FORMS OF REGIONAL
INTEGRATION








Preferential tariff agreement
Free trade area
Customs union
Single market
Common market
Monetary union
Economic union
Political union
1
ECONOMICS OF
CUSTOMS UNION
Jacob Viner’s theory
2
SIMPLE MODEL OF A
CUSTOMS UNION

Customs Union

A group of countries among which trade takes
place freely without being restricted by the
barriers of tariffs (customs duties) or quotas
(quantitative restrictions) on trade, and which
adopts a common external tariff - all member
countries impose the same tariffs on countries
outside the customs union
3
SIMPLE MODEL OF A
CUSTOMS UNION



Elimination of tariffs on imports rofm 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
4
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
5
SIMPLE MODEL OF A
CUSTOMS UNION

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 was published in 1950 it was realised
that customs unions might as well be seen as a step
towards protectionism

Jacob Viner (1892-1970) was Canadian economist, professor
at Chicago University and Princeton University. Viner was 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.
6
SIMPLE MODEL OF A
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)

The 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.
7
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
8
Trade creation and trade
diversion

We shall use a modified definition in
terms of welfare changes:


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
9
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.
10
A Partial Equilibrium Model

Two countries:



H (home country)
P (potential partner country)
W (world market)
11
A Partial Equilibrium Model

SH(p): domestic supply function

DH(p): 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
12
A Partial Equilibrium Model




World price: pW
The price in the partner country: pP
The closed equilibrium price in the home
country: pH
Let
pw < p P < pw + t < p H

Then the country H will cover part of its
domestic demand by import from the
world market
13
A Partial Equilibrium Model
Fig.1, Country H in a general tariff protection regime
14
A Partial Equilibrium Model

Assume that country H is considering a possibility of
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. The tariff t for the trade with rest of world is
maintained.

The effective supply for country H in the union will be SCU,
while domestic supply will decrease to sCU and domestic
demand will increase to dCU. Import will expand from dt - st
to dCU - sCU. Facing this possibility, is it beneficial for
country H to enter the customs union with country P?
15
p
consumers'
surplus in TP
EH
p
H
p +t
W
Sd(p)
Et
tariff revenues
in TP
Sw(pw+t)
(a)
p
W
producers'
surplus in TP
s
t
q
H
Dd(p)
d
t
q
Fig. 2, Welfare effect of tariff protection
16
p
consumers'
surplus in CU
Sh(p)
EH
pH
Et
p +t
W
(a)
p
(b)
CU
(c)
(d)
no tariff
revenues in CU
ECU
(e)
p
Sw(pw+t)
Scu(pcu)
W
producers'
surplus in CU
sCU
st qH
dt
dCU
Fig. 3, Welfare effect of customs union for country H
q
17
A Partial Equilibrium Model


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.
But we can observe at the same time a
reduction of the more expensive domestic
production in favour of cheaper imports
from partner's country and increase of
domestic supply.
18
A Partial Equilibrium Model
p
consumers'
surplus in CU
Sh(p)
EH
pH
Et
p +t
W
(a)
p
(b)
CU
(c)
(d)
no tariff
revenues in CU
ECU
(e)
p
Sw(pw+t)
Scu(pcu)
W
producers'
surplus in CU
sCU
st
qH
dt
dCU
q
19
A Partial Equilibrium Model

The total welfare effect for the home country
from creating the customs union with country P
can be expressed as follows:



(1) 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) in the Fig. 3.
(2) At the same time producers' surplus is decreasing
by an amount equal to the area (a).
(3) The government is losing tariff revenues equal to
the regions (c) and (e).
20
A Partial Equilibrium Model



Considering gains and losses we can see that areas (a) and
(c) do not represent a gain, because they are compensated
by losses (in producers' surplus and government tariff
revenues), but only an internal redistribution of welfare
between producers and consumers.
Hence, 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).
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.
21
A Partial Equilibrium Model

Defining trade diversion as a negative welfare
effect and trade creation as a positive welfare
effect, the net welfare effect given as
w = reg(b) + reg(d) - reg(e)

indicates, whether the trade creation or the trade
diversion prevails in a particular case of the
customs union. We can make no general
statement about the positive or negative effects
of customs unions. An empirical investigation of
each particular case is necessary.
22
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
23
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
24
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
25
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
26
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

Imports
D H ( p t ) - S H ( p t ) = 270 - 200 = 70
27
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
28
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.
29
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
30
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
31
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.
32
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.
33
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.
34