Question

a) Explain a Customs Union. (2 pts)

b) Why does creating a Customs Union create trade and benefit a country? Use a graph in your explanation. (3 pts)

c) Now assume that a small country (A) forms a Customs Union with another country (C), however that country is not the low cost producer, which is a third country (B). Use a graph in your explanation of the “trade diversion” and “trade creation” due to the formation of this Customs Union between A and C (as we showed in class). (5 pts)

Answer 1

(a) The customs union is a type of trade agreement between two or more countries. This means that they have decided not to impose mutual customs duties (import duties) on goods and services and agree to impose common foreign tariffs on goods and services coming from countries outside their union.

The theory of customs union was developed by Jacob Viner in 1950 and he introduced the key concepts of 'trade creation and trade diversion'. He showed that the establishment of a customs union combines the elements of free trade with the elements of greater protection and can improve or worsen resource allocation and welfare which is depending on different aspects of trade creation and trade diversion. Therefore, customs union has static and dynamic effects.

EU is one of the examples of Customs union.

(b) The creation of a customs union definitely make benefits for the country that includes in the union. The effects of customs union can be differentiate in two parts; 1) Static effects and 2) Dynamic effects

Static effects include the reallocation of resources between existing industries using currently available supplies of factors of production and existing technology. some industries expand, others narrow, and consumers get benefit from lower prices on certain products; otherwise everything continues as before.

As well as dynamic effects refers to some developments that make the economy of the Union dynamic, such as increasing competition, encouragement of technological changes, encouragement of investments and increasing economies of scale.

Generally, the effects of customs union on production, consumption and trade is be explained in terms of trade creation and trade diversion. Trade creation is the key benefit to the member countries from a customs union.

Trade creation occurs when relatively expensive domestic production in one member country is replaced by cheap imports from another member country. This increases the well-being of member countries as it leads to greater specialization of production based on comparative advantage. The customs union, which creates trade, also increases the welfare of non-members as part of the increase in real income (due to its greater specialization in manufacturing) is spread over to increased imports from the rest of the world.

A trade-creating customs union can be illustrated below with the help of a table and diagram.

Country	Unit Cost (in $)	Unit cost (in $) with imposition of 100% import duty	Unit cost (in $) after formation of customs union
A	500	500	500
C	420	840	420
B	340	680	680

The home country A is the least efficient country and its unit cost of producing good X is $500. In the partner country C, which is more efficient, the unit cost of production of the same good X is $420. The rest of the world represented by the non-member country B, which is the most efficient country and the cost of producing the same good X in country B is $340. If, before the formation of customs union, the home country iimposes 100% tariff on all imports, the unit cost of good X from country C and country B become $420 and $340 respectively.

In these circumstances, it is desirable for the home country A to produce the commodity domestically in the absence of customs union. If the customs union is formed and duty is removed on imports from country C, the partner country C becomes the least cost country. Now the home country will prefer to import good X from country C rather than produce it domestically. So the formation of customs union has resulted in the creation of trade.

Diagrammatic representation of trade creation

In the diagram, D_A and S_A are the demand and supply curves respectively of the home country A. S_C is the supply curve of country C which is assumed to be perfectly elastic. Before the formation of the customs union, country A has imposed a tariff of P_CP_t per unit on import of good X from country C so that country C's commodity X is available in country A at OP_t price. Country A's total consumption of good X is OQ₃ out of which OQ₂ is supplied by domestic producers and the remaining quantity, Q₂Q₃ is imported from country C. The consumer's surplus in this trade equilibrium is D₀ P_t F and producer's surplus is S₀EP_t. The revenue reciepts of the government in country A are EFLK.

Now, after the formation of the customs union between country A and country C, the tariffs are removed between them.

c) About 'trade creation' between countries in customs union is illustrated above (answer b) and now we need to move 'trade diversion effect'. Here also a small country A forms a customs union with another country C, however that country is not the low cost producer, which is a third country B.

Trade diversion

Trade divergence occurs when a country changes the source of imports from a country with more efficient production to a country with less efficient production due to the customs union. Reorienting trade itself reduces welfare while shifting production from more efficient producers outside the customs union to less efficient producers within the union. Thus, trade diversion worsens international resource allocation and drives production away from comparative advantage.

Country	Unit cost (in $)	Unit cost (in $) with 50% import duty	Unit cost (in $) after formation of customs union
A	500	500	500
C	420	630	420
B	340	510	510

Following figure illustrates trade diversion under static analysis. In the figure, D_A and S_A are the demand and supply curves respectively of the home country A. S_B and S_C are the perfectly elastic supply curves of countries Band C resp. The selling price of good X in country A is OP_A whereas, the selling prices of countries B and C are respectively OP_B and OP_C. Thus, country B is the most efficient and country A is the least efficient.

Country A has imposed a tariff of P_BP_t per unit of good X imported. Hence, good X imported from country B costs opt in country A and country B's supply curve of good X in country A shifts to P_tS_t. The price good X imported from country C is OZ (OP_C + P_BP_t tariff). Hence good X is imported from the least cost country B and there is no import from country C. The total demand for good X in country A is OQ₃, out of which domestic supply is OQ₂ and the remaining part , Q₂Q₃ is met by imports from country B. On the import of Q₂Q₃ of good X, the government gets a tariff of MNFE.

Now, country A forms a customs union with country C. Because of the removal of tariff on imports of good X from country C, good X is now available at OP_C price at country A. The fall in the price of good X from OP_t to OP_C increases its demand from OQ₃ to OQ₄ reduces the domestic supply from OQ₂ to OQ₁ and increases the imports from Q₂Q₃ to Q₁Q_4. And imports from the least costcountry B have ceased.

As a result of these changes, consequent upon the formation of the customs union, the consumer's surplus increases by the area P_tFHP_C. But not all of this is a net gain to the country because part of the total gain to the consumers represents the loss of the producer's surplus ( P_tEGP_C) lost by producers to consumers and another part (EFLK) represents the loss of tariff revenue of the government. The welfare gain in country A from pure trade creation is given by the sum of the areas of two shaded triangles EKG and FHL. Thus, the trade -diverting customs union also leads to some trade creation. The total loss of tariff revenue is represented by MNFE. After the formation of the customs union and the abolition of tariff, consumers' gain only part of it. That is EKLF and the remaining part KMNL (the area of the shaded rectangle) represents the welfare loss to the country because of the shift from a low-cost source (country B ) to high-cost source of supply (partner country C). This is the detrimental effect of a customs union which Viber described as the trade diversion effect.