IB DP Economics: Economic integration

This study guide follows the IB Diploma Programme Economics guide (first assessment 2022, published February 2020), the course examined from the 2022 session onwards. It covers sub-topic 4.4, Economic integration. The agreements, the three types of bloc, their advantages and disadvantages, monetary union and the World Trade Organization (WTO) are SL and HL. Trade creation, trade diversion and the evaluation of monetary union are HL only, and they are marked that way below.

The guide sets agreements at knowledge depth (AO1), blocs, monetary union and the WTO at analysis depth (AO2), and the advantages and disadvantages at evaluation depth (AO3). It lists no diagram or calculation for this sub-topic. The small calculations below are illustrations of the ideas, not listed guide skills. Every country, firm and figure is fictional.

Use this guide with the revision notes and the practice questions. The course page is the IB DP Economics hub, and the printable checklist lets you tick off each outcome. For the trade ideas this builds on, see benefits of international trade. To find weak spots first, try the free 10-minute diagnostics.

What the guide asks for

Content	Skill the guide expects	Level
Preferential trade agreements	Describe bilateral, regional and multilateral agreements	SL and HL
Trading blocs	Explain free trade areas, customs unions and common markets	SL and HL
Advantages of blocs	Evaluate access to markets, labour mobility, bargaining power, stability	SL and HL
Trade creation	Explain and evaluate it as an advantage	HL only
Disadvantages of blocs	Evaluate loss of sovereignty and the challenge to multilateral talks	SL and HL
Trade diversion	Explain and evaluate it as a disadvantage	HL only
Monetary union	Explain what it is	SL and HL
Monetary union, advantages and disadvantages	Evaluate	HL only
The WTO	Explain its objectives, functions and the factors limiting its influence	SL and HL

The guide frames this unit around winners and losers. Integration can bring efficiency and welfare gains, but the guide notes that the benefits may not be shared equally. Keep that in mind whenever you evaluate.

Preferential trade agreements

A preferential trade agreement gives the countries in it better terms of trade with each other than with outsiders. The guide names three kinds.

• Bilateral: between two countries only. Fictional Veldoria and Tamarek agree to cut tariffs on each other’s goods.
• Regional: between several countries, normally neighbours. A group of countries in one area agree common trading terms.
• Multilateral: between many countries across the world. The guide gives the WTO as the multilateral body.

The difference is the number of parties and the geographic spread. A multilateral deal applies terms to a very wide group, while bilateral and regional deals favour a smaller group and so discriminate against everyone else.

Types of trading bloc

The three types differ in how deep the integration goes. Each type includes the features of the one before it.

Feature	Free trade area	Customs union	Common market
No tariffs or quotas between members	Yes	Yes	Yes
Each member sets its own tariffs on outsiders	Yes	No	No
Common external tariff on outsiders	No	Yes	Yes
Free movement of labour and capital between members	No	No	Yes

Free trade area. Trade between members is free, yet each one keeps its own policy towards non-members. This creates a problem. Suppose Tamarek charges 5% on goods from non-member Orsin, and Veldoria charges 30%. An Orsin good costs 80 at the factory. Sent directly to Veldoria, it costs 80 × 1.30 = 104. Sent through Tamarek, it costs 80 × 1.05 = 84 and then enters Veldoria duty-free. The saving is 104 − 84 = 20 a unit. Free trade areas therefore apply rules of origin, which test whether a good truly comes from a member.

Customs union. All members charge the same external tariff. Orsin goods now cost 104 in both Tamarek and Veldoria, so the detour pays nothing. The price is that members lose control over their own tariff rates.

Common market. A common market adds free movement of labour and capital. A worker in Tamarek can take a job in Veldoria without a work permit. Firms can build factories in any member state.

Advantages of trading blocs

Greater access to markets and economies of scale

A firm in a small country has a small home market. Inside a bloc it can sell to all members without tariffs. Higher output can lower average cost.

Worked example. Fictional firm Kessan Bearings has fixed costs of 600 000 and a variable cost of 4 a unit. At home it sells 50 000 units.

Average cost = (600 000 + 4 × 50 000) ÷ 50 000 = 800 000 ÷ 50 000 = 16.

After the bloc forms it sells 300 000 units.

Average cost = (600 000 + 4 × 300 000) ÷ 300 000 = 1 800 000 ÷ 300 000 = 6.

Average cost falls by 10, a fall of 62.5%. The firm can cut prices and still profit. Evaluation: this only helps if demand in partner states is large enough and the firm can actually raise output.

Greater employment opportunities

Where there is freedom of labour, workers can move to where jobs are. Suppose Tamarek has a labour force of 2 000 000 and 11% are unemployed, which is 220 000 people. If 40 000 unemployed workers move to Veldoria and find jobs, Tamarek’s unemployed fall to 180 000 and its labour force to 1 960 000. Unemployment is 180 000 ÷ 1 960 000 = 9.2%. The workers gain, and Veldoria’s firms fill vacancies. Evaluation: Tamarek may lose skilled workers it needs, and wages in Veldoria may come under pressure.

Stronger bargaining power

A bloc negotiates as one party in multilateral talks. A group of small economies has more weight together than any member has alone.

Greater political stability and cooperation

Countries with strong trade links have more to lose from conflict. Regular meetings to manage the bloc build habits of cooperation.

Trade creation (HL only)

Trade creation happens when a member switches from a high-cost domestic producer to a lower-cost partner. Resources move to their better use, so efficiency rises and prices fall.

Worked example. Fictional Veldoria makes gadgets at a cost of 100. Partner Tamarek makes them at 90, and outsider Orsin at 80. Before the bloc, Veldoria charges 30% on all imports.

Source	Cost	Price in Veldoria before the bloc	Price after the bloc
Domestic	100	100	100
Tamarek	90	90 × 1.30 = 117	90
Orsin	80	80 × 1.30 = 104	104

Before the bloc, domestic gadgets are cheapest at 100. After it, Tamarek’s price of 90 beats both. Veldoria switches to Tamarek. This is trade creation. If 1 000 units switch, the saving in production cost is (100 − 90) × 1 000 = 10 000.

Disadvantages of trading blocs

Trade diversion (HL only)

Trade diversion happens when a member drops a cheaper non-member supplier for a dearer partner, only because partner goods now enter tariff-free.

Worked example. Veldoria also buys textiles. Its own cost is 135, Tamarek’s is 100 and Orsin’s is 80. The 30% tariff applies before the bloc.

Source	Cost	Price before	Price after
Domestic	135	135	135
Tamarek	100	100 × 1.30 = 130	100
Orsin	80	80 × 1.30 = 104	104

Before the bloc, Veldoria buys from Orsin at 104. After it, Tamarek’s price of 100 is lowest, so the trade is diverted to Tamarek.

Consumers pay 4 less (104 − 100). But the real resource cost rises by 100 − 80 = 20 a unit, because the world’s cheapest producer lost the sale. The government also loses the tariff it used to collect on Orsin’s goods, 80 × 0.30 = 24 a unit. Net effect per unit = 4 − 24 = −20, which equals the rise in resource cost. On 5 000 units the net loss is 100 000. A bloc with more trade creation than diversion is better for its members. The result depends on how far partner costs are from world costs.

Loss of sovereignty

Members accept common rules. In a customs union they cannot set their own external tariff. In a common market they also accept free movement of workers. Decisions are made jointly, so a government cannot always do what its voters want.

Challenge to multilateral trading negotiations

Blocs favour insiders and discriminate against outsiders. Members may feel less need for a global deal, and negotiating blocs are harder to bring to agreement than individual countries. Many separate deals can also overlap and conflict. This can slow the WTO’s work.

Monetary union

In a monetary union, member countries adopt a single currency run by one central bank. It goes beyond a common market because the exchange rate between members disappears.

Advantages and disadvantages (HL only)

The guide lists the heading only, so the points below are standard analysis. Check them against what your teacher expects.

Advantages

• No conversion costs between members. A firm that converts 2 400 000 units of currency a year at a 1.5% cost saves 2 400 000 × 0.015 = 36 000 a year.
• No exchange-rate risk between members, so planning and investment are easier.
• Prices are easy to compare across borders, which raises competition.
• A credible central bank may bring lower inflation.

Disadvantages

• Members lose their own monetary policy. One interest rate must suit all. If Veldoria has inflation of 7% and Tamarek 0.5%, and their weights in the union are 60% and 40%, the union-wide figure is 0.6 × 7 + 0.4 × 0.5 = 4.4%. A policy suited to 4.4% is wrong for both.
• Members cannot use a falling exchange rate to recover competitiveness after a shock.
• A weak member may need support from stronger ones, which creates political tension.

The World Trade Organization

The WTO is the multilateral body in the guide. Its objectives are to lower barriers to trade, to promote fair competition and to help trade flow predictably.

Its main functions are:

• A forum where members negotiate trade rules.
• Administering the trade agreements members have signed.
• Settling disputes between members through a formal process.
• Monitoring members’ trade policies.
• Helping developing members with technical assistance.

The guide asks for factors that affect its influence.

• Difficulty of agreement on services and primary products. Services barriers are rules and regulations, not simple tariffs, which makes them hard to compare and negotiate. Primary products, especially farm goods, matter for jobs and food security, so governments protect them fiercely.
• Unequal bargaining power. Large economies can threaten large retaliation and employ teams of trade lawyers. Small economies often cannot, so they accept deals that favour bigger members.

Evaluating integration

Use this chain when you answer an AO3 question.

1. Claim: state the advantage or disadvantage.
2. Mechanism: explain how it works.
3. Stakeholders: who gains and loses (consumers, firms, workers, government, outsiders)?
4. Weight: how large is it, and over what time?
5. Judgement: which side outweighs the other, and why?

Judgement depends on the size of the members, how different their costs are, how fast labour can move, and how much they lose in sovereignty.

Common errors

• Giving a free trade area a shared outside tariff. Each member keeps its own.
• Treating trade diversion as the same as a trade war. Diversion is a switch of supplier inside a bloc’s policy.
• Calling a rise in consumer savings a net gain when tariff revenue is lost.
• Listing monetary union points without applying them to a case.
• Giving a one-sided answer to an AO3 question.

Official syllabus

IB Diploma Programme Economics guide, first assessment 2022, published by the International Baccalaureate Organization, February 2020. Sub-topic 4.4, Economic integration.