International Economic Relations

Economic Integration

Bo Gao
b.gao@lboro.ac.uk
Consultation and Feedback Hours: Fridays 11.00-13.00 in BE. 1.14
(no appointment needed). Contact me to set up Teams or in-person
meetings if you are not available Fridays 11.00-13.00.
Intended Learning Outcomes:
• After the lecture, you are supposed to:
• Understand the forms of economic integration, find an example in
the real world for each form of economic integration;

• Understand trade creation and trade diversion effects of joining a

customs union, know how to analyse the welfare effects of trade
creation and trade diversion;

• Understand the dynamic benefits from customs union and know how
to evaluate the impacts in real world;

• Know how to analyse the effects of joining a customs union or

leaving a customs union (e.g. Brexit) on the trade.
Economic Integration :

• Forms of economic integration

• Trade creation and trade diversion
• Dynamic benefits from customs union
Forms of economic integration
• Preferential trade arrangement (PTA).
• Free trade area (FTA)
• Customs union
• Common market
• Economic union

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Forms of economic integration
• Preferential trade arrangement (PTA).
➢ Member countries agree to set lower barriers to trade
within the group than with non-member countries
• Free trade area (FTA)
➢ Involves eliminating barriers to intra-group trade while
allowing each country to maintain its own barriers to
trade with non-members.

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Any potential problems?

Rules of origin

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Rules of origin
• Rules of origin are the criteria needed to determine the
national source of a product.
• Their importance is derived from the fact that duties and
restrictions in several cases depend upon the source of
imports.
• There is wide variation in the practice of governments with
regard to the rules of origin.
• While the requirement of substantial transformation is
universally recognized, some governments apply the
criterion：change of tariff classification, or the ad valorem
percentage, or manufacturing/processing operation.
Forms of economic integration
• Customs union
➢ Intra-group trade faces no barriers and members
maintain a common external tariff on trade with non-
members.

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Any potential problems?

e.g. 10%

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Forms of economic integration
• Customs union
➢ Intra-group trade faces no barriers and members maintain
a common external tariff on trade with non-members.
➢ For example, a car from the US entering the EU customs
union currently attracts a tariff of 10% of the car's value. It
doesn't matter if the car arrives in France, Spain or
anywhere else - the same one-off 10% charge is applied.
➢ That car can then move between all the customs union
countries without incurring extra costs or custom checks.

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Forms of economic integration
Customs union
➢ Common external tariff means no independent
trade agreements for members.
➢ This common external tariff has been a debated
point during the negotiation of Brexit deal.
➢ Labour proposes a customs union with a “say” in
trade deals: politically and legally difficult.
➢ No checks between NI and Ireland.
Forms of economic integration
• Common market
➢ Extends free trade among members to factors of
production (labour migration and capital flows),
as well as to goods and services.
• Economic union
➢ In addition to common market, members
harmonize or even unify the monetary and fiscal
policies.

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 Forms of economic integration

Loosest

Most
advanced

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Exercise
• Go to
http://rtais.wto.org/UI/PublicMaintainRTAHome.
aspx
• 1) Select “RTAs by country/territory”
• Click EU
• 2) Select “RTAs in force”
• Search EU
Participation in Regional Trade Agreements

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Trade creation and trade diversion

• Trade creation occurs when some domestic

production in a member nation is replaced by
lower-cost imports from another member.
➢ Leads to increased welfare for members as nations
specialize in comparative advantages.
➢ Recall the trade gains from Ricardian model.
Illustration of a trade-creation
customs union
• Consider 3 countries: A, B and C (or the rest of
the world).
• Country A and B are forming a customs union.
• Before forming the customs union, country A
sets identical tariffs to the imports from B and C.
• The pre-tariff price of a product from country B is
lower than the pre-tariff price of the same
product from country C.
• As a result, country A imports from country B.
Before forming a customs union

PB +T

PB
D
X1 X2 X
Imports
Illustration of a trade-creation
customs union
• After forming a customs union with B, i.e.
removing the tariff for imports from country B,
• Country A should continue to import from B.
• As shown from the following figure:
After forming a customs union

PB +T

PB
D
X3 X1 X2 X4 X
Imports
Illustration of a trade-creation
customs union
• After forming a customs union with B:
➢ Import from country B is larger. Therefore, trade
is created;
➢ Domestic production is decreased from X1 to X3,
which is replaced by the imports;
➢ Price is decreased from PB+T to PB. Therefore,
some domestic production is replaced by lower-
cost imports.
Welfare effects
P ➢Consumer: +(a+b+c+d)
➢Producer: -a
S
➢Government: - c
➢Total welfare: + (b+d)

P +T
B ➢Trade creation increases
a b c d
PB
welfare.
D
➢The whole analysis is
X3 X1 X2 X4 X similar to the reverse of
Imports
tariff in a small country.
Trade diversion
• Trade diversion occurs when lower-cost
imports from non-members are replaced by
higher-cost imports from members.
➢ This is due to removal of tariff to the members.
➢ By itself, trade diversion lowers welfare as it shifts
resources away from comparative advantages.
Illustration of a trade-diversion
customs union
• Consider 3 countries: A, B and C (or the rest of the
world).
• Country A and B are forming a customs union.
• Before forming the customs union, country A sets
identical tariffs to the imports from B and C.
• The pre-tariff price of a product from country B is
higher than the pre-tariff price of the same product
from country C.
• As a result, country A imports from country C:
PB+T >PC+T
Before forming a customs union

PB +T
PC+T
PB
PC
D
X1 X2 X
Imports
Illustration of a trade-diversion
customs union
• After forming a customs union with B, i.e.
removing the tariff for imports from country B,
• The price of imports from country B is lower
than the price of imports from country C:
PC+T > PB
• As shown from the following figure:
After forming a customs union
P ➢Trade is diverted from country
C to country B, from lower-cost
S
imports to higher-cost imports
(PC< PB).
➢Trade diversion customs
union also has trade creation
PC+T
PB effect: more imports, production
PC from X1 to X3, replaced by the
D lower-cost imports.
X3 X1 X2 X4 X
Imports ➢Trade diversion decreases
welfare while trade creation
increases welfare.
 Welfare effects
P ➢Consumer: +(a+b+c+d)
➢Producer: -a
S
➢Government: - (c+e)
➢Total welfare: b+d-e

• Gains from trade creation: b+d

a b c d
PC+T • Loss from trade diversion: -e
e PB
PC
➢Overall welfare: >0 or <0?
D
➢The whole analysis is similar
X3 X1 X2 X4 X
Imports to the reverse of tariff in a large
country.
 The problem: trade creation > trade
diversion ?

• Trade creation is more likely to be greater than

trade diversion if:
➢ Initial tariff is very high.
✓ There is a greater probability that customs union will
create trade among members rather than divert trade
from non-members to members.
➢ Cost difference between goods purchased with and
outside the union is a relatively small.
✓ This makes it less likely that customs union will lead to
costly trade diversion.
Initial tariff

a b c d Small initial tariff:

e b+d<e

X
Initial tariff

a c d High initial tariff:

b b+d>e
e

X
Cost difference

a c
b d
Large cost difference:
e b+d<e

X
Cost difference

a c d
b
Small cost difference:
e
b+d>e
D

X
Ways to think about other benefits
from customs union
• Increased competition.
• Economies of scale.
• Stimulus to investment.
• Increased competition.
➢ When a customs union is formed and trade
barriers are eliminated, producers in each nation
must become more efficient to meet the
competition of other producers within the union.
➢ The competition is also likely to stimulate the
development and utilization of new technology.
• Economies of scale.
➢ When a customs union is formed and trade
barriers are eliminated, significant economies of
scale can be achieved.
• Stimulus to investment.
➢ Stimulus to investment is a possible response to
take advantage of enlarged market and meet the
increased competition.
➢ Outsiders invest more in the union to avoid the
tariff and exploit the large market.
Core readings
• International Economics by Dominick Salvatore,
chapter 10

• Other readings related to the intended learning

outcomes are recommended and encouraged.