Economics of a Customs

Union

Making A European Market N.Dytianquin 1

European Studies program University of Maastricht
 AGENDA
• To apply Vinerian analysis to explain the static
effects of a customs union
• To explain the dynamic effects of a customs
union

Making A European Market N.Dytianquin 2

European Studies program University of Maastricht
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
 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

Making A European Market N.Dytianquin 3

European Studies program University of Maastricht
ECONOMIC EFFECTS OF INTEGRATION
 Static welfare effects (immediate one-off effects)
trade creation vs trade diversion, trade suppression
 Dynamic welfare effects (medium to longer run):

 economies of scale  growth effects

 pro-competitive effects  increased technical
 terms of trade effects progress
 learning effects  factor price equalization
effects
 agglomeration effects
Note: some dynamic effects occur with higher
form of integration (e.g. , single market)
Making A European Market N.Dytianquin 4
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TRADE CREATION/DIVERSION

A B C
Tariff - 100% 100%
Production costs 60 25 35
Price in A before CU 60 50 70
Price in A after CU with B 60 25 70
Price in A after CU with C 60 50 35

Making A European Market N.Dytianquin 5

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Trade Creating CUs

Home country unites with Country B

P Welfare Effects
CS = +a+b+c+d+e+m+f+g+h+k
PS = -a-e
TR = -c-g
NET = +(b+m+f) + (d+h+k)
Pb+t a Sb+t
Pc b c d Sc
e m f g h k Sb Quantity imported
Pb With tariff: Q Q 3 4
With trade creation: Q1Q6

Q 1 Q2 Q3 Q4 Q5 Q 6 Q

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 Trade Diverting and Suppressing CUs
Home country unites with Country C Welfare Effects
CS = +a+b+c+d
P PS = -a
TR = -c-g (but g is called trade diversion)
Trade diversion = -g (Country A now buying
quantity of imports Q3Q4 from country C instead
of at cheaper price from country B)
NET = +(b+d) – (g)

Pb+t a Sb+t gain in DWL trade diversion

Pc b c d Sc If country A traded with cheapest country B it
would have imported more at Q1Q6 but now
e mf g h k Sb imports Q Q from country C. Trade
Pb 2 5 suppression
is Q1Q3+ Q4Q6 or areas (m+f)+(h+k) from country
B as this is the quantity of imports that
contravenes comparative advantage. Quantity
Q1 Q2 Q3 Q4 Q5 Q6 Q Q3Q4 originally imported from country B is now
bought from partner country C.
Note: the closer Pb and Pc are, the smaller trade diversion is in comparison to
gain in deadweight loss (DWL)
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 INCIDENCE OF EFFECTS
CUs likely to increase welfare if:
 Production structure: more complementary than
substitutive: (the more diversified, the more opportunities for specialization)
 Size of the union: (the greater the size, the greater the likelihood of a low
cost producer)
 Level of initial tariffs: (the higher the level of initial or pre-union tariff, the
greater the possibility for trade creation)
 Initial cost differences: (the smaller the differences in costs of production
between members and third countries, the greater the likelihood for trade creation)
 Transportation and transaction costs: (the closer the countries are
geographically, the lower the transport costs of moving goods)
 Flexibility/adaptability of the CU members (institutional
structures): (the greater the trade flows and economic relations between the
countries before forming the CU, the greater the scope for integration)

Making A European Market N.Dytianquin 8

European Studies program University of Maastricht
Why are there dynamic gains in a
CU/Single Market?
There are additional gains to a CU over time because of:
 increased competition leading to greater technical efficiency (“cold
shower” effect)
 changes in efficiency as economies of scale are utilized in the course
of integration
 increased competition between firms erodes market power as
national firms cross borders which also creates new urban centers
 the existence of more product varieties available to consumers
 Learning and exposure to new technologies and labor skills/
expertise as capital and labor move
These gains are grouped under the heading of dynamic gains from
market integration in contrast to the static gains which arise from
resource reallocation within countries

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 ECONOMIES OF SCALE EFFECTS

 Economies of scale in production for a firm imply that average

costs fall as output is increased. This is shown by a fall in the
long-run average cost curve of the firm (decreasing costs).
 Scale economies may be associated with the size of plant
(engineering economies, or the length of the production run), or with
the size of the firm, reducing per unit R&D and marketing expenditure
which are now spread over a larger output volume. Such economies
are known as internal economies of scale.
 External economies of scale are associated with the expansion
of an industry which lead to the cost curves of firms within the
industry falling as total output is increased. They may be due
to the development of specialized services or improvement of
marketing facilities resulting from the expansion of industry
output.
 Internal economies of scale imply imperfect competition and
economic integration will have pro-competitive effects as
segmented markets are brought together. External economies of
scale do not imply any change in market structure.

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 ECONOMIES OF SCALE EFFECTS-2

Pre-union:
Domestic price at home = World price + own tariff : we assume prohibitive
tariffs ( so no imports from rest of the world, thus no revenue effect lost)
Post-union:
Domestic price of union = World price + common external tariff CET (t*)
Making A European Market N.Dytianquin 11
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 ECONOMIES OF SCALE EFFECTS-3

• Welfare effects of economies of scale

• COUNTRY H (Home Country)
– Consumers in Country H after formation of CU gain area A + B on account of
cheaper prices after integration.
– If Home were producing the good before the union, then A represents the
producer surplus but this gets lost when it buys from the Partner country after the
union, so A as producer surplus cancels out.
Area F represents trade diversion since after formation of the union, Country H
imports from the union member country and not from the cheaper supplier from
the rest of the world and could have bought the good at a cheaper price.
• COUNTRY P (Partner Country)
– For the partner country who is the efficient producer there is a gain of area C+D,
of which C also represents the cost-reduction effect of being able to produce the
good at a cheaper price since the partner country enjoys economies of scale and
is now facing a larger market by producing for country H as well. Areas C+D
represents the increase in consumer surplus due to lower prices after integration
and area E is the increase in producer surplus of Partner country by supplying
Home country production as well. This could be viewed as trade suppression as
this quantity of additional production could have just been imported from the rest
of the world.

Hence the total net welfare effect for both countries inside the union is
(+A+B+C+D+E) - F
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WELFARE EFFECTS: ECONOMIES OF SCALE

Home Post-Union Pre-Union Net

CS +A+B + A+B
PS -A +A – F –F
Total +B +A – F +A+B –F

Note: tariffs were prohibitive so no government revenue was lost in the post-union case since
home country was not importing in the pre-union case. Otherwise, if the tariffs were not
prohibitive, there would be a revenue effect in the post-union case

Partner Post-Union Pre-Union Net

CS +C+D +C+D
PS +E – C +C +E
Total +D+E +C +C+D+E

Union-wide Post-Union Pre-Union Net

CS +A+B+C+D +A+B+C+D
PS -(A+C)+E +A+C −F +E−F
Total +B+D+E +A+C −F +A+B+C+D+E−F
Making A European Market N.Dytianquin 13
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COMPETITION EFFECTS

 In imperfect competition firms exercise

market power to the extent that price
exceeds marginal cost
 By increasing the size of the market,
economic integration reduces the extent of
monopoly pricing practices. Prices fall, and
consumer welfare increases by more than
producer surplus falls, as shown on the
next slide.

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 COMPETITION EFFECTS - 2

Welfare Effects
CS = +(a+b+c+d)
S=MCSR PS = -(a+b)
Pm NET =+(c+d)
Before integration, profit
b maximization induce the
a c
d monopolistic home country
Pc firm to produce Quantity Qm
AC=MCLR=LS which it sells at Pm.When this
D=AR country joins a customs union,
prices fall to Pc and
MR consumers increase
consumption to Qc made up
of Qm produced domestically
Qm Qc plus imports of QmQc from
the customs union.
Making A European Market N.Dytianquin 15
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 COMPETITION EFFECTS - 3
• Another side effect of the competition effect is the
inducement by local firms in home market to:
– reduce excess profits (economic rents);
– reduce X-inefficiencies and
– restructure their operations to achieve
economies of scale
• Economic rents consist of margin of excess
profits or wage rates from market protection
existing in the home market BEI
• X-inefficiencies: firms not producing at minimum
average costs (due to slack in decision-making,
overstaffing, waste, bureaucracy, red tape, excess
overhead costs or excess inventories) or state
intervention (licensing system, taxation or subsidy)
• foreign seller able to reduce additional direct and
indirect costs (e.g., delays at the border to check
papers, costs of differing technical regulations,
inefficient production and marketing costs as BEI ― before economic integration ;
foreign firms adjust to new markets in a member AEI ―after economic integration
state) Source: Adapted from Nello (2012), p. 124

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OTHER DYNAMIC EFFECTS

• Price convergence effects

Goods market integration should ideally lead to price convergence or
same prices for identical goods within the EU. When goods are higher in
one member state, free mobility of goods will make its citizens buy
more goods from members states with lower prices so there will be
pressure to lower prices until they are equal with the other member
state. This assumes of course the transportation costs will not outweigh
the price advantage of buying from a cheaper country.

• Learning effects
Benefits of technological learning and sharing of R&D activities and
spending on key technologies of interest to member states. Integration
could also facilitate catching up of technological laggards with
technological frontrunners, and could also hasten technology diffusion.

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TECHNOLOGICAL LEARNING EFFECTS

Source: EU Innovation Scoreboard 2012

Making A European Market/ International N.Dytianquin 18
Economics Skill European Studies program University of Maastricht
 OTHER DYNAMIC EFFECTS

• Terms of trade effects

When small countries band to form a
customs union, they become large Imports
enough to generate market power and TOT 2
influence world prices. TOT 1
CU Member
ROW
Trade-diverting CUs are assumed to
alter terms of trade in their favor by
lowering import prices of non-
members. This depends though on
elasticities of domestic and foreign
demand and supply and level and
structure of tariffs before integration.

CU improves its terms-of-trade.

TOT line becomes steeper and offer Exports
curve of CU with ROW shifts to the left
indicating lesser volume of trade than
pre-union (trade suppression).

Making A European Market/ International N.Dytianquin 19

Economics Skill European Studies program University of Maastricht
 Goods Integration in the EU
Triangular framework
• Approximation
– Cooperation and
harmonization of rules and
procedures
• Liberalization
– Removal of tariffs and quotas,
deciding of common external
tariff, removing border
controls
• Regulation
– Common policies in trade,
competition, agriculture and
coal and steel
Supported by flanking policies on transport and
exceptions (derogations) on military goods,
state-owned firms and intellectual property

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 Goods Integration in the EU -2

• Problem with framework is lack of mother principle to link

them
• Two conflicting approaches
– Economic approach (ideal involving full goods market
integration)
– Policy approach (involves only removal of frontier and border
controls and depends on explicit provisions of the Rome Treaty)
• Rome Treaty consists of 4 elements
– Tariff union
– Indirect tax union
– Abolition of internal quotas
– Uniform external quota liberalization
But silent on common external quota on non-members

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 Goods Integration in the EU -3

• New regulatory strategy for goods integration has 5

principles
– Non-discrimination (national regulation should not favor domestic
over other EU goods)
– Dasonville test (all trading rules capable of hindering movement
of goods)
– Mutual recognition (goods deemed to have passed SHEC in one
member state should be mutually accepted in another)
– Proportionality (if an objective is pursued in national legislation,
regulatory obligations should be proportional to that objective)
– Burden of proof (burden of proof of showing that SHEC needs a
national restriction falls on member creating the barrier)

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Goods Integration in the EU -4
Barriers in free mobility of goods

• Physical frontiers
– eliminating frontiers implied either eliminating border checks or
moving checks elsewhere (plant health, statistics)
• Technical standards
– mutual recognition replaced harmonisation of standards
• Public procurement
– tiny share of cross-border purchases; rules on tendering
• Fiscal differences
– original concern was with indirect tax differences because of the
role of frontier checks in policing trade
– more recent ‘level playing field’ concerns (corporate profits tax)

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 Goods Integration in the EU -5
• Further deepening in goods market needed in
– Reducing trade costs and removing home bias
• Home bias due to language differences, information barriers,
contracting costs and insecurity, lingering regulatory barriers,
different currencies (non-existent now)
– Increasing intra-EU trade
• 8-16% increase in EU trade from 1999 data compared to
expectations of 30% to 90%
– Increasing price convergence
• At least for identical goods but difficult to achieve because of
– Prevailing price structures
– Oligopolies (price rigidity)
– Distribution structure
– Consumer behavior (different elasticities and product differentiation)

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