JEM081
ADVANCED ECONOMICS OF EUROPEAN INTEGRATION:
Microeconomic Aspects
Lecture 3
Topic 3, Economics of Customs Union
VINER’S MODEL OF CUSTOMS
UNION
Dr. Wadim Strielkowski
IES FSV CUNI
October 7, 2013
Contents
•
•
•
Traditional partial equilibrium approach to an analysis of
customs union
Welfare effects of customs union compared to general tariff
protection regime
Customs union: is it always a better arrangement than tariff
protection?
Readings:
Baldwin, R, Wyplosz, C.: The Economics of European
Integration. McGraw-Hill Higher Education, 2003. Ch.5
Turnovec, F.: Political Economy of European Integration.
Karolinum, Charles University Press, Prague, 2003, Ch. 4.
Viner, J.: Customs Union Issue, 1950.
Pugel, W., International Economics, McGraw Hill, 2003,
Chapter 11.
2
Customs union
• a group of countries among which trade takes
place freely without being restricted by the barriers
of tariffs or quotas on trade, and which adopts a
common external tariff - all member countries
impose the same tariffs on countries outside the
customs union
• the theory of customs union - a good example of
the relevance of economic theory for practical
economic policies
3
Customs unions in European
history
• The best-known customs unions have included the
Zollverein, Benelux and the EEC, now called the EU.
• The Zollverein was formed by German states in the
1830's. These states became the German nation in
1871.
• Belgium, the Netherlands and Luxembourg
established Benelux in the 1944.
• Belgium, France, Italy, Luxembourg, the
Netherlands and West Germany set up the EEC (EU)
in 1957.
4
Customs unions related to the EU
• EU-Andorra: established in 1991.
• EU-San Marino: established in 2002.
• EU-Turkey: established in 1996.
5
Customs unions in the world
• Andean Community (CAN): formed in 1988.
• East African Community (EAC): formed in 2005.
• Customs Union of Belarus, Kazakhstan and Russia:
formed in 2010.
• Israel-Palestinian Authority: formed in 1994.
• Southern Common Market (MERCOSUR): formed in
1991.
• Southern African Customs Union (SACU): formed in
1910 (the oldest still existing CU in the world (RSA,
Botswana, Lesotho, Swaziland, Namibia).
• Switzerland-Lichtenstein: formed in 1924.
6
Customs unions in economic
theory
• Customs union theory builds on strict assumptions
such as perfect competition in commodity and
factor markets and hence it is often referred to as
orthodox customs union theory
• It also only deals with the static welfare effects of a
customs union.
• Customs union has both positive and negative
welfare effects, compared to a situation in which
every member state is practicing protectionism
• The theory is relatively new (started in 1950)
7
Economic theory of customs
union
• any economic theory of regional product market
integration has to address the question of
economic justification of particular integration
forms (the question whether an arrangement would
be superior to the status quo and to participation in
world-wide trade liberalisation)
• until the beginning of the 1950s it was commonly
held that the customs unions and free trade areas
were steps promoting free international trade
• only after pioneering work of Jacob Viner’s
published in 1950 it was realised that customs
unions might as well be seen as a step towards
protectionism
8
Simple model of a customs
union
• Elimination of tariffs on imports from member
countries
• Adoption of a common external tariff on imports
from the rest of the world
• Apportionment of customs revenue according to
an agreed formula
9
Simple model of a customs
union: assumptions
• Pure competition in commodity and factor markets
• Factor mobility within countries but not between
them
• No transportation costs
• Tariffs are the only form of trade restrictions
• Prices reflect the opportunity costs of production
• Trade is balanced
• Resources are fully employed
10
Viner’s contribution
• Jacob Viner (1892-1970) - Canadian economist,
professor at Chicago University and Princeton
University, an international trade theorist; his book
The Customs Union Issue introduced the
distinction between the trade-creating and the
trade-diverting effects of customs unions
• contribution of Jacob Viner was an introduction of
welfare consideration into the theory of
international trade in general and particularly into
the theory of customs unions
11
Trade creation and trade
diversion
• ground-stones of Viner's theory of customs unions
are concepts of trade diversion and trade creation
effects of different arrangements of regional
integration.
• original Viners’ definition of these concepts was
formulated in terms of trade flows:
• trade diversion: switch in trade from less
expensive to more expensive producers
• trade creation: switch in trade from more
expensive to less expensive producers
12
Trade creation and trade
diversion
• in 1965 Johnson suggested that the concept of
trade diversion and trade creation should be more
precisely defined on the basis of welfare effects
rather than in terms of trade flows
• trade creation - welfare change due to the
replacement of higher cost domestic production
and/or higher cost imports by lower-cost imports
• trade diversion - welfare change due to the
replacement of imports from a low cost source by
imports from a higher cost source
13
Trade creation and trade
diversion
• in terms of world allocation of resources: trade
creation is beneficial to welfare, while trade
diversion worsens allocation
• a customs union is economically justified if it leads
to a trade creation, while a customs union
generating a trade diversion leads towards a
deeper protectionism and decrease of efficiency
14
Viner’s model - assumptions
• perfect competition in commodity and factors
markets,
• perfect factor mobility within the individual
countries, but not among the countries,
• full employment and foreign trade equilibrium,
• perfectly price elastic supply on the world market,
• economies and/or diseconomies of scale are not
considered
15
Viner’s model - assumptions
• transport costs are not considered,
• at least three participants of the trade are
considered; countries A and B, discriminating in
trade with the rest of the world, and the world
market,
• a partial equilibrium approach is adopted: one
commodity markets are considered,
• customs union formation will not increase the tariff
protection.
16
Viner’s model – a small country
and a big country
• A partial equilibrium model: customs union of a
small country and a big country
• two countries:
H (home country)
P (potential partner country)
• world market W
• country H is assumed to be a small country,
country P is assumed to be a big country
17
Viner’s model – a small country
and a big country
• a partial market for one commodity
• let
SH(p)
be a domestic supply function
DH(p)
be domestic demand function for this
commodity in the country H
• the supply by the partner country and the world
market supply of the commodity is assumed to be
perfectly elastic, hence the country H cannot
influence the price
18
Viner’s model – initial situation of
general tariff protection
• let us denote
pW
world price
t
non-discriminatory tariff
pP
the price in the partner country P
pH
the closed equilibrium price in the home
country
pW+t
tariff protected price in H
• Assume that
pW < pP < pW+t < pH
• Initial situation: the small country H covers part of
its domestic demand by tariff protected import
from the world market and considers formation of
customs union with big country P
19
Country H in general tariff
protection regime (before CU
formation)
p
CE equilibrium
Sd(q)
TP equilibrium
EH
p
H
Et
St(q)
p +t
W
p
P
p
W
Ew
Sw(q)
FT equilibrium
Dd(q)
s
w
s
t
q
H
d
t
d
w
q
20
Welfare before CU formation
• domestic supply of
country H is st,
domestic demand dt
and import from the
world market at the
price pW + t is dt – st
• welfare (shaded area in
the graph) including
tariff revenues (dt - st)t.
p
consumers'
surplus in TP
Sd(q)
tariff revenues
in TP
EH
p
H
Et
p +t
W
p
P
p
W
St(q)
(a)
Sw(q)
producers'
surplus in TP
s
t
q
H
Dd(q)
d
t
q
21
Viner’s model – customs union with
big country P
• assume that country H is considering a possibility
of switching from tariff protection to customs
union with the country P
• after the customs union is created the trade inside
the union will be tariff free, for the price pCU = pP
less than the pW + t
• will there be a trade creation or trade diversion,
welfare improvement for H compared to tariff
protection?
22
Country H in customs union with
big country P (after CU formation)
p
Sh(q)
CU equilibrium
EH
pH
Et
p +t
p
=
CU
St(q)
ECU
W
p
Ew
P
p
W
sCU
st
qH
dt
dCU
Scu(q)
Sw(q)
q
23
Equilibrium in customs union of
a small and big country
•
•
•
•
•
•
comparing to tariff
protection:
effective supply curve for
country H in the customs
union will be SCU
domestic equilibrium supply
will decrease from st to sCU
domestic equilibrium
demand will expand from dt
to dCU
the difference dCU - sCU
represents the import from
the country P
equilibrium price will
decrease from pW+t to pP
p
Sh(q)
CU equilibrium
EH
pH
Et
p +t
St(q)
ECU
W
p =p
Ew
CU P
p
W
sCU st qH
dt
dCU
Scu(q)
Sw(q)
q
24
Welfare effects of customs
union of a small and big country
p
consumers'
surplus in CU
Sh(q)
no tariff
revenues in CU
EH
pH
Et
p +t
W
p
=
CU
p
(a)
(b)
P
(c)
(d)
ECU
(e)
p
W
St(q)
Scu(q)
Sw(q)
producers'
surplus in CU
sCU
st
qH
dt
dCU
q
25
Is customs union more beneficial
for country H than tariff protection?
• welfare effects of customs union
formation for small country H
• comparing customs union to initial
situation of a general tariff protection
regime, is there a welfare gain in
country H?
• Comparing customs union to potential
general free trade regime
26
Comparison of welfare in CU
and TP
p
consumers'
surplus in CU
p
consumers'
surplus in TP
Sd(q)
Sh(q)
no tariff
revenues in CU
EH
pH
Et
p +t
W
p =p
CU P
p
(a)
(b) (c)
(e)
(d)
ECU
W
Et
St(q)
p +t
W
p
P
p
W
Scu(q)
Sw(q)
producers'
surplus in CU
sCU st qH
tariff revenues
in TP
EH
p
H
(a)
Sw(q)
producers'
surplus in TP
dt
dCU
q
St(q)
s
t
q
H
Dd(q)
d
t
q
27
Trade creation and trade
diversion in CU
•
•
before the union was
created the country H was
importing from the world
market for lower price than
in the customs union with
country P
strictly Vinerian approach
classifying such a customs
union as purely trade
diverting and, therefore,
economically unjustified, is
rather misleading and
problematic
p
consumers'
surplus in CU
Sh(q)
no tariff
revenues in CU
EH
pH
Et
p +t
W
p =p
CU P
p
(a)
(b)
(c)
(d)
ECU
(e)
W
St(q)
Scu(q)
Sw(q)
producers'
surplus in CU
sCU st qH
dt
dCU
q
28
Trade creation and trade
diversion in CU
• together with trade
diversion following
from increase of
producers’ price we can
observe at the same
time a reduction of the
more expensive
domestic production in
favor of cheaper
imports from partner's
country and decrease
of domestic supply
p
consumers'
surplus in CU
Sh(q)
no tariff
revenues in CU
EH
pH
Et
p +t
W
p =p
CU P
p
(a)
(b)
(c)
(d)
ECU
(e)
W
St(q)
Scu(q)
Sw(q)
producers'
surplus in CU
sCU st qH
dt
dCU
q
29
Trade creation and trade
diversion in CU
• The total welfare
effect for the
country H:
• The decrease of the
equilibrium price
from pW + t to pCU =
pP leads to an
increase of
consumers' surplus
by the amount equal
to regions denoted
as (a), (b), (c) and
(d)
p
consumers'
surplus in CU
Sh(q)
no tariff
revenues in CU
EH
pH
Et
p +t
W
p =p
CU P
p
(a)
(b)
(c)
(d)
ECU
(e)
W
St(q)
Scu(q)
Sw(q)
producers'
surplus in CU
sCU st qH
dt
dCU
q
30
Trade creation and trade
diversion in CU
• At the same time
producers' surplus
is decreasing by an
amount equal to the
area (a).
• The government is
losing tariff
revenues equal to
the regions (c) and
(e)
p
consumers'
surplus in CU
Sh(q)
no tariff
revenues in CU
EH
pH
Et
p +t
W
p =p
(a)
(b)
CU P
(c)
(d)
ECU
(e)
p
W
St(q)
Scu(q)
Sw(q)
producers'
surplus in CU
sCU
st qH
dt
dCU
q
31
Trade creation and trade
diversion in CU
• Considering gains and
losses we can see that
areas (a) and (c) do not
represent a gain, they
are compensated by
losses in producers'
surplus and
government tariff
revenues, but only an
internal redistribution
of welfare between
producers and
consumers
p
consumers'
surplus in CU
Sh(q)
no tariff
revenues in CU
EH
pH
Et
p +t
W
p =p
CU P
p
(a)
(b)
(c)
(d)
ECU
(e)
W
St(q)
Scu(q)
Sw(q)
producers'
surplus in CU
sCU st qH
dt
dCU
q
32
Trade creation and trade
diversion in CU
• the positive welfare
effects of the
customs union for
the home country
consists of areas (b)
and (d). The trade
creation effect was
defined by Johnson
as a sum of these
two areas, reg (b) +
reg (d)
p
consumers'
surplus in CU
Sh(q)
no tariff
revenues in CU
EH
pH
Et
p +t
W
p =p
CU P
p
(a)
(b) (c)
(d)
ECU
(e)
W
St(q)
Scu(q)
Sw(q)
producers'
surplus in CU
sCU st qH
dt
dCU
q
33
Trade creation and trade
diversion in CU
• Negative welfare
effect is given by
the region (e), the
loss of tariff
revenues, used
before for welfare
redistribution, by
Johnson this
represents a trade
diversion effect
p
consumers'
surplus in CU
Sh(q)
no tariff
revenues in CU
EH
pH
Et
p +t
W
p =p
(a)
(b)
CU P
(c)
(d)
ECU
(e)
p
W
St(q)
Scu(q)
Sw(q)
producers'
surplus in CU
sCU
st qH
dt
dCU
q
34
Trade creation and trade
diversion in CU
• the net welfare
effect given as
reg(b)+reg(d)-reg(e)
indicates, whether
the trade creation or
the trade diversion
prevails in a
particular case of
the customs union
p
consumers'
surplus in CU
Sh(q)
no tariff
revenues in CU
EH
pH
Et
p +t
W
p =p
(a)
(b)
CU P
(c)
(d)
ECU
(e)
p
W
St(q)
Scu(q)
Sw(q)
producers'
surplus in CU
sCU
st qH
dt
dCU
q
35
Trade creation and trade
diversion in CU
• Conclusion: one
can make no
general statement
about the total
welfare effects of
customs unions, an
empirical
investigation of
each particular case
is necessary
p
consumers'
surplus in CU
Sh(q)
no tariff
revenues in CU
EH
pH
Et
p +t
W
p =p
CU P
p
(a)
(b)
(c)
(d)
ECU
(e)
W
St(q)
Scu(q)
Sw(q)
producers'
surplus in CU
sCU st qH
dt
dCU
q
36
Customs union puzzle: tariff
reduction versus customs union
• Let before the customs union formation the
tariff is t0 and
pP < p+t0 < pH
then in the customs union with the country
P the country H will import from country P
instead from world market
• t0 will remain to be common external tariff
in the customs union
37
Customs union equilibrium
p
Sh(q)
CU equilibrium
EH
pH
Et
p +t
p
=
CU
St(q)
ECU
W
p
Ew
P
p
W
sCU
st
qH
dt
dCU
Scu(q)
Sw(q)
q
38
Customs union equilibrium and
welfare
•
•
domestic supply of country
H in the customs union will
be sCU, domestic demand
will be dCU and import from
P to H will be dCU – sCU
positive trade creation
effect: area (b) and (d),
negative trade diversion
effect: area (e), total positive
effect if
reg(b) + reg(d) > reg(e)
p
consumers'
surplus in CU
Sh(q)
no tariff
revenues in CU
EH
pH
Et
p +t
W
p =p
CU P
p
(a)
(b)
(c)
(d)
ECU
(e)
W
St(q)
Scu(q)
Sw(q)
producers'
surplus in CU
sCU st qH
dt
dCU
q
39
What is better: customs union or
tariff reduction
• let us consider situation when country H decides
(instead of forming CU with P) reduce unilaterally
tariff protection from original level t0 to the level of
price pP, it means that new tariff tn is constructed in
such a way that tn=pP-pW
• in this case we shall get the same market
equilibrium in country H as in the case of customs
union with P: the same domestic supply, domestic
demand and import, but import now will come from
the world market instead of from country P
• is it better or worse than the customs union with
P?
40
Tariff reduction equilibrium
p
Dd(q)
Sd(q)
Eto equilibrium
with tariff to
Etn equilibrium
with tariff tn
EH
p
H
E to
p +to
W
Sto(q)
Etn
p +tn
W
EW
p
W
s
tn
s
to
q
H
d
to
d
tn
Stn(q)
Sw(q)
q
41
Customs union puzzle: tariff
reduction versus customs union
• in the customs union tariff protection
is abolished in internal union trade
and the government does not collect
any tariff revenues
• in a new situation with reduced tariff tn
government tariff revenues will remain
on the level of imports multiplied by
tariff
42
Welfare of tariff reduction
reg(b)+reg(d)+reg(f)+reg(g)
p
Sd(q)
EH
p
H
E to
p +to
W
p +tn
Welfare effect of
tariff reduction
from t0 to tn
(a)
(b)
W
(f)
(c)
(d)
(e)
Sto(q)
Etn
EW
(g)
p
W
Stn(q)
Sw(q)
Dd(q)
s
tn
s
to
q
H
d
to
d
tn
q
43
Customs union puzzle: tariff
reduction versus customs union
• Welfare gain of country H due to tariff
reduction to tn (compared to the situation of
tariff protection with t0) corresponds to the
areas (b), (d), (f) and (g)
• (b)+(d) = increase in consumer surplus
minus loss in producers surplus (a) minus
decrease of the government tariff revenues
(c) from the original imports
• (f)+(g) = increase of government tariff
revenues from extended imports from the
world market
44
Welfare in customs union and
tariff reduction
p
reg(b)+reg(d)+reg(f)+reg(g)
consumers'
surplus in CU
Welfare effect of
Sd(q) tariff reduction
from t0 to tn
p
Sh(q)
no tariff
revenues in CU
EH
pH
Et
p +t
W
p =p
CU P
p
(a)
(b) (c)
(d)
ECU
(e)
W
EH
p
H
St(q)
p +to
Scu(q)
Sw(q)
p +tn
E to
W
(a)
(b)
W
(f)
(c)
(d)
(e)
Sto(q)
Etn
EW
(g)
p
W
Sw(q)
Dd(q)
producers'
surplus in CU
s
sCU st qH
Stn(q)
dt
dCU
q
tn
s
to
q
H
d
to
d
tn
q
45
Tariff reduction generates more
welfare than customs union
• When we compare this result to the welfare effect
of customs union with country P, we can conclude
that tn < to implies
reg(b)+reg(d)+reg(f)+reg(g)>reg(b)+reg(c)-reg(e)
• the right side of inequality represents welfare effect
(for country H) of customs union with country p
and the left side represents welfare effect (for
country H) of original tariff reduction t0 the level tn
such that pP = pW+tn without entering the customs
union with P
46
Problems and questions
• why the customs unions are created at all,
when the theory indicates that the same
production and consumption effect and
better welfare effect can be achieved by
unilateral tariff reduction?
• do we have incompetent decision makers
or there is something missing in the
theory?
• the answers probably should be looked for
in oversimplified structure of the Vinerian's
framework of customs union models
47
Some oversimplifications to be
removed
• Perfect elasticity of partner's country
supply is a rather strong assumption, that
is, perhaps, valid for economic relations
between San Marino and Italy, but hardly
for non-trivial economies.
• Customs union has usually measurable
effects in both (in our simplified two
country model) or all (in a more general
models) participating countries. Hence the
assumption that export from country P to
country H has no influence on price should
be relaxed
48
Some oversimplifications to be
removed
• Single commodity market assumption is also
rather misleading. Changes in supply, demand and
price on one partial market influence also other
partial markets, so multi-commodity analysis can
lead to more realistic results
• Vinerian’s models analyze only static effects,
ignoring dynamic effects, such as restructuring,
economy of scale etc. Firms faced with increased
competition will try to lower their costs to stay in
the market and increased technical efficiency due
to increased competition can have a welfare effect,
exceeding many times the limited static effect.
49
Model of a customs union of two
small countries on one-commodity
market
• assume as before two countries H and P, and the
world market W
• In this case let both countries H and P are small
economies, they still face a perfectly elastic world
supply curve, but after formation of eventual
customs union of H and P the customs union
supply curve will be the sum of the two domestic
supply curves, the customs union demand curve
will be the sum of the two domestic demand curves
and the customs union equilibrium price will be
different from closed equilibrium prices in the both
member countries
50
Two small countries supply and
demand, closed equilibrium
• let
SH(p) be a supply function in H
DH(p) be a demand function in H
SP(p) be a supply function in P
DP(p) be a demand function in P
• Closed equilibrium (qH,pH) in H
pH: SH(p)=DH(p), qH= SH(pH)=DH(pH)
Closed equilibrium (qP,pP) in P
pP: SP(p)=DP(p), qP=SP(pP)=DP(pP)
51
Two small countries supply and
demand, closed equilibrium
COUNTRY H
COUNTRY P
EcH
pH
EcP
pP
pw
qH
qP
52
Two small countries supply and
demand, tariff protection
COUNTRY H
COUNTRY P
EcH
pH
pt
EtH
EcP
pP
pw
stH qH dtH
qP
53
Customs unions of H and P, joint
supply and demand
• Considering customs union of H and P,
there will be a free trade among H and P
leading to joint equilibrium, and common
external tariff for trade protection with
respect of the rest of the world
• Supply in customs union: “sum” of two
supply functions, demand in customs
union: “sum” of two demand functions
• What means “sum” in our case?
54
Sum of supply and demand
functions in H and P
Country H
Customs union of
H and P
Country P
SH
DP
DCU
DH
SCU
SP
pH
p +t
W
p
CU
pP
p
W
CU
H
s
q
H
CU
H
d
d
CU
q
P
P
CU
P
s
q
CU
55
Sum of supply functions
Sum of supply functions in H and P
0
0
0
if 0  p  min{ pSH
, pSP
}

0
0
if either pSH
 p  pSP
S H ( p)
SCU ( p )  
0
0
S
(
p
)
or
p

p

p
P
SP
SH

0
0
 S H ( p )  S P ( p )
if p  max{ pSH
, pSP
}
56
Sum of demand functions in H
and P
Sum of demand functions in H and P
0
0

0
if p  max{ pDH
, pDP
}

0
0
if either pDP
 p  pDH
 DH ( p )
DCU ( p )  
0
0
D
(
p
)
or
p

p

p
P
DH
DP

0
0
 DH ( p )  DP ( p)
if p  min{ pDH
, pDP
}
57
Customs union price
Knowing customs union supply and demand function
SCU(p) and DCU(p), we can calculate equilibrium price of
customs union pCU of small countries H and P as the
solution of equation
SCU ( p)  DCU ( p )
and comparing it to world price and tariff protected
price we can decide whether the customs union of H
and P has some justification or not. The necessary
condition for welfare increasing customs union of H
and P in this case is
p CU < pW + t
58
Welfare in customs union of two
small countries
• country H imports from the country P for the price
pCU and the welfare effects for country H are given
by known formula reg(a)+reg(b)-reg(c), i.e. gain in
consumers' surplus minus loss of government
tariff revenues
• country P is an exclusive exporter into country H
and its welfare effect is given by the area (d),
increase in producers' surplus minus decrease of
consumers' surplus, which is, under given
assumptions, always positive.
59
Welfare in customs union of two
small countries
• Then the total welfare
effect of customs union
for the both countries
is reg(a)+reg(b)reg(c)+reg(d)
• Taking into account a
bit more realistic case
of an influence of
customs union on
market equilibrium in
both considered
countries, the total
balance of welfare
changes increases
country H
country P
EH
pH
p +t
W
p
CU
p
P
p
(a) (b)
(d)
(c)
EP
W
s1H sH2 qH dH2 dH1
d1P qP s1P
60
EXAMPLE
• One commodity market in country H with
domestic demand and supply functions:
S H (p) = - 50 + 50p
D H (p)= 370 - 20p
•
•
•
•
A potential partner country: P
World price: pW = 4
Non-discriminative ad valorem tariff: t = 1
Price in partner country: pP = 4.5
61
EXAMPLE
• From
- 50 + 50p = 370 - 20p
• we get closed equilibrium price
*
p =
420
=6
70
• and closed equilibrium quantity
q* = S H ( p* ) = D H ( p* ) = 250
62
EXAMPLE
• Case 1: Welfare of closed equilibrium
– Price of zero demand
370 - 20p = 0  p = 18.5
– Price of zero supply
- 50 + 50p = 0  p = 1
63
EXAMPLE
– Consumers’ surplus
1
CS = (18.5 - 6) 250 = 1562.5
2
– Producers’ surplus
1
PS = (6 - 1) 250 = 625
2
– Total welfare in closed equilibrium
TW CE = CS + PS = 1562.5 + 625 = 2187.5
64
EXAMPLE
• Case 2: Tariff Protection
– Tariff protected market price
pt = p w + t = 4 + 1= 5
– Domestic demand
D H ( p t ) = 370 - 20 * 5 = 270
– Domestic supply
S H ( pt ) = - 50 + 50 * 5 = 200
( p t ) - S H ( p t ) = 270 - 200 = 70
D–H Imports
65
EXAMPLE
– Consumers’ surplus
1
CS = (18.5 - 5) 270 = 1822.5
2
– Producers’ surplus
1
PS = (5 - 1) 200 = 400
2
– Government tariff revenue
TR = 70 * 1 = 70
66
EXAMPLE
• Total welfare under tariff protection:
TW TP = CS + PS + TR =
1822.5 + 400 + 70 = 2292.5
• Compared to closed equilibrium consumers are
gaining, producers are losing, total welfare
effect is positive.
67
EXAMPLE
• Case 3: Customs Union of H with P
– Customs Union market price
p CU = p P = 4.5
– Domestic demand
D H ( p CU ) = 370 - 20 * 4.5 = 280
– Domestic supply
S H ( p CU ) = - 50 + 50 * 4.5 = 175
– Imports
D H ( p CU ) - S H ( p CU ) = 280 - 175 = 105
68
EXAMPLE
– Consumers’ surplus
1
CS = (18.5 - 4.5) 280 = 1960
2
– Producers’ surplus
1
PS = (4.5 - 1) 175 = 306.25
2
– Total welfare
TW CU = CS + PS = 1960 + 306.25 = 2266.25
69
EXAMPLE
• Welfare effect of CU compared to tariff
protection:
WE CU = TW CU - TW TC =
2266.25 - 2292.5 = - 26.25
• Conclusion: By Viner’s model of customs
union, in this particular case tariff protection
is for country H economically more beneficial
than customs union.
70
Likelihood of gains and losses
from customs union
• The larger is the economic area of the CU and the
more numerous are the countries of which it is
composed, the greater will be the scope for TC.
• It is likely that TC will be greater than TD if
countries joining together in a CU are similar in
the range of products they produce before the
formation of the union.
– This is because TC occurs through the
replacement of domestic production by more
efficient production within the union.
– If future members produce essentially different
goods, there will be little scope for such
replacement and, hence, little trade creation.
71
Likelihood of gains and losses
from customs union
• TC is more likely in the long-run, through dynamic
gains.
• TC is more likely, the greater are the initial tariff
rates among future partners.
• TC is more likely, the higher is the elasticity of
demand for imports on which duties are removed.
• The gains from integration are likely to be greater,
the greater is the ratio of intra-trade (trade with
future partners) to total trade.
72
Questions?
• Analysis of customs union: Viner’s model
• Welfare approach to customs union
• Customs union and tariff protection
• Examples of CU in International trade.
73