Regional Economic Integration

Regional Economic Integration

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

McGraw-Hill/Irwin

Global Business Today 7e

by Charles W.L. Hill

Welcome to Global Business Today, Seventh Edition by Charles W.L. Hill.

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Chapter 8

Regional Economic Integration

Chapter 8: Regional Economic Integration

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Introduction

  • Regional economic integration – agreements between countries in a geographic region to reduce tariff and non-tariff barriers to the free flow of goods, services, and factors of production between each other
  • in theory, regional economic integration benefits all members
  • Over the last two decades, the number of regional trade agreements has been on the rise

You’ve probably heard of NAFTA, and perhaps also the European Union, but do you know what these agreements are and why they’re important to international companies? Both NAFTA and the European Union, or EU, are forms of regional economic integration which refers to agreements between countries in a geographic region to reduce tariff and nontariff barriers to the free flow of goods, services, and factors of production between each other. In other words, these agreements are designed to promote free trade, and depending on the level of integration, allow the factors of production to move freely between countries.

To get a better idea of what we’re getting at here, imagine if the U.S. was actually a group of countries that had signed an agreement to become a political union. As you know, goods move freely between states as do the factors of production like labor and capital. There are no tariffs that limit California exporting oranges to Ohio for example. Similarly, you don’t have to get a permit to work in New York if you live in New Jersey. So, workers go where they can be most productive, industry goes where it can be most efficient.

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Introduction

Question: Is regional economic integration a good thing?

Answer:

  • While regional trade agreements are designed to promote free trade, there is some concern that the world is moving toward a situation in which a number of regional trade blocks compete against each other
  • if this scenario materializes, the gains from free trade within blocs could be offset by a decline in trade between blocs

The idea behind regional economic integration is that without trade barriers, member countries will be better off. However, there is some concern that as more countries become involved in regional agreements, the trading blocs will begin to compete against each other.

In this chapter, we’ll look at the different types of economic integration, and explore some of the trading blocs that exist today. We’ll also consider the benefits and costs of integration, and what it means to companies.

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Levels of Economic Integration

  • There are five levels of economic integration

1. Free trade area – all barriers to the trade of goods and services among member countries are removed, but members determine their own trade policies with regard to nonmembers

  • the most popular form of integration
  • Examples include
  • the European Free Trade Association (between Norway, Iceland, Liechtenstein, and Switzerland)
  • the North American Free Trade Agreement (between the U.S., Canada, and Mexico)

There are five levels of economic integration. At the first level, the free trade area, all barriers to the trade of goods and services among member countries are removed, but members determine their own policies toward nonmembers.

The European Free Trade Area (EFTA) is the most enduring free trade area. It was established in 1960, and currently has four members, Norway, Iceland, Liechtenstein, and Switzerland.

Another free trade area that you’re probably familiar with is the North American Free Trade Area or NAFTA. We’ll talk more about NAFTA later.

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Levels of Economic Integration

Figure 8.1: Levels of Economic Integration

Here you can see the five levels of economic integration – the free trade area, the customs union, the common market, the economic union, and the political union.

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Levels of Economic Integration

2. Customs union – eliminates trade barriers between member countries and adopts a common external trade policy

  • most countries that enter a customs union desire further integration in the future
  • Examples include
  • the Andean Pact (between Bolivia, Columbia, Ecuador, Venezuela, and Peru)

The next level of economic integration is the customs union which eliminates trade barriers between members, and adopts a common policy toward nonmembers.

The EU began as a customs union, but as we’ll discuss later, has moved beyond this level of integration. The Andean Pact between Bolivia, Columbia, Ecuador, and Peru is a current example of a customs union.

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Levels of Economic Integration

3. Common market – no barriers to trade between member countries, a common external trade policy, and the free movement of the factors of production

  • can be difficult to achieve and requires significant harmony among members in fiscal, monetary, and employment policies
  • Examples include
  • MERCOSUR (between Brazil, Argentina, Paraguay, and Uruguay) hope to achieve this status

The common market has no barriers to trade between members, a common policy toward nonmembers, and the free movement of the factors of production. This is a significant step up from a customs union, and requires members to cooperate on fiscal, monetary, and employment policies.

The EU was a common market for many years, before moving to the next level of integration. The goal of MERCOSUR, which is an agreement between Brazil, Argentina, Paraguay, and Uruguay, is to eventually become a common market.

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Levels of Economic Integration

4. Economic union – involves the free flow of products and factors of production between members, the adoption of a common external trade policy, and in addition, a common currency, harmonization of the member countries’ tax rates, and a common monetary and fiscal policy

  • involves sacrificing a significant amount of national sovereignty
  • Examples include
  • the European Union (EU)

The next level of economic integration is the economic union which involves the free flow of the factors of production between members, the adoption of a common external trade policy, a common currency, harmonization of tax rates, and a common monetary and fiscal policy. As you can see, this is again a significant increase in integration from the previous level.

The EU is currently an imperfect example of an economic union. As we’ll discuss later, not all members have adopted the common currency, and there are still differences in tax rates across the countries.

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Levels of Economic Integration

5. Political union – independent states are combined into a single union

  • requires that a central political apparatus coordinate economic, social, and foreign policy for member states
  • The EU is headed toward at least partial political union, and the United States is an example of even closer political union

Finally, in a political union, independent states are combined into a single union where the economic, social, and foreign policy of members is coordinated.

You might be thinking that this description sounds a lot like the U.S., and you’d be right. The EU is also headed toward this level.

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The Case for Regional Integration

  • There are both economic and political arguments supporting regional economic integration
  • Generally, many groups within a country oppose the notion of economic integration

Why do countries agree to integrate their economies? There are economic reasons, and political reasons. Let’s start with the economic reasons.

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The Economic Case for Integration

  • Regional economic integration is an attempt to achieve additional gains from the free flow of trade and investment between countries beyond those attainable under international agreements such as the WTO
  • Since it is easier to form an agreement with a few countries than across all nations, there has been a push toward regional economic integration

We know from our discussion of trade theory in Chapter 5 that free trade is beneficial to countries. Recall, also from our discussion in Chapter 7, that, for various reasons, trade barriers still exist despite the efforts of the WTO. Regional economic integration offers countries a way to achieve the gains from free trade, at least on a limited basis, more quickly than would be possible under the WTO process.

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The Political Case for Integration

  • Politically, integration is attractive because
  • by linking countries together, making them more dependent on each other, and forming a structure where they regularly have to interact, the likelihood of violent conflict and war will decrease
  • by linking countries together, they have greater clout and are politically much stronger in dealing with other nations

The political case for integration has two main points. First, by linking countries together, making them more dependent on each other and forming a structure where they regularly have to interact, the chance for violent conflict and war decrease. Second, economic integration gives the bloc of countries greater clout and makes them much stronger politically when dealing with other countries.

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Impediments to Integration

  • Integration is not easy to achieve or maintain
  • There are two main impediments to integration

it can be costly – while a nation as a whole may benefit from a regional free trade agreement, certain groups may lose

it can result in a loss of national sovereignty

So, given the benefits of integration, why doesn’t it occur more often? There are two main impediments to integration. First, while a nation as a whole benefits from integration, some groups may actually lose. You might recall that critics of NAFTA for example, were concerned about the potential for job loss in the U.S. if companies shifted production to take advantage of Mexico’s low cost labor.

Second, countries that integrate their economies lose some degree of national sovereignty. Integration requires that countries give up some control over monetary policy, fiscal policy, and trade policy. You probably know for example, that most of the countries belonging to the EU have given up their currencies and adopted the euro instead. The loss of autonomy also affected Germany in 2008 when its right to protect Volkswagen from a takeover was being challenged by the European Court of Justice.

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Case Against Regional Integration

  • Regional economic integration only makes sense when the amount of trade it creates exceeds the amount it diverts
  • Trade creation occurs when low cost producers within the free trade area replace high cost domestic producers
  • Trade diversion occurs when higher cost suppliers within the free trade area replace lower cost external suppliers

Some economists have raised questions about the value of economic integration. They point out that it only makes sense when the amount of trade it creates is greater than the amount that is diverting.

Trade creation occurs when low cost producers within a free trade area replace high cost domestic producers, while trade diversion occurs when higher costs suppliers within a free trade area replace lower cost external suppliers.

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Regional Economic Integration in Europe

  • Europe has two trade blocs
  • the European Union with 27 members
  • the European Free Trade Association with 4 members
  • The European Union is expected to become a superpower of the same order as the United States

Now, let’s look at how economic integration evolved in Europe. Europe has two main trading blocs – the European Union and the European Free Trade Association. Let’s focus on the larger bloc, the European Union.

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Evolution of the European Union

  • The European Union (EU) is the result of
  • the devastation of two world wars on Western Europe and the desire for a lasting peace
  • the desire by the European nations to hold their own on the world’s political and economic stage
  • The forerunner of the EU was the European Coal and Steel Community (formed in 1951)
  • The Treaty of Rome established the European Economic Community in 1957
  • the name was changed to the EU in 1994

The European Union is the result of the devastation of two world wars on Western Europe, and the desire for lasting peace, and the desire by the European nations to hold their own in the world.

The forerunner to the EU was the European Coal and Steel Community, which was formed in 1951 to remove trade barriers in coal, iron, steel, and scrap metal. Then, in 1957, the European Economic Community was formed with the goal of becoming a common market.

The European Community became the European Union in 1994 after the Maastricht Treaty was ratified. We’ll talk more about that later.

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Evolution of the European Union

Map 8.1: Member States of the European Union in 2010

As you can see, the original agreement between Belgium, France, West Germany, Italy, Luxembourg, and the Netherlands was expanded in 1973 to include Great Britain, Ireland, and Denmark. In 1981, Greece joined, then Spain and Portugal in 1986, and Austria, Finland, and Sweden in 1986. Ten more countries joined in 2004, and three joined in 2007 to make a total of 27 members.

The EU now has a population of almost 500 million and a GDP of €11 trillion.

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Political Structure of the EU

  • The four main institutions of the EU are

the European Commission – proposes EU legislation, implements it, and monitors compliance

the European Council – the ultimate controlling authority within the EU

the European Parliament – debates legislation proposed by the commission and forwarded to it by the council

the Court of Justice – the supreme appeals court for EU law

There are several institutions that govern the EU. The European Commission is responsible for implementing EU law and monitoring member states to be sure they’re in compliance. The Council of the European Parliament is the ultimate controlling authority. The European Parliament debates legislation proposed by the commission and forwarded to it by the council, and the Court of Justice acts as the supreme appeals court for EU law.

You can learn more about each of these institutions, and their responsibilities in your text, and see an example involving the European Commission in the Management Focus.

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The Single European Act

  • The Single European Act (1987) committed EC countries to work toward establishment of a single market by 1992
  • The Act proposed to
  • remove all frontier controls between EC countries
  • apply the principle of mutual recognition to product standards
  • open procurement to non-national suppliers
  • lift barriers to competition in retail banking and insurance
  • remove all restrictions on foreign exchange transactions between member countries
  • abolish restrictions on cabotage

Now, let’s move on to the Single European Act. This Act has had a profound effect not only on Europe, but the rest of the world as well. It was adopted in 1987, and committed members of the EU to work toward the establishment of a single market by December 1992.

The Single European Act was a sort of last ditch effort to get members to commit to actively focus on moving forward. Until this Act, the EC had fallen short of its goals.

The Single European Act set a number of goals. First, all frontier controls were to be removed between member countries. Second, there was to be mutual recognition of product standards so that products developed to meet standards established in one country also were accepted in other countries. Third, public procurement was to be opened to non-national suppliers.

Fourth, barriers to competition in retail banking and insurance were to be lifted. Fifth, all restrictions to foreign exchange transactions between members were to be removed. Sixth, restrictions on cabotage, or the right of foreign truckers to pick up and deliver goods within another member’s borders, were to be eliminated.

Together, it was expected that these changes would lower the cost of doing business in the EU, but they were also expected to complicate supply side effects.

The Single European Act had a significant impact on Europe’s economy because it enabled many companies to shift from national to pan European production and distribution systems, and capitalize on scale economies in the process. Again, think of our example of the U.S. If a company had to treat each state differently when it produced or distributed its products, the firm’s cost structure would be much higher than it is when it can look at the entire country as a single market. This is the same type of effect the Single European Act had.

There are still problems though, as the Country Focus in your text on the single European market for financial services illustrates. As of 2007, there is still not a fully functioning single market for financial services in the EU.

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The Establishment of the Euro

  • The Maastricht Treaty (1991) committed EU members to adopt a single currency, the euro
  • the euro is used by 16 of the 27 member states
  • created the euro zone, the second largest currency zone in the world after that of the U.S. dollar
  • countries that participate have agreed to give up control of their monetary policy
  • Britain, Denmark and Sweden have opted out of the euro zone

You probably already know however, that the EU has made significant headway in establishing a common currency, the euro. Let’s look at how that occurred.

In 1991, members signed the Treaty of Maastricht and committed to adopt a single currency by 1999. This created the single largest currency zone in the world after the U.S. dollar. Euro notes and coins started circulating in 2002.

Remember though, that three members, Britain, Denmark, and Sweden opted out of the euro zone.

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The Establishment of the Euro

Question: What are the benefits of the euro?

Answer:

  • handling one currency, rather than many
  • easier to compare prices across Europe
  • increased competition promotes greater efficiencies in production
  • the pan-European capital market should further develop
  • range of investment options open both to individuals and institutions should increase

Why was it important to adopt a common currency? Well, there are several reasons. Having one currency, rather than several, is easier for companies and individuals. Instead of having to convert currencies, the same currency is used across the bloc, so companies will save the cost and risks of converting currencies.

Having a single currency will also make it easier to compare prices across Europe. Think of the U.S. for example, you can easily compare the price of a Big Mac across the country. Adopting a single currency will make it easier to do the same thing in Europe, and force companies to lower prices.

The lower prices should then encourage producers to look for ways to reduce their production costs in order to maintain their profit margins. So, by adopting a common currency, we should greater efficiency.

Another benefit of the euro is that it should boost the development of a highly liquid pan-European capital market. Finally, the capital market will provide a greater range of investment options to individuals and institutions.

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The Establishment of the Euro

Question: What are the costs of the euro?

  • Membership implies a loss of control over monetary policy
  • The European Central Bank (ECB) was established to manage monetary policy, but some question its ability to act independently
  • The EU is not an optimal currency area – an area where similarities in the underlying structure of economic activities make it feasible to adopt a single currency and use a single exchange rate as an instrument of macro-economic policy
  • countries may react differently to changes in the euro

So, there are many benefits of adopting the euro, but as you’ve probably guessed there are also costs involved in doing so. A major cost involved in adopting a common currency is that individual countries lose control over monetary policy. The three countries that opted out of the euro zone did so because they didn’t want to give up this autonomy.

The European Central Bank was established to manage monetary policy in the European Union. The European Central Bank acts like the Federal Reserve in the U.S.

The European Central Bank sets interest rates and the monetary policy across the euro-zone, however, it can’t take instructions from politicians, instead, a governing council made up of individuals from member countries determines what policies should be followed.

A second disadvantage of the euro is that the EU is not an optimal currency area, or an area where similarities in the underlying structure of economic activities make it feasible to adopt a single currency and use a single exchange rate as an instrument of macro-economic policy. In other words, because of differences in member economies—take Portugal and Finland for example—they might react differently to external shocks. So, a change in the euro exchange rate that helps Finland might actually hurt Portugal.

Some critics have argued that instead of establishing the euro and then moving toward political union, the EU should have achieved political union status first.

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The Establishment of the Euro

  • Since its establishment the euro has had a volatile trading history with the U.S. dollar
  • initially, the euro was valued at $1.17, then fell in value relative to the dollar, but strengthened to an all-time high of $1.54 in March 2008
  • in early 2010, the exchange rate was €1=$1.35

How has the euro done so far? Well, since its establishment, it’s had a volatile trading history relative to the U.S. dollar. It initially fell relative to the dollar, but by March of 2008, it had reached a new high of $1.54! Then, it fell to just $1.35 by early 2010.

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Enlargement of the European Union

  • Many countries, particularly from Eastern Europe, have applied for membership in the EU
  • Ten countries joined in 2004 expanding the EU to 25 states, with population of 450 million people, and a single continental economy with a GDP of €11 trillion
  • In 2007, Bulgaria and Romania joined bringing membership to 27 countries
  • Turkey has also applied for membership, but is not expected to join until 2013, if at all

What’s ahead for the EU? Perhaps an expansion. Several countries, particularly those from Eastern Europe have applied for membership. Even without further expansion the union is likely to get more complicated thanks to the new members that joined in 2007. Turkey has been lobbying hard to become part of the trading bloc, but so far has been rejected on the basis of human rights issues.

As we said before, the EU is now comprised of 27 countries, has a population of 500 million people!

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Economic Integration in the Americas

  • Regional economic integration is on the rise in the Americas
  • The most significant attempt is the North American Free Trade Agreement
  • Other agreements include
  • the Andean Community
  • MERCOSUR
  • There are also attempts to form a Free Trade Area of the Americas

Now, let’s move to look at integration in the Americas. While the level of integration in the Americas is still relatively low compared to what’s been happening in Europe, it’s on the rise.

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Economic Integration in the Americas

Map 8.2: Regional Integration in the Americas

As you can see, the most significant effort at integration in the Americas involves Canada, the U.S., and Mexico in the NAFTA. The Andean Community and MERCOSUR are also efforts at integration. Let’s talk about these, beginning with NAFTA.

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NAFTA

  • The North American Free Trade Agreement (NAFTA) between the U.S., Canada, and Mexico became law in 1994 and
  • abolished tariffs on 99 percent of goods traded
  • removed barriers on the cross-border flow of services
  • protects intellectual property rights
  • allows each country to apply its own environmental standards
  • establishes two commissions to impose fines and remove trade privileges when environmental standards or legislation involving health and safety, minimum wages, or child labor are ignored

The agreement between the U.S., Canada, and Mexico, known as NAFTA, became law in 1994. Under NAFTA, tariffs on 99 percent of the goods traded between Mexico, Canada, and the U.S. were abolished, and so were most of the restrictions on the cross-border flow of services.

The agreement also protects intellectual property, removes most restrictions on FDI between the three countries, and allows each country to maintain its own environmental standards.

In addition, two commissions were established to intervene when environmental standards or legislation involving health and safety, minimum wages, or child labor are violated.

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NAFTA

Question: What are the benefits of NAFTA?

Answer:

  • Mexico
  • increased jobs as low cost production moves south and more rapid economic growth
  • The U.S. and Canada
  • access to a large and increasingly prosperous market and lower prices for consumers from goods produced in Mexico
  • U.S. and Canadian firms with production sites in Mexico are more competitive on world markets

What are the benefits of NAFTA? NAFTA’s supporters argue that it’ll provide economic gains to all members.

Mexico should benefit from more jobs as companies from Canada and the U.S. shift production south to take advantage of lower costs labor. As you know, the jobs will help Mexico grow economically.

In the U.S. and Canada, consumers will benefit from the lower priced products that come from Mexico, and companies will benefit not only from low cost labor, but also from having access to a large and more prosperous market.

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NAFTA

Question: What are the drawbacks of NAFTA?

Answer:

  • Jobs could be lost and wage levels could decline in the U.S. and Canada
  • Mexican workers could emigrate north
  • Pollution could increase due to Mexico’s more lax standards
  • Mexico would lose its sovereignty

NAFTA’s critics worried that the loss of jobs and wage levels that was to occur as a result of NAFTA would be detrimental to the U.S. and Canada. They also raised concerns that pollution would increase as companies shifted production to take advantage of Mexico’s looser environmental regulations.

In addition, some critics raised concerns that Mexico would lose its sovereignty as the country became dominated by U.S. firms that weren’t really committed to helping the economy grow, but rather just saw it as a cheap assembly location.

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NAFTA

Question: How successful has NAFTA been?

Answer:

  • Studies of NAFTA’s early impact suggest that both advocates and detractors may have been guilty of exaggeration
  • trade between the three countries has increased by 250 percent
  • the members have become more integrated
  • productivity has increased in member nations
  • employment effects have been small
  • Mexico has become more politically stable

So, who was right? Well, after the first decade of NAFTA, most people agree that both the critics and the supporters of the agreement were probably guilty of exaggeration. For example, one study showed that the concern over jobs turned out to be a non-issue. It found that NAFTA created about 31,000 new jobs in the U.S., and that the U.S. lost about 28,000 jobs because of imports.

One positive that has come from the agreement is increased political stability in Mexico. This of course, is also beneficial to the U.S. and Canada.

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NAFTA

Question: Should NAFTA accept new members?

Answer:

  • Several other Latin American countries have indicated their desire to eventually join NAFTA
  • Currently both Canada and the U.S. are adopting a wait and see attitude with regard to most countries

What’s in the future for NAFAT? Perhaps enlargement. Several other Latin American countries including Chile have indicated that they’d like to join, but for now, the U.S. and Canada are taking a wait and see attitude.

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The Andean Community

  • The Andean Pact (1969) was based on the EU model
  • the agreement had more or less failed by the mid-1980s
  • In the late 1980s, Latin American governments began to adopt free market economic policies
  • In 1990, the Andean Pact was re-launched, and now operates as a customs union
  • In 2003, it signed an agreement with MERCOSUR to restart negotiations towards the creation of a free trade area
  • current members include Bolivia, Ecuador, Peru, and Columbia

Now let’s look at some of the other regional groupings in the Americas. We’ll start with the Andean Pact between Bolivia, Chile, Ecuador, Columbia, and Peru which was formed in 1969, and modeled after the EU. However, by the mid-1980s, it became clear that the Pact had more or less failed to achieve any of its goals.

This started to turn around though, in the late 1980s when many Latin American countries began to adopt free market policies, and in 1990 the Andean Pact was re-launched, and now operates as a customs union.

In 2003, The Andean Community signed an agreement with MERCOSUR to work toward a free trade area.

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MERCOSUR

  • MERCOSUR (1988) – a free trade pact between Brazil and Argentina
  • in 1990, it was expanded to include Paraguay and Uruguay
  • MERCOSUR has been successful at reducing trade barriers between member states
  • However, critics worry that MERCOSUR is diverting trade rather than creating trade, and local firms are investing in industries that are not competitive on a worldwide basis
  • current members include Brazil, Argentina, Paraguay, Uruguay, and Venezuela

What is MERCOSUR? MERCOSUR began in 1988 as a free trade agreement between Brazil and Argentina. It was expanded to include Paraguay and Uruguay in 1990, and has been making progress toward free trade between the countries.

However some critics have argued that rather than creating trade, MERCOSUR, by establishing high tariffs to outside countries, is actually diverting trade in some industries, and that companies in these industries would be unable to compete in global markets.

In recent years, the future of this group has been shaky.

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Other Trade Pacts in the Americas

  • Two other trade pacts in the Americas are

1. the Central American Common Market

  • Costa Rica, El Salvador, Guatemala, Honduras, Nicaragua, and the Dominican Republic
  • these countries were joined by the U.S. in 2003 to create a free trade agreement, the Central American Free Trade Agreement (2003)

2. CARICOM (1973), a customs union between English-speaking Caribbean countries

  • six members formed the Caribbean Single Market and Economy (CSME) in 2006 to lower trade barriers and harmonize macro-economic and monetary policy

There are two other trade agreements in the Americas, the Central American Trade Agreement and CARICOM. The Central American Trade Agreement began as the Central American Common Market and was established in the 1960s between Costa Rica, El Salvador, Guatemala, Honduras, and Nicaragua. The Dominican Republic joined a bit later. The U.S. agreed to form a bilateral free trade agreement with the group in 2005, and since then, there is a move to lower trade barriers between the group and the six countries.

CARICOM was an agreement between English speaking countries that was signed in 1973. However, the group never really accomplished its goals, and in 2006, the Caribbean Single Market and Economy was established with the goal of creating a grouping modeled after the EU.

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Free Trade of the Americas

  • Talks began in 1998 to establish a Free Trade of The Americas (FTAA) by 2005
  • The FTAA was not established as planned
  • Current support for the agreement by the U.S. and Brazil is limited
  • If the FTAA is established, it would create a free trade area of nearly 800 million people

Finally, talks began in 1998 to establish a Free Trade Area of the Americas by 2005. The goal wasn’t met, and discussions are still underway. If the FTAA is established, it will create a free trade area of almost 800 million people.

However, progress is uncertain at this point. The U.S. wants tougher enforcement of intellectual property rights and lower manufacturing tariffs, and Brazil and Argentina want the U.S. to lower its agricultural subsidies. Since there appears to be little effort to compromise, the agreement has stalled for the moment.

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Economic Integration Elsewhere

  • There have been various attempts at regional economic integration throughout Asia and Africa
  • The success of these attempts have been limited
  • The most significant efforts are the Association of Southeast Asian Nations and the Asia-Pacific Economic Cooperation

Finally, let’s look at some of the efforts towards regional economic integration that are occurring elsewhere in the world. The most important efforts are the Association of South East Asian Nations, or ASEAN, which was formed in 1967, and the Asia-Pacific Economic Cooperation.

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ASEAN

  • The Association of Southeast Asian Nations (ASEAN) (1967) – foster freer trade between member countries and to achieve some cooperation in their industrial policies
  • Brunei, Indonesia, Malaysia, the Philippines, Singapore, Thailand, Vietnam, Myanmar, Laos, and Cambodia
  • An ASEAN Free Trade Area (AFTA) (2003) between the six original members of ASEAN came into full effect to reduce import tariffs among members
  • Vietnam, Laos, and Myanmar have all joined

ASEAN includes Brunei, Cambodia, Indonesia, Laos, Malaysia, the Philippines, Singapore, Thailand, and Vietnam.

ASEAN’s goals are to promote free trade between members, and achieve cooperation on industrial policy, but so far, it hasn’t made much progress. However, a new agreement came into effect in 2003 between the six original members to create a free trade area by 2010, with the newer members joining by 2015.

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Asia-Pacific Economic Cooperation

  • Asian Pacific Economic Cooperation (APEC) was founded in (1990) to increase multilateral cooperation in view of the economic rise of the Pacific nations and the growing interdependence within the region
  • APEC currently has 21 members including the United States, Japan, and China

Another grouping, the Asian Pacific Economic Cooperation, or APEC, was founded in 1990 with 21 members including the U.S., Japan, and China. The goal of this group is to increase multilateral cooperation between the countries. If this group eventually becomes a common market, it will probably be the world’s largest!

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Regional Trade Blocs in Africa

  • There are nine trade blocs on the African continent
  • However progress toward the establishment of meaningful trade blocs has been slow
  • Many countries believe that they need to protect their industries from unfair foreign competition making it difficult to create free trade areas or customs unions

You may wonder whether Africa has made any effort at economic integration. It has, there are actually nine trade blocs on the continent, but they are trade blocs in name only.

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Implications for Managers

Question: Why is regional economic integration important to international companies?

Answer:

  • Regional economic integration means that markets that had been protected from foreign competition are increasingly open
  • these developments are particularly significant in the European Union and NAFTA
  • However, regional economic integration is likely to increase competition

What are the implications of regional economic integration for managers? Well, we’ve talked a bit about some of the implications already – the larger markets it offers, and the greater competition that it implies.

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Opportunities

  • Formerly protected markets are now open to exports and direct investment
  • The free movement of goods across borders, the harmonization of product standards, and the simplification of tax regimes mean that firms can realize potentially enormous cost economies by centralizing production in those locations where the mix of factor costs and skills is optimal

Certainly integration offers opportunities for companies. Markets that had been protected from foreign are open, and firms have the potential to make significant cost savings thanks to the free movement of goods across borders, the harmonization of product standards, and the simplification of tax regimes.

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Threats

  • Lower trade and investment barriers could lead to increased price competition within the EU and NAFTA
  • increased competition within the EU is forcing EU firms to become more efficient, and stronger global competitors
  • Firms outside the blocs risk being shut out of the single market by the creation of a “trade fortress”
  • firms may be limited in their ability to pursue the strategy of their choice if the EU intervenes and imposes conditions on companies proposing mergers and acquisitions

However, the business environment becomes more competitive, and for non-EU and non NAFTA firms, challenges come from the likely long-term improvements in the competitive positions of many European and North American companies.

There is a risk that firms may be shut out of a single market like the EU by the creation of a trade fortress where the EU establishes very high barriers to non-EU firms.

In addition, firms may find that their choice of strategy is limited as the EU continues to increase its role in competition policy and intervenes to impose conditions on companies proposing mergers and acquisitions.

8-*

Classroom Performance System

In a _______, all barriers to the free flow of goods and services between member countries are removed, and a common policy toward nonmembers is established

Free trade area

Customs union

Common market

Economic union

Now, let’s see how well you understand the material in this chapter. I’ll ask you a few questions. See if you can get them right. Ready?

Question 1: In a _________, all barriers to the free flow of goods and services between member countries are removed, and a common policy toward nonmembers is established.

  • Free trade area
  • Customs union
  • Common market
  • Economic union

If you picked B, you’re right!

8-*

Classroom Performance System

The European Union is an example of a(n)

Free trade area

Customs union

Common market

Economic union

Question 2: The European Union is an example of

  • A free trade area
  • A customs union
  • A common market
  • An economic union

If you picked D, you’re correct!

8-*

Classroom Performance System

The ultimate decision making body of the European Union is the

Council of the European Union

European Parliament

Court of Justice

European Commission

Question 3: The ultimate decision making body of the European Union is the

  • Council of the European Union
  • European Parliament
  • Court of Justice
  • European Commission

The correct answer is A. Did you get it right?

8-*

Classroom Performance System

Studies show that after its first decade

There was a small net gain of jobs in the U.S.

Exports from the U.S. failed to grow

NAFTA’s overall impact has been significant

The U.S., Canada, and Mexico all experienced a decrease in productivity

Question 4: Studies show that after NAFTA’s first decade,

  • There was a small net gain of jobs in the U.S.
  • Exports from the U.S. failed to grow
  • NAFTA’s overall impact has been significant
  • The U.S., Canada, and Mexico all experienced a decrease in productivity

Did you pick A? I hope so!

Welcome to Global Business Today, Seventh Edition by Charles W.L. Hill.

Chapter 8: Regional Economic Integration

You’ve probably heard of NAFTA, and perhaps also the European Union, but do you know what these agreements are and why they’re important to international companies? Both NAFTA and the European Union, or EU, are forms of regional economic integration which refers to agreements between countries in a geographic region to reduce tariff and nontariff barriers to the free flow of goods, services, and factors of production between each other. In other words, these agreements are designed to promote free trade, and depending on the level of integration, allow the factors of production to move freely between countries.

To get a better idea of what we’re getting at here, imagine if the U.S. was actually a group of countries that had signed an agreement to become a political union. As you know, goods move freely between states as do the factors of production like labor and capital. There are no tariffs that limit California exporting oranges to Ohio for example. Similarly, you don’t have to get a permit to work in New York if you live in New Jersey. So, workers go where they can be most productive, industry goes where it can be most efficient.

The idea behind regional economic integration is that without trade barriers, member countries will be better off. However, there is some concern that as more countries become involved in regional agreements, the trading blocs will begin to compete against each other.

In this chapter, we’ll look at the different types of economic integration, and explore some of the trading blocs that exist today. We’ll also consider the benefits and costs of integration, and what it means to companies.

There are five levels of economic integration. At the first level, the free trade area, all barriers to the trade of goods and services among member countries are removed, but members determine their own policies toward nonmembers.

The European Free Trade Area (EFTA) is the most enduring free trade area. It was established in 1960, and currently has four members, Norway, Iceland, Liechtenstein, and Switzerland.

Another free trade area that you’re probably familiar with is the North American Free Trade Area or NAFTA. We’ll talk more about NAFTA later.

Here you can see the five levels of economic integration – the free trade area, the customs union, the common market, the economic union, and the political union.

The next level of economic integration is the customs union which eliminates trade barriers between members, and adopts a common policy toward nonmembers.

The EU began as a customs union, but as we’ll discuss later, has moved beyond this level of integration. The Andean Pact between Bolivia, Columbia, Ecuador, and Peru is a current example of a customs union.

The common market has no barriers to trade between members, a common policy toward nonmembers, and the free movement of the factors of production. This is a significant step up from a customs union, and requires members to cooperate on fiscal, monetary, and employment policies.

The EU was a common market for many years, before moving to the next level of integration. The goal of MERCOSUR, which is an agreement between Brazil, Argentina, Paraguay, and Uruguay, is to eventually become a common market.

The next level of economic integration is the economic union which involves the free flow of the factors of production between members, the adoption of a common external trade policy, a common currency, harmonization of tax rates, and a common monetary and fiscal policy. As you can see, this is again a significant increase in integration from the previous level.

The EU is currently an imperfect example of an economic union. As we’ll discuss later, not all members have adopted the common currency, and there are still differences in tax rates across the countries.

Finally, in a political union, independent states are combined into a single union where the economic, social, and foreign policy of members is coordinated.

You might be thinking that this description sounds a lot like the U.S., and you’d be right. The EU is also headed toward this level.

Why do countries agree to integrate their economies? There are economic reasons, and political reasons. Let’s start with the economic reasons.

We know from our discussion of trade theory in Chapter 5 that free trade is beneficial to countries. Recall, also from our discussion in Chapter 7, that, for various reasons, trade barriers still exist despite the efforts of the WTO. Regional economic integration offers countries a way to achieve the gains from free trade, at least on a limited basis, more quickly than would be possible under the WTO process.

The political case for integration has two main points. First, by linking countries together, making them more dependent on each other and forming a structure where they regularly have to interact, the chance for violent conflict and war decrease. Second, economic integration gives the bloc of countries greater clout and makes them much stronger politically when dealing with other countries.

So, given the benefits of integration, why doesn’t it occur more often? There are two main impediments to integration. First, while a nation as a whole benefits from integration, some groups may actually lose. You might recall that critics of NAFTA for example, were concerned about the potential for job loss in the U.S. if companies shifted production to take advantage of Mexico’s low cost labor.

Second, countries that integrate their economies lose some degree of national sovereignty. Integration requires that countries give up some control over monetary policy, fiscal policy, and trade policy. You probably know for example, that most of the countries belonging to the EU have given up their currencies and adopted the euro instead. The loss of autonomy also affected Germany in 2008 when its right to protect Volkswagen from a takeover was being challenged by the European Court of Justice.

Some economists have raised questions about the value of economic integration. They point out that it only makes sense when the amount of trade it creates is greater than the amount that is diverting.

Trade creation occurs when low cost producers within a free trade area replace high cost domestic producers, while trade diversion occurs when higher costs suppliers within a free trade area replace lower cost external suppliers.

Now, let’s look at how economic integration evolved in Europe. Europe has two main trading blocs – the European Union and the European Free Trade Association. Let’s focus on the larger bloc, the European Union.

The European Union is the result of the devastation of two world wars on Western Europe, and the desire for lasting peace, and the desire by the European nations to hold their own in the world.

The forerunner to the EU was the European Coal and Steel Community, which was formed in 1951 to remove trade barriers in coal, iron, steel, and scrap metal. Then, in 1957, the European Economic Community was formed with the goal of becoming a common market.

The European Community became the European Union in 1994 after the Maastricht Treaty was ratified. We’ll talk more about that later.

As you can see, the original agreement between Belgium, France, West Germany, Italy, Luxembourg, and the Netherlands was expanded in 1973 to include Great Britain, Ireland, and Denmark. In 1981, Greece joined, then Spain and Portugal in 1986, and Austria, Finland, and Sweden in 1986. Ten more countries joined in 2004, and three joined in 2007 to make a total of 27 members.

The EU now has a population of almost 500 million and a GDP of €11 trillion.

There are several institutions that govern the EU. The European Commission is responsible for implementing EU law and monitoring member states to be sure they’re in compliance. The Council of the European Parliament is the ultimate controlling authority. The European Parliament debates legislation proposed by the commission and forwarded to it by the council, and the Court of Justice acts as the supreme appeals court for EU law.

You can learn more about each of these institutions, and their responsibilities in your text, and see an example involving the European Commission in the Management Focus.

Now, let’s move on to the Single European Act. This Act has had a profound effect not only on Europe, but the rest of the world as well. It was adopted in 1987, and committed members of the EU to work toward the establishment of a single market by December 1992.

The Single European Act was a sort of last ditch effort to get members to commit to actively focus on moving forward. Until this Act, the EC had fallen short of its goals.

The Single European Act set a number of goals. First, all frontier controls were to be removed between member countries. Second, there was to be mutual recognition of product standards so that products developed to meet standards established in one country also were accepted in other countries. Third, public procurement was to be opened to non-national suppliers.

Fourth, barriers to competition in retail banking and insurance were to be lifted. Fifth, all restrictions to foreign exchange transactions between members were to be removed. Sixth, restrictions on cabotage, or the right of foreign truckers to pick up and deliver goods within another member’s borders, were to be eliminated.

Together, it was expected that these changes would lower the cost of doing business in the EU, but they were also expected to complicate supply side effects.

The Single European Act had a significant impact on Europe’s economy because it enabled many companies to shift from national to pan European production and distribution systems, and capitalize on scale economies in the process. Again, think of our example of the U.S. If a company had to treat each state differently when it produced or distributed its products, the firm’s cost structure would be much higher than it is when it can look at the entire country as a single market. This is the same type of effect the Single European Act had.

There are still problems though, as the Country Focus in your text on the single European market for financial services illustrates. As of 2007, there is still not a fully functioning single market for financial services in the EU.

You probably already know however, that the EU has made significant headway in establishing a common currency, the euro. Let’s look at how that occurred.

In 1991, members signed the Treaty of Maastricht and committed to adopt a single currency by 1999. This created the single largest currency zone in the world after the U.S. dollar. Euro notes and coins started circulating in 2002.

Remember though, that three members, Britain, Denmark, and Sweden opted out of the euro zone.

Why was it important to adopt a common currency? Well, there are several reasons. Having one currency, rather than several, is easier for companies and individuals. Instead of having to convert currencies, the same currency is used across the bloc, so companies will save the cost and risks of converting currencies.

Having a single currency will also make it easier to compare prices across Europe. Think of the U.S. for example, you can easily compare the price of a Big Mac across the country. Adopting a single currency will make it easier to do the same thing in Europe, and force companies to lower prices.

The lower prices should then encourage producers to look for ways to reduce their production costs in order to maintain their profit margins. So, by adopting a common currency, we should greater efficiency.

Another benefit of the euro is that it should boost the development of a highly liquid pan-European capital market. Finally, the capital market will provide a greater range of investment options to individuals and institutions.

So, there are many benefits of adopting the euro, but as you’ve probably guessed there are also costs involved in doing so. A major cost involved in adopting a common currency is that individual countries lose control over monetary policy. The three countries that opted out of the euro zone did so because they didn’t want to give up this autonomy.

The European Central Bank was established to manage monetary policy in the European Union. The European Central Bank acts like the Federal Reserve in the U.S.

The European Central Bank sets interest rates and the monetary policy across the euro-zone, however, it can’t take instructions from politicians, instead, a governing council made up of individuals from member countries determines what policies should be followed.

A second disadvantage of the euro is that the EU is not an optimal currency area, or an area where similarities in the underlying structure of economic activities make it feasible to adopt a single currency and use a single exchange rate as an instrument of macro-economic policy. In other words, because of differences in member economies—take Portugal and Finland for example—they might react differently to external shocks. So, a change in the euro exchange rate that helps Finland might actually hurt Portugal.

Some critics have argued that instead of establishing the euro and then moving toward political union, the EU should have achieved political union status first.

How has the euro done so far? Well, since its establishment, it’s had a volatile trading history relative to the U.S. dollar. It initially fell relative to the dollar, but by March of 2008, it had reached a new high of $1.54! Then, it fell to just $1.35 by early 2010.

What’s ahead for the EU? Perhaps an expansion. Several countries, particularly those from Eastern Europe have applied for membership. Even without further expansion the union is likely to get more complicated thanks to the new members that joined in 2007. Turkey has been lobbying hard to become part of the trading bloc, but so far has been rejected on the basis of human rights issues.

As we said before, the EU is now comprised of 27 countries, has a population of 500 million people!

Now, let’s move to look at integration in the Americas. While the level of integration in the Americas is still relatively low compared to what’s been happening in Europe, it’s on the rise.

As you can see, the most significant effort at integration in the Americas involves Canada, the U.S., and Mexico in the NAFTA. The Andean Community and MERCOSUR are also efforts at integration. Let’s talk about these, beginning with NAFTA.

The agreement between the U.S., Canada, and Mexico, known as NAFTA, became law in 1994. Under NAFTA, tariffs on 99 percent of the goods traded between Mexico, Canada, and the U.S. were abolished, and so were most of the restrictions on the cross-border flow of services.

The agreement also protects intellectual property, removes most restrictions on FDI between the three countries, and allows each country to maintain its own environmental standards.

In addition, two commissions were established to intervene when environmental standards or legislation involving health and safety, minimum wages, or child labor are violated.

What are the benefits of NAFTA? NAFTA’s supporters argue that it’ll provide economic gains to all members.

Mexico should benefit from more jobs as companies from Canada and the U.S. shift production south to take advantage of lower costs labor. As you know, the jobs will help Mexico grow economically.

In the U.S. and Canada, consumers will benefit from the lower priced products that come from Mexico, and companies will benefit not only from low cost labor, but also from having access to a large and more prosperous market.

NAFTA’s critics worried that the loss of jobs and wage levels that was to occur as a result of NAFTA would be detrimental to the U.S. and Canada. They also raised concerns that pollution would increase as companies shifted production to take advantage of Mexico’s looser environmental regulations.

In addition, some critics raised concerns that Mexico would lose its sovereignty as the country became dominated by U.S. firms that weren’t really committed to helping the economy grow, but rather just saw it as a cheap assembly location.

So, who was right? Well, after the first decade of NAFTA, most people agree that both the critics and the supporters of the agreement were probably guilty of exaggeration. For example, one study showed that the concern over jobs turned out to be a non-issue. It found that NAFTA created about 31,000 new jobs in the U.S., and that the U.S. lost about 28,000 jobs because of imports.

One positive that has come from the agreement is increased political stability in Mexico. This of course, is also beneficial to the U.S. and Canada.

What’s in the future for NAFAT? Perhaps enlargement. Several other Latin American countries including Chile have indicated that they’d like to join, but for now, the U.S. and Canada are taking a wait and see attitude.

Now let’s look at some of the other regional groupings in the Americas. We’ll start with the Andean Pact between Bolivia, Chile, Ecuador, Columbia, and Peru which was formed in 1969, and modeled after the EU. However, by the mid-1980s, it became clear that the Pact had more or less failed to achieve any of its goals.

This started to turn around though, in the late 1980s when many Latin American countries began to adopt free market policies, and in 1990 the Andean Pact was re-launched, and now operates as a customs union.

In 2003, The Andean Community signed an agreement with MERCOSUR to work toward a free trade area.

What is MERCOSUR? MERCOSUR began in 1988 as a free trade agreement between Brazil and Argentina. It was expanded to include Paraguay and Uruguay in 1990, and has been making progress toward free trade between the countries.

However some critics have argued that rather than creating trade, MERCOSUR, by establishing high tariffs to outside countries, is actually diverting trade in some industries, and that companies in these industries would be unable to compete in global markets.

In recent years, the future of this group has been shaky.

There are two other trade agreements in the Americas, the Central American Trade Agreement and CARICOM. The Central American Trade Agreement began as the Central American Common Market and was established in the 1960s between Costa Rica, El Salvador, Guatemala, Honduras, and Nicaragua. The Dominican Republic joined a bit later. The U.S. agreed to form a bilateral free trade agreement with the group in 2005, and since then, there is a move to lower trade barriers between the group and the six countries.

CARICOM was an agreement between English speaking countries that was signed in 1973. However, the group never really accomplished its goals, and in 2006, the Caribbean Single Market and Economy was established with the goal of creating a grouping modeled after the EU.

Finally, talks began in 1998 to establish a Free Trade Area of the Americas by 2005. The goal wasn’t met, and discussions are still underway. If the FTAA is established, it will create a free trade area of almost 800 million people.

However, progress is uncertain at this point. The U.S. wants tougher enforcement of intellectual property rights and lower manufacturing tariffs, and Brazil and Argentina want the U.S. to lower its agricultural subsidies. Since there appears to be little effort to compromise, the agreement has stalled for the moment.

Finally, let’s look at some of the efforts towards regional economic integration that are occurring elsewhere in the world. The most important efforts are the Association of South East Asian Nations, or ASEAN, which was formed in 1967, and the Asia-Pacific Economic Cooperation.

ASEAN includes Brunei, Cambodia, Indonesia, Laos, Malaysia, the Philippines, Singapore, Thailand, and Vietnam.

ASEAN’s goals are to promote free trade between members, and achieve cooperation on industrial policy, but so far, it hasn’t made much progress. However, a new agreement came into effect in 2003 between the six original members to create a free trade area by 2010, with the newer members joining by 2015.

Another grouping, the Asian Pacific Economic Cooperation, or APEC, was founded in 1990 with 21 members including the U.S., Japan, and China. The goal of this group is to increase multilateral cooperation between the countries. If this group eventually becomes a common market, it will probably be the world’s largest!

You may wonder whether Africa has made any effort at economic integration. It has, there are actually nine trade blocs on the continent, but they are trade blocs in name only.

What are the implications of regional economic integration for managers? Well, we’ve talked a bit about some of the implications already – the larger markets it offers, and the greater competition that it implies.

Certainly integration offers opportunities for companies. Markets that had been protected from foreign are open, and firms have the potential to make significant cost savings thanks to the free movement of goods across borders, the harmonization of product standards, and the simplification of tax regimes.

However, the business environment becomes more competitive, and for non-EU and non NAFTA firms, challenges come from the likely long-term improvements in the competitive positions of many European and North American companies.

There is a risk that firms may be shut out of a single market like the EU by the creation of a trade fortress where the EU establishes very high barriers to non-EU firms.

In addition, firms may find that their choice of strategy is limited as the EU continues to increase its role in competition policy and intervenes to impose conditions on companies proposing mergers and acquisitions.

Now, let’s see how well you understand the material in this chapter. I’ll ask you a few questions. See if you can get them right. Ready?

Question 1: In a _________, all barriers to the free flow of goods and services between member countries are removed, and a common policy toward nonmembers is established.

  • Free trade area
  • Customs union
  • Common market
  • Economic union

If you picked B, you’re right!

Question 2: The European Union is an example of

  • A free trade area
  • A customs union
  • A common market
  • An economic union

If you picked D, you’re correct!

Question 3: The ultimate decision making body of the European Union is the

  • Council of the European Union
  • European Parliament
  • Court of Justice
  • European Commission

The correct answer is A. Did you get it right?

Question 4: Studies show that after NAFTA’s first decade,

  • There was a small net gain of jobs in the U.S.
  • Exports from the U.S. failed to grow
  • NAFTA’s overall impact has been significant
  • The U.S., Canada, and Mexico all experienced a decrease in productivity

Did you pick A? I hope so!


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