Economic Integration Trading Blocs II

Trade creation (Viner, 1950). When countries join an FTA or customs union, trade between members increases as goods previously produced domestically are now imported MORE CHEAPLY from another member. WELFARE GAIN — resources reallocated to better uses.

Trade diversion. Trade SHIFTS from a more efficient non-member supplier to a less efficient member supplier because the common external tariff makes non-members non-competitive. WELFARE LOSS — global production is now less efficient.

Worked example.

• Pre-FTA: Country imports cars from Japan ($20,000) with 10$22,000.
• Country joins FTA with USA. US cars cost $25,000 but enter tariff-free.
• Japan's cars STILL cost $22,000 (tariff unchanged for non-members).
• BUT: Country's CU partner has internal $25,000 vs external$22,000... actually wait — Japan is still cheaper. No diversion here.

Better example:

• Pre-CU: Country imports cars from Japan at $20,000 + 30$26,000. Could also import from Germany at $25,000 + 30$32,500. Country imports from Japan.
• Country joins CU with Germany. Common external tariff still 30% (Japan now $26,000). German cars enter tariff-free at$25,000.
• Country switches from Japan to Germany. Country pays LESS ($25,000 <$26,000) — gain.
• BUT global resources are misallocated: Japan was actually more efficient ($20,000 <$25,000).
• This is trade DIVERSION.

Net welfare effect: depends on whether trade creation (which is welfare-enhancing) exceeds trade diversion (which is welfare-reducing).

Studies suggest most major trade blocs (EU, NAFTA/USMCA) generated NET CREATION but also significant diversion.

Eurozone-specific tensions. Shared currency means:

• No individual monetary policy. Shock to one country (Greek crisis) can't be addressed by depreciation.
• Asymmetric shocks: northern Europe and southern Europe may need different rates.
• Fiscal union INCOMPLETE: no eurozone budget to transfer to crisis countries; Germany resists transfer union.
• Result: Greek crisis 2010-12 saw austerity, deep recession, 25% unemployment — a country with own currency could have devalued.

Optimal Currency Area (Mundell 1961). Currency area works best when:

• High labour mobility (workers move from depressed to booming regions).
• Fiscal transfers (rich regions support poor regions during shocks).
• Similar business cycles (members face shocks together).

EU has only PARTIAL OCA conditions, which is why eurozone is sometimes called "incomplete monetary union".

Gains and losses of integration overall:

• Gains: scale, competition, factor mobility, political solidarity.
• Losses: sovereignty loss, asymmetric shock vulnerability, bureaucratic complexity.