CUSTOMS UNIONS AND FREE TRADE AREAS

to have similar demand conditions; but country H is a relatively

inefficient producer, whereas country P’s supply curve is relatively
elastic and competitive, although above world market price P for
outputs in excess of L”.

Before the free trade area is formed, country P consumes and

produces M at price Ty, its tariff keeping out all imports. Country H
produces Z and consumes N, the difference ZN being imported at
price Py from the lowest-cost source, namely the rest of the world.
Customs revenue in country H is denoted by LNXP Ty.

If countries H and P formed a free trade area (Figure 2.3a),

area supply at price 7, (=OM+OL") would clearly be less than area
demand at that price (M+N"), but the difference (L’V) would be
less than country P’s capacity to supply at that price. In a free
trade area that excluded the least-cost source of supply, country
P would supply country H's market with Z'N" (=L"M) at price 75,
leaving an amount equal to OL” for its home market, its remaining
requirement (L”M) being imported from the rest of the world at
price Py. In this case after integration there would be a single
equilibrium price in the free trade area that would be equivalent
to the lower of the two members’ prices before the establishment
of the free trade area.

It can be seen that in country H the production effect a

(Vinerian trade creation) plus the consumption effect ¢ would
outweigh the cost of trade diversion (stippled area b). The
difference between the cost of trade diversion, b, and the initial
customs revenue represents an internal transfer from the exchequer
to consumers and not a loss of real income to the community. In
country P the same amount would be produced and consumed
as before, at the same price, but government revenue would
increase by an amount that equalled the hatched rectangle. This
would represent a national income gain to country P. As far as
he rest of the world is concerned, its exports would clearly be
larger than before (L”"M>LN) because of the shifting of country
P’s supply to satisfy country H's demand. The free trade area would
represent an improved position for both countries and also,
presumably, for the rest of the world.

This outcome may next be compared with that which would

result if instead countries H and P formed a tariff-averaging customs
union (Figure 2.3b). In this case it can be seen that union supply at
price CET would be greater than demand, so that the common
external tariff would set only the upper limit of the price. The
equilibrium price would be Pg, where supply equalled demand

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