PPB 3213 INTERNATIONAL BUSINESS

AND GLOBALIZATION

INDIVIDUAL ASSIGNMENT

NAME: HO YU HAN

MATRIX NO: D20162076287

GROUP A

LECTURE NAME: PROFESOR MADYA DR. NEK

KAMAL BIN YEOP YUNUS
Explain the static effects and dynamic effects of economic integration. What is the
difference between trade creation and trade diversion resulting from economic integration?

Introduction

What is Economic Integration? Economic integration is an arrangement between different

regions that often includes the reduction or elimation of trade barriers and the coordination of

monetary and fiscal policies. The aim of economic integration is to reduce costs for both

consumers and producers and to increase trade between the countries involved in the agreement.

With further explained this, as economies become more integrated, trade barriers lessen and

economic and political coordination between countries increases.

There are seven stages of economic integration: preferential trading area, free trade area, custom

union, common market, economic union, economic and monetary union and complete economic

integration. The final stage represents a complete monetary union and fiscal policy

harmonization. The advantages of economic integration fall into three categories which are trade

benefits, employment and political cooperation. More specifically, economic integration

typically leads to a reduction in the cost of trade, improved availability of and a wider selection

of goods and services and efficiency gains that lead to greater purchasing power. Employment

opportunities tend to improve because trade liberalization leads to market expansion, technology

sharing and cross border investment flows. Political cooperation among countries can improve

because of stronger economic ties which can help sesolve conflicts peacefully and lead to greater

stability.

Despite the benefits, economic integration has costs. The disadvantages include trade diversion

and the erosion of natinal sovereignty, for instance, trade unions can divert trade from non-

members even if it is economically detrimental for them to do so. Additionally, members of

economic union are typically required to adhere to rules on trade, monetary policy and fiscal

policy which are established by an unselected external policymaking body. Because economists

and policymakers believe economic integration leads to significant benefits for society, there are

many institutions that attempt to measure the degree of economic integration across countries

and regions.

The methodology for measuring economic integration typically involves the combination of

multiple economic indicators, including trade in goods and services, cross-border capital flows,

labor migration and others. Assessing economic integration also includes measures of

institutional comformity such as membership in trade unions and the strength of instituitions that

protect consumer and investor rights. Some fast facts about economic integration are it can

broaden markets, boost employment and spur political cooperation, trade unions may divert trade

from non-members even if doing so is detrimental to one or more members. Last fact refer to

strict nationalists may oppose economic integration on the basis of a loss of sovereignty.

Pinder (1968) believes EI as a process towards a union, during which both the removal of

discrimination between member countries and the co-ordination of economic policies have to be

considered as important elements of integration. Hence, Pinder suggests a definition as “both the

removal of discriminations between the economic agents of the member countries, and the

formation and application of co-ordinated and common policies on a sufficient scale to ensure

that major economic and welfare objectives are fulfilled”.

Maksimova (1976) believes it as “a process of developing deep and stable relationships about the

division of labor between national economies. This process aims at the formation of international

economic entities, within the framework of groups of countries with the same type of socio-
economic system, which are consciously regulated in the interest of the ruling classes of these

countries” (Jiawen Yang).

Static Effects of Economic Integration

Viner (1950) introduced the static theory through the concepts of trade creation (TC) and trade

diversion (TD). Viner (1950) believes that TC leads to welfare rising as trade shifts from a high

cost supplier member country to a low cost supplier member country in the union. Meanwhile,

TD lowers the welfare as it leads to shift trade from a low cost supplier non member country to a

high cost supplier member country in the union.

Trade creation as taking place whenever economic integration leads to a shift in product origin

from a domestic producer whose resource costs are higher to a member producer whose resource

costs are lower. This shift represents a movement in the direction of the free-trade allocation of

resources and thus is presumably beneficial for welfare. Trade diversion takes place whenever

there is a shift in product origin from a non-member producer whose resource costs are lower to

a member country producer whose resource costs are higher. This shift represents a movement

away from the free-trade allocation of resources and could reduce welfare.

Figure 1 Trade Creation and Welfare

Before the economic integration, the price of the good in country A is $1.50 (equal the $1.00

price in country B plus the 50 percent tariff). With integration between A and B, the tariff is

removed and A now imports 150 units (250 units-100 units) rather than 40 units (200 units-160

units) from B. 60 units (160-100) of the increased imports displace previous home production

and 50 units (250-200) reflect the greater comsumption at the new $ 1.00 price facing country
A’s consumers. The net welfare impact is the sum of areas b and d, or

(1/2)(60)($0.50)+(1/2)(50)($0.50)=$27.50.

This is a trade creation union in Viner’s sense because 60 units (160-100) have been switched from

home production in country A to lower cost production in B. In additional to the switch in the

source of production, consumers gain from a larger quantity consumed. (Viner neglected the

consumption effect). The welfare impact on country A is clearly positive. Consumers have

received the additional consumer surplus of areas a+b+c+d. Of this amount, a is a transfer of

producer surplus from country A’s suppliers, while c formerly was tariff revenue that now accrues

to A’s consumers. Therefore, the net welfare gain for the country consists of areas b+d. In terms

of the example, b=(1/2)(60units)($0.50/unit)=$15, while d=(1/2)(50units)($0.50/unit)=$12.50.

Country A as a whole has increased its welfare by $15=$12.50=$27.50. The effect is unambiguous

because this trade creation represents a movement in the direction of comparative advantage.

The ambiguity concerning the welfare effect of economic integration arises when trade diversion

occurs. This possiblility is illustrated in the partial equilibrium analysis in Figure 2. Suppose that
the three countries-A, B and C had examined. A be the home country, B the potential union partner

and C the non-member country. The production cost in C is $1.00 and the cost of B is $1.20, but

the product price in home country A is $1.50 because A has a 50 percent tariff in place. In this

instance, country A will buy from country C because C’s price and the tariff is lower that tariff

inclusive price of country B which equals $1.20 + 50% ($1.20) or $1.80. (not shown in Figure 2)

Figure 2 Trade Diversion and Welfare

Before the union with country B, country A has 50 percent tariff on imports of the good. Thus

country C’s tariff- inclusive price in A’s market is $1.50 and country B’s tariff- inclusive price is

$1.80 (not shown). Before the union, A imports 50 units (180 units – 130 units) from C. When the

unions is formed with B, country A imports 100 units (200-100), all coming from partner B which

no longer faces a tariff. The net welfare change for A is the difference between areas b+d (a

positive effect due to a lower price in A) and area e (a negative effect due to lost tariff revenue by

A that is not captured by A’s consumers). In this example, welfare is reduced because

b+d=(1/2)(30)($0.30)+(1/2)(20)($0.30)=$4.50+$3=$7.50.while e=(50)($0.20)=$10.

Suppose now that country A forms a customs uniom with country B and drops its protection against

B’s good as part of the integration agreement, while at the same time maintaining its protection

against country C. Country A can now purchase the product for $1.20 from country B, compared

with the tariff-inclusive price of $1.50 from C. Even though C is still the low cost supplier in term

of real resources costs, C is no longer competitive in A’s market because of A’s preferential

treatment of country B. Consequently, country A shifts from C to B as a source of this product.

The impact in A is to reduce the domestic price from $1.50 to $1.20, a change that produces a

welfare gain equal to the two deadweigh triangles b and d.

Country A is now importing from country B and charging no tariffs, the government in A is no

longer collects any revenue. The revenue that was previously collected was equal to the

difference between the low cost supply price ($1.00) in country C and the previous domestic

price ($1.50) for each unit imported. The value of this revenue is equal to the area of rectangles c

and e. Rectangle c reflects that part of the government revenue give up after integration, which is

transferred to domestic consumers through the reduction in the domestic price. Rectangle e

represents the difference in cost between the non-member source and the new higher cost

member source and as such it is the cost of moving to the less efficient producer in terms of lost

government revenue. The net effect of economic integration between country A and country B in

this case depends on the sum (b+d-e). There is no certainty that the sum of b + d will be larger

that area e.
Dynamic Effects of Economic Integration

Improvement of welfare must be the ultimate objective of an economic activity. Hence, the

desirability or the successfulness of TI must be evaluated through its contribution to the welfare

generation (Balassa, 1961). Many prominent researches indicate that the Vinerian analysis of TC

and TD and its developments are insufficient in assessing welfare of a TI arrangement. Thus, the

requirement of an alternative way of evaluating the welfare is emerged (Balassa, 1961; Hasson,

1962; Cooper and Massell, 1965; Krauss, 1972; Sheer, 1982).

Balassa (1961) believes that the economic welfare resulting from an integration arrangement can

be measured by using four criterions. They are “(a) a change in quantity of commodities

produce, (b) a change in degree of discrimination between domestic and foreign goods, (c) a

redistribution of income between nationals of different countries, and (d) income redistribution

within individual countries”. First two criterions measure the change in potential welfare or in

the static sense it is the improvement in the allocation of resources at a given point of time.

Other two measure the welfare effects of income redistribution. Balassa indicates that the

potential welfare in the static sense or the “static efficiency, however, is only one of the possible

success criteria that can be used to appraise the effects of economic integration”. Further he

points out the importance of expanding an investigation to study the impact of integration on

“dynamic efficiency” instead of limiting to the resources allocation under static assumption.

Balassa (1961) defines the “dynamic efficiency” as “the hypothetical growth rate of national

income achievable with given resource use and saving ratio. Dynamic efficiency can be

represented by the movement of this frontier in the northeast direction”. As he indicates,

technological progress, the allocation of investment, dynamic inter-industry relationships in

production and investment, and uncertainty and inconsistency in economic decisions can be

considered as the factors affecting the dynamic efficiency of an economy.

Market Extension

Dynamic effect include drastic Long Run outcomes such as exit. Brexit: UK existed from EU in

June 2016. (Immigrants, forgotten middle class)

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.
 Figure 3

Under temporary unemployment, when inefficient firms exit from the market, workers in such

firms become unemployed. Eventually, they need to move to other industries.

Increase Competitive

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.

Innovations occcurs in Europe, the US and Asia: US restricts exports to Chinese semiconductor

frim Fujian Jinhua (evolution)

Trade Creation vs. Trade Diversion

In economic textbooks and academic papers the overshadowing debate has been whether

Economic Integration serves as a building or stumbling block for the process of global free trade

and integration as now governed under the World Trade Organisation.That is why economists

have been so interested in the phenomena of trade creation and trade diversion. This idea was

first introduced by the Canadian economist Jacob Viner in the 1950s.

Trade creation is when Economic Integration gives cause to new trade that did not take place

before the agreement was entered into. This may happen because previous barriers to trade

between the member countries have been dismantled.

Trade diversion happens when countries that enter into a preferential trade agreement end up

buying goods and services from each other that could have been produced more efficiently by a

country outside the area affected by the agreement.

Conclusions

There are four general conclusions that can be make regarding trade creation and diversion:

1. The more closely the price in the price in the partner country approaches the low cost

world price, the more likely the effect of integration on the market in question will be

positive.

2. The effect of the integration is more likely to be positive the higher the initial tariff rate

as areas b and d will be larger. (At extreme, if the tariff were initially prohibitive so that

country A’s imports were zero, there would be no welfare loss at all from trade

diversion.)
3. The more elastic the supply and demand curves, the greater the quantity response by both

consumers and producers; thus the larger are b and d.

4. Integration is more likely to be beneficial when there is a greater number of participating

countries, because there is a smaller group of countries from which trade can be diverted.

(The extreme case occurs when all countries in the world embrace integration because

there could be no trade diversion.)

Moreover, the creation or diversion effects, there are other static, more institutional effects of

economic integration that manay accompany the formation of a union. First, economic

integration can be lead to administrative savings by eliminating the need for government of

officials to monitor the partner goods and services that cross the borders. Providing around-

the-clock customs surveillance at all possible crossover points can be costly.Second, the

economic size of the union may permit to improve its collective terms of trade the rest of the

world compared with average terms previously obtained by individual member countries.

Finally the member countries will have greater bargaining power in trade negotiation with

the rest of world than they would have had negotiating on their own.
References

Drud Hansen, J., & Nielsen, J. U. M. (1997). An Economic Analysis of the EU, McGraw

Hill, Cambridge.

Mundell, R. A. (1961). A theory of optimum currency areas. The American Economic

Review, 51(4), 657-665.

Viner, J. (1950). The Customs Union Issue, Carnegie Endowment for International

Peace. New York.

Balassa, B. (1961). The Theory of Economic Integration. Homewood, Illinois: Richard D. Irwin.

Pinder, J. (1968). Positive Integration and Negative Integration. The World today, Mar, 88-110.

Maksimova, M. (1976). Comments on Paper: Types of Economic Integration by B. Balassa.

Machlup F. eds. Economic Integration Worldwide. London: Macmillan.