Trading blocs: free trade areas, customs unions, common markets and economic unions

How deep can integration go?

A regional trading bloc is a group of countries that agree to lower and gradually remove barriers to trade, and sometimes to the movement of labor and capital, among themselves. The deeper the integration, the more each rung adds.

Regional trading bloceach rung keeps everything below it

• Free trade area Memorize no barriers on trade among members
• Customs union Memorize + common external trade policy
• Common market Memorize + free movement of labor and capital
• Economic union Memorize + common institutions, coordinated economic policy
• Monetary union Memorize + a common currency

• A free trade area removes tariffs and quotas on trade among members. Each member keeps its own trade policy toward everyone else.
• A customs union adds a common external trade policy, normally one tariff schedule for imports from outside.
• A common market adds free movement of labor and capital between members.
• An economic union adds common economic institutions and coordinated policies, such as shared rules on regulation or fiscal limits.
• A monetary union adds a common currency, with one monetary policy for all members.

Type	Free internal trade	Common external trade policy	Free movement of labor and capital	Common institutions and policy	Common currency
Free trade area	Yes	No	No	No	No
Customs union	Yes	Yes	No	No	No
Common market	Yes	Yes	Yes	No	No
Economic union	Yes	Yes	Yes	Yes	No
Monetary union	Yes	Yes	Yes	Yes	Yes

Exam tip To name a bloc, look for the first feature that is missing. No common external tariff means a free trade area; no free movement of labor means a customs union.

Why do countries form blocs?

Regional deals are faster, easier and less contentious than global negotiations, and aligning policies among a few countries is simpler. Members get the usual gains from trade: specialization, scale, more competition, investment and technology transfer. They also gain extra bargaining power when acting together and less risk of conflict among interdependent neighbors. Growth in one member also spills over into the others.

Regional trading bloc

• Benefits Use it
  • Quicker, easier deals than global negotiations
  • Usual trade gains specialization, scale, competition, investment, technology transfer
  • Less conflict risk interdependence
  • Bargaining power acting together
  • Growth spillovers between members
• Costs Use it
  • Adjustment costs displaced workers
  • Sovereignty worries big and small members
  • Less independent policy no own rates or currency in a monetary union
  • Trade diversion costlier member sources

The costs fall mainly on adjustment. Less efficient firms exit and their workers must move, and some are worse off for good. Sovereignty worries arise when large and small economies join. Deeper integration also removes policy freedom. Free trade and mobile factors undermine policies that control relative prices inside one country. In a monetary union a member has no own interest rate and cannot devalue its currency, so persistent imbalances can build into a crisis that spreads to the other members.

Go deeper Why some regional blocs deliver little growth spillover

Spillovers depend on real integration, not just a signed treaty. Where roads, ports and telecoms are poor, trade among members stays small and growth does not pass across borders. Two members of similar size can see very different spillovers depending on how well connected they are to the rest of the bloc.

Go deeper A monetary union without a fiscal union

Sharing a currency means sharing one monetary policy, but taxes and spending stay national. A member with high deficits and weak growth cannot devalue and has no central transfers, so doubts about its debt can spread to the others. The sovereign-debt stress of the early 2010s in one monetary union is the textbook case.

What are trade creation and trade diversion?

A bloc changes who sells to whom. Trade creation happens when cheaper imports from a member replace costlier home production. Efficiency improves. Trade diversion happens when imports switch from a cheaper non-member to a costlier member, because only the non-member still pays the tariff. Efficiency falls.

Effects of a bloc on trade

• Trade creation Memorize good for efficiency
  • Before home producer, higher cost
  • After cheaper member imports replace it
• Trade diversion Memorize bad for efficiency
  • Before cheapest outsider supplies the import
  • After costlier member replaces it, only the outsider pays the tariff

$$P_t = P\,(1 + t)$$

The two effects work against each other, so a bloc can leave a country better or worse off. In the diversion, Home pays 110 in real resources for a unit that cost 100, a loss of 10 a unit (the tariff revenue it used to collect was a transfer). In the creation, it saves 44 − 40 = 4 a unit.

$$N = U_c\,s - U_d\,e$$

Here $U_c$ is the units of trade creation, $s$ the saving per unit, $U_d$ the units diverted and $e$ the extra cost per unit.

What limits deeper integration?

Two things. Cultural differences and history, including past wars and conflicts, can make the political process hard. And a high degree of integration limits how far members can follow separate economic and social policies. That limit is sharpest in a monetary union, where monetary policy is not national and a currency cannot be devalued to fix a persistent imbalance.

For investors, a bloc makes doing business in a large, single market cheaper, and firms gain from scale. Differences in tastes, culture and competition remain, though, so the benefit is smaller than a single country’s market would suggest, and trouble in one member can spread to the others.