Chapter 7

Regional Economic Integration

and Cooperative Agreements





!          Define different forms of economic integration and describe how each form affects international business.

!          Describe the static and dynamic effects as well as the trade creation and diversion dimensions of economic integration.

!          Present different regional trading groups such as the European Union (EU), the North American Free Trade Agreement (NAFTA) and Asia-Pacific Economic Cooperation (APEC).

!          Describe the rationale for and success of commodity agreements.

!          Discuss the effects of economic integration on the environment.



Chapter Overview


Regional economic integration represents a relatively new phenomenon in the history of world trade and investment. Chapter 7 introduces the basic types of economic integration and discusses both its potential positive and negative effects. It examines in detail both the European Union (its structure and its operations) and the North American Free Trade Agreement. It then briefly examines a variety of other regional economic groups. The chapter concludes with a discussion of various commodity agreements, producer alliances and cartels, including the Organization for Petroleum Exporting Countries.



Chapter Outline



This case describes the way in which Ford Europe recently dealt with the challenges of an increasingly competitive and dynamic European marketplace. Ford began production operations in Europe in 1911 and ran the various operations there as separate subsidiaries until 1967, when it created the regional umbrella of Ford Europe and began designing and assembling similar automobiles throughout Europe. In 1995, Ford merged its North American and European operations, shifted its focus to one of product lines rather than regions, and assigned Europe responsibility for the development of small and mid-size cars. Sensing this centralized strategy was pushing Ford too far away from its local markets, in 2000 Ford’s European management undertook a “transformation strategy.” Ford closed certain factories and turned others into “flex factories” where they can produce multiple cars on one production line. Following the Firestone tire recall and the global economic downturn, Ford suffered a worldwide loss of $5.45 billion in 2001. In Europe, however, after incurring a $1.1 billion loss in 2000, Ford Europe broke even in 2001. Given the continuing challenges of the global economic environment, Ford may be hard pressed to continue such success in Europe in the years to come.


Teaching Tip: Carefully review the PowerPoint slides for Chapter 7 and select those you find most useful for enhancing your lecture and class discussion. For additional visual summaries of key chapter points, also review the maps and tables in the text.


I.                   INTRODUCTION

Regional trading groups are an important influence on the strategies of MNE’s because economic blocs define the size of regional markets and the rules under which firms must operate. While WTO members are required to grant the same favorable trade conditions to all other WTO members, the organization allows a departure from this principle in the case of regional trade agreements.



Regional economic integration represents an agreement between or among countries within a geographic region, i.e., an economic bloc, to reduce and ultimately remove within the bloc tariff and nontariff barriers to the free flow of goods, services, capital and labor. Neighboring countries tend to ally because of their proximity to one another, somewhat similar regional tastes, the relative ease of establishing channels of distribution and a willingness to cooperate with one another for the greater benefit of all allied parties.

A.                Types of Regional Economic Integration

1.                  Free Trade Area (FTA). A free trade area represents an economic bloc in which all barriers to trade are abolished among member countries, but each member maintains its own independent external trade barriers beyond the bloc.

2.                  Customs Union. A customs union represents an economic bloc in which all barriers to trade are abolished among member countries, and common external barriers are levied against non-members.

3.                  Common Market. A common market represents an economic bloc in which all barriers to trade are abolished among member countries, common external barriers are levied against non-members and restrictions on the internal flows of capital and labor are abolished.

4.                  Economic Integration. Economic integration, i.e., an economic union, represents an economic bloc in which members abolish all barriers to trade and flows of capital and labor within the bloc; establish common external trade and investment barriers; harmonize commercial, monetary and fiscal policies; establish a common currency and establish a supranational political structure to deal with economic issues. (The limited degree of political integration represents a tradeoff between the loss of sovereignty on the one hand, and economic gains on the other.)

B.                 The Effects of Economic Integration

Regional economic integration can affect member countries in social, cultural, political and economic ways. (MNEs are particularly interested in the economic effects.) Static effects represent the shifting of resources from inefficient to efficient firms as trade barriers fall. Dynamic effects represent the impact of overall growth in the market, the expanding of production, the realization of greater economies of scope and scale and the increasingly competitive nature of the market.

1.         Trade Creation. Trade creation occurs when production shifts from less efficient domestic producers to more efficient regional producers for reasons of absolute or comparative advantage, thus giving customers access to a wider variety of lower-cost, higher quality products.

2.         Trade Diversion. Trade diversion occurs when, as a result of common external barriers, trade shifts from more efficient external sources to less efficient suppliers within the bloc.

C.        Major Regional Trading Groups

Firms are interested in regional trading groups for their markets, sources of raw materials and production factors and locations.


III.       The European Union (EU)

The European Union represents the most advanced regional trade and investment bloc in the world today. Key milestones for the European Union are summarized in Table 7.1. Map 7.1 identifies the members of the EU. Detailed information on the history, structure and function of the EU is available on its website.

A.                The EU’s Organizational Structure

While the European Council is designed to lead the EU, the European Commission functions as its draftsman and servant, the European Parliament is its sounding board and the European Court of Justice is the supreme appeals court for EU law. These governance bodies set the parameters under which MNEs must operate within the bloc.

1.                  The European Commission. The European Commission provides the EU’s political leadership and direction; it consists of 20 members appointed by member countries for four-year renewable terms. The Commission is responsible for proposing EU legislation, implementing it and monitoring compliance with EU laws by member states.

2.         The European Council. Also known as the Council of Ministers, the European Council is composed of one representative from the government of each member state, but the particular membership varies according to the topic under consideration. The Council can adopt, amend, or ignore Commission-proposed legislation. It sets priorities, gives political direction and resolves issues the European Commission cannot.

3.                  The European Parliament. Composed of 626 members (allocated on the basis of country population) elected every five years, the European Parliament considers legislation presented by the European Commission; if the legislation is approved, it is then submitted to the European Council for final adoption. The Parliament also has control over the EU budget and supervises executive decisions.

4.         The European Court of Justice. The European Court of Justice ensures consistent interpretation and application of EU treaties. Dealing mostly with economic matters, it serves as an appeals court for individuals, firms and organizations fined by the Commission for infringing upon Treaty Law.



The Single European Act of 1987 was designed to eliminate all remaining barriers to trade within the European Union and to harmonize commercial policy; nonetheless, numerous barriers still remain.

A.                Common Trade and Foreign Policy

During the initial formation of the EU, the focus was primarily upon economic integration. Over time, however, member countries began to recognize the benefits that could be realized from a common foreign policy as well. In 1993 the EU began to formalize common objectives on armed conflicts, human rights and other international foreign policy issues, although national attitudes often remain splintered.

B.        The EURO

The EURO represents a common European currency established on Jan. 1, 1999 as part of the EU’s move toward monetary union. The EURO is administered by the European Central Bank (ECB), which was established on July 1, 1998 to set monetary policy and manage the EURO’s exchange rate system. Member countries, i.e., those part of the European Monetary Union (EMU), include all members of the EU except the UK, Sweden, and Denmark. New bank notes were issued in 2002. In general, the transition from a series of national currencies to a single European currency has been smoother than predicted.

C.                EU Expansion

The next level of EU expansion, set for 2004, is to include Poland, Hungary, the Czech Republic, Slovenia, Slovakia, Latvia, Estonia, Lithuania, Malta and Cyprus. Bulgaria and Romania have been given a date of 2007; Turkey has been put on hold for human rights violations. The integration of such disparate countries will not be easy—several are far from meeting the requirements for participation in the EU. Even so, the size of the market will expand considerably and the EU’s economic power will grow as well.

D.        Implications of the EU on Corporate Strategy

Although Europe is moving closer together, it is still not as homogeneous as is the U.S. Thus, while foreign firms will need to develop a pan-European strategy, they should retain essential national strategies as well.

E.                 Where Next for the EU?

The EU will move closer to a free-market, borderless economy as the European Court of Justice continues to remove obstacles to takeovers and other forms of market entry into previously protected sectors. However, the recent downturn in the economy appears to be slowing the pace and altering requirements with respect to further economic integration.



The North American Free Trade Agreement (NAFTA) went into effect in 1994 following its signing by Canada, Mexico and the U.S., thus creating a regional economic bloc of countries of quite different sizes and sources of national wealth. It represents a powerful free trade area with a combined population and total GNI greater than that of the 15-member EU. In general, the NAFTA calls for the elimination of tariff and nontariff barriers, harmonization of the rules of trade, liberalization of restrictions on services and foreign investment, enforcement of intellectual property rights and a dispute settlement process.

A.                Rules of Origin and Regional Content

NAFTA’s rules of origin require that at least 50 percent of the net cost of most products originate within the region if those products are to be eligible for the more liberal tariff conditions available within the bloc.

B.                 Special Provisions of NAFTA

The NAFTA is a unique sort of trade agreement in that it also addresses two side issues: (a) regional labor laws and standards and (b) strengthened environmental standards.

C.        Impact of NAFTA on Trade, Investment and Jobs

While trade within the NAFTA region has more than tripled since 1994, the investment and employment pictures are less clear. While some FDI has been flowing out of Mexico since the maquiladoras were stripped of their duty-free status in 2001, other FDI has been flowing into Mexico from countries like Germany and Japan.

D.                NAFTA Expansion

Representatives from 34 countries continue to meet to try to create the Free Trade Area of the Americas (FTAA). In the meantime, Canada and Mexico have both entered into free trade agreements with Chile. In addition, Mexico entered into a free trade agreement with the EU on July 1, 2001, which will end all tariffs on their bilateral trade by 2007.

E.        Implications of NAFTA on Corporate Strategy

NAFTA is causing firms from all three member countries to re-examine their trade and investment strategies. A number of industries, such as automotive products and electronics, already view the region as one large market and have rationalized their production, products and financing accordingly. Although low-end manufacturing tends to be moving south to Mexico, more sophisticated manufacturing and services are increasing in the U.S. In addition, Canadian firms are generating more competition for U.S. firms along the U.S.-Canadian border than are Mexican companies along the U.S.-Mexican border. Finally, as Mexican incomes continue to rise, Mexican demand for foreign products is also increasing.



The major trade group in South America is MERCOSUR, a customs union established in 1991 by Brazil, Uruguay, Paraguay and Argentina. Unfortunately, Argentina’s economic crisis is threatening the stability of the entire region. The Andean Group, first created in 1969, has recently changed its focus from one of isolationism to being open to trade and investment. Other regional groups include the Latin American Integration Association (ALADI) and the Caribbean Community and Common Market (CARICOM). The Association of Southeast Asian Nations (ASEAN) was first organized in 1967. On Jan. 1, 1993, it officially formed the ASEAN Free Trade Area for the purpose of cutting tariffs on interregional trade to a maximum of 5% by 2008. The Asia-Pacific Economic Cooperation (APEC) community comprises 21 countries that border the Pacific Rim on both the east and the west. Formed in 1989 to promote multilateral economic cooperation within the Pacific region, APEC leaders have committed themselves to achieving free and open trade in the region by 2010 for the industrial nations and by 2020 for the remainder. However, given its size as well as the diverse interests of its members, progress may be problematic. Several regional trade groups also exist in Africa where, with the notable exception of the Union of South Africa, markets are relatively small and undeveloped. Often, however, such groups have been preoccupied with political rather than trade issues. Further, many African nations rely more on trade links with former colonial powers than with each other.



A commodity agreement is designed to stabilize the price and supply of a primary commodity.

A.                Producers’ Alliances and International Commodity Control Agreements (ICCAs)

While producers’ alliances represent exclusive membership agreements between or among producing countries (a cartel), international commodity control agreements (ICCAs) represent agreements between or among producing and consuming countries. Examples of the former are the Organization of Oil Exporting Countries (OPEC) and the Union of Banana Exporting Countries; examples of the latter are the International Cocoa Organization (ICO) and the International Sugar Organization (ISO). Often a quota system is used to determine how producing (and consuming) countries will divide total output in order to stabilize the price.

B.                 The Organization of Petroleum Exporting Countries (OPEC)

The Organization of Petroleum Exporting Countries (OPEC) represents a producer cartel, i.e., a group of commodity-producing countries with significant control over supply and banded together in order to control output and price. OPEC’s oil exports represent about 55 percent of the crude oil traded internationally. It controls prices by establishing production quotas on member countries, which include Algeria, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates and Venezuela.

C.                The Environment

Although many environmental problems are national in nature, they may have cross-national ramifications that can only be solved through international treaties and other agreements. Examples would be the concern over water quality along the U.S.-Mexican border and the impact of acid rain along the U.S.-Canadian border. Even when regional agreements do exist, they do not solve problems on a global basis. One of the key economic issues dealt with by the United Nations is environmental protection and socioeconomic development. Contrary to popular belief, many MNEs rank among the world’s most environmentally responsible firms. Often MNEs welcome environmental agreements because they put all companies on the same level, so that one firm is not disadvantaged as compared to others.



The Seattle WTO Protest Spotlights Free Trade’s Effect on the Environment

Individual countries and regional trade groups have made environmental issues much more of a priority since the protests associated with the meeting of the World Trade Organization in Seattle in 1999. While some groups take the position that increased trade should help the environment, others admit that it can in fact be harmful. The WTO advocates dealing with specific environmental issues while increasing trade at the same time, but developing countries are concerned environmental issues could be used as an excuse to impose trade sanctions against them.



How Much Territory Will Regional Integration Cover?

Regional economic integration deals with the specific problems facing member countries, whereas the WTO is concerned about trade issues facing the world as a whole. As a result, regional integration may help the WTO achieve its objectives as the process leads to the liberalization of issues not covered by the WTO. Regional economic integration can also serve to lock in trade liberalization across developing countries.




Teaching Tip: Visit for additional information and links relating to the topics presented in Chapter 7. Be sure to refer your students to the on-line study guide, as well as the Internet exercises for Chapter 7.




CLOSING CASE: Wal-Mart de Mexico


1.         How has the implementation of NAFTA affected Wal-Mart’s success in Mexico?

The NAFTA has facilitated Wal-Mart’s success in Mexico in various ways. First, it reduced tariffs on American-sourced goods from 10% to 3%. Second, it encourages Mexico to improve its transportation system and infrastructure, thus helping solve Wal-Mart’s logistical problems. Third, it eases restrictions on foreign direct investment; as a result, many of Wal-Mart’s foreign suppliers have built plants in Mexico, where they can better serve the whole of the NAFTA region.


2.                  How much of Wal-Mart’s success is due to NAFTA, and how much is due to Wal-Mart’s inherent competitive strategy? In other words, could any other U.S. retailer have the same success in Mexico post-NAFTA, or is Wal-Mart a special case?

The same benefits that have accrued to Wal-Mart following the implementation of the NAFTA are also available to other competitors. However, Wal-Mart uses its sheer size and volume of purchases to negotiate prices to rock-bottom levels that are not available to smaller competitors. It also works closely with suppliers on inventory levels, using an advanced information system that informs suppliers when additional merchandise will be needed, thus allowing them to plan production runs more accurately and pass along the captured cost reductions. Then, rather than pocketing the accrued cost savings, Wal-Mart reduces its prices. Retailers that wish to compete with Wal-Mart will either have to meet Wal-Mart’s prices or position themselves in a different segment of the market.


3.                  What do you think Commercial Mexicana S.A. should do, given the competitive position of Wal-Mart?

Commercial Mexicana is considering three basic options as it tries to survive in the new competitive environment driven by the presence of Wal-Mart in Mexico: remaining independent, merging with a local retail chain, or merging with a foreign retail chain. First, the firm needs to carefully examine the market and determine (a) ways in which it can differentiate itself from Wal-Mart (such as Target’s slightly up-scale market approach) and (b) whether it possesses or at least has access to sufficient assets to survive in the current environment. As part of that decision-making process, Commercial Mexicana should attempt to get lower prices from its suppliers and also attempt to source and sell some truly distinctive products. Commercial Mexicana also needs to consider both the available sourcing and market opportunities it enjoys, given its location within the NAFTA region. Finally, it should assess (a) what it can offer to and (b) what it would desire from a local or foreign partner. With that information in hand, Commercial Mexicana will be in a better position to make effective operating decisions.




Additional Exercises: The Economic Integration Process


Exercise 7.1. Ask students to compare the market entry strategies of exporting, licensing and foreign direct investment in (a) a free trade area, (b) a customs union, (c) a common market and (d) an economic union. What barriers and what incentives are they likely to encounter? (Be sure students assume the perspective of a firm located outside of the regional bloc of interest.)


Exercise 7.2. Prior to the breakup of the USSR, COMECON (also known as the Council for Mutual Economic Assistance (CMEA)) held the Soviet bloc together economically. It represented a trade association that existed to help fulfill the output goals of the central planning authorities of Russia and its satellite countries. Ask students to discuss the reasons they believe COMECON disintegrated in a post-Soviet environment


Exercise 7.3. Ask students to think of the major geographic areas of the world: Europe, Asia (including Oceania), Africa, South America and North America. Have them speculate the extent to which they expect regional economic integration to occur in each of those areas (a) in 10 years and (b) in 25 years. Then ask them to discuss the extent to which they expect global economic integration to occur in the next 25 years. Which organization(s) do they expect will play a major role in that process?