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A Static Analysis of the Customs Union Issue IF309 EU: Economic & Financial Aspects Preferential trading agreements (PTA’s) are one of the biggest issues facing world trade, they involve groups of countries charging high trade tariffs to the rest of the world while lower on no trade tariffs are charged to the countries within the preferential trading agreement. The European Union and NAFTA (North American Free Trade Association) are examples of these, while the countries within the agreements benefit, the ones outside do not which puts a serious block on some developing countries growth. I will be making use of economic theory to examine this. For ease of explanation and due to space limitations, I will only be looking at the static economy, it is static in the sense that it is restricted by its assumptions as they appear unrealistic, but analysis of this type does make conceptual understanding far easier. Before we begin, I feel that it is important for me to distinguish between 2 types of PTA, a free trade area which is a group of countries with no trade barriers between themselves and a customs union which is a free trade area with common external tariffs and quotas. These terms are very important as they are where some of the comparisons lie in the relevant theories, the first of these looking at production effects, trade creation and trade diversion before briefly examining the free trade vs. customs union issue in the same terms. I will then look at these concepts in relation to consumption effects before looking at some of the factors that will in theoretical terms create a greater gain in welfare. I have previously mentioned the assumptions and they are included in the paragraph below. There are only 3 countries, A, B and C, A and B always form a union and C is the rest of the world, Tariffs are the only instrument of trade policy, there is perfect competition, production costs per unit of output are constant and directly determine retail prices and the economies are static with no expectations. There are also no new goods, no innovation and no depreciation of capital stock. All goods and services are homogeneous and have unit income elasticity’s of demand; there are no non tradable commodities, no intra union trade and no inventories. As far as intervention is concerned, fiscal and monetary operations are ruled out and country C which falls outside the union is assumed not to retaliate. The most accepted theory on trade creation and trade diversion was supplied by Viner in 1950 Fig 1 Country A B C Price 35s 26s 20s Source: Theory of Customs Unions: A General Survey by RG Lipsey Economic Journal Vol 70 Sept – Dec 1960 p497 If country A levied a Tariff of 100%, it would be enough to protect its domestic market that is producing commodity X. If A formed a customs union with B it would only have to pay 26s instead of 35s., this is trade creation. Now before the existence of the customs union A would have had to pay a tariff on goods imported from B and C, she would always buy goods from C as they are produced at the cheaper price. However with the formation of the customs union with B, the tariff which was say 50% is waived, and A will buy from B as opposed to C who is producing the good more efficiently. This is how Viner described trade diversion, trade is being diverted from a lower to a higher real cost source. What this means is that B is sufficiently tariff protected to eliminate competition from C which will secure A’s market for B’s inefficient industry. However A and B are both producing the product inefficiently and a customs union is formed then B will capture the union market at the expense of A, this is trade creation which results from trade diversion. Viner always regarded trade creation as good and trade diversion bad. “Where the trade creating force is predominant, one of the members at least must benefit, both may benefit, the combined two must have a net benefit, and the world at large benefits; but only the outside world loses, in the short run at least, and can gain in the long run only as a result of the general diffusion of the increased prosperity of the customs union area.
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