A free trade area, a customs union, a monetary union, and a full economic union are all forms of regional economic integration, but they differ in terms of their level of integration and the extent of policies harmonization among member countries.

• A free trade area is a form of regional economic integration where member countries eliminate tariffs, quotas, and other trade barriers among themselves while maintaining their own external trade policies.
  • In a free trade area, countries can independently negotiate trade agreements with non-member countries.
  • The primary goal is to promote the free flow of goods and services between member countries, stimulating trade and economic growth.
  • Examples of free trade areas include the North American Free Trade Agreement (NAFTA) and the European Free Trade Association (EFTA).
• A customs union is a deeper form of regional economic integration that builds on a free trade area by not only eliminating trade barriers among member countries but also establishing a common external trade policy. Member countries apply a unified tariff schedule to imports from non-member countries, and they negotiate trade agreements collectively as a bloc.
  • The purpose is to create a more cohesive and integrated market and to prevent trade barriers from arising between member countries.
  • The European Union (EU) is an example of a customs union.
• A monetary union involves the adoption of a common currency and a centralized monetary policy among member countries.
  • In a monetary union, countries share a single currency, which is managed by a central monetary authority. This eliminates exchange rate fluctuations and trade barriers associated with currency conversions within the union.
  • The most well-known example of a monetary union is the Eurozone, where countries within the European Union use the euro as their common currency and are subject to the monetary policies set by the European Central Bank (ECB).
• A full economic union represents the highest level of integration among member countries. It encompasses not only the elimination of trade barriers and the adoption of a common currency but also the harmonization of economic policies, including fiscal, monetary, and regulatory frameworks.
  • In a full economic union, member countries aim for a high degree of economic coordination, including a unified fiscal policy, a common market for goods, services, and factors of production, and a shared governance structure.
  • An example of a full economic union is the economic integration within the United States, where there is a common currency (the U.S. dollar), a unified market, and a centralized fiscal and monetary system.

In summary, a free trade area focuses on eliminating trade barriers among member countries, a customs union adds a common external trade policy, a monetary union includes the adoption of a common currency, and a full economic union encompasses the highest level of integration with harmonized economic policies. The level of integration increases from a free trade area to a customs union, a monetary union, and ultimately to a full economic union.

• Trade creation refers to the situation where the formation of a regional trading bloc leads to an increase in overall economic welfare through the expansion of trade.

• • This occurs when member countries of the trading bloc replace higher-cost domestic production with lower-cost imports from other member countries.
  • By eliminating trade barriers, such as tariffs and quotas, within the trading bloc, member countries can access goods and services at lower prices, leading to increased consumer welfare and economic efficiency.
  • Trade creation enhances economic integration, fosters specialization based on comparative advantage, and can lead to increased economic growth within the trading bloc.
• Trade diversion occurs when the formation of a regional trading bloc leads to a shift in trade patterns that diverts trade away from more efficient non-member countries to less efficient member countries within the bloc.
  • This happens when member countries of the trading bloc impose trade barriers, such as tariffs, on non-member countries while granting preferential treatment to fellow member countries.
  • As a result, trade that was previously conducted with more efficient non-member countries is redirected to less efficient member countries solely because of their membership in the trading bloc.
  • Trade diversion can lead to a loss of economic efficiency and overall welfare, as resources are inefficiently allocated to less competitive industries within the trading bloc.

• The figure above illustrates a scenario where a country initially imports a product from the most efficient country but imposes a tariff on imports of that product.
  • The price paid by consumers is P_T, the quantity consumed is Q_T^Total, and the government earns tariff revenue of c+e.
  • When the country joins the trade bloc, trade is redirected to a member country within the bloc. As a result, the price to consumers decreases to P_NT^EU, and the quantity consumed increases to Q_NT^Total.
    • Consumer surplus increases by the amounts a, b, c, and d.
    • However, producer surplus decreases by an amount equal to a.
    • In this case, tariff revenue also decreases by an amount equal to c+e.
  • The overall welfare of the country will be reduced if the combined areas of b and d are smaller than the area of e.
  • This implies that the gains in consumer surplus and the reduction in tariff revenue are not sufficient to offset the loss in producer surplus, resulting in a net welfare reduction for the country.