Economic Integration: Trade Creation and Diversion

Economic Integration

Trade creation occurs when members of an economic integration group begin focusing their efforts on those goods and services for which they have a comparative advantage and start trading more extensively with each other. Trade creation results in efficient, low-cost producers in member countries gaining market share from high-cost member producers, as well as generating increased exports. These results occur because the efficient regional producers are able to offer lower prices and higher quality output than their competitors inside and outside the group.

Trade diversion occurs when members of an economic integration group decrease their trade with non-member countries in favor of trade with each other. One common reason is that the removal of trade barriers among member countries makes it less expensive to buy from companies within the group, and continuing trade barriers with non-member countries makes it more difficult for them to compete. Thus, trade diversion can lead to the loss of production and exports from more efficient non-member countries to less efficient member countries that are protected by tariffs or other barriers.

Seven Levels of Economic Integration

1.1 Preferential Agreement

A number of countries grant each other a number of tariff and trade advantages in order to generate trade amongst themselves. They do not apply these advantages to third parties.

1.2 Free Trade Area

A free trade area is an economic integration arrangement in which all barriers to trade of goods and services (for example, tariffs) among member countries are removed. No discriminatory tariffs, quotas, subsidies, or administrative impediments are allowed to distort trade between members.

1.3 Customs Unions

A customs union is a form of economic integration in which all tariffs between member countries are eliminated and a common trade policy towards non-member countries is established. This policy results in a uniform external tariff structure. Under this arrangement, a country outside the union will face the same tariff on exports to any member country receiving the goods. Once within the customs union, goods can move freely.

1.4 Common Market

A common market is a form of economic integration characterized by:

• No barriers to trade among member countries
• A common external trade policy
• Free mobility of factors of production among member countries

1.5 Economic Union

An economic union is a deeper form of economic integration characterized by free movement of goods, services, and factors of production between member countries and full integration of economic policies.

1.6 Monetary Union

A monetary union has a common currency, or a permanently fixed exchange rate among currencies, and creates a supranational institution (a central bank) to design and execute monetary policy.