International Trade - Theory and Policy, 2010a

9.10 Economic Integration: Free Trade Areas, Trade Creation, and Trade
Diversion
LEARNING OBJECTIVES
1. Distinguish the different types of economic integration.
2. Learn the effects of trade creation and trade diversion.
3. Understand how free trade area formation can make a country worse off in terms of the
theory of the second best.
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 inChapter 7 "Trade Policy Effects with Perfectly Competitive
Markets", Section 7.9 "Retaliation and Trade Wars". There it is shown that if countries cooperate and set zero
tariffs against each other, then both countries 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 that liberalize labor and capital movements across
borders, that coordinate fiscal policies and resource allocation toward agriculture and other sectors, and
that coordinate their monetary policies.
Any type of arrangement in which countries agree to coordinate their trade, fiscal, or monetary policies is
referred to as economic integration. There are many different degrees of integration.
Preferential Trade Agreement
A preferential trade agreement (PTA) 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 nondiscriminatory tariffs, would remain in all other
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