Economic integration can unintentionally reward a less efficient producer within a trading bloc.

8 Regional Economic Integration

Learning Objectives

After studying this chapter, you should be able to

1 Define regional economic integration and identify its five levels.

2 Discuss the benefits and drawbacks of regional economic integration.

3 Describe regional integration in Europe and its pattern of enlargement.

4 Discuss regional integration in the Americas and analyze its future prospects.

5 Characterize regional integration in Asia and how it differs from integration elsewhere.

6 Describe integration in the Middle East and Africa and explain the slow progress.

A LOOK BACK

Chapter 7 examined recent patterns of foreign direct investment. We explored the theories that try to explain why it occurs and saw how governments influence investment flows.

A LOOK AT THIS CHAPTER

This chapter explores the trend toward greater integration of national economies. We first examine the reasons why nations are making significant efforts at regional integration. We then study the most prominent regional trading blocs in place around the world today.

A LOOK AHEAD

Chapter 9 begins our inquiry into the international financial system. We describe the structure of the international capital market and explain how the foreign exchange market operates.

Nestlé’s Global Recipe

Vevey, Switzerland — Although based in small Switzerland, Nestlé (www.nestle.com) sells its products in nearly every country on the planet. Nestlé is the world’s largest food company. It operates across cultural borders 24 hours a day and earns just 2 percent of its sales at home.

Nestlé is known for its ability to turn humdrum products like bottled water and pet food into well-known global brands. The company also takes regional products to the global market when the opportunity arises. For example, Nestlé first launched a cereal bar for diabetics in Asia under the brand name Nutren Balance and is now taking it to other markets worldwide.

Nestlé must navigate cultural and political traditions in other countries because food is an integral part of the social fabric everywhere. Nestlé learned from its past and does all it can to ensure mothers use pure water to mix its baby milk formulas. Today, the company makes every effort to be sensitive to the traditional ways in which babies are fed. Nestlé must also watch for changes in attitudes due to greater cross-cultural contact caused by regional integration. Pictured above, a pharmacist in Rome, Italy, reaches for a package of Mio brand baby milk made by Nestlé.

Source: Alessia Pierdomenico/CORBIS-NY.

The laws of regional trading blocs also affect the business activities of Nestlé. When Nestlé and Coca-Cola announced a joint venture to develop coffee and tea drinks, they first had to show the European Union (EU) Commission that they would not stifle competition across the region. Firms operating within the EU also have to abide by EU environmental protection laws. Nestlé works with governments to minimize the packaging waste that results from the use of its products by developing and managing waste-recovery programs. As you read this chapter, think of all the ways business activities are affected when groups of nations band together in regional trading blocs.1

Regional trade agreements are changing the landscape of the global marketplace. Companies like Nestlé of Switzerland are finding that these agreements lower trade barriers and open new markets for goods and services. Markets otherwise off-limits because tariffs made imported products too expensive can become quite attractive once tariffs are lifted. But trade agreements can be double-edged swords for many companies. Not only do they allow domestic companies to seek new markets abroad, but they also let competitors from other nations enter the domestic market. Such mobility increases competition in every market that takes part in an agreement.

Trade agreements can allow companies to alter their strategies, sometimes radically. As we will see in this chapter, for example, nations in the Americas want to create a free trade area that runs from the northern tip of Alaska to the southern tip of South America. Companies that do business throughout this region could save millions of dollars annually from the removal of import tariffs under an eventual agreement. Multinationals could also save money by supplying entire regions from just a few regional factories, rather than have a factory in each nation.

We began Part Three of this book by discussing the gains resulting from specialization and trade. We now close this part of the book by showing how groups of countries are cooperating to dismantle barriers that threaten these potential gains. In this chapter, we focus on regional efforts to encourage freer trade and investment. We begin by defining regional economic integration and describing its five different levels. We then examine the benefits and drawbacks of regional trade agreements. Finally, we explore several long-established trade agreements and several agreements in the early stages of development.

What Is Regional Economic Integration?

The process whereby countries in a geographic region cooperate to reduce or eliminate barriers to the international flow of products, people, or capital is called regional economic integration (regionalism). A group of nations in a geographic region undergoing economic integration is called a regional trading blocs.

regional economic integration (regionalism)

Process whereby countries in a geographic region cooperate to reduce or eliminate barriers to the international flow of products, people, or capital.

The goal of nations undergoing economic integration is not only to increase cross-border trade and investment but also to raise living standards for their people. We saw in Chapter 5, for example, how specialization and trade create real gains in terms of greater choice, lower prices, and increased productivity. Regional trade agreements are designed to help nations accomplish these objectives. Regional economic integration sometimes has additional goals, such as protection of intellectual property rights or the environment, or even eventual political union.

Levels of Regional Integration

Since the development of theories demonstrating the potential gains available through international trade, nations have tried to reap these benefits in a variety of ways. Figure 8.1 shows five potential levels (or degrees) of economic and political integration for regional trading blocs. A free trade area is the lowest extent of national integration, political union is the greatest. Each level of integration incorporates the properties of those levels that precede it.

Free Trade Area

Economic integration whereby countries seek to remove all barriers to trade between themselves, but each country determines its own barriers against nonmembers, is called a free trade area. A free trade area is the lowest level of economic integration that is possible between two or more countries. Countries belonging to the free trade area strive to remove all tariffs and nontariff barriers, such as quotas and subsidies, on international trade in goods and services. However, each country is able to maintain whatever policy it sees fit against nonmember countries. These policies can differ widely from country to country. Countries belonging to a free trade area also typically establish a process by which trade disputes can be resolved.

free trade area

Economic integration whereby countries seek to remove all barriers to trade between themselves, but each country determines its own barriers against nonmembers.

FIGURE 8.1 Levels of Regional Integration

Customs Union

Economic integration whereby countries remove all barriers to trade among themselves, but erect a common trade policy against nonmembers, is called a customs union. Thus the main difference between a free trade area and a customs union is that the members of a customs union agree to treat trade with all nonmember nations in a similar manner. Countries belonging to a customs union might also negotiate as a single entity with other supranational organizations, such as the World Trade Organization.

customs union

Economic integration whereby countries remove all barriers to trade between themselves but erect a common trade policy against nonmembers.

Common Market

Economic integration whereby countries remove all barriers to trade and the movement of labor and capital between themselves, but erect a common trade policy against nonmembers, is called a common market. Thus a common market integrates the elements of free trade areas and customs unions and adds the free movement of important factors of production—people and cross-border investment. This level of integration is very difficult to attain because it requires members to cooperate to at least some extent on economic and labor policies. Furthermore, the benefits to individual countries can be uneven because skilled labor may move to countries where wages are higher, and investment capital may flow to where returns are greater.

common market

Economic integration whereby countries remove all barriers to trade and the movement of labor and capital between themselves but erect a common trade policy against nonmembers.

Economic Union

Economic integration whereby countries remove barriers to trade and the movement of labor and capital, erect a common trade policy against nonmembers, and coordinate their economic policies is called an economic union. An economic union goes beyond the demands of a common market by requiring member nations to harmonize their tax, monetary, and fiscal policies and to create a common currency. Economic union requires that member countries concede a certain amount of their national autonomy (or sovereignty) to the supranational union of which they are a part.

economic union

Economic integration whereby countries remove barriers to trade and the movement of labor and capital, erect a common trade policy against nonmembers, and coordinate their economic policies.

Political Union

Economic and political integration whereby countries coordinate aspects of their economic and political systems is called a political union. A political union requires member nations to accept a common stance on economic and political matters regarding nonmember nations. However, nations are allowed a degree of freedom in setting certain political and economic policies within their territories. Individually, Canada and the United States provide early examples of political unions. In both these nations, smaller states and provinces combined to form larger entities. A group of nations currently taking steps in this direction is the European Union—discussed later in this chapter.

political union

Economic and political integration whereby countries coordinate aspects of their economic and political systems.

Table 8.1 identifies each country involved in the European Union and the members of every regional trading bloc presented in this chapter. As you work through this chapter, refer back to this table for a quick summary of each bloc’s members.

TABLE 8.1 The World’s Main Regional Trading Blocs

EU

European Union

Austria, Belgium, Britain, Bulgaria, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greec e, Greek Cyprus (southern portion), Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, Netherlands, Poland, Portugal, Romania, Slovakia, Slovenia, Spain, Sweden

EFTA

European Free Trade Association

Iceland, Liechtenstein, Norway, Switzerland

NAFTA

North American Free Trade Agreement

Canada, Mexico, United States

CAFTA-DR

Central American Free Trade Agreement

Costa Rica, El Salvador, Guatemala, Honduras, Nicaragua, Dominican

Republic, United States

Andean

Andean Community (CAN)

Bolivia, Colombia, Ecuador, and Peru

ALADI

Latin American Integration Association

Argentina, Bolivia, Brazil, Chile, Colombia, Ecuador, Mexico, Paraguay, Peru, Uruguay, Venezuela

MERCOSUR

Southern Common Market

Argentina, Brazil, Paraguay, Uruguay, Venezuela (Bolivia, Chile, Colombia, Ecuador, and Peru are associate members)

CARICOM

Caribbean Community and Common Market

Antigua and Barbuda, Bahamas, Barbados, Belize, Dominica, Grenada, Guyana, Haiti, Jamaica, Montserrat, St. Kitts and Nevis, St. Lucia, St. Vincent

and the Grenadines, Suriname, Trinidad and Tobago

CACM

Central American Common Market

Costa Rica, El Salvador, Guatemala, Honduras, Nicaragua

FTAA

Free Trade Area of the Americas

34 nations from Central, North, and South America and the Caribbean

ASEAN

Association of Southeast Asian Nations

Brunei, Cambodia, Indonesia, Laos, Malaysia, Myanmar, Philippines, Singapore, Thailand, Vietnam

APEC

Asia Pacific Economic Cooperation

Australia, Brunei, Canada, Chile, China, Hong Kong, Indonesia, Japan, South Korea, Malaysia, Mexico, New Zealand, Papu New Guinea, Peru, Philippines, Russia, Singapore, Taiwan, Thailand, United States, Vietnam

CER

Closer Economic Relations Agreement

Australia, New Zealand

GCC

Gulf Cooperation Council

Bhrain, Kuwait, Oman, Qatar, Saudi Arabia, United Arab Emirates

ECOWAS

Economic Community of West African States

Benin, Burkina Faso, Cape Verde, Gambia, Ghana, Guinea, Guinea-Bissau, Ivory Coast, Liberia, Mali, Niger, Nigeria, Senegal, Sierra Leone, Togo

AU

African Union

Total of 53 nations on the continent of Africa

Effects of Regional Economic Integration

Few topics in international business are as hotly contested and involve as many groups as the effects of regional trade agreements on people, jobs, companies, cultures, and living standards. The topic often spurs debate over the merits and demerits of such agreements. On one side of the debate are people who see the bad that regional trade agreements cause; on the other, those who see the good. Each party to the debate cites data on trade and jobs that bolster their position. They point to companies that have picked up and moved to another country where wages are lower after a new agreement was signed, or to companies that have stayed at home and kept jobs there. The only thing made clear as a result of such debates is that both sides are right some of the time.

There is also the cultural aspect of such agreements. Some people argue that they will lose their unique cultural identity if their nation cooperates too much with other nations. As we saw in this chapter’s opening company profile, Nestlé tries to be sensitive to cultural differences across markets. But such large global companies are often lightning rods for those warning of cultural homogenization. Let’s take a closer look at the main benefits and drawbacks of regional integration.

Benefits of Regional Integration

Recall from Chapter 5 that nations engage in specialization and trade because of the potential for gains in output and consumption. Higher levels of trade between nations should result in greater specialization, increased efficiency, greater consumption, and higher standards of living.

Trade Creation

Economic integration removes barriers to trade and/or investment for nations belonging to a trading bloc. The increase in the level of trade between nations that results from regional economic integration is called trade creation. One result of trade creation is that consumers and industrial buyers in member nations are faced with a wider selection of goods and services not available before.2 For example, the United States has many popular brands of bottled water, including Coke’s Dasani (www.dasani.com) and Pepsi’s Aquafina (www.pepsi.com). But grocery and convenience stores inside the United States stock a wide variety of lesser-known imported brands of bottled water, such as Stonepoint from Canada. Certainly, the free trade agreement between Canada, Mexico, and the United States (discussed later in this chapter) created export opportunities for other Canadian brands.

trade creation

Increase in the level of trade between nations that results from regional economic integration.

Another result of trade creation is that buyers can acquire goods and services at lower cost after removal of trade barriers such as tariffs. Furthermore, lower-priced products tend to drive higher demand for goods and services because they increase purchasing power.

Greater Consensus

In Chapter 6 we saw how the World Trade Organization (WTO) works to lower barriers on a global scale. Efforts at regional economic integration differ in that they comprise smaller groups of nations—ranging from several countries to as many as 30 or more. The benefit of trying to eliminate trade barriers in smaller groups of countries is that it can be easier to gain consensus from fewer members as opposed to, say, the 153 countries that comprise the WTO.

Political Cooperation

There can also be political benefits from efforts toward regional economic integration. A group of nations can have significantly greater political weight than each nation has individually. Thus the group, as a whole, can have more say when negotiating with other countries in forums such as the WTO. Integration involving political cooperation can also reduce the potential for military conflict between member nations. In fact, peace was at the center of early efforts at integration in Europe in the 1950s. The devastation of two world wars in the first half of the twentieth century caused Europe to see integration as one way of preventing further armed conflicts.

Employment Opportunities

Regional integration can expand employment opportunities by enabling people to move from one country to another to find work or, simply, to earn a higher wage. Regional integration has opened doors for young people in Europe. Forward-looking young people have abandoned extreme nationalism and have taken on what can only be described as a “European” attitude that embraces a shared history. Those with language skills and a willingness to pick up and move to another EU country get to explore a new culture’s way of life while earning a living. As companies seek their future leaders in Europe, they will hire people who can think across borders and across cultures.

Drawbacks of Regional Integration

Although regional integration tends to benefit countries, it can also have substantial negative effects. Let’s examine each of these potential consequences.

Trade Diversion

The flip side of trade creation is trade diversion—the diversion of trade away from nations not belonging to a trading bloc and toward member nations. Trade diversion can occur after the formation of a trading bloc because of the lower tariffs charged between member nations. It can actually result in increased trade with a less-efficient producer within the trading bloc and reduced trade with a more efficient, non-member producer. In this sense, economic integration can unintentionally reward a less efficient producer within the trading bloc. Unless there is other internal competition for the producer’s good or service, buyers will likely pay more after trade diversion because of the inefficient production methods of the producer.

trade diversion

Diversion of trade away from nations not belonging to a trading bloc and toward member nations.

A World Bank report caused a stir over the results of the free trade bloc between Latin America’s largest countries, MERCOSUR (discussed later in this chapter). The report suggested that the bloc’s formation only encouraged free trade in the lowest-value products of local origin, while deterring competition for more sophisticated goods manufactured outside the market. Closer analysis showed that while imports from one member state to another tripled during the period studied, imports from the rest of the world also tripled. Thus the net effect of the agreement was trade creation, not trade diversion as critics had charged. Also, the Australian Department of Foreign Affairs and Trade released results of a study that examined the impact of the North American Free Trade Agreement (NAFTA) on Australia’s trade with and investment in North America. The study found no evidence of trade diversion following the agreement’s formation.3

Shifts in Employment

Perhaps the most controversial aspect of regional economic integration is its effect on people’s jobs. The formation of a trading bloc promotes efficiency by significantly reducing or eliminating barriers to trade among its members. The surviving producer of a particular good or service, then, is likely to be the bloc’s most efficient producer. Industries requiring mostly unskilled labor, for example, tend to respond to the formation of a trading bloc by shifting production to a low-wage nation within the bloc.

Yet figures on jobs lost or gained as a result of trading bloc formation vary depending on the source. The U.S. government contends that rising U.S. exports to Mexico and Canada have created a minimum of 900,000 jobs.4 But the AFL-CIO (www.aflcio.org), the federation of U.S. unions, disputes these figures and claims a loss of jobs due to NAFTA. Trade agreements do cause dislocations in labor markets; some jobs are lost while others are gained.