This lesson examines the various levels of economic integration. The guiding question for this lesson is the recognition that economic integration comes in many different forms from a simple trading relationship to full integration such as membership of the EU and that each level of integration contains both costs and benefits.
What is economic integration and what are the various forms of closer integration? What is the difference between trade creation and trade diversion.
Lesson time: 80 minutes, SL 1 hour
Distinguish between bilateral and multilateral (WTO) trade agreements.
Explain the different levels of economic integration from preferential trade agreements to full Political Union. Distinguish between a free trade area, a customs union and a common market.
Explain the concepts of trade creation and trade diversion in a customs union. (HL only)
Explain that economic integration will increase competition among producers within the trading bloc and allow member countries to gain from economies of scale. (HL only)
Discuss the possible advantages and disadvantages of a monetary union for its members.
1. Beginning activity - begin with the opening activity and then discuss this as a class. (Allow 10 minutes in total)
2. Processes - technical vocabulary - the students can learn the background information from the opening video, activity 1 and the list of key terms. (20 minutes)
3. Applying the theory - activities 3 - 5 focus on the EU and applies the topic to current issues within the EU - the UK's potential exit from the bloc and the troubles of some of its members, particularly Greece. (20 minutes)
4. Developing the theory - activities 6 and 7 contain the HL sections of the topic - trade diversion and trade creation. (20 minutes)
5. Link to the assessment - activity 8 consists of a paper two type questions on this topic. (10 minutes) or 40 if completed in class.
Economic integration - involves different countries coordinating and linking their economic policies, for example bilateral trade agreements between two nations or at the other end of the scale, a monetary union such as the EU.
Preferential Trading Agreement – examples of this include the EU / African Caribbean trade agreement or ACP (Pacific Group of States). PTAs offer preferential (i.e. lower tariff barriers) between participating nations, but not free trade between members.
Free Trade Area - a more comprehensive arrangement than preferential trading areas. Examples include NAFTA (North America free trade area).
Customs Union - an agreement between member countries to ensure free trade within those countries but also common external barriers.
Common Market - this is a customs union plus, consisting of common standards on goods and services and the free movement of capital.
Economic Union - this involves a common currency, such as the Euro as well as universal monetary policy.
Political Union - this consists of a larger and consolidated group of nations or states, that share a joint government that is internationally acknowledged e.g. UK, UAE.
Bilateral agreement - an agreement between two nations or trading groups that gives each party favoured trade status.
Multilateral agreement - an agreement between a number nations or trading groups that give each party favoured trade trade status.
Trade creation - occurs when entry to a customs union means that the production of a good or service switches from a high cost producer to a lower cost one.
Trade diversion - occurs when the production of a good or service diverts from a low cost producer to a higher cost one.
The activities on this page are available as a class handout at: Economic integration
In small groups investigate the nations that your own country enjoys a partnership with. This could be as part of a trading bloc or perhaps an economic union. What advantages and disadvantages does this offer your nation?
Your response should include factors such as:
- a greater range of products to purchase
- ease of access to travel / work visas
- competition from overseas businesses
- the impact on the local job market of immigrant labour.
Overall do you believe that your country benefits from the relationships that it enjoys with other nations or not?
Start by watching the following presentation which compares different types of economic integration before continuing with the rest of the reading. You may also wish to view this presentation during the discussion on the same topic later on in the lesson:
Activity 1: Different levels of economic integration
Start by watching the following short video and then complete the tasks that follow:
(a) Explain the difference between a Free Trade Area (FTA) and a Preferential Trade Agreement
The PTA does not guarantee free trade between members, simply preferential trade e.g. lower import barriers than those placed on non PTA members.
(b) Explain the difference between a Free Trade Area (FTA) and a Customs Union.
A customs union provides free trade within those countries but also common external barriers.
(c) Explain the term common external barriers, illustrated on the customs union diagram to the right:
Countries A, B and C are part of the free trade area and there are no trade barriers between those three nations. All nations within the customs union must adopt common external barriers with an outside country D.
(d) How does the absence of a common external barrier present a weakness for FTAs?
External barriers are only as strong as the weakest link so if the UK is able to export its products to USA, for example, then American manufacturers may then be able to repackage those goods and services and then export them to Canada and Mexico, thus avoiding Canada and Mexico's external tariff barriers.
(e) Why might membership of a customs union brings more benefits to members in the form of increased trade than a simple FTA?
It is sometimes argued that a customs union makes trading easier because a firm, operating in say France, need only have their product pass EU standards before selling their product across the EU. This brings about benefits through increased economies of scale and increased competition in the market.
(f) Explain some of the weaknesses of customs union membership?
Negotiating separate third party deals is not allowed and membership also compels individual nations to abide by common rules agreed by the other members.
(g) Explain the term Monetary Union?
This is a customs union with common standards, free movement of capital and labour e.t.c.
(h) Explain the difference between a Customs Union and a full Economic Union?
A full economic union involves a common currency, such as the Euro as well as a universal monetary policy.
Activity 2: Free Trade v Customs Union
Watch the following two short videos which compare the impact of a free trade agreement with a full customs union on the economies of different nations. Watch both and then discuss the advantages and disadvantages of a country joining one rather than the other.
Firstly the case in support of a full customs union:
Now watch the following video which describes the arguments in support of a free trade agreement:
1. Which of these arguments do you find most convincing?
2. Would you support your government converting their current free trade agreements into a full customs union? Would you support your government withdrawing from the EU (if applicable) and instead joining free trade agreements?
The responses should consider the following:
- the countries that your nation currently trades with?
- the level of integration that your nation already has with their trading partners?
- the level of wealth of your respective nation. As a general rule wealthier nations would be net contributors to any customs union / single market while poorer nations would tend to be net gainers. This is because customs unions work by nation states contributing to a central fund, based on their level of income and then accessing central funds relative to need. Wealthier nations would generally pay a higher amount into the central pot and also have a less obvious case to receive funds based on need.
Activity 3: TOK connections
What criteria can be used to assess the benefits and the costs of increased economic integration? Might increased economic integration ever be considered undesirable?
Such a response requires a consideration of the economic v social costs / benefits. For example, a number of the Southern EU states may well have struggled under the strict economic conditions of Monetary Union membership, while a number of Northern EU states have faced resistance from their own populations at the large numbers of migrants that have arrived on their shores.
Activity 4: Monetary Union
Start by watching the short video and then explain the benefits and costs of Monetary Union membership.
Easier for customers and businesses to complete cross border trades e.g. tourists.
Loss of government control, especially monetary policy e.g. Italy, Greece no longer allowed to devalue their currency in order to rescue their economies when things were going wrong.
The cheap loans offered by the ECB to alleviate the problems have not gone far enough, as far as some Southern European nations are concerned.
Activity 5: A focus on Greece
Start by watching the following short video and then summarise why Greece appears to have suffered as a consequence of Monetary Union membership?
The one size fits all criteria was designed to impose German style economic discipline on the Greece and other Southern European members. By signing up to the Euro and abandoning their national currency, monetary policy was now controlled by the European Central Bank and non by Athens.
This means that when faced with sluggish economic activity and budget deficits they were no longer able to employ ultra loose monetary policy and instead borrowed money (available at low interest rates) to tide them over. As the debts mounted the difficulties escalated, leading to a series of 'bail outs' and yet the nation's enormous debt remains largely untouched.
Trade diversion v trade creation (HL only)
Start by watching the video which explains the concepts of trade diversion and trade creation. After the video read the handout that your teacher will give you.
Activity 6: Trade creation
The diagram to the right illustrates the cotton market in Portugal, prior to joining a Customs Union. The nation imported its cotton from Greece and placed a tariff on all imported cotton, indicated by the WS + tariff.
(a) Portugal and Greece join the EU, a customs Union and Portugal is forced to remove the tariff on cotton imports. Indicate this on the diagram and show the following points:
i. welfare gain from increased consumer surplus
ii. welfare gain from greater world efficiency
iii. the increase in trade as a result (the trade creation).
The trade creation is shown by (Q3-Q4) - (Q1-Q2).
(b) Are there any losers from this trade creation?
The loser from this process are the Portugese cotton producers, who have lost out to cheaper imported cotton. Their market share falls from 0-Q3 to 0-Q1.
Of course any customs union is a two way street and so there may also be industries where Portugese firms enjoy a comparative advantage over Greece and they too can benefit from tariff free trade, perhaps in the export of olive oil to Greece and other EU nations.
Activity 7: Trade diversion
The diagram to the right illustrates once again the domestic raw cotton market in Portugal. The nation imports its raw cotton from Vietnam without tax due to a bilateral trade agreement between themselves and Vietnam.
On joining the EU Portugal is now forced to place tariffs against Vietnamese cotton (this being EU policy). The cheapest cotton available within the EU is from Italy, but is more costly than pre-tariff Vietnamese cotton.
(a) Illustrate this on the diagram and show the following:
i. welfare loss from reduced consumer surplus
ii. welfare loss from reduced world efficiency
iii. the reduction in world trade as a result of the trade diversion.
i. The loss of consumer surplus is represented by area b.
ii. Welfare loss resulting from more cotton produced by inefficient producers is represented by the green shaded area.
iii. The lost trade is shown by (Q1-Q2) - (Q3-Q4).
Activity 8: Link to the assessment (old syllabus)
An example of relevant paper two examination questions:
(a) i. Explain the difference between a free trade area and a customs union? [2 marks]
While membership of both provides participating members with the benefits of free trade, a customs union also requires members to adopt common trade barriers with nations outside the trading bloc.
ii. State two examples of trade protection. [2 marks]
- hidden / administrative trade barriers
- domestic subsidies
- VERs (voluntary export restraints).
(b) Using an appropriate diagram, explain the impact on the market for a product, following an increase in the size of the tariff from 40% - 80%. [4 marks]
2 marks for an accurately labelled diagram, illustrating a rise in the size of the tariff and 2 marks for an explanation that the increased tariff will reduce the quantity of imports from Q1, Q4 to Q2, Q3.
Domestic producers will increase their share of the market by Q1 - Q2.
(c) Distinguish between a free trade area, a customs union and a common market. [4 marks]
One of the key differences is the level of integration, which in order of integration is FTA, customs union and then finally a common market, which has the highest level of integration.
Other key differences are that in a free trade area, tariff free trade applies to participating members, but individual members are free to apply their own tariffs to member nations outside the bloc, as Canada has recently negotiated with the EU, despite membership of NAFTA. Such an agreement would not be possible for EU members as the customs union (EU) applies a common external tariff, making third party negotiations impossible.
Offering the highest level of integration for participating nations, a common market also includes free movement of the factors of production and common policies on product regulation.
(d) Using information from the text/data (included in the examination paper) and your knowledge of economics, evaluate the impact of trade diversion and trade creation on a nation joining a customs union. [8 marks]
Command term: Evaluate
Key terms to define - customs union, trade creation and trade diversion, comparative advantage.
The benefits received from increased trading, brought about by greater trade creation include:
The gains arising from increased specialisation, according to the theory of comparative advantage, as well as greater competition arising from access to a larger market. This will also include the advantages gained from greater efficiency and the economies of scale gained through access to a larger market.
Responses should also describe the benefits to the consumer in terms of lower prices, a greater range of products and improved product quality.
This could be illustrated by a diagram, showing the benefits enjoyed by consumers from a reduction in prices due to the elimination of tariff barriers. In the diagram, Greece has joined a customs union and consumers (textile businesses) have instantly benefited from a reduction in prices, represented on the diagram by Pg+t to Pg and as the supply chain progresses Greek consumers will benefit from lower priced cotton products.
On the other hand, the disadvantages of joining a customs union, example include:
The potential losses through trade diversion including examples of how a country may be forced to abandon previous trading partners.
This could be illustrated by a diagram, such as the one drawn to the right, illustrating the negative impact of joining a customs union. As the diagram illustrates, prior to joining the customs union, Italy purchased their raw cotton at price Pv from Vietnam, the cheapest available. However, after joining the EU Italy was forced to apply a common tariff on Vietnamese cotton (this being EU policy) and the price for the Italian textile industry rises to Pt, driving up the price of clothing for consumers.
With the command term being evaluate, responses should then draw an appropriate conclusion based on the evidence presented. This might include a recognition that the gains from trade are often unequal with losers as well as winners, for example the closure of inefficient producers due to increased competition from imports.
A recognition also that this may cause some unemployment and may also be unpopular politically. This should be balanced by the notion that there will also be winners from a reduction in trade barriers, allowing a nation to take advantage of those goods and services where they enjoy an absolute or comparative advantage.