Economic integration (some HL tasks)

Introduction

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.

Enquiry question

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

Lesson objectives:

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.

Teacher notes:

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.

Key terms:

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. PTAs apply to specific goods and services only, rather than a universal agreement covering all products.

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

Beginning activity

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?

Activity 1: Different levels of economic integration

Start by watching the following short video and then complete the tasks that follow, the video begins with a short song, 2 minutes and 22 seconds long which you might wish to skip to the end of before showing to your classes.

(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.

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 union of nations that agree to a single currency and common interest rate policy.

(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: Monetary Union (HL only)

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 3: 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 4: Trade creation (HL only)

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 Portuguese 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 Portuguese 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 5: Trade diversion (HL only)

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 6: Link to the assessment (HL only)

An example of relevant paper two examination questions:

(a) Define the following terms from the passage.

i. 'Unregulated free trade'. [2 marks]

Unregulated free trade is when countries form an agreement allowing goods and services to be traded freely without constraints such as tariffs, duties or quotas.

A vague response that unregulated free trade involves trading without restrictions should score only one mark.

ii. 'Regulations on environment and consumer protection'. [2 marks]

Regulations on environment and consumer protection are sometimes referred to as red tape or bureaucratic barriers. Firms wishing to export their produce must first pass a series of environmental regulations and consumer quality control measures to prove that their produce matches the same standards as products produced in the home country.

(b) i. State three examples of trade protection. [3 marks]

tariff
quota
hidden / administrative trade barriers
domestic subsidies
VERs (voluntary export restraints).

ii. 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.

(c) 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.

(d) 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.

(e) Illustrate using an appropriate diagram why regulations aimed at 'regulations on environment and consumer protection' are a form of protection. [4 marks]

This is a form of trade barrier because it adds to the costs of production for businesses wishing to export their product to a certain market. This can make them more expensive than domestically produced goods and services, which do not necessarily have to undergo the same regulations. This can be illustrated by a fall in supply for the product, i.e. a left shift in the supply curve showing a rise in price and a fall in quantity as a result of the additional costs placed on exporting firms.

2 marks for a correctly labelled diagram and 2 marks for an accurate description of why bureaucratic barriers are a form of tariff barrier. Incorrect or absently labelled diagrams will score only one mark. Responses which include only a relevant diagram or only an explanation can score a maximum of only 2 marks.

(f) Using an appropriate diagram show the benefits gained by reduced tariff barriers to countries participating in the EU / US trade deal. [4 marks]

2 marks for a diagram showing a tariff diagram with a perfectly elastic EU supply and a domestic supply curve sloping upwards from left to right. After the abolition of the tariff the EU supply rises from EU S + tariff to EU supply. This leads to a fall in the price paid by consumers and an increase in the number of imported goods and services consumed. Similarly, efficient American firms benefit from access to EU markets and EU consumers also benefit from lower priced American goods and services. Areas A and B represent the gains from greater world efficiency and an increase in consumer surplus.

2 marks for an appropriate definition that following the abolition of the tariff the price of products will fall allowing consumers to purchase more goods and services. Consumers will benefit from lower prices and a greater variety of products to purchase. Efficient firms from both regions will benefit from access to a bigger market. There is also likely to be an increase in competition and there may also be greater benefits from economies of scale.

Incorrect or absently labelled diagrams will score only one mark. Responses which include only a relevant diagram or only an explanation can score a maximum of 2 marks.

(g) 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. [15 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 Portuguese 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.

Responses for question (g) should be graded according to the following mark bands:

Marks	Level descriptor
0	The response is below the standards described below.
1-3	The response indicates little understanding of the demands of the question The response uses little relevant theory Little attempt is made to make use of the text/data.
4-6	The response indicates some understanding of the demands of the question The response makes limited use of demand side / supply side policies. There is limited evaluation contained in the response The response makes limited use of the text/data to support their arguments.
7-9	The response indicates an understanding of the demands of the question Some relevant theory is used in the response The response contains some evaluation The response makes some use of the text/data.
10-12	The response indicates an understanding of the demands of the question The response uses relevant theory appropriately Evaluation is used appropriately There is appropriate use of the text/data.
13-15	The response indicates an understanding of the demands of the question The response makes effective use of relevant theory Evaluation is used effectively The response makes effective use of the text/data.

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