International Trade Theory and Policy
by Steven M. Suranovic

Trade 110-2

Economic Integration: Overview

For a variety of reasons it often makes sense for nations to coordinate their economic policies. Coordination can generate benefits that are not possible otherwise. A clear example of this is shown in the discussion of trade wars among large countries on page 110-1. There it is shown that if countries cooperate and set zero tariffs against each other, then both countries are likely to benefit relative to the case when both countries attempt to secure short-term advantages by setting optimal tariffs. This is just one advantage of cooperation. Benefits may also accrue to countries who liberalize labor and capital movements across borders, who coordinate fiscal policies and resource allocation towards agriculture and other sectors and who coordinate their monetary policies.

Any type of arrangement in which countries agree to coordinate their trade, fiscal, and/or monetary policies is referred to as economic integration. Obviously, there are many different degrees of integration.

Preferential Trade Agreement (PTA)

A preferential trade agreement is perhaps the weakest form of economic integration. In a PTA 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. The country is free to charge a higher tariff on imports from non-WTO members, however. In 1998 the US proposed legislation to eliminate tariffs on imports from the nations in sub-Sahara Africa. This action represents a unilateral preferential trade agreement since tariffs would be reduced in one direction but not the other. [Note: a PTA is also used, more generally, to describe all types of economic integration since they all incorporate some degree of "preferred" treatment.]

Free Trade Area (FTA)

A free trade area 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. Of the thousands of pages of text that made up the NAFTA, most of them described rules of origin.

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.

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.

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.

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.

Perhaps the best example of an economic and monetary union is the United States. Each US state has its own government which sets policies and laws for its own residents. However, each state cedes control, to some extent, over foreign policy, agricultural policy, welfare policy, and monetary policy to the federal government. Goods, services, labor and capital can all move freely, without restrictions among the US states and the Nations sets a common external trade policy.

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. Since GATT and WTO agreements commit all member nations to reduce trade barriers simultaneously, it is sometimes referred to as a multilateral approach to trade liberalization.

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 to trade liberalization.

The key question of interest concerning the formation of preferential trade arrangements is whether these arrangements are a good thing. If so, under what conditions. If not, why not.

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 non-discrimination. 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.

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.

There is much that has been written on this subject recently. Here we have merely scratched the surface. For a good overview of the issues from an historical perspective see Bhagwati (1992) and Irwin (1994). For a review of the recent literature regarding the merits of regionalism versus multilateralism see Winters (1996).

In what follows here we present the economic argument regarding trade diversion and trade creation. 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. As mentioned above, preferential trade arrangements 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.

International Trade Theory and Policy - Chapter 110-2: Last Updated on 4/1/98