Regional Economic Integration
Welcome friends. So, I welcome you again to the course of International Business. So, I
think today we are going to start our a new unit all together which is called the Regional
Economic Integration, right.
So, by now I think you must be very clear how important trade is and why it is important
for countries to open up their economies and from a closed economy they need to move
to an more open economy. The simple reason is that you know as trade becomes more
prosperity rises right.
But there is not you know on the other side there can be an argument against
globalization also, but we have seen that as you know through research also it has been
marked; that as you know trade increases countries tend to gain right.
So, the best thing that anybody could think of ever doing trade is always with our nearest
you know countries. So, regional economic integration is basically an idea which talks
about the same concept of how countries can come together or you know nations can
come together and have a you know policy a common policy for them so, that they can
make trade much easier right.
(Refer Slide Time: 01:40)
So, let us see what exactly the definition says. Regional economic integration refers to an
agreements between groups of countries in geographical regions, to reduce and remove
tariff and non tariff barriers. So, we have seen that you know there are tariff and non
tariff barriers which always tries to hindrance the flow of trade right.
So, the major idea of this regional economic integration is to reduce and remove those
tariff and non-tariff barriers right. Sometimes it has been observed that tariff which is the
monetary barriers are still ok, but non-tariff barriers like for example, you know the
policies, the guidelines, you know the paperwork they are even tougher and more
So, the idea is to remove or either you know reduce it. So, that there is a free flow of
goods, services and the factors of production between the member nations ok. It is also
known as regional trade agreements, trade blocks or regional economic forces and
regional grouping. So, you can call it in different names right, but the idea is the same.
It is also said as to be a collaborative arrangement between different countries to take
advantage of the market opportunities and to promote economic growth. So, why trade
blocks have been forms? So, the idea was very simple that whenever there is a you know
there are when different members countries when that countries are in isolation; so for
any trade there has to be a lot of policy you know that lot of paperwork, there is a lot of
you know different conditions which have to be fulfilled. So, that makes trade very
complicated and very difficult.
So, in order to make a smooth flow; if countries could come together or nations could
come together and behave as if there is a common you know kind of a common spirit or
a common market then, the flow of trades and services could become much easier; and
as it becomes easier, it seems to be like more of like a common market or a one single
market unified market. So, that is the whole idea why this things have grown right.
The objective of this is to increase cross border trade and investment and to raise
standard of living of the country. So, the whole idea is that, the advantage from one
country moves to another country and in the process as we have seen through Ricardo’s
comparative advantage theory and Adam Smith’s theory we have seen that, as you know
trade will happen; countries which are you know now poorer condition or the people are
living in a poor you know the standard of living is poor, they also tend to gain.
In fact, interestingly one research says that when there is a you know it was Samuelson’s
research in which he said that, whenever there is a you know trade between a richer
country and a poorer country; it is not that the richer country will tend to gain which is
generally an hypothesis we make, but in many a cases for example, if the country is in a
well the Ricoh system if the country is well developed in the poorer country, then it is in
this condition; the poorer country tends to gain more in comparison than the to the richer
For example, if a if Samuelson’s idea could be taken further we can understand that, if
today India and US will trade, then it is not US which will gain rather that will be India
will which will gain, but the condition is that India’s ecosystem or the logistics supply
chain systems have to be very robustly designed for that.
(Refer Slide Time: 05:19)
To ensure security of market access for smaller countries by forming trade blocks with
the larger countries. This is also a idea behind the regional economic integration. Some
of the examples are very popular ones for example, the NAFTA, North American Free
Trade Agreement right; European union. So, we must be hearing a lot about the
European Union in the recent times because of the Britain’s exit right; which is largely
Then you have APEC, which is Asia Pacific Economic Cooperation right. South East
South Asian association for Regional Cooperation which is SAARC, popularly known as
SAARC. So, SAARC summit you must have heard. Association of South East Asian
Nations or ASEAN right. So, these are the different kinds of regional economic
Now, there is a different levels in which free trade this regional economic integration or
the trade blocks have been leveled.
(Refer Slide Time: 06:17)
So, we will start with the most basic one which is called the free trade area and then we
then move on to the more you know sophisticated ones. So, the most basic level of
regional economic integration is called the free trade area right. It is the lowest level of
integration. Here all the barriers to the trade of goods and services among the member
countries are removed, but members determine their own trade policies with regard to
the non-member countries.
So, what happens? For example, if there are a member countries right. So, there as
different member countries let us say A, B and C. So, among these countries there is no
barrier, but each country can formulate its own policy with other countries. So, for a
common country X, B can have a different policy, A can have a different policy, C can
have a different policy right.
Example of this is European free trade agreement which was the most basic one which
started with right. And it had member countries like Norway, Iceland, Liechtenstein and
Switzerland right. In fact, it started with 7 countries and out of which 3 later on joined
the European Union ok. Another one is the NAFTA, the North American Free Trade
Agreement which has US, Canada and Mexico.
(Refer Slide Time: 07:40)
So, the next one as we move off from the free trade area is called the customs union
right. As it says, it is a higher form of integration than the free trade area and why it is
one level up because, it eliminates the trade barriers between the member countries not
only that which this was also there in the free trade area.
But, it adopts a common policy, external trade policy against the non-member countries.
So, as you saw here; that here every country was free to have a different policy with X
right , but in this case when you come to the customs union we have a common external
trade policy against the non-member countries.
So, one of the example is the Andean Pact between Bolivia, Columbia, Ecuador,
Venezuela and Peru right. So, these countries have made this pact and they are termed as
a customs union right.
(Refer Slide Time: 08:40)
So, the next one is the common market right. The common market actually it has all the
features of the free trade area as well as the customs union right. Now, as it says in
addition that you know the added feature here is that it rest it; the restriction on the
movement of the factors of production between the member countries is completely
removed in this case.
So, the factors of production basically are like land, labor, capital right technology. So,
these are again this as this is given a very free movement, that is why in the case of
customs union you know and free trade area when FDI and other things were becoming
very tough; it becomes more simpler in a common market case ok.
The restriction is abolished on immigration, emigration and cross border investments ok.
That is what I was talking about the FDI. Higher level of integration then customs union
as you had seen in the last, the Indian pact and all you had seen.
One example of the common market would be the MERCOSUR which is a pact between
Brazil, Argentina, Paraguay and Uruguay. Another most many more popular one is the
Gulf Cooperation Council largely called as GCC right which was established in 1981 and
it has 6 member countries right; like Saudi Arabia, Kuwait, Bahrain, Qatar, UAE and
(Refer Slide Time: 10:00)
Now, the whole idea of this GCC is to create another kind of a European Union. So,
among the member you know the mostly the Islamic nations and the you know the in the
Gulf, so they want to create a similar kind of a situation right; and even they intend to
have one common you know currency even, which they are trying to work on it, but it
has not been successful yet right. Two new members were have attempted to come in;
one is Jordan and other is Morocco right.
(Refer Slide Time: 10:40)
The next in the you know as you grow up from the free trade area, then the customs
union and then the common market; the next is the economic union. Now, what happens
here is that there is a free flow of products and factors of production between the
member countries and, a common external trade policy and a common currency.
So, this is the one extra feature; which the common market did not have. It requires
harmonization of the member countries’ tax rates and a common monetary and fiscal
policy, social welfare programs etcetera right.
So, the economic union talks about a little much higher because, the countries have to
think about a common economic policy as such right. So, the monetary and the fiscal
policy has to be common. Economic Union involves full integration between two or
more economies. So, example is the European Union.
So, at the moment the European Union as you know, Britain has just recently come out
of it right in on January 2020. So, earlier there were around 28 countries including UK
minus 1; so now, there are 27 nations; which are part of the economic union.
(Refer Slide Time: 11:56)
The next is a quite a idealistic situation which is called the Political Union. Now Political
Union involves all features of the economic union and also a complete political
integration between member nations ok. The member nations share a common decision
making and judicial body and there is complete unity between the member nations ok.
This requires that a central political apparatus coordinate the economic, social and
foreign policy of the member states. And, it also requires the establishment of a common
parliament and other political institutions. Recently, example the United States of
America includes 13 separate colonies operating under the article of confederation. But
you know political union because is a very tougher task and it is very highly an Utopian
state which is very difficult to achieve right.
(Refer Slide Time: 12:51)
Now, through a common diagram you can see how this is you know the level of
integration low and high and as terms of complexity low and high. So, the free trade area
is at the bottom; which has a low level of integration and low complexity also. And then
you have the next which is the customs union, slightly higher level of integration and
higher level of complexity.
Then you have the common market which is more complex and but a higher integration.
Then economic policy, which is very high level of integration, but the complexity is also
very very high now. And obviously, political union is the highest right; as you can see
So, in the political union, no barriers for international internal trade, free movement of
labor, the harmonized tax rate, common monetary and fiscal policy; we just studied all
these things are in the level of integration right.
(Refer Slide Time: 13:42)
Now, what is the effect of this integration? Is it all the time good or it has some adverse
effects also that needs to be discussed. So, when we talk about the effects of integration.
So, it is set to be 2 types of you know effects. One is the static effect and the dynamic
effect. Now, what it says? Regional economic integration reduces or eliminates those
barriers for member countries. It produces both static effects and dynamic effects.
What is the static effect? Static effects are the shifting of resources right; when you shift
the resources from inefficient to efficient companies as trade barriers fall ok. As the trade
barriers fall, from an inefficient to a efficient company we move on the resources. Static
effects apply primarily to trade barriers themselves. For member countries, they go down
and for non-member countries they go up.
What is the dynamic effect? Dynamic effects are the overall growth in the market and the
impact on the company caused by expanding production and by the company’s ability to
achieve greater scale of economy right. Dynamic effect applies to economic changes
affecting the newly structured market.
So, if you see the difference if you are try to understand. In static what is happening? Just
the resource is moving from one thing to the other right from an inefficient to the
efficient; in dynamic what is happening? The companies are achieving a larger market
and there is a higher economies of scale being applied right.
(Refer Slide Time: 15:18)
So, static effects may develop 2 conditions right. Trade creation and trade diversion; now
what is this trade creation? Trade creation occurs when high cost domestic producers;
that means, a company in India which is producing may be at a very high-cost are
replaced by low cost producers within the free trade area, let us say tomorrow we have a
free trade area between let us say India and two other countries x and y.
Now, if suppose the cost of production is very high in India; we can import these goods
from we can get these goods from x or y whatever it is if that is a low cost producer. It
may also occur when higher cost internal producers external producers are replaced by
the lower cost external product producers within the free trade area. So, it is basically
who produces the in the lowest cost within the free trade area.
The next is trade diversion, this occurs when lower cost external suppliers right are
replaced by higher cost suppliers within the free trade area. So, these are some of the
effects that can happen because of the integration.
A regional free trade agreement will benefit the world only if the amount of trade it
creates exceeds the amount it diverts; because diversion obviously, is not going to you
know help, because you simply saw that the lower costs external supplier is being
replaced by a higher cost supplier within the trade area. So, this is not a desirable thing.
So, the amount of trade should exceed the amount it diverts.
(Refer Slide Time: 16:55)
Let us say this take this example, United States and Mexico imposed tariffs on imports
right they imposed tariffs on the imports from all countries and then they set up a free
trade area, scrapping all the trade barriers between themselves but maintaining tariffs
with the rest of the world. So, they have removed that barriers within themselves, but
they have maintained the tariffs to the rest of the world.
Now, if the US began to import textiles from Mexico, would it create any advantage?
That is the question right. If the US previously produced all its own textiles at a higher
cost than Mexico suppose then, the agreement has shifted production to the cheaper
source; that means, Mexico is a cheaper source so, it has shifted.
According to the theory of comparative advantage Ricardo’s theory, trade has been
created within the regional grouping and there would be no decrease in trade with the
rest of the world. Clearly the change would be for the better right. So, if you have an
absolute advantage in both what Ricardo had said then, still you have to go for one in
which you have a specific skill or a specialization you have a specialization.
But if however, the US previously imported textiles from let us say Costa Rica which
produced them more cheaply than Mexico or the US then trade has been now diverted
from a low cost source to a higher cost. I hope this is clear. So, this is the case of a
diversion. So, now Costa Rica was supplying at a much lower rate and Mexico was you
know Costa Rica is the lowest, Mexico is then and then US.
Suppose, the earlier days US was getting the textile from Costa Rica; now because of the
free trade agreement they are getting it from Mexico. So, in this case we are not getting it
from the cheapest supplier right or the cheapest source. So, that is what is not a very
(Refer Slide Time: 18:56)
Let us say how it let us see this. Trade barriers drop for the member countries static
effect. So, only the member countries the trade barriers have dropped, plus trade barriers
remain higher for the non-member countries in case of a static effect. Now, market size
increases, this is a dynamic effect.
Now, let us see what happens. What is the impact? So, when the trade barriers drop for
the member countries trade creation happens right because; obviously, the barriers have
dropped, but since the you know non-member countries you have created a higher
barrier. Now, trade is being diverted as the case of Costa Rica and Mexico you saw, that
Costa Rica was the cheapest supplier, but then the trade has diverted now from the
cheapest to the second best right which is Mexico.
So, in this case what happens? What is the impact? So, in the first case when you saw
that when trade barriers dropped trade creation happened investment shifts from the less
efficient firms possibly leading to FDI right. So, in this case investment may shift from
the less efficient firms possibly to the leading to the FDI; that means, Mexico can set up
a plant in US; that means, right.
In the next case when there was a trade diversion what happened? FDI increases from
firms outside the free trade area agreement to avoid barriers. Now, Costa Rica which is
not a part of the free trade agreement or area. So, they would now want to in order to
avoid barriers they would try to come to the US and set up their own shop right.
In case of a dynamic effect trade creation happens; now what happens here? When the
market size increases; the home country firms increase FDI to achieve economies of
scale. So, this is a situation this is the impact of the free trade agreements ok.
(Refer Slide Time: 20:55)
Now, take this example again the other one. So, the country there are 3 countries X, Y
and Z right; and production cost is 500, 400; 300 arbitrarily it is given to you. Assume,
that the production cost determines the price of the good and tariffs remain as the only
source of divergence between price and cost it is possible to understand the effects of
preferential tariff liberalization under a customs union.
Initially suppose if X imposes a tariff of 100 percent right. So, what happens? Demand in
X would have a choice among domestic products at a price of 500 or import from Y at a
price of 800 and imports from Z at a price of 600.
Because it has 100 percent is the tariff. So 400; so it has doubled 100 percent plus 400
plus 400 800. 300 plus 300 is 600. So, in such a situation X would not import the good
because, now the domestic one is getting cheaper right. Suppose, if X and Y form a
customs union. So here X and Y these two, they form a customs union.
(Refer Slide Time: 22:07)
And impose the same hundred percent tariff on imports from Z right. So, consumers in X
will face a choice between indigenous products at a price of 500 or imports from Y at a
price of 400 right and imports from Z at 600. So, X would then obviously, imported from
So, because now Y is can sell at 400 there is no import duty. So, it is selling at 400; so X
would buy at 400 right. This is an example of trade creation right; which replaces the
relatively inefficient indigenous production which is that 500 with efficient low cost
imports from the partner country, leading to welfare gains.
(Refer Slide Time: 22:50)
Now, let us take the same case and continue with it; in case before the formation of the
custom union X levies a tariff of 50 percent, then what happens? Consumers demand in
X would have a choice between domestic goods at a price of 500 or imports from Y at a
price of 600.
Why 600? 400 plus 50 percent duty right which is 200. So, 400 plus 200 Y becomes 600,
and imports from Z at a price of 450 why? Again it was 300 so plus 50 percent; so that
makes, 300 plus 150; so 450.
Now, in this case what happens? X would import the good from the lowest-cost import
source that is country Z right. So, that was Costa Rica for our case. At this stage if X and
Y form a customs union consumers in X will be faced with the choice of paying 500 for
the indigenous product and 400 for imports from Y and 450 for imports from Z.
Now, in this case what is happening? X will now import from Y right. Imports will be
switched from the low-cost supplier right, Z to the higher-cost supplier, Y; now
although, you have an agreement, but because of this now this is 450; so the movement
of the good has switched from the lowest cost supplier to the higher cost supplier right.
So, this is an example of trade diversion ok.
So, trade diversion takes place when a country shifts its source of imports from a more
efficient country to a less efficient country right; because of the tariff-preferences in the
customs union. This will lead to a lowering of welfare, as it entails a less efficient
allocation of resources.
(Refer Slide Time: 24:44)
Now, with the third case the second which is the dynamic effect; what happened? There
is a economies of scale. So, the average cost per unit falls as the number of units
produced rises. So, dynamic effects of integration occur when trade barriers come down
and the size of the market expands. Because of the larger size of the market, companies
can increase their production, which will result in lower cost per unit, a phenomena
called economies of scale.
So, companies can produce more cheaply, which is good because they must become
more efficient to survive. This could result in more trade between the member countries
or an increase in FDI as a market increases and it becomes feasible for MNEs the
multinationals to invest in the larger market.
So, what it says is as the market expands; obviously, the scope for you know FDI also
increases because, now companies in order to survive will have to produce at a much
lower cost and they can do that also because they are getting a larger market.
So, on terms of the volume because of the larger volume they can go for a higher you
know lower price by increasing this scale of economy right; and lowering the price.
(Refer Slide Time: 25:53)
Increased competition, another important effect of the free trade agreement is the
increase in efficiency due to increased competition. Many MNEs in Europe have
attempted to grow through mergers and acquisitions to achieve the size necessary to
compete in the larger market. So, what has happened? Because of this free trade you
Its competition has increased. And in order to for survival what companies have done
through reduce the inefficiency they have tried to merge and acquire other companies
and try to be as lean as possible; by although the size has increased, but their efficiencies
would increase because the asset values grow right.
So, companies in Mexico were forced to become more competitive with the passage of
NAFTA due to competition from Canadian and US companies right. So, this could result
in investment shifting from less efficient to more efficient companies or it could result in
existing companies become more efficient; either you become efficient or you merge
with other companies or you get taken over by other companies which are more efficient.
So, in the overall run what happens is everybody gains ok.
(Refer Slide Time: 27:00)
So, trade creation we have discussed right trade creation occurs when some domestic
production in a nation or in the member of a custom union replaced by a lower cost
imports from another; so we just saw this example. So, what is the benefit of this trade
creation? It increases the welfare of the member nations because it leads to greater
specialization in production.
So, a country which is doing good, it will create it will do more of that. So, the efficiency
goes to the low cost producer. A trade creating custom union also increase the welfare of
the non-members because, some of the increase in its real income spills over to the
increased imports from the rest of the world. But that is we cannot say exactly how much
this can be counted right, but that also is a benefit to the non-importing or the nonmember
(Refer Slide Time: 27:45)
We will stop here with this last slide. So, the other point we talked about is a trade
diversion. So, trade diversion we understood as an economic term related to internal
economies in which trade is diverted from a more efficient exporter.
So, we saw that when it came to Costa Rica, Mexico and US towards a less efficient one.
So, Costa Rica was the lowest producer of textiles cost you know producer. Now,
although, it was lowest cost, but we moved it to Mexico just because we were a member
So, but the formation of a free trade agreement or a customs union. The total cost of the
goods become cheaper when trading within the agreement because of the low tariff. So,
the tariff played a important role and because of the low tariff; now Mexico become
cheaper and in then Costa Rica.
This is as compared to trading with countries outside the agreement with lower cost
goods, but higher tariff. The terms were used by old Chicago school economist Jacob
Viner in his 1950 paper, the customs union case right. So, I will wind up here will
continue from here in the next lectures.
So, today we just have tried to understand what is this economic integration, why
economic integration is important because, if you remember at this very moment when
you know all countries they are weighing up to increase their trade right.
So, for example, the whole purpose of the US presidents coming to India; besides, it is
political mileage that it would want to take from the Indians living in America. I also
wants to have a much better trade policy where both India and US can gain because, we
have seen that through Adam smith’s theory, Ricardo’s theory and many other
economists theory, that the point is whenever trade happens; every country tends to gain
right; however, we may criticize, but there is a chance that countries would gain right.
So, in order to do that; so it becomes very important that if our trade barriers and you
know the tariff and non-tariff barriers are low, the countries would do better because the
market becomes like one common market right. So, that is why regional economic
integrations have played a very vital role in improving the trade conditions among
member nations. So, this is all for today, we will continue in the next lecture.
Thank you very much.
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