3.4 (HL):
Pros and cons of a customs union
P 314 – 316
Learning Objectives
1. In a customs union, explain and illustrate
the concepts of:
a) trade creation and
b) trade diversion
2. Explain gains from economies of scale.
Recall: The Effects of a Tariff...
Price
of Steel
Domestic supply
A
Deadweight loss
B
Price with tariff
Price without
G
tariff
0
C
E
D
F
Imports
with tariff
Q1 S
Q2 S
Imports without tariff
Tariff
Domestic
demand
Q2 D Q1 D
World
price
Quantity
of Steel
Trade Creation:
How an FTA, CU, promotes trade
Price
of Steel
Domestic supply
Regained efficiency
and consumer surplus
Price before joining
FTA or union
Other FTA
member’s price
0
Tariff removed
Domestic
demand
Q1 S
Q2 S
Q2 D Q1 D
Regained Imports without tariff
Quantity
of Steel
The good news is…
Imports will increase – which we call “trade
creation”. Production of a good will transfer
from high-cost producers to lower-cost
producers. Comparative advantage is
promoted, resulting in an overall gain in
economic efficiency.
But when joining a customs union…
The disadvantage occurs when imports from
countries that were not subject to tariffs – but
now are because they are outside the union –
become more expensive than imports from
fellow union members.
When imports become more expensive due to
trade barriers, an overall loss in welfare will
occur.
Trade Diversion:
How a customs union restricts trade
Price
of Steel
Domestic supply
Deadweight loss
Customs Union
Member’s Price
Import Price before
joining union
0
Tariff on
non-member
Non-union
member’s
Domestic
price
demand
Restricted
Imports
Q1 S
Q2 S
Q2 D Q1 D
Imports without tariff on non-union member
Quantity
of Steel
The Bad news…
Imports will decrease – which we call “trade
diversion”. Production of a good will transfer
from low-cost producers to higher-cost
producers.
Comparative advantage is discouraged, resulting
in an overall loss in economic efficiency.
Recall: 1.5 E economies of scale
Different forms of economic integration allow
member countries to gain from economies of
scale – reduced average costs as output is
increased – due to increased efficiency gains,
specialisation, division of labour and
commercial advantage.
All due to increased exports.