Economic integration is the process designed to eliminate discrimination among economic units located within different political boundaries. The traditional categories include Free Trade Area (FTA), Customs Union (CU), Common Market (CM), Economic Community (EC), and Complete Economic Integration (CEI). The various categories delineate the degree to which barriers to economic interaction are formally removed. In an FTA participating countries agree to remove barriers to trade among each other. In a CU the member countries agree not only to remove barriers to trade but also to set common levels of protection against all nonmember countries. Examples of a CU include the 1940s Benelux countries agreement (among Belgium, the Netherlands, and Luxembourg) and the Southern African Customs Union, signed in 1969 and still in existence. The CM agreement goes a step further than a CU agreement by removing barriers to movements of factors (essentially labor and capital) among members in addition to the CU components. An EC represents an additional step toward complete economic integration in that there is some degree of harmonization of national policies where community policies and institutions take precedence over national policies. An example of the latter is the Common Agricultural Policy of the European Economic Community.
A formal definition of a CU was provided by the General Agreement on Tariffs on Trade (GATT) in 1952:
A customs union shall be understood to mean the substitution of a single customs territory for two or more customs territories, so that (i) duties and other restrictive regulations of commerce are eliminated with respect to substantially all the trade between the constituent territories of the union … and (ii) substantially the same duties and other regulations of commerce are applied by each of the members of the union to the trade of territories not included in the union.
The implementation of a CU represents a reduction in protection between member countries, but it keeps in place discriminatory policies against nonmember countries. Although the former represents a clear movement toward less restricted trade and increased world welfare, the discrimination against nonmembers represents a potential loss in world trade and welfare. Thus whether a CU represents an overall movement toward less restricted trade and increased world welfare depends on the relative strength of these two forces, which are typically discussed as the static effects of economic integration under the categories of Trade Creation and Trade Diversion.
Trade Creation refers to the shift from higher-cost domestic producers to lower-cost partner producers. It is thus a shift from less efficient to more efficient production and is trade expanding. It also reflects a gain in country welfare. Trade Diversion refers to the shift from lower-cost nonmember suppliers to higher-cost partner suppliers, which takes place because of the tariff faced by nonmember products. It thus represents a loss in efficiency and a decrease in welfare. There are also accompanying consumption effects as consumers switch from domestic products to the now cheaper import products. Whether or not the CU represents a movement toward less restricted trade and enhanced welfare in the static sense depends on the relative size of these two effects. Whether the overall effect is positive or negative depends on a number of considerations, including the complementarity or competitiveness of the individual economies, the size of transportation costs between member countries, the height of tariffs before and after integration, the economic size of the member countries, and the elasticities of supply and demand within the member countries. Empirical estimates of the static effects of economic integration have generally been a net, though small, positive.
Economists tend to agree that the major benefits of economic integration occur because of the dynamic effects associated with increased economic interaction between member countries. These dynamic considerations include the benefits associated with a more competitive economic environment, which reduces the degree of monopoly power that possibly existed in the preintegration environment. In addition, access to larger markets within the integrated area may result in economies of scale in the expanding export sector as a result of both internal and external economies of scale. The growing and more profitable economic environment may also generate greater investment from both internal and external sources. Finally, there may also be dynamic benefits resulting from increased economic interaction with other countries in terms of increased access to technology, foreign institutions, and cultural factors.
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Alfred J. Field Jr.