CUSTOMS UNIONS AND FREE TRADE AREAS

(IM"=US). Once more, trade creation (the production effect a and

the consumption effect ¢) would clearly exceed trade diversion b,
although the trade creation effects would be smaller than in the
case of the free trade area.

The principal difference between the two alternative situations

would arise for country P. In the case of the customs union its
consumers would suffer a consumption loss, denoted by d.
Although its producers would enjoy a net gain, there would be
an adverse production effect, denoted by e. In the case of the
free trade area there would be no loss from the production and
consumption effects, but there would be a gain in government
revenue that was larger than the net gain that would accrue to
country P with the customs union. In the case of the customs
union, moreover, trade with the rest of the world would be
eliminated, whereas it would increase in the alternative of the
free trade area.

Taking these considerations into account, the customs union

alternative can be said to be inferior to the free trade area
arrangement if judged purely in terms of static efficiency
considerations. The difference between the two alternatives
results essentially from the indirect trade deflection that occurs
in the free trade area case, which rules of origin cannot prevent.
In limiting cases this may make a free trade area equivalent in
its effects to a customs union that takes the lowest pre-union
tariff as the basis of the common external tariff. Evidently, if
there are transport costs, which have so far been ruled out, the
more geographically dispersed are the members of a free trade
area, the smaller is likely to be the indirect trade deflection
that results.

2. A second case will now be considered in which, unlike the

first, a price differential would arise for the product in the free
trade area. In this case country P’s supply is again assumed to be
relatively competitive and elastic, but it is now assumed to be
incapable of satisfying country H's demand (Figure 2.4).

Before the free trade area is formed, both countries are

assumed to have prohibitive tariffs. Country P produces and
consumes M, and country H produces and consumes N. If a free
trade area were formed (Figure 2.4a), country P’s supply at price
T, would be incapable of satisfying the extra demand in country
H, and the equilibrium free trade area price in country H would
therefore be Pp, (L'N'=0OM"). At the same time, the price in
country P could not rise above 7}, at which level imports from

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