For a variety of reasons it often makes sense for nations to coordinate their economic policies. Coordination can generate benefits that are not possible otherwise. A clear example of this is shown in the discussion of trade wars among large countries on page 110-1. There it is shown that if countries cooperate and set zero tariffs against each other, then bothcountries are likely to benefit relative to the case when both countries attempt to secure short-term advantages by setting optimal tariffs. This is just one advantage of cooperation. Benefits may also accrue to countries who liberalize labor and capital movements across borders, who coordinate fiscal policies and resource allocation towards agriculture and other sectors and who coordinate theirmonetary policies.
Any type of arrangement in which countries agree to coordinate their trade, fiscal, and/or monetary policies is referred to as economic integration. Obviously, there are many different degrees of integration.
Preferential Trade Agreement (PTA)
A preferential trade agreement is perhaps the weakest form of economic integration. In a PTA countries would offer tariff reductions,though perhaps not eliminations, to a set of partner countries in some product categories. Higher tariffs, perhaps non-discriminatory tariffs, would remain in all remaining product categories. This type of trade agreement is not allowed among WTO members who are obligated to grant most-favored nation status to all other WTO members. Under the most-favored nation (MFN) rule countries agree not todiscriminate against other WTO member countries. Thus, if a country's low tariff on bicycle imports, for example, is 5%, then it must charge 5% on imports from all other WTO members. Discrimination or preferential treatment for some countries is not allowed. The country is free to charge a higher tariff on imports from non-WTO members, however. In 1998 the US proposed legislation to eliminate tariffson imports from the nations in sub-Sahara Africa. This action represents a unilateral preferential trade agreement since tariffs would be reduced in one direction but not the other. [Note: a PTA is also used, more generally, to describe all types of economic integration since they all incorporate some degree of "preferred" treatment.]
Free Trade Area (FTA)
A free trade area occurs when a group ofcountries agree to eliminate tariffs between themselves, but maintain their own external tariff on imports from the rest of the world. The North American Free Trade Area is an example of a FTA. When the NAFTA is fully implemented, tariffs of automobile imports between the US and Mexico will be zero. However, Mexico may continue to set a different tariff than the US on auto imports from non-NAFTAcountries. Because of the different external tariffs, FTAs generally develop elaborate "rules of origin". These rules are designed to prevent goods from being imported into the FTA member country with the lowest tariff and then transshipped to the country with higher tariffs. Of the thousands of pages of text that made up the NAFTA, most of them described rules of origin.
A customsunion occurs when a group of countries agree to eliminate tariffs between themselves and set a common external tariff on imports from the rest of the world. The European Union represents such an arrangement. A customs union avoids the problem of developing complicated rules of origin, but introduces the problem of policy coordination. With a customs union, all member countries must be able toagree on tariff rates across many different import industries.
A common market establishes free trade in goods and services, sets common external tariffs among members and also allows for the free mobility of capital and labor across countries. The European Union was established as a common market by the Treaty of Rome in 1957, although it took a long time for the transition to take...