trade Diversion The size of the tariff • assume that A has a specific tariff tB = tC = t* set on imports from both countries B and C. • The tariff raises the domestic supply prices to PTB and PTC, • The size of the tariff is : t* = PTB- PB = PTC - PC. D S PaT PcT PB Pc S2 S1 D1 D2 Country A

  25. Trade Diversion The size of the tariff • with the tariff, the product is cheaper from country C • country A will import the product from country C and will not trade initially with country B. D S Tariff revenue PaT PcT c PB e Pc import S2 S1 D1 D2 Country A

  26. Trade Diversion • assume countries A and B form a FTA • Country A eliminates the tariff on imports from country B. • Now tB = 0 but tC remains at t*. • The domestic prices on goods from countries B and C are now PB and PTC, respectively. • Since PB < PTC • country A would import all of the product from country B after the FTA and would import nothing from country C. • At the lower domestic price, PB, imports would rise to D2 - S2 • 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. D S PaT PcT a b c d PB e Pc import S2 S1 D1 D2 Country A

  27. Trade Diversion: Effect of joining FTA • Consumers of the product in the importing country benefit from the free trade area; because reduction price of imported good • CS: a + b + c + d • Producers in the importing country suffer losses as a result of the free trade area; because reduction of price • PS: -a • The government loses all of the tariff revenue that had been collected on imports of the product. • Govt. Rev. : -(c+ e) • The aggregate welfare effect for the country is found by summing the gains and losses to consumers, producers and the government • Welfare: + (b+d)-e D S PaT PcT a b c d PB e Pc import S2 S1 D1 D2 Country A

  28. Trade Creation • In general, trade creation means that a free trade area creates trade that would not have existed otherwise. • As a result, supply occurs from a more efficient producer of the product. • In all cases trade creation will raise a country's national welfare.

  29. Trade Creation • country C is assumed capable of supplying the product at a lower price than country B. • assume that A has a specific tariff tB = tC = t* set on imports from both countries B and C. • The tariff raises the domestic supply prices to PTB and PTC, • The size of the tariff is : t* = PTB- PB = PTC - PC. D S PBT PCT PB Pc S2 D2 S1=D1

  30. Since, with the tariffs, the autarky price in country A , labeled PA in the diagram, is less than the tariff-ridden prices PTB and PTC, • Thus, the product will not be imported. • Instead country A will supply its own domestic demand at S1 = D1. • In this case the original tariffs are prohibitive.

  31. Trade Creation • assume countries A and B form a FTA • country A eliminates the tariff on imports from country B. • Now tB = 0 but tC remains at t*. • The domestic prices on goods from countries B and C are now PB and PTC, respectively. • Since PB < PA country A would now import the product from country B after the FTA. • At the lower domestic price PB, imports would rise to the blue line distance, or D2 - S2. • Since trade now occurs with the FTA, and it did not occur before, trade is said to be created. D S PBT PCT PB Pc S2 D2 S1=D1

  32. Trade Creation: Welfare Effects of Free Trade Area Formation • Consumers of the product in the importing country benefit from the free trade area --- because The reduction in the domestic price of both imported goods and the domestic substitutes raises consumer surplus in the market • CS=a+b+c • Producers in the importing country suffer losses as a result of thefree trade area. • PS:-a • Since initial tariffs were prohibitive and the product was not • originally imported there was no initial tariff revenue. Thus the FTA induces no loss of revenue. • GR: 0 • The aggregate welfare effect for the country is found by summing the gains and losses to consumers and producers • Welfare effect: + (b+c) D S PBT PCT c a b PB Pc S2 D2 S1=D1

  33. Multilateralism vs. Regionalism • In the post World War II period many nations have pursued the objective of trade liberalization. • One device used to achieve this was the GATT and its successor, the WTO. • Although the GATT began with less than 50 member countries, the WTO claimed 132 members by 1997. • Country that pursue the objective of trade liberalization through GATT and WTO agreements commit all member nations to reduce trade barriers simultaneously, it is sometimes referred to as a multilateral approach or multilateralism to trade liberalization.

  34. An alternative method used many countries to achieve trade liberalization includes the formation of preferential trade arrangements, free trade areas, customs unions and common markets. • Since many of these agreements involve geographically contiguous countries, these methods are sometimes referred to as a regional approach or regionalism to trade liberalization. (also known as Regional Trade Agreement or RTA) • .

  35. The key question of interest concerning the formation of preferential trade arrangement is whether these arrangements are a good thing. • One reason supporters of free trade may support regional trade arrangements is because they are seen to represent movements towards free trade. • Indeed, Section 24 of the original GATT allows signatory countries to form free trade agreements and customs unions despite the fact that preferential agreements violate the principle of nondiscrimination. • When a free trade area or customs union is formed between two or more WTO member countries, they agree to lower their tariffs to zero between each other but will maintain their tariffs against other WTO countries. • Thus, the free trade area represents discriminatory policies. • Presumably the reason these agreements are tolerated within the WTO is because they represent significant commitments to free trade, which is another fundamental goal of the WTO.

  36. contradict opinion---WTO is preferable • However, there is also some concern among economists that regional trade agreements may make it more difficult, rather than easier, to achieve the ultimate objective of global free trade. • The fear is that although regional trade agreements will liberalize trade among its member countries, the arrangements may also increase incentives to raise protectionist trade barriers against countries outside the area. • The logic here is that the larger the regional trade area, relative to the size of the world market, the larger will be that region's market power in trade. • The more market power, the higher would be the region's optimal tariffs and export taxes. • Thus, the regional approach to trade liberalization could lead to the formation of large "trade blocs" which trade freely among members but choke off trade with the rest of the world. • For this reason some economists have argued that the multilateral approach to trade liberalization, represented by the trade liberalization agreements in successive WTO rounds, is more likely to achieve global free trade than the regional or preferential approach.

  37. Argument of trade creation vs trade diversion • These concepts are used to distinguish between the effects of free trade area or customs union formation that may be beneficial from those that are detrimental. • RTA are often supported because they represent a movement in the direction of free trade. • If free trade is economically the most efficient policy, it would seem to follow that any movement towards free trade should be beneficial in terms of economic efficiency. • It turns out that this conclusion is wrong. • Even if free trade is most efficient, it is not true that a step in that direction necessarily raises economic efficiency. • Whether a preferential trade arrangement raises a country's welfare and raises economic efficiency depends on the extent to which the arrangement causes trade diversion versus trade creation.

  38. Regionalism: Building blocs or stumbling blocks? • Here we distinguish between • the effects of regional integration (trade creation, trade diversion, terms of trade, + so called "dynamic" effects) per se. This is needed to establish the circumstances under which an RTA could be welfare increasing. • and then the relationship between regionalism and multilateralism. Hence even if an RTA treated in isolation might be welfare improving for its’ members, we might want to consider the impact of the RTA processes on multilateral trade liberalisation. • Important also to bear in mind that the “new” regionalism is different in important ways to the “old” regionalism

  39. Shallow and Deep Integration • Early RTAs and GATT/WTO negotiations facilitated shallow integration: • Shallow integration: removal of barriers to cross-border flows of commodities • Role of multilateral liberalization: GATT/WTO • Role of RTAs - reduction of border trade barriers • New RTAs typically involve elements of “deep integration” • Deep integration: institutions that facilitate trade • Exploiting externalities and correct for market failures. • Additional roles for RTAs

  40. “old” regionalism • often with objective of supporting state-led import substitution policies with scepticism regarding private market, export led growth, and multinationals. • Import substitution policies were generally performing badly and one of the supposed explanations was the small size of national markets. Hence regional integration designed to overcome this. • Frequently involved high levels of external protection, and industrial planning at the regional level. • Commercial links with industrialised countries + membership of the multilateral system were not perceived as priorities. • The process of trade liberalisation tended to by highly selective usually based on positive lists (ie lists of those industries to be included), as opposed to negative lists (lists of those to be excluded) • Effective liberalisation in many schemes was very modest, with special and differential treatment often given to poorest members, and lengthy, costly bureaucratic costs and delays.

  41. “new regionalism” • Some agreements often less ambitious but simpler eg. confined simply to increased market access via exchanges of preferences (eg. LAIA/ALADI) • Closely linked to structural reform processes including a general opening to world markets, promotion of the private sector, and withdrawal of the state from direct economic activity • Indeed the increasing trend in RTAs is to introduce issues of “deeper” integration - public procurement, technical regulations & standards, non-tariff barriers • can link N-S countries (though largely only the US, EU, and Canada) , and not just N-N, or S-S. • eg.NAFTA was pioneering in that it was the first such integration scheme between an industrialised and non-industrialised country, and because it did not just deal with traditional tariffs but also with issues of deeper integration. • Note however, proliferation of overlapping agreements • + impact on third countries via ROOs and trade diversion

  42. Arguments in favour of the New Regionalism • Progress on a range of issues impossible to achieve via the multilateral system, hence need to go down the regional route. • new regionalism typically involves “deeper” integration issues where countries more prepared to grant these + agree on these regionally. • regionalism as a means of promoting development eg. the Cotonou. • Help promote better relations with neighbouring countries • May be useful to try and lock-in commitment to liberalisation • RIA seen as an important means of trying to attract FDI (as opposed to old regionalism which was more opposed to it)

  43. Arguments in favour of the New Regionalism • Gives countries greater negotiating power in hemispheric and world fora where they can negotiate as a group. • impact of trade on productivity (especially for developing countries). • Better than non-reciprocal preferences (eg. GSP, EBA) which • (a) exclude the products of greatest interest to LDCs; • (b) may reinforce sectors where LDCs do not have a comp advantage and therefore slow the process of industrialisation • Emerging trading blocs as "natural FTAs” • can further multilateralism (Baldwin’s domino theory)

  44. New Regionalism • Increased geographical dispersion of production through trade that supports • (1) exploitation of different factor proportions for parts of the production process (Ricardian-HOS efficiency gains) • (2) local economies of scale and increased productivity through finer specialization and division of labour in production (“Smithian” efficiency gains); • Integration in global value-chains • Fragmentation of production • Higher profitability from niche products • Quality and health standards harmonisation lead to increased productivity • Inter-firm and intra-firm coordination • Standards • Technology transfer and scale economies

  45. New Regionalism • Externalities arising from institutional changes and linkages may lead to a wide increase in productivity • Expanded regional trade → deep integration → externalities → increased productivity → increased growth • Intra-firm arrangements (e.g. FDI) • Supermarkets (private) • Inter-firm (e.g., private standards: Europgap) • national adoption of export-related norms • regional/bilateral agreements • multilateral arrangements

  46. Ricardian vs Smithian Gains • Inter-industry trade creation • Final demand • Comparative advantage • Factor endowments • Constant returns • Exogenous technology • Homogenous goods • No role for standards • “Ship and forget” • Intra-industry trade creation • Horizontal quality differentiation • Vertical specialization (value chains) • Productivity and specialization • Technology determinants • Increasing returns • Endogenous technology • Heterogeneous goods • Standards and harmonisation • NOT “ship and forget”

  47. Aggregate Welfare Effects of a Free Trade Area • The analysis above considers the welfare effects upon participants in one particular • market in one country that is entering into a free trade area. However, when a free trade • area is formed, presumably many markets and multiple countries are affected, not just • one. Thus to analyze the aggregate effects of a FTA, one would need to sum up the • effects across markets and across countries.

  48. The simple way to do that is to imagine that a country entering a FTA may have some • import markets in which trade creation would occur and other markets in which trade • diversion would occur. The markets with trade creation would definitely generate • national welfare gains while the markets with trade diversion may generate national • welfare losses. It is common for economists to make the following statement, "If the • positive effects from trade creation are larger than the negative effects from trade • diversion, then the FTA will improve national welfare." A more succinct statement, • though also somewhat less accurate, is that "if a FTA causes more trade creation than • trade diversion then the FTA is welfare improving."

  49. However, the converse statement is also possible, i.e., "if a FTA causes more trade • diversion than trade creation then the FTA may be welfare reducing for a country." This • case is actually quite interesting since its suggests that a movement to free trade by a • group of countries may actually reduce the national welfare of the countries involved. • This means that a movement in the direction of a more efficient free trade policy may not • raise economic efficiency. Although this result may seem counterintuitive, it can easily • be reconciled in terms of the theory of the second-best.

  50. Free Trade Areas and the Theory of the Second-Best • One might ask, if free trade is economically the most efficient policy, how can it be that • a movement to free trade by a group of countries can reduce economic efficiency? The • answer is quite simple once we put the story of FTA formation into the context of the • theory of the second-best. Recall that the second-best theory suggested that when there • are distortions or imperfections in a market, then the addition of another distortion (like a • trade policy) could actually raise welfare, or economic efficiency. In the case of a FTA, • the policy change is the removal of trade barriers rather than the addition of a new trade • policy. However, the second-best theory works much the same in reverse.