Theory of Economic Integration: A Review

Abstract

The theory of economic integration is the branch of economics concerned with analysing the effects of different forms of integration on the economies of member states and the rest of the world. Its relevance for Europe is the progress made since the foundation of the European Community and European Free Trade Area in 1958 and 1960 in dismantling trade barriers, adopting a common external tariff (in the case of the EC), establishing a single market and, more recently, creating a common currency. The basic theory of customs union, first expounded by Viner in 1950 and later extended by Meade and Lipsey, provides the theoretical foundation on which the theory of integration rests. While Viner’s work was important in showing that customs unions and free trade areas are not always welfare-enhancing and may even lower global economic welfare, in its simple form the theory was incomplete. It focused mainly on the short-run effects of regional integration and failed to provide a convincing rationale for why countries enter into such arrangements. Subsequently, Viner’s analysis was modified and added to by relaxing some of the more limiting assumptions on which it rested, preparing the way for a deeper understanding of the integration process. In particular, our understanding of how integration affects countries was strengthened by the incorporation of economies of scale and terms of trade effects, which Viner had largely ignored.

Beginning in the 1980s, important advances were made by extending the analysis to incorporate the effects of increasing returns and imperfect competition. An important role in this respect was played by the emergence of the new trade theories. The launching of the Single Market programme in 1987 led to greater attention being given to the effects of deep integration on markets in which intra-industry trade was the predominant form of competition. On top of the normal gains from lower prices and improved resource allocation, potentially much greater gains could be reaped from intra-industry specialisation. At the same time, integration theory became much more interested in the effects of integration on economic growth. The application of endogenous growth theories to integration theory appeared to show that much the largest gain from integration results from a permanent increase in the regional growth rate. More recently, integration theory has become concerned about the location effects of integration, reflecting the growing interest of trade theorists in the importance of geography. New models of trade, incorporating the effects of factor mobility, external economies of scale and product competition, have established the importance of location in the analysis of the effects of integration. In short, integration theory has come a long way from where it started out fifty years or more ago, leaving us with a much more comprehensive picture of how it impacts on countries both inside and outside the region.