Lecture 5: Traditional customs union theory

1
Lecture 5 Traditional customs union theory

• Objectives
• to understand the trade and welfare effects when
  two or more countries form a customs union
• to introduce the concepts of trade creation and
  trade diversion fundamental to customs union
  theory
• to set out the conditions under which customs
  unions are most likely to yield positive economic
  benefits

2
The gains from trade
Wine
B
A
P
R
Clothing
3
Partial equilibrium analysis of gains from trade
Price
SH
DH
PA
Pw
Q2
Q1
Quantity
.. trade improves welfare
4
Partial equilibrium analysis of tariffs
Price
SH
DH
Pw'
Pw
Q2
Q4
Q3
Q1
Quantity
.. lower tariffs improve welfare
5
Customs union theory

• Pre-1950 view was that customs unions implied a
  move towards free trade and were therefore
  welfare-improving
• Jacob Viner (1950) showed that customs unions
  have contradictory effects on welfare due to
  their trade creation and trade diversion effects
• Lipsey (1957) extended this analysis to include
  consumption effects
• customs union theory addresses the trade and
  welfare effects on both members and the rest of
  the world of a change from national tariff
  protection to a customs union

6
Illustrating Viner's trade creation and trade
diversion effects
Trade creation the welfare change due to the
replacement of (higher-cost) domestic production
of import goods by (lower-cost) imports Trade
diversion the welfare change due to the
replacement of imports from a low cost source by
imports from a high cost source
7
Trade creation and diversion - small country in a
small union
Price
SH
DH
PU(1t)PU'
SU'
PW(1t)PW'
SW'
y
x
a
b
SU
PU
z
PW
SW
Quantity
B
C
E
D
8
The Kemp-Wan theorem

• Argument so far is that a CU may not lead to an
  overall welfare improvement for Union members.
  Also, trade diversion hurts ROW exporters.
  However, if we allow the possibility of costless
  redistribution between partners, then it is
  possible to prove that a CU need never harm any
  country. This argument is known as the Kemp-Wan
  theorem (1976). It depends on the CET being a
  variable and being set at the appropriate level.

9
What conditions maximise the chance that a CU is
beneficial?

• Net benefits to welfare will tend to be higher,
• if ex ante tariffs are high, because the
  pre-union position then involves greater
  production and consumption distortions
• the lower the CET and thus post-CU prices
  (because this reduces the scope for trade
  diversion).
• ex ante imports from the rest of the world are
  low (because this enhances the prospects for
  division of labour and minimises trade
  diversion).
• if the participating economies are of a
  potentially competitive nature.