Syllabus points
- Distinguish the forms of economic integration.
- Explain trade creation and trade diversion.
- Explain the role of the World Trade Organization (WTO).
- Evaluate the benefits and costs of monetary union.
Forms of economic integration
Integration is a spectrum, each stage deeper than the last:
| Form | What members agree |
|---|---|
| Preferential trade agreement | Reduced tariffs on selected goods between members |
| Free trade area | No tariffs between members; each keeps its own external tariff |
| Customs union | Free trade internally plus a common external tariff |
| Common market | Customs union plus free movement of labour and capital |
| Monetary union | Common market plus a single currency and a common central bank |
Trade creation and trade diversion
When a country joins a customs union, two opposing effects arise:
- Trade creation: high-cost domestic production is replaced by lower-cost imports from a member. Resources move to their comparative advantage — a welfare gain.
- Trade diversion: lower-cost imports from an efficient non-member are replaced by higher-cost imports from a member, purely because the member's goods are now tariff-free — a welfare loss.
The net effect on welfare depends on which dominates. This is the central analytical tool for evaluating any trade bloc.
The World Trade Organization
The WTO promotes freer, rule-based multilateral trade. Its functions are to provide a forum for trade negotiations, administer trade agreements, and settle disputes between members. Evaluation: it has lowered tariffs substantially and gives smaller economies a rules-based route to challenge larger ones, but decision-making by consensus is slow, and critics argue outcomes have favoured developed economies.
Monetary union: evaluation
- Benefits: eliminates transaction costs and exchange-rate risk between members, improves price transparency and competition, and can attract investment through a larger, more stable market.
- Costs: members lose independent monetary policy and the exchange rate as an adjustment mechanism. A single interest rate may suit some members and not others, so an asymmetric shock hitting one member cannot be met with a tailored monetary response — adjustment falls on fiscal policy, wages and labour mobility.
Worked example
Country A produces a good at $80. Before joining, it imports from efficient non-member C at $50 plus a $40 tariff = $90, so it buys domestically at $80. After joining a customs union with member B (cost $70, now tariff-free), it imports from B at $70. Domestic production at $80 is replaced by a $70 import: trade creation. But the world's lowest-cost producer, C at $50, is still excluded — the potential gain is not fully realised, illustrating trade diversion relative to free trade.
Common exam mistakes
- Confusing a free trade area (own external tariffs) with a customs union (common external tariff).
- Treating all trade blocs as unambiguously welfare-improving — always weigh creation against diversion.
- Forgetting that monetary union means surrendering independent monetary policy.
Exam technique
Name the exact form of integration, then evaluate using trade creation vs diversion, and for monetary union the loss of policy autonomy under asymmetric shocks.
Quick revision
- PTA → FTA → customs union → common market → monetary union (deepening).
- Trade creation = welfare gain; trade diversion = welfare loss.
- WTO: negotiation forum, administers agreements, settles disputes.
- Monetary union: lower transaction costs vs lost monetary independence.