International Economic

Integration

Assoc. Prof. Dr. Ngo Thi Tuyet Mai

CHAPTER

3 Theories of International
Economic Integration

2
Content
◼ Introduction
◼ Welfare effects of customs union
▪ Static
▪ Dynamic
◼ Effects of completion on the increased
efficiency in production - EU
◼ Customs Union & protection?

3
Form of Economic Integration

4
Customs union (FTA+)

◼ Removes all barriers to trade among members

and harmonizes trade policies toward the rest of
the world.

◼ The theory of CU is a good example of the

relevance of economic theory for practical
economic policies
Customs unions in the world

◼ Andean Community (CAN): 1988

◼ East African Community (EAC): 2005
◼ Customs Union of Belarus, Kazakhstan and
Russia: 2010
◼ Israel – Palestinian Authority: 1994
◼ Southern Common Market (MERCOSUR): 1991
◼ Southern African Customs Union (SACU): 2010
◼ Switzerland-Lichtenstein: 1924
Customs Unions in economic
theory – The static approach
◼ 1950, Jacob Winer (1982-1970)
◼ Viner’s model - assumptions:
1. There are three countries A, B, C (Country A is a very small; C:
represents all other countries in the world)

2. Perfect competition in commodity and factor markets

3. Perfect factor mobility within countries but not among
the countries
4. Full employment and foreign trade equilibrium
5. Perfectly price elastic supply on the world market
6. Economies and/or diseconomies of scale are not
considered
Customs Unions in economic
theory
◼ Viner’s model - assumptions:
7. Transport costs are not considered
8. At least three participants of the trade are considered;
countries A and B, discriminating in trade with the rest of
the world, and the world market
9. A partial equilibrium approach is adopted; one
commodity markets are considered (three countries can
produce commodity: X)
10. Customs union formation will not increase the tariff
protection
Static effects of a Customs Union
◼ Trade creation:
- With a new partner in CU
- Switch from high-cost domestic production to
lower costs foreign production
◼ Trade diversion
- With the rest of the world
- Switch from low-cost foreign suppliers to
higher-cost foreign suppliers in partner
country
Trade-Creating Customs Unions

◼ Trade creation occurs when domestic

production in a member nation is replaced by
lower-cost imports from another member
nation.
◼ Leads to increased welfare for members as
nations specialize in comparative advantages.
◼ Leads to increased welfare for non-members as
increased real income spills over into
increased imports from the rest of the world.
Table 3.2&3.3: Unit cost of production of a good in
euros
Country A B C
Unit cost of 60 50 35
production
Import duty ((%) from country A
100% 100 70
50% 75 52.5
• Suppose that three countries can produce the same good (X), but with
varying levels of efficiency; Country A (very small country); Country C: all
other countries in the world
• All goods and services are homogeneous; Ad valorem tariffs
• Tariff rates are the same both for final goods and for inputs
• The Country C has the lowest unit cost of production
Before CU, country A will import X from Country C, WHY ?
After CU (A forms a CU with B only): A imposes a tariff of 100% on X
imported from C? => A will import X from B, WHY ?
Table 3.2&3.3: Unit cost of production of a good in
euros
Country A B C
Unit cost of 60 50 35
production
Import duty ((%) from country A
100% 100 70
50% 75 52.5

• Before CU: the country C will become the world

supplier of this good
• Suppose the country A levy a tariff of 100%:
• The domestic price of imported good will be
increased
• It shifts consumption away from imports towards
country A’s domestic production
Table 3.2&3.3: Unit cost of production of a good in
euros
Country A B C
Unit cost of 60 50 35
production
Import duty ((%) from country A
100% 100 70
50% 75 52.5

After CU (A forms a CU with B):

• Country A will import good from the country B, at a
cost of €50 per unit.

=> They are better of than with a non-discriminatory

tariff
Table 3.2&3.3: Unit cost of production of a good in
euros
Country A B C
Unit cost of 60 50 35
production
Import duty ((%) from country A
100% 100 70
50% 75 52.5

After CU (A forms a CU with C):

• Country A will purchase the good at a unit price of € 35
from country C.

 The formation of CU encourages trade creation as the

result of a shift from a dearer to a cheaper source of
supply
Trade-Diverting Customs Unions

◼ Trade diversion occurs when lower-cost

imports from non-members are replaced by
higher cost imports from members.
◼ By itself, trade diversion lowers welfare as it
shifts resources away from comparative
advantages.
◼ Trade diverting customs union also results in
trade creation. Change in welfare depends on
relative magnitude of creation and diversion.
Table 3.2&3.3: Unit cost of production of a good in
euros
Country A B C
Unit cost of 60 50 35
production
Import duty ((%) from country A
100% 100 70
50% 75 52.5

Before CU:
•If A imposes a tariff of 50% on imported good from B and C => A would
import good from country C at €52.5, WHY?
After CU (A &B):
•A would purchase good from B at €50 per unit, WHY?
The outcome in this case is trade diversion (the cheapest foreign supplier
is replaced by a relatively dearer CU partner). This creates a global welfare
loss
Figure 3.1. Flows of imports of a good to country A, before
and after the creation of a CU with country B

Patterns of consumption change following the creation of a CU.

For example:
▪ When Britain joined the EU in 1973, the share of its imports from other EU
partner countries increased significantly over a decade
▪ Trade between Mexico and the US doubled over the five years that preceded
the creation of NAFTA in 1994
Figure 3.1. Flows of imports of a good to country A, before
and after the creation of a CU with country B

Patterns of consumption change following the creation of a CU.

• “Inter–country substitution” occurs when one country replaces another as
the source of supply for some good
• “inter-commodity substitution” occurs when one commodity is substituted,
at least the margin, for another one as a result of a shift in relative prices
Q&A

Do you think by CU (common external tariff) may

promote a more efficient allocation of resources
within the CU from is internal point of view?
Effects of a Customs Union

Three countries: A, B, C
SS&DD: A’s domestic supply and
demand curves
BB: B’s supply curve
CC: C’s supply curve

Figure 3.2- The effects of a tariff and a CU on economic

efficiency for a singer good in country A’s market
=> Trade expansion due to the creation of the CU equals the sum of the
reduction in home production Q2Q3 and the increase in home consumptions
Q4Q5
Trade-Diverting Customs Unions

◼ Trade diversion occurs when lower-cost

imports from non-members are replaced by
higher cost imports from members.
◼ By itself, trade diversion lowers welfare as it
shifts resources away from comparative
advantages.
◼ Trade diverting customs union also results in
trade creation. Change in welfare depends on
relative magnitude of creation and diversion.
=> Trade expansion due to the creation of the CU equals the sum of the
reduction in home production Q2Q3 and the increase in home consumptions
Q4Q5
The Theory of the Second Best and Other
Static Welfare Effects of Customs Unions

◼ The theory of the second best was formalized by

Richard Lipsey and Kelvin Lancaster in 1956.
◼ It was once believed that any movement toward freer
trade would increase welfare, so formation of a
customs union would necessarily result in increased
welfare for members and non-members.
◼ In 1950, Viner showed that formation of a customs
union could increase or reduce welfare, depending on
the circumstances under which it takes place.
The Theory of the Second Best and Other
Static Welfare Effects of Customs Unions

◼ Theory of the Second Best

If all conditions required to maximize welfare
cannot be satisfied, trying to satisfy as many
conditions as possible does not necessarily or
usually lead to the second-best position.
The Theory of the Second Best and Other
Static Welfare Effects of Customs Unions

◼ Conditions More Likely to Lead to Increased

Welfare
1. Higher pre-union trade barriers of member
nations.
2. Lower customs union’s trade barriers with
non-members.
3. Greater number of nations forming customs
union, and the larger their size.
The Theory of the Second Best and Other
Static Welfare Effects of Customs Unions

◼ Conditions More Likely to Lead to Increased

Welfare
4. More competitive rather than complementary
economies of member nations.
5. Closer geographical proximity of member
nations.
6. Greater pre-union trade and economic
relationship among potential member nations.
The Theory of the Second Best and Other
Static Welfare Effects of Customs Unions

◼ Other Static Effects of Customs Unions

1. Administration savings from elimination of
customs officers, border patrols, and others.
2. Reduction in demand for imports from and
supply of exports to rest of the world will
likely lead to improvement in collective terms
of trade of member nations.
3. By acting as a single unit, customs union will
likely have more bargaining power than
members separately.
Dynamic Benefits from Customs Unions

◼ Dynamic Benefits of Customs Unions

1. Increased competition, leading to greater
efficiencies and technological improvements.
2. Economies of scale from the enlarged market.
3. Stimulus of investment to take advantage of
enlarged market, and to meet increased
competition.
4. Better utilization of community resources as labor
and capital move freely (assumes common
market).
Case study

The Customs Union between the European Union

and Turkey and its
Impacts on Turkey’s Economy
Q&A
The end