International Economics

MBA 6641, International Economics 1

Course Learning Outcomes for Unit VII Upon completion of this unit, students should be able to:

6. Differentiate international trade currency areas and economic unions. 6.1 Define free trade areas. 6.2 Apply the concept of free trade areas to an economic union.

Course/Unit Learning Outcomes

Learning Activity

6.1 Unit Lesson Chapter 10 Chapter 12

6.2 Unit Lesson Chapter 10 Chapter 12

Required Unit Resources Chapter 10: Economic Integration: Customs Unions and Free Trade Areas Chapter 12: International Resource Movements and Multinational Corporations

Unit Lesson

Introduction As countries engage in more international trade, they start to find additional benefits of integrating their economies. There are multiple degrees to which countries can integrate. Though not necessary, you can think of these as sequential steps toward closer economic integrations. First, consider an economy that has (high) tariffs on any imports, thus discouraging, if not outright eliminating, any trade. From what has been covered so far in this course, you would likely think that countries would be better off by simply outright reducing all of their tariffs, and you would be correct in that thinking. The problem is that the world does not always adhere to sound economic theory.

Economic Integration Countries often start out using preferential trade agreements. These agreements lower trade barriers just among the countries involved in the trade agreement. This does not eliminate the tariffs, but it does lower them relative to countries that are not members to the agreement. The next step is for countries to remove all barriers between members of the agreement. This is called a free trade area. An example is the USMCA (United States, Mexico, and Canada trade agreement), a tweak of the agreement formerly known as NAFTA (North American Free Trade Agreement). While the USMCA is hailed as an example of a free trade area, in practice it is far from it. There are various regulations and carve outs in the agreement that keep it from truly being free trade.

UNIT VII STUDY GUIDE

Trade Zones, Unions, and Multinational Corporations

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The next stage in moving toward further economic integration after a free trade area is forming a customs union. With a customs union, member countries not only have the free trade they had with a free trade area, they also have harmonized trade policy with the rest of the world. So, all members of a customs union would have the same tariff rate on imports from another country. In the initial years of its formation, the European Union was a customs union. Eventually, though, the European Union took the next step in economic integration and became a common market. In a common market, labor and capital are able to move freely among member nations. Such free movement allows the resources to move to where they will be the most productive. Any time resources are more productive, the economy benefits. The final stage of economic integration is an economic union. Building on a common market, an economic union also has unified monetary policy and fiscal policy. The European Union is currently struggling with the effects of not having unified (or at least harmonized) fiscal policy. The European Union has a largely (but not completely) unified monetary policy with the euro, but the separate fiscal policies have led to problems in countries like Greece and Italy. An example of a complete (and largely successful) economic union is the United States. Monetary policy is handled by the Federal Reserve. Government spending and tax policy is handled by Congress and the president. States do have their own budgets but compared to the taxes and spending by the federal government, the state spending and taxing is quite small. States are forbidden from issuing their own currency.

Gains and Losses from Economic Integration You should see a trend in material through this course. More trade equals gains, while less trade equals losses. This is true when it comes to economic integration, too. Trade creation happens when a trade relationship results in domestic production being replaced by lower cost production by a nation party to the trade relationship. As has been shown throughout the course, more trade leads to a more efficient use of resources and more production. This efficiency benefits both the exporting and importing nations. Not only that, but there are spillover effects to a trade relationship that increases overall trade. The reason for these spillover effects is that as the members of the trade agreement are made better off (i.e., their incomes increase), they increase imports overall, even from countries that are not members of the trade agreement. Not all trade agreements result in more trade, however. Trade agreements could result in countries favoring imports from member countries at the expense of nonmember countries. This is a problem. The nonmember countries can produce the products at a lower cost than the member countries, but because of existing tariffs on the nonmember countries, the final cost from the member nation is lower than from more efficient nonmember nation. Depending on the severity of the inefficiency, welfare for members of the trade agreement may actually decrease. It is a certainty that welfare in the rest of the world will decrease.

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Fortunately, economic theory helps shed light on when a trade agreement is likely to be beneficial (see Figure 1).

The preceding discussion has focused on what is called the static effects of trade. Static analysis examines the immediate effect of a policy, without allowing for any other changes in other important factors. Dynamic analysis examines how other factors might change in response to the policy and what sort of secondary effects the policy would have (Salvatore, 2020). Some dynamic effects of economic integration include some of the benefits covered in previous units. Trade agreements can result in greater competition as firms that used to have near monopoly power in their domestic markets are exposed to competition from similar firms in other countries. Firms can also realize greater economies of scale by having larger markets to which to sell. Trade agreements can also stimulate investment both from domestic investors looking to take advantage of the greater trade opportunities, and from investors outside the agreement looking for access into the larger markets without having to suffer the tariffs. One thing cannot be stated enough, though, and that is that while trade agreements are nice, starting from a position of no trade barriers at all is the best economic policy. Trade agreements are good in so much as they bring the world closer to that idealized reality.

International Resource Movements and Multinational Corporations The preceding discussion has focused on removing trade barriers for the export and import of goods and services, but recall that a common market allows for the free movement of capital and labor. Capital and labor can still move in the absence of a common market, but their movement is hindered just like trade barriers hinder trade in goods and services.

Figure 1: Economic theories and trade agreements

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Resource movement is important for efficiency in economic systems. Consider a few historical examples. Imagine the California Gold Rush if settlers were not able to come West. Imagine the recent finds of oil in North Dakota if workers or machinery were not able to move to North Dakota to drill. The potential production would not have happened. The movement of resources is aided by two primary factors: international capital flows and multinational corporations. International capital flows allow investors from one nation to invest in production in another nation (Salvatore, 2020). So an investor in, say, Alabama, can help a company in Ghana buy equipment by providing financial capital to the Ghanaian company. There are several benefits to this investment. First, the Ghanaian company has more financial resources to expand their production. The Ghanaian economy overall benefits as the company expands. Second, the investor in Alabama gains access to a potentially more profitable investment (recall the convergence material from Unit VI). The investor also benefits from diversification. The company in Ghana may produce an entirely different type of product with a different market than what the Alabama investor has access to invest in Alabama. Also, the various risks in Ghana are going to be different than in Alabama. Hurricane risk in Ghana is going to be different than in Alabama. There will, of course, be other risks in Ghana that Alabama does not have, but the more uncorrelated these risks are, the more the diversification is going to benefit the investor. Alabama (and the United States in general) is going to benefit from the additional return the investor earns as it enables the investor to invest and consume more in Alabama. This is similar to spillover effects from trade agreements. Multinational corporations benefit in similar ways just described with the investor except that the multinational corporation will own the resources and have more hands-on control of the production decisions. As we draw near the end of the course, a common theme should be emerging that freedom of movement is beneficial to economies. This includes freedom to trade goods and services, freedom to move resources, and freedom to invest financial resources where desired. These benefits apply not only to the parties involved but often have spillover effects as the higher incomes of one party benefit those around that party. A rising tide truly does lift other boats.

Reference Salvatore, D. (2020). International economics (13th ed.). Wiley.

https://online.vitalsource.com/#/books/9781119554950