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The economic theory of integration and the EU

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Economics of Europe 2013 Lecture 2: The economic theory of integration and the EX. customs union in practice This week we shall be looking at what impact the creation of the SEC/E customs union may have had on trade patterns. But first we need to remind ourselves a little about the economic theory of trade. Gains from trade Countries trade with one another either to obtain goods that for some reason they cannot produce for themselves, or to obtain goods that another country can produce relatively cheaply.

Here the theory of comparative advantage, put forward by the eighteenth century British economist and parliamentarian, David Richard (1772-1823), provides a key insight. Richard argued that even if country A can produce all goods more cheaply than country B (I. E. Country A has an absolute advantage in production), nevertheless both countries will gain from trade if each exports those goods in which it has a comparative advantage in production. To give you a very simple example: Consider two countries: Britain and America, making Just two products: pottery and grain.

Their production per man year is: Table 1 Production per man year Britain Units of Pottery Units of Grain 3 America 9 12 America can clearly produce both pottery and grain more cheaply than Britain in terms of labor input I. E. It has an absolute advantage in the production of both goods. But what about comparative advantage? Since Britain can produce either 6 units of pottery or 3 units of grain per man year (or a mixture of the two), the opportunity cost of 1 unit of pottery is 3/6 (or h) unit grain, whilst in America it is 12/9 or 11/3 units of grain.

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So in Britain pottery production, in terms of loss of grain, is relatively cheaper than in America. It has a comparative advantage in pottery production. Similarly, in Britain the opportunity cost of 1 unit of grain is 6/3 or 2, and in America it is 9/12 or %. So America has a comparative advantage in producing grain. It will be to the mutual advantage of both countries if Britain specializes in pot production, and America specializes in grain production and Britain then trades pots for American grain.

By this trade the overall world production of both pots and grain increases, and both countries benefit. To show the way the welfare of a country benefits under free trade consider Diagram 1 below: Diagram 1: The Gains from Trade 2 Initially Britain is not engaging in trade, a situation known as tributary. G is the demand curve for grain and SO is the supply curve for grain (e entirely from domestic production). The initial equilibrium is therefore at X, where IQ of grain is supplied, entirely from domestic production, at price Pl .

The welfare enjoyed at this point can be represented by the sum of the consumer surplus (ii the difference between what consumers would be prepared to pay for grain and what they actually pay), the triangle DIP, and the producer surplus (the difference between what producers actually receive for their grain and the minimum accessory to induce production), the triangle SPIN. Now assume that Britain starts trading, and buys grain on the world market.

We assume (not unreasonably, given that there will be many producers all competing fiercely to sell their grain) that Britain is facing a fixed world price 'e. A perfectly elastic world supply curve, which is lower than the market price of wheat in Britain. So at this price Britain's new demand tort grain becomes SQ, and the quantity to grain supplied by producers is SQ. SQ to SQ is supplied by imports. What has happened to welfare? The consumer surplus has risen to DIP" But the producer surplus has fallen to SPEW. British This means there is an overall net gain in welfare shown by the triangle EX..

If there were universal free trade all countries would trade in the goods and services in which they have a comparative advantage and countries would be allocating resources to production as efficiently as possible. Trade Barriers The model above does, however, show quite clearly that trade can result in a cost to local producers of the good being imported, who must switch to some other form of production, presumably one in which Britain has a comparative advantage. This may exult in some redistribution of income in the country.

This is why it is usually producer groups who lobby for some form of protectionism, or protection from trade in their goods, by government imposition of various types of trade barrier which has the effect of raising the price of imported goods. The benefit to consumers of free trade, being more diffuse, is often less immediately apparent. The most usual trade barrier is the imposition of a tariff, or essentially a tax, on imports. These can take two main forms: a. An ad valor tariff is a set percentage of the value of the good being imported. If the international price of the good alls, so does the tariff. . A specific tariff, which is a specific amount of money that does not vary with the price of the good. Typically a cost per unit of the good. These tariffs are vulnerable to changes in the market or inflation unless updated periodically. But there can also be significant non-tariff barriers (Nets) to trade, and these can often be used to restrict trade even when there have been agreements between countries to reduce tariffs. Nets include: I. Import quotas. Quotas place a limitation in value or in physical terms on imports of certain goods for a certain period of time. 4 v'. Licenses.

These require that certain imports can only be imported 'under license' and these can restrict the quantity of goods, their cost, the country of origin, the customs points through which the goods are imported, etc. Use of standards. Countries may impose unreasonable standards of labeling, packaging and testing of products (often under the pretext of protecting the health and safety of the local population) in order to block sales of imports. Administrative or bureaucratic delays at the point of entry. Voluntary export restraints by certain countries in certain goods (usually negotiated between the countries. )

Currency manipulation and exchange controls. If a country is able to maintain its exchange rate at an artificially low level (low interest rates; intervention in currency markets by selling own currency, etc. ) then imports into the country will appear expensive and exports cheap. This is what China has been doing for the last few years. Exchange controls can physically limit the amount of foreign exchange available, and hence also limit imports. (UK had exchange controls from 1939 to 1979). We should note that countries can also manipulate trade and protect domestic producers by measures to subsidies their exports. 5

Returning to our simple model we can look at the effect of the imposition of a tariff, or indeed any other NTH which has the effect of raising import prices: Diagram 2: The imposition of a tariff (on grain imports into Britain) Here Britain has imposed a tariff on imported grain which has the effect of raising the price within Britain from UP to UP+T. This means that the quantity of grain demanded by consumers will fall back from SQ to SQ and the amount of wheat produced by British farmers will increase from SQ to SQ. Imports will fall back to SQ to SQ. The government will receive t(SQ to SQ) in revenue from the tariff.

What will be the overall effect on welfare compared with free trade? The consumer surplus falls by the area 1+2+3+4, but the producer surplus increases by the area 1 and the government will gain revenue from the tariff equal to the area 3. The net effect is a loss (to consumers) of the areas 2+4. So imposing a tariff leads to an overall loss in welfare. Obviously, the opposite also holds true. If Britain removed the tariff on grain, it could revert to the situation shown in Diagram 1, with an overall increase in welfare equivalent to areas 2 & 4. (This is the situation Artist and Nixon show in their diagram 3. N page 57 'e. The welfare gain from removing a tariff. ) Note that in this discussion nothing has been said about the response of other countries. In other words, countries do not need to wait for other countries to agree to lower their trade barriers before lowering theirs. Even unilateral reductions in trade barriers are welfare enhancing for the importing country. Global and Regional Integration Recognizing the damage done to the world economy by the rise of protectionism between the two world wars, since World War 1 1 there has been sustained global moves to remove trade barriers between countries.

These have been facilitated by the General Agreement on Tariffs and Trade (GATE), which lasted from 1947 until 1993, and its successor the World Trade Organization (WTFO), set up in 1995. According to Nell (p. 79) referring to work by the World Bank, the average level of world tariffs for all products has fallen from an ad valor rate of roughly 40% in 1948 to 7% in 2008. The term economic integration is used to describe the process by which impediments to trade like tariffs between countries are removed so that the economies of countries become increasingly interlinked.

Apart from moves towards lobar integration under GATE and the WTFO, since the asses in particular, there has been a rapid growth in regional integration, which has established numerous trading blocs of two or more countries. Trade agreements between two countries are referred to as bilateral agreements, and three or more as multilateral agreements. There are various degrees of integration within trading blocs, which collectively can be referred to as preferential trade areas (Pats). Starting at the lowest level, these are: 7 Preferential Trade Agreements.

Participating nations reduce trade barriers and so give preferential access to certain reduces traded between them. Example: Asia-Pacific Trade agreement. Free Trade Area (FAT). Member countries sign a free trade agreement which eliminates most trade barriers on most goods and services traded between them. (The distinction between a PTA and FAT is largely a matter of degree. ) However each participating country in a Free Trade Area is free to set its own tariffs with the outside world.

But varying external tariffs between countries in the FAT means that there is an incentive for all imports from outside the FAT to be brought in through the country with the lowest external riff, and then be re-exported within the free trade area to reach the final point of destination. In order to avoid this Fats often use what are known as 'rules of origin of goods' whereby only those goods which meet the criteria of a minimum level of local inputs or local value-added are allowed to take advantage of the free trade provisions when they are re-exported within the FAT.

Examples include: North American Free Trade Agreement (NONFAT: free trade area between the USA, Canada, and Mexico) and the European Free Trade Area (FETA) which was founded in 1960 and then comprised Austria, Denmark, Norway, Portugal, Sweden, Switzerland and the I-J, but now is made up of Just the non-E countries of Liechtenstein, Iceland, Norway and Switzerland. Customs Union (CUE). Here member countries have a free trade area between themselves, but a common external tariff (GET) on imports from the outside world. (Sometimes different countries may still keep other trade barriers, e. . Import quotas, with the outside world. ) The common external tariff of a customs' union marks a very important difference from Free Trade Areas since it necessitates countries ceding decision-making powers over external riffs to some central authority, and it has to have a central budgetary mechanism for handling tariff revenues. Politically this means a loss of sovereignty for the member countries, and the establishment of supranational institutions. Example: the SEC customs union created by the 8 Treaty of Rome in 1957 and completed in 1968.

As Article 23 of the Treaty of Rome stated: "The Community shall be based upon a customs union which shall cover all trade in goods and which shall involve the prohibition between Member States of customs duties on imports and exports and of all charges having equivalent effect, ND the adoption of a common customs tariff in their relations with third countries. " Common Market (CM). This is a customs union which allows not Just for free mobility of goods, but also of the factors of production (capital, labor, and technology) across the borders of member countries.

Within Europe, the intention to create a common market was enshrined in the Treaty of Rome but given a legislative boost by the Single European Act of 1986 to be completed by 1992. Economic Union (CEO) is a common market plus the complete unification of monetary and fiscal policies. This entails the establishment of more central supranational iodides like a Central Bank, Central Tax Authorities, etc. The seventeen countries in the Rezone, established by the 1992 Treaty of Machinist which established the Euro and the European Central Bank, are getting close to complete Economic Union.

They have monetary union, but do not yet have fiscal union. However in March 2012 all members of the ELI, apart from the Czech Republic and the I-J, signed the European Fiscal Compact, the intention of which is to implement stricter caps on government spending and borrowing and automatic sanctions tort countries breaking the rules (we will look at this more in Lecture 7). A Political Union (PIG) is when the nations become literally one country, with one government, as happened after the unification of East and West Germany. As we have seen, this was always the final goal of the original architects of the ELI.

Trade creation and trade diversion Preferential trade arrangements, like the EX. customs union/single market, appear to represent a move in the direction of free trade. If, as we said earlier, free trade is economically the most efficient policy I. E. It is a first-best' situation, then it might be assumed that moves in the direction of free trade represents a move towards this first-best solution. Work by the Chicago School economist, Jacob Vainer (The Customs Union Issue, 1950), however, shows this is not necessarily so as a customs union may also be a move towards protectionism. Vainer was a Canadian, and it seems that his work on this issue was prompted by his thinking about the effects of the Canadian federation, a customs union. ) The example below illustrates this. When we looked at the welfare effects of free trade, or of removing a tariff in Diagrams 1&2 above there were effectively only two trading partners: Britain and the rest of the world. In a customs union, however, there are at least three countries involved: 2 members of the customs union and at least one other country outside the customs union. This extra country is added in Diagram 3 below.

Let us suppose it is France. 10 Diagram 3: Trade Creation and Trade Diversion within a customs union The above diagram describes a situation where there are three countries, Britain, France and America. Before the establishment of a customs union, Britain has a tariff on all grain imports making the price of grain from France IF+T and from America PA Since, even with the tariff, grain from America is cheapest, Britain will import SQ to SQ quantity of grain from America. Britain now forms a customs union with France, which means that import tariffs on French grain are removed.

The cheapest grain to buy now is French, so imports will increase to the quantity SQ to SQ. The overall welfare consequences of the creation of the customs union, compared with the situation before, is: the consumer surplus has risen from area DOPY+T to DXL. (e. An increase of the areas 1+2+3+4) 11 the (domestic) producer surplus has fallen from SPA+T to SWAP (ii. A fall of area 1) What about revenue from tariffs? This tariff has fallen by T(SQ-SQ) 'e. A fall of areas 3+5. So the overall welfare consequence of the formation of the customs union is an increase in welfare of areas 2+4 and a decrease of area 5.

Following Vine's work, areas 2+4 are referred to as the trade creation effect. It is a free trade effect brought about by abolishing the tariff within the customs union, so allowing the import of goods from another member of the customs union which can be produced more cheaply than domestically. This will lead to greater specialization of production between member nations based on comparative advantage. The decrease in welfare of area 5 is the loss of welfare brought about by trade version. It is a protectionist effect.

Because the customs union has maintained tariffs with the rest of the world, the demand for imports is met by the relatively high- cost producer within the trading bloc, rather than the lowest-cost producer on the world market. So what can we say about the overall welfare effect of the creation of a customs unions/ If area 5 is less than 2+4 there will be an overall welfare gain. If area 5 is greater than 2+4 then there will be an overall welfare loss. If area 5 is equal to 2+4 then the welfare effect will be neutral. Since general predictions of the welfare effects of introducing a customs union are impossible in advance, ii. Hey will depend on the actual situation, this is known as Vine's ambiguity. There has been a move from one sub-optimal (ii. Non free trade) situation to another sub-optimal situation (still non free-trade). You cannot clearly say whether there has been a welfare gain or a loss. A different and possibly more elegant diagrammatically way of looking at trade creation and trade diversion is given in Diagram 4 below (see Artist and Nixon, p. 58). In order to simplify, the separate demand and supply curves for grain of Diagram 1 re replaced by the import demand curve for grain, defined as domestic demand minus domestic supply.

The world price of grain is UP' as before, but there is also grain now available from France at a somewhat higher price Pu. (We assume for simplicity that, as with the rest of the world, the supply of grain from France is infinitely elastic, so the price will not change with supply. ) Diagram 4: trade creation and diversion within a customs union 2 The situation before the formation of the CUE assumes as before that Britain has a non-preferential tariff on all imported grain at rate t, which means that the price of rain from France is Pu+t; and the price of grain from the rest of the world is Up+t.

Initially, then, the equilibrium is at f with all grain imports (mm) coming from the rest of the world as they are cheaper than French imports. But if Britain and France now enter into a customs union, so Britain removes the import tariff on grain from France, grain from France is now available at price Pu, which is below P'. +t. So the new equilibrium is g, where Britain imports mm 'of grain from France. As far as welfare effects are concerned, consumers have gained by an amount equal o A+C, but there has been a loss in tariff revenue to the government (A+B).

This gives a net effect of C-B. The area C is the trade creation effect. The area B is is the trade diversion effect. Britain did in fact experience both trade creation and trade diversion after Joining the SEC in 1972. As a result of the SEC customs union it began to benefit from freer trade with its new European partners, but because of the SEC common external tariff it had to start paying more for many of its imports from the rest of the world, particularly those from former Empire or Commonwealth countries (egg. Lamb and butter from New 13

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