Effects of Economic Integration

  9. EU is a Customs Union
full Customs Union (1968) The EC became a full customs union in 1968, when tariffs and quotas were all removed on trade among its original member countries, and a common tariff system was adopted vis-a-vis non member countries.

(1) Free Trade in Industrial Products: there are no longer tariffs or quotas on trade of industrial goods. Still there are some NTBs such as state monopolies, different tax systems, different customs classifications.

(2) Free Trade in Agricultural Products : Each country came into EEC with its own domestic farm program. The Rome Treaty does not spell out Common Agricultural Policy. By 1964 they adopted Common Grain Policy (at least for grains). 40% of EU budget (€150 billion in 2016). Annually, €60 billion (EU) > $37 billion (US)

The EC is still the largest importer of farm products in the world and the US is the largest exporter. US agricultural policy is aimed at opening up foreign markets except in dairy products. The single most important element of Europe's trade policy, from America's viewpoint, is the Common Agricultural Policy (CAP). It is a price stabilization policy for agricultural commodity markets. Price stabilization program was adopted in the United States when the Commodity Credit Corporation was established in 1933.

Turkey joined the EU Customs Union in 1995. Started negotiations with EU in 2005, but was stopped due to its policy toward Islam (Erdogan)

One says "As-salaam-Alaikum" (peace be upon you), and Muslims respond saying "Wa-Alaikum as-Salam." (also peace be upon you)"

Common Agricultural Policy 

Europe's CAP in EC is best illustrated in the following diagram.

Farmers suffer from price instability and lobby for price stabilization. In theory, CAP is designed to protect farmers by insuring stable prices. In practice, CAP as well as US farm price stabilization programs are subsidy programs, i.e., target price is above unit cost. (Initially, Europe's program did not have acreage restrictions, but now it does, imitating US programs.) CAP consumes more than 40% of the Commission's budget (about €145 billion). The main beneficiaries are France (20%), Germany and Spain (13% each), and the UK (9%).

Target Price = base price for grains to be established annually to protect European farmers.

(Intervention Price = the price at which the Community will buy from domestic producers.)

Threshold price = target price less transportation and marketing costs of imported grains.

Variable Import Levy = Threshold price - world price.

These programs produce huge surpluses such as "milk lakes" and "butter mountains" costing $14 Billion a year.

 bad harvest  
 good harvest  


  10. EU is a Common Market

 Although the EC has been successful in eliminating tariffs and other barriers to trade among its members, a number of restrictions have remained. The Community intended to remove many of these restrictions by 1992, but did not succeed.

While these countries are being integrated, their corporate tax rates, income tax rates and VAT rates differ. (Tax rates of Europe)

(i) Differrent industrial standards (e.g. frequency standards for TV sets), safety rules. A representative of Phillips (a large Dutch firm) said that his firm had to make 9 different types of television sets for European companies.
European Committee for Standardization (CEN, Comité Européen de Normalisation) was set up in 1961. Slow going.

All EU members + Iceland, Norway, Switzerland (EFTA)+ Macedonia, Turkey

(ii) limitation on movements of skilled workers. Differing licensing requirements for doctors, lawyers and other professionals.  

Many American medical students go overseas and get degrees in Central and Eastern European countries. 1 in 4 medical doctors are trained overseas. Those who wish to practice must pass the US Medical licensing examinations. (Canada, Israel, and India have similar requirements.)

Schengen Agreement (1985)

originally signed near Schengen, Luxemburg in 1985
fully implemented since July 1, 1995

"Schengenland" is an area of free circulation of citizens of seven Member States signatories to the Schengen Agreement: Belgium, the Netherlands, Luxembourg, France, Germany, Portugal and Spain. No need to show passports. (France still continues temporary passport control)

After 2004, membership increased to 25 countries. (UK, Romania, Bulgaria are not members.)

(i) European Union citizens and legal EU residents of the 25 Member States could travel throughout the bloc without showing passports.

(ii) Visa with no territorial restrictions (visitors can stay up to 90 days per six-month period.

(iii) Nonmember country nationals with a residence permit valid in one Schengen country may travel on a valid passport without a visa , for up to 90 days per six-month period to other Schengen ountries.

(iv) Covid-vaccination further complicates movement of people.

In 2006, directive on the right to move freely: pasportless travel if a national identity card is issued from an EU country.


 Read more about Schengen Agreement.

Map of Schengen countries


  11. EU is an Economic Union
 Single Currency  Europe now has a single currency, Euro.

 (i) A single currency makes Europe a single market.

(ii) No member country can manipulate exchange rates to insulate its economy from shocks originating in other member countries.

(iii) A price change in a foreign market (inside EU) will be directly transmitted to each member country, necessitating adjustments in real variables (such as unemployment and output).

Inflation in one country is transmitted to other markets. A member country no longer retains the ability to neutralize inflationary shocks from other countries.

 Advantages of single currency (SC)
  1. SC stimulates growth and employment (due to mobility of resources)
  2. efficiency: SC eliminates the costs of converting between currencies (reduces transaction costs)
  3. greater stability of the new currency, relative to the dollar and the yen
  4. management of a single monetary policy (A national monetary policy is no longer an option)

1. One-off cost of introducing a single currency

2. Due to language differences, European labor is not as mobile as American workers.

3. No central EU fiscal authorities that regulate natioinal debts. (only European Central Bank)

4. Inability to devalue one's currency.

5. Inability to oust members with delinquent sovereign debts (e.g., Greece)

Dangers of Single Currency: Sovereign debts

Thessaloniki, Greece

Sovereign debts have been rising since the monetary conversion in 2002. This is due to lack of financial regulation of national finances.

European Banking Authorities will be set up to regulate banking activities. Still, there is no central authority to regulate national debts.

Also, inflation occurs during the conversion in many member countries. For instance, Italian lira was converted into euro at then exchange rate of 1950 lira/euro. If the price of a product were 20,000 lira before the conversion, shopkeepers and public employees would often inflate the price/wage to 20 euro (when the correct price would have been about 10 euro.)

Raising prices through this conversion made some European countries less competitive (e.g., Greece, Italy, Spain, Portugal)


Debt write-down, not write-off

write-down: reduce the value of an asset. Hair-cut

write-off: debt is eliminated (100%)

 Three phases

Phase A: The European Council launches the single currency and identifies the countries that will participate.

Phase B: within 1 year: Monetary Union is effectively launched with the irrevocable fixing of parities. (A country should not overvalue its currency in the conversion process.)

Phase C: within 3 years after Phase B, the transition completed with the introduction of notes and coins.

Possible paths?

In 2008, the weak eurozone nations were PIIGS (Portugal, Italy, Ireland, Greece, and Spain)

In 2018, Europe has the PHIGS (Poland, Hungary, Italy, Greece and Spain) problem. If sovereign debts are not contained,

(i) Germany may exit from the single currency and return to Deutsche Mark.

(ii) Germany may yet form another currency union with those European countries with trade surpluses.

European Chips Act

European Commission President announced. To be adopted this year.

shortage: automotive chip shortage (2000 chips per car) → 2 million units cut in 2023.

€45 billion (for building foundries and research) by 2030 to overcome chip shortage: 70% subsidy in EU vs 25% in the US.

Shrinking US influence

(i) Emmanual Macron and Ursula von der Leyen visitd China, trying to improve EU-China relations. In contrast, President Biden wants to oust China in the chip supply chains.

(ii) BRICS (Brazil, Russia, India, China and South Africa) agreed to create a new reserve currency, making the world less reliant on USD.

(iii) Xi and Putin make pancakes.

(iv) EU confronts US that it spies on European allies.



  12. External Relations of the EC

Association Agreements to create CU and to accord eventual community membership have been signed with a few countries. Malta and Cyprus were admitted, but Turkey's application is still under review.

  1. Preferential trade agreements have been made with all EFTA countries. Its members included 7 countries: Austria, Sweden, Norway, Liechtenstein, Switzerland, Iceland, and Finland. After the enlargement of EU in 1995, EFTA just consists of Iceland, Norway, Liechtenstein and Switzerland.

    EFTA members signed an agreement with the EU in 1992 to create European Economic Area. EEA guarantees four freedoms of traffic of the EU (of products, services, persons and capital). The European Economic Area include 19 countries and 380 million people.

    Switzerland rejected the EEA.

  2. Mediterranean Policy: preferential agreements in 1972 were reached with Morocco, Tunisia, Algeria, Egypt, Lebanon, and Israel.

    Barcelona Conference (Nov 27-28, 1995)

    to promote peace and stability, and to establish a Euro-Mediterranean Partnership between 15 Member States of the European Union and 12 Mediterranean countries. The Med 12 are:

    Algeria, Morocco, Tunisia, Egypt, Israel, Jordan, Lebanon, Palestinian autonomous territories, Syria, Turkey, Cyprus, and Malta. (The last two joined EU in May 2004. Turkey is an associate member.)

    goal: establish an FTA by 2010.

  3. In 1975, Lome Convention: preferential trade arrangements with 58 countries of Africa, the Caribbean and Pacific Region (ACP), which were former colonies of France, Belgium, and England.
  4. Asia-Europe Meetings (ASEM) http://europa.eu.int/comm/external_relations/asem/intro/

ASEM = cooperation to bring together the 15 EU Member States + 10 Asian nations (Brunei, China, Indonesia, Japan, South Korea, Malaysia, the Phillipines, Singapore, Thailand, and Vietnam) created in 1996 (Bangkok).


  13. The Effects of Economic Integration on Trade
Static Effects Static effects deal with snapshots immediately after integration.
Trade Creation Effect

Tariff preferences have trade creation effect and trade diversion effect. In the shor run, Demand and Supply curves stay put and not affected by integration.

The two red traingles represent the positive welfare gains from the trade creation effect.

 Trade Diversion Effect Three countries:

(i) A, B are members of a CU
(ii) C is not

Assume (i) horizontal foreign supply curve

(ii) C (nonmember) is more efficient than B (member)

Figure 4, Trade Diversion

Under the free trade situation, England imports the product from Australia.

After joining the customs union, the tariff inclusive price of imports from Australia rises, but the price of imports from France remains the same. Accordingly,

England now imports from France, rather than from Australia.

CU diverts imports away from the more efficient exporter Australia, which is not a member.

 Dynamic Effects include the response of the economy over time as it responds to the changes.
(i) Market extension

Viner's analysis of CU focuses on static gains: the abolition of tariffs among members has the trade creation and diversion effects. However, the static theory ignores the dynamic effects of CU on economic growth.

Dynamic effects include drastic Long Run outcomes such as exit. Brexit : UK existed from EU in June 2016. (immigrants, forgotten middle class) Demand and supply curves shift after integration.)

(i) the most obvious dynamic consequence of a CU is market extension. Efficient producers enjoy free access to national markets of all member countries. Obviously, inefficient producers lose even the national market and are forced to exit from the market.

Before forming a CU, however, access to foreign markets was hindered or blocked by trade restrictions. CU enables firms to achieve economies of scale.

An efficient firm not only survives but also has access to all markets within a customs union, but inefficient firms lose even the little markets they had before. (The Parable of Talents)

Figure 4.

"But from those who do nothing, even what little they have will be taken away." The Parable of Talent.
Talent = about 130 pounds or 60 kg. 1 talent of silver (gold) = $16,000. ($1.4 million)

The number of firms declines, and the market is dominated by fewer firms or a single firm.

temporary unemployment When inefficient firms exit from the market, workers in such firms become unemployed. Eventually, they need to move to other industries.

(ii) Increased Competition

Domestic firms are no longer protected from high tariffs. Increased competition implies the survival of low cost firms and lower prices. Increased competition also encourages product innovation and technology competition . ⇒ increased innovation.

Innovations occur in Europe, the US and Asia: US restricts technology exports (to Chinese seminconductor firm Fujian Jinhua).

Country Patent grants, 2014
US 301,000
China 233,000
Japan 227,000
South Korea 130,000
European Patent Office 65,000




  14. International Integration in other Continents
  SR objective: market extension - replace small national markets with a large supernational market

LT goal: economic growth through increased international specialization, economies of scale and expanded trade

These goals are sought by many LDCs. The Treaty of Rome has become the model for a global movement toward economic integration.

African Union

President Obama delivers a speech to the Africa Union at the Nelson Mandela Hall, Addis Ababa, Ethiopia ©

A continental union.

The goal is to achieve independence and cooperation of African states (rather than a free trade)

Headquartered in Addis Ababa, Johannesburg, 55 member states

GDP = $2.5 trillion

population = 1.3 billion

EAEC (Eurasian Economic Community, 1996)

Belarus, Russia, Kazakhstan, Kyrgyzstan, Uzbekistan, Tajikistan.

Not a FTA yet (only a goal).

Population: 214 million. GDP = 2.3 trillion.


European Free Trade Association

Information about EFTA

Current members include Iceland, Lichtenstein, Norway and Switzerland. Largest partner in trade in services of EU.

They are likely to be absorbed by EU eventually. GDP = $920 billion. GDP per capita = $68,000.

 Arab Maghreb Union

Maghreb (Algeria, Morocco, Tunisia and Libya)

North Africa is becoming a key supplier of energy. Airbus and Sumitomo Electric are moving into this region (FDI).

This region is an alternative to Eastern European countries that absorb Europe's FDI.

 Latin American Integration Association (ALADI) Asociation Latinoamericana di Integracion (ALADI)

Initially, integration in Latin America took two parallel forms. (1) Latin American Integration Association, and (2) Central American Common Market. Subsequently, the Andean Common Market has been added.

The motivation for closer integration among these countries: (a) the success of EC, and (b) slow economic growth and social modernization in this continent.

Members: 13 countries (Argentina, Bolivia, Brazil, Chile, Colombia, Cuba, Ecuador, Mexico, Paraguay, Panama, Peru, Uruguay, Venezuela.)

GDP = $6.27 trillion, per capita GDP = $12,500


Despite recent setbacks by Brexit, integration efforts in Europe has been largely successful. This success is largely due to (a) common racial stock (predominantly Caucasian), (b) common cultural heritage of Western Europeans, and (c) similarity of European languages which are derivatives of Germanic language with common Latin roots.

Efforts to integrate Asian economies have been hampered by three obstacles:

(a) Racial and language diversity of Asian countries. Asian races are more populous and diverse than European races. Diverse languages: tonal Chinese language, Ural-Altai language group (Manchu, Mongolian, Japanese, Korean, etc.),

(b) Japanese occupation of Asian countries in World War II, and

(c) Two large economies, China and India, have no urgent need to intergrate with other economies.

Despite these obstacles, bilateral FTA fervor is sweeping Asia.

Association of South East Asian Nations (ASEAN) (the most successful)

(i) established in 1967

(ii) now 10 countries: Brunei, Canbodia, Indonesia, Laos, Malaysia, Myanmar, the Philippines, Singapore, and Thailand. Vietnam

(iii) currently transforming into AFTA (ASEAN Free Trade Area)

(iv) GNP= $300 billion, intra-ASEAN trade rose to $68 billion in 1995.

(v) plans to expand. two proposals, Tokyo centered Asian trade alliance, and Asia-Pacific economic zone, excluding US and Japan.

China-ASEAN FTA came into effect on January 1, 2010. In terms of population, it is the largest FTA (1.9 billion). In terms of GDP, it is the third largest: EU, NAFTA, China-ASEAN FTA.

Combined GDP of RCEP = $49.5 trillion.


Regional Comprehensive Economic Partnership

ASEAN (10) + its partners (China, Japan, South Korea, Australia and New Zealand). If signed, it will be the biggest FTA.

India opts out.

Trend bilateral trade agreements: China-South Korea Free Trade, went into effect on December 20, 2015.

Other Customs Unions