30056

European Economic Policy

The Classic Theory of FTA and CU
Globalization

Video 1

Video 2
Globalization

Extract from Joe Biden’s electoral program for the US Presidency, 2020
US vs. China Trade War
US vs. China Trade War
Globalization

• Video 3

• Video 4
Learning objectives for this group of lectures:

• Understanding the rationale for economic integration among

countries

• Understanding and comparing different forms of protectionism

• Understanding the working of Free Trade Areas (FTAs) and Customs

Unions (CUs)

• Understanding pros and cons of FTAs vs. CUs

Economic Integration
 Theory of Economic Integration

• The theory of economic integration studies how intermediate

situations between pure protectionism and free trade affect
efficiency in the use of resources for every country.

Free trade Full protection

no restriction to Protectionism with: Autarky is the highest level
import and export - Tariff / custom duties of protectionism (no import
- Quantitative restrictions (quotas) allowed) as it leads to the
- Standards / regulations closed-economy equilibrium.

Two typical arrangements are studied: Free Trade Areas (e.g. NAFTA), Customs
Unions (e.g. EU)

Fundamental hypotheses: perfect competition and “small country”

 Recall: D and S

p
DH SH • DH = domestic demand in H→
maximum price for each unit of the
good that consumers in H are willing
to pay

• SH = domestic supply in H→
minimum price @ which producers in
H are willing to sell each unit of the
good

q
 Hypotheses

Consider one country H and

one homogeneous good,
produced both @home as p DH SH
well as somewhere else in
the world

• perfect competition
• insignificant transport costs
• upward sloping domestic pw Sw
supply SH
q
A B
• world supply Sw perfectly
elastic @ price pw => small
country hypothesis
 Free trade

p DH SH

pw Sw

q
O A B

Free trade

• OA = Domestic supply
• OB = Domestic demand
• AB = Imports from RoW
 How to achieve protection?

One possibility is represented by tariffs.

A tariff can be calculated according to two main formulas:

– Ad valorem: TH = Pw (1 + t)
eg, If Pw = 40 EUR and t = 20% -> TH = 40 EUR (1 + 0.20) = 48
EUR

– Specific: TH = Pw + T
eg, If Pw = 40 EUR and T = 8 EUR -> TH = 40 + 8 = 48 EUR

We will mostly consider SPECIFIC tariffs in this set of slides.

Autarky – prohibitive tariff

p DH SH

pw+ T = TH = pH

pw Sw

q
QH

Autarky
• pw + T = pH; T is the “prohibitive” (specific) tariff
• QH = Domestic supply = Domestic demand => autarky
• There are no imports from the rest of the world
 Autarky vs free trade

p DH SH

pw+ T = TH = pH

pw Sw

q
A B
QH

What situation makes consumers better off? What is best for producers?

…how can you answer this question?

How to evaluate agents’ welfare?
 Changes in PS and CS

p p
D S

a p1 c
p1
Change in Change in PS
p2 CS b p2 d

q q
If price decreases consumers …while producers are
are better off by the area in worse off by the area in
figure on the left (trapezoid figure on the right
p1p2ba)… (trapezoid p1p2cd).

The net gain for the country is the difference between these two areas

NOTE: in case the government is involved (tariff revenues), we have to take into account that, too!!
 From free trade to autarky - change in PS

p DH SH

pw+ T = TH = pH

Price goes up → producers are better-off

T

pw Sw

q
A B
QH
 From free trade to autarky - change in CS

p DH SH

pw+ T = TH = pH

Price goes up → consumers are worse-off

T

pw Sw

q
A B
QH
From free trade to autarky - change in total welfare

p DH SH

pw+ T = TH = pH
Consumers lose some surplus…which
T does not increase PS → net loss

pw Sw

q
A B
QH
Non-prohibitive tariff tools

We can distinguish three main tools through which protectionism can be

implemented:

- Tariffs (specific or ad valorem)

- Quotas (i.e. quantitative restrictions to imports)
- Non-Tariff Barriers (NTBs), e.g. safety standards
https://www.nzmeatboard.org/quotas/eu-sheepmeat-and-goatmeat
 Non-tariff barriers

• Non-Tariff Barriers are determined by the set of rules that each country
imposes to regulate industrial production methods, safety standards,
environment, consumer protection, etc.
• Sanitary and phytosanitary measures refer to restrictions for substances and
measures for preventing dissemination of disease (such as certification, testing and
inspection and quarantine).
• For example, the EU prohibits the placing on the market and the import of meat treated with
certain hormones and of chlorine-washed chicken.
• Another example: kinder eggs in the US
• Technical measures refer to labelling and other measures protecting the
environment, standards on technical specifications and quality requirements (e.g. to
flammability or azo dyes).
• These requirements (legitimate when they aim at preserving consumers’ health)
constitute a burden on producers and build a complex layer of multiple requirements
constituting additional costs (thus higher prices).

VIDEO : Why a MINI ready for the European market cannot be sold in the U.S
 Non-prohibitive tariff

p DH SH

pH

pw+T= TH Supply with tariff T

T
pw Sw
q
A A’ B’ B

Non-prohibitive tariff

• TH=pw+T (specific tariff T) or TH=pw (1+ t) (ad valorem tariff t)

• OA’ = Domestic supply; OB’ = Domestic demand;

• A’B’ = imports from the rest of the world => smaller than AB
 RECAP - The “classic” theory of Economic Integration
Free trade vs. Autarky
*
Country “Home”
Hypotheses
DH SH
p • consider one country H and one homogeneous good

pw+ T = TH = pH • perfect competition in goods and factor markets

• insignificant transport costs and balanced current account
T
• upward sloping domestic supply SH
pw Sw
• pH = internal equilibrium price of country H; pw = world prices < pH
O A QH B q
• World supply Sw (perfectly elastic => small country hypothesis)

Free trade Autarky

• OA = Domestic supply • pw + T = TH = pH ; T is the “prohibitive” (specific) tariff
• OB = Domestic demand • OQH = Domestic supply = Domestic demand
• AB = Imports from RoW • There are no imports from the rest of the world
 RECAP - The “classic” theory of Economic Integration
Free trade vs. Protectionism
*
Country “Home”
Hypotheses
DH SH
p • consider one country H and one homogeneous good (e.g., apples)

pH • perfect competition in goods and factor markets

Pw(1+t) = TH • insignificant transport costs and balanced current account

• upward sloping domestic supply SH
pw Sw • pH = internal equilibrium price of country H; pw = world prices < pH
O A A’ B’ B
q • World supply Sw (perfectly elastic => small country hypothesis)

Free trade Protectionism

• OA = Domestic supply • [pw (1+ t)] = TH (ad valorem tariff t)
• OB = Domestic demand • OA’ = Domestic supply; OB’ = Domestic demand;
• AB = Imports from RoW • A’B’ = imports from the rest of the world => lower than AB b. of tariff
 A numerical example

p
A numerical example of a protectionist policy
20
DH SH Suppose that the demand curve in country H, DH, is q = 20-p, while
the inverse supply curve SH is q = p-2.

Equilibrium quantity and prices in H in this case would be,

11 respectively, QH = 9 and pH = 11.

4 Sw If the world price of the considered good is pw = 4 and country H

adopts a free trade policy, then the total demand of consumers in
2 9 16 q country H will increase to 16 (by solving q = 20-p, with p = 4), with a
domestic production of 2 (by solving q = 4-2) and imports 14, the
difference between total demand and domestic supply.
 A numerical example

p
Suppose now that country H, in order to stimulate local production,
20 decides to apply a specific tariff T = 3.
DH SH
We will have that the final price of the imported good faced by the
consumers in H will increase, and notably we will have TH = pw + T =
7. The higher price of the imported good will reduce total demand to
11 q = 13 of which 5 (by solving q = 7-2) will be produced locally while
8 will be imported.
7
T=3
4 Sw If a specific tariff T = 7 is set, than TH = pw + T = 11 = pH and hence
all the resulting total demand of 9 will be served by domestic
production, with no imports from the rest of the world: T=7 would
2 5 9 13 16 q thus be a prohibitive tariff.
Free Trade Areas
and
Custom Unions
Regional Integration Agreements (RIAs)

• RIAs are groupings of countries formed with the objective of reducing

barriers to trade between members of the group

• They constitute a driving force of globalization, and are permitted by the

WTO rules under article XXIV of GATT

• EU is a prominent example of RIA

• As of January 2020, 303 RIAs are in force (see full list here)

• Almost all countries are nowadays members of a RIA, with more than 1/3
of global trade taking place within RIAs

• Two main modes: “Free Trade Areas” vs. “Customs Unions”

Trade agreements between countries

2 countries: Home (H) and Partner (P)

H P Starting point: protectionism with all trade

partners
i.e. H and P maintain positive tariffs TH, TP
Rest of between themselves.
the = Protectionism (TH,P > 0)
World

H P H and P now set zero tariffs between them (free trade).

= free trade (TH,P = 0)

Two possibilities: Free Trade Area (FTA) and Customs Union (CU)

H P H P

Rest of Rest of
the the
World World

Free Trade Area H-P Customs Union H-P

Countries maintain Countries agree on a unique
individual tariffs TH, TP with Common External Tariff with
the RoW but liberalize trade the RoW and liberalize trade
between themselves between themselves
NAFTA/USMCA (US, European Union - 1969
Canada, Mexico)

= free trade (TH,P = 0) = protectionism (TH,P > 0)

 customs union - a group of states that have agreed to charge the same import duties as each other and usually to allow free trade between
themselves.

The EU is a customs union

There is free trade among EU members.

A product coming from another country has
the same treatment (e.g. tariff) independently
of the point of entry in the EU.

Common external tariff (CET)

 Trade deflection

• Suppose that a Free Trade Agreement (FTA) is in place between countries

Home (H) and Partner (P);

P • Suppose that country P autonomously decides to have free trade with

H country C while country H keeps its protectionist policy vis-à-vis
country C (OK in a FTA, impossible in a Customs Union).
For example:
C P is Mexico, that has a free trade agreement with the U.S. (H) and with the
European Union (C).
But there is no free trade agreement between the EU (C) and the US (H),
thus still tariffs between H and C.

If you are based in Europe (C), you can export duty-free to Mexico (P)
but it you want to export from Europe to the U.S. (H), you have to pay the tariff
What if, in order to avoid the American tariff, first you export duty-free to Mexico, and then you
re-export the same product from Mexico to the U.S.?

This phenomenon is named: (direct) trade deflection

 The rules of origin to prevent trade deflection

To prevent trade deflection that shrinks country H’s -

Another example of US’s - tariff revenues, the agreement (such as the
trade deflection: NAFTA/USMCA) writes down rules of origin to
assess the nationality of traded goods.

Rules of origin: only goods that have “origin” in the

H tH/P=0% P FTA (H and P) can freely circulate between H and P.
How to assess this? Only goods whose value
tH=10% tP=6% added is mostly created in P are said to have
Rest of “origin” in P
the World = Free trade only for products made in the FTA
= tariff TH

Goods manufactured in C entering country H, directly

or indirectly (via P), have to pay TH

If H and P are in a Customs Union, no need to check nationality of imported goods, the tariff is the
same in the entire CU.
If instead H and P are in a FTA, there should be custom controls to check the origin…
 The rules of origin in Free Trade Agreements

• There is no harmonised set of rules of origin (RoO) but there are some common provisions
entailed in free trade agreements (WTO page).

• While product-specific rules of origin differ between different sectors, general rules of
origin normally apply to all sectors (video).

• There are two basic criteria for determining the origin of products:
1. Wholly obtained or produced: it applies to commodities and related products that have
been entirely grown, harvested or extracted from the soil in the territory of that member
country or have been manufactured exclusively from these products (e.g. plants, animals
born and raised, fish when caught in the territorial waters).
2. Sufficient working or processing (sufficiently transformed): for complex products
there are different criteria such as:
• Changes in tariff classification;
• Percentage of regional value content.
NAFTA’s rules of origin and automotive maquiladoras (FDIs) in
Mexico

36
The Economics of Free Trade Areas
and
Customs Unions
 The Setup
• Let’s consider the demand for an homogeneous good in two countries: home (H) and partner (P).
• Both countries can produce the good (SH and SP)…
…or they could buy it from the rest of the world at price pw (SW)
Notice: SP is flatter than SH : for all prices, P can supply more units of the good than H (= P is
more efficient than H in producing the good)

Country “Home” Country “Partner”

p DH p
SH DP

SP

pw Sw pw Sw
q q

We will analyze the consequences of the creation of a FTA or a CU between H and P under
different circumstances
 FTAs - Four cases to be considered

both in H and P large «enough»

Prohibitive tariff Country P is
only in P not large «enough»

Country P is
large «enough» not large «enough»
both in H and P case 1 case 2
Prohibitive
tariff only in P case 3 case 4
 Case 1

Hypotheses:
• Let’s consider two countries: home (H) and partner (P)
• Prohibitive tariff TH in H: OHQH is domestically produced and consumed, no imports from RoW
• Prohibitive tariff TP in P; OPQP is domestically produced and consumed, with no imports from
RoW

Country Country
“Home” “Partner”
p
DH SH p
DP

TH = pH
SP
TP= pP
pw Sw pw Sw
OH QH q OP QP
q
 Case 1
Then:
• A Free Trade Area is formed: goods can freely circulate between H and P
• Each country maintains autonomous trade policies with RoW (tH  tP) → rules of origin ensure
that only products originated or mainly produced in the area are entitled to be freely exchanged.
• H has access to P’s production: we can draw the supply SH+P…
• …and the effective supply under the FTA (SH,FTA), which takes into account that P can supply up
to OPQP at the price pFTA = pP
• At the price pFTA = pP country H’s demand of imports from country P is represented by the
quantity CD
• P exports EQP =CD. It satisfies its demand OPQP by producing domestically OPE and importing
EQP from the rest of the world (indirect trade deflection) at price pw (consumers pay the after-
tariff price Tp)
• NOTICE: P is “large enough” to be able to satisfy H’s demand of imports at the price pFTA = pP

Country Country
p “Home” “Partner”
DH SH p
DP
SH,FTA
TH = pH
SP
SH+P
pFTA = pP TP= pP
pw Sw pw Sw
OH C QH D q OP E QP q
 Case 1
Welfare analysis - HOME:
• Consumers in H gain from the FTA because they can now
buy the good at price pFTA=pP<pH
→ ΔCS= A
p
DH SH
1
• The net effect for country H is
TH = pH → ΔCS - ΔPS= A - B = 1 + 2
SH,FTA
A SH+P DH SH
pFTA = pP 1
pw Sw
q TH = pH
OH C QH D
B A1 2 SH,FTA
• Producers in H lose from the FTA because they can now pFTA = pP
sell fewer units at price pFTA=pP<pH pw SH+P Sw
p → ΔPS= B
DH SH OH C QH D q
1
TH = pH
SH,FTA
B A
pFTA = pP
pw SH+P Sw
OH C QH D q
 Case 1
Welfare analysis - PARTNER:
• Consumers in P consume the same quantity OPQP under the
FTA than in autarky (recall: OPE is produced domestically and
is EQP is imported from RoW)
p
DP
• The government in P gains the tariff revenue
→ ΔGS = 4
SP

pw Sw
p
OP E QP
q DP

• Producers in P produce the same quantity OPQP under the

FTA than in autarky (recall: OPE is consumed domestically SP
and is EQP exported)
p
DP 4
pw Sw
OP E QP q
SP

pw Sw
OP E QP
q
 Case 1
Welfare analysis - RECAP:
• H gains from the FTA in that its consumers can now buy the good at price pFTA=pP<pH =>
trade creation (1) + (2)
• H does not experience trade diversion (which happens when a country changes trade partner)
→ the effect on H is unambiguously positive: (1) + (2)

• P satisfies its demand OPQP by producing domestically OPE and importing EQP from the rest
of the world (indirect trade deflection); the Government gains the revenue on the imported
goods (4).
→ the effect for P is unambiguously positive (4)

Country Country
p “Home” “Partner”
DH SH p
DP
SH,FTA
TH = pH
SP
1 2 SH+P
TP= pP
pFTA = pP
pw pw
4 Sw
Sw
OH C QH D q OP E QP q
 Case 2

Hypotheses:
• Let’s consider two countries: home (H) and partner (P).
• Prohibitive tariff TH in H; OHQH is domestically produced and consumed , with no imports from
RoW.
• Prohibitive tariff TP in P; OPQP is domestically produced and consumed, with no imports from
RoW.
• P is not “large enough” (more on this in the next slide)

Country Country
“Home” “Partner”
p
DH SH p

DP
TH =pH
SP

TP= pP
pw Sw pw Sw
OH QH q OP QP
q
 P uvozi po ceni Pw, a placa
Case 2 tarifu sama sebi Pp tu
Then: profitira
• A Free Trade Area is formed: goods can freely circulate between H and P
• Each country maintains autonomous trade policies with RoW (tH  tP) → rules of origin
ensure that only products originated or mainly produced in the area are entitled to be freely
exchanged
• H has access to P’s production: we can draw the supply SH+P…
• …and the effective supply under the FTA (SHFTA), which takes into account that P can supply
only up to OPQP at the price pP
• Notice: pFTA > pP because country H’s demand of imports from country P at price pP can’t be
satisfied (P is not “large enough)!
• At pFTA , H’s demand for imports is represented by the quantity CD
• P exports OPE =CD. It satisfies its demand OPQP by importing OPQP from RoW (indirect
trade deflection) at price pw (consumers pay the after-tariff price Tp)

Country Country
p “Home” “Partner”
DH SH p
DP

TH =PH
SP
SH+P SH,FTA
pFTA
pFTA
pP TP= pP
pw Sw pw Sw
OH C QH D q OP QP E q
 Case 2
Welfare analysis:
• H gains from the FTA in that its consumers can now buy the good at price pFTA<pH => trade
creation (1) + (2)
• H does not experience trade diversion (which happens when a country changes trade partner)
→ the effect on H is unambiguously positive: (1) + (2)

• P satisfies its demand OPQP by importing OPQP from the rest of the world (max indirect
trade deflection); the Government gains the revenue on the imported goods (4)
• Producers export OPE to Home: ΔPS = 5
→ the effect for P is unambiguously positive (4 + 5)
Note that we observe price discrimination: price pP in P and price pFTA in H

Country Country
p “Home” “Partner”
DH SH p
DP

TH =PH
SP
1 2 1 SH+P SH,FTA
pFTA
pFTA 5
pP TP= pP
4
pw Sw pw Sw
OH C QH D q OP QP E q
 Case 3

Hypotheses:
• Let’s consider two countries: home (H) and partner (P)
• Less than prohibitive tariff TH in H; OHA is domestically produced and OHB demanded, AB is
imported from RoW
• Prohibitive tariff TP in P; OPQP is domestically produced and sold, with no imports from RoW

Country Country
“Home” “Partner”
p
DH SH p
DP

SP
TH
TP= pP
pw Sw pw Sw
OH A B q OP QP
q
 Case 3
Then:
• A Free Trade Area is formed: goods can freely circulate between H and P
• Each country maintains autonomous trade policies with RoW (tH  tP) → rules of origin
ensure that only products originated or mainly produced in the area are entitled to be freely
exchanged
• H has access to P’s production: we can draw the supply SH+P…
• …and the effective supply under the FTA (SHFTA), which takes into account that P can supply
up to OPQP at the price pFTA = pP
• At the price pFTA = pP country H’s demand of imports from country P is represented by the
quantity CD. NOTICE: H was importing from RoW and is now importing from P, because it
is cheaper! (trade diversion)
• P exports EQP =CD. It satisfies its demand OPQP by producing domestically OPE and
importing EQP from RoW (indirect trade deflection) at price pw (consumers pay the after-
tariff price Tp) Country
Country “Partner”
p “Home”
DH SH p
DP

SH,FTA SP
TH
SH+P TP= pP
pFTA = pP
pw Sw pw Sw
OH C A B D q OP E QP q
 3 je posto su oni pre uvozili AB
Case 3 po ceni Pw, a sada uvoze CD po
Welfare analysis: ceni Pp
• H gains from the FTA in that its consumers can now buy the good at price pFTA<pH => trade
creation (1) + (2)
• H experiences trade diversion (3): H substitutes imports AB at price pw with the same
quantity at price pFTA>pw, hence experimenting a loss (note that the government loss in tariff
revenues - area pwTH*AB - is partly compensated by consumer surplus)
→ the effect on H is ambiguous: (1) + (2) – (3)

• P satisfies its demand OQP producing domestically OPQP and importing EQP from the rest of
the world (indirect trade deflection); the Government gains the revenue on the imported
goods (4)
→ the effect for P is unambiguously positive ( )
Country Country
“Home” “Partner”
p
DH SH p
DP

SH,FTA SP
TH
1 2 SH+P TP= pP
pFTA = pP
3 4
pw Sw pw Sw
OH C A B D q OP E QP q
 Case 4

Hypotheses:
• Let’s consider two countries: home (H) and partner (P)
• Less than prohibitive tariff TH in H; OHA is domestically produced and OHB demanded, AB is
imported from RoW
• Prohibitive tariff TP in P; OPQP is domestically produced and sold, with no imports from RoW
• P is not “large enough” (more on this in the next slide)

Country Country
“Home” “Partner”
p
DH SH p

DP

SP
TH
TP= pP
pw Sw pw Sw
OH A B q OP q
QP
 Case 4
Then:
• A Free Trade Area is formed: goods can freely circulate between H and P.
• Each country maintains autonomous trade policies with RoW (tH  tP) → Rules of origin
ensure that only products originated or mainly produced in the area are entitled to be freely
exchanged.
• H has access to P’s production: we can draw the supply SH+P…
• …and the effective supply under the FTA (SHFTA), which takes into account that P can supply
only up to OPQP at the price pP
• Notice: pFTA > pP because country H’s demand of imports from country P at price pP can’t be
satisfied (P is not “large enough”)!
• At pFTA , H’s demand for imports is represented by the quantity CD
• P exports OPE =CD. It satisfies its demand OPQP by importing OPQP from RoW (indirect
trade deflection) at price pw (consumers pay the after-tariff price Tp)
• H was importing from RoW and is now importing from P, because it is cheaper! (trade
diversion)
Country Country
p “Home” “Partner”
DH SH p
DP

SP
TH SH,FTA
SH+P pFTA
pFTA
pP TP= pP
pw Sw pw Sw
OH C A B D q OP QP E q
 Case 4
Welfare analysis:
• H gains from the FTA in that its consumers can now buy the good at price pFTA<TH => trade
creation (1) + (2)
• H experiences trade diversion (3): H substitutes imports AB at price pw with the same
quantity at price pFTA>pw, hence experimenting a loss (note that the government loss in tariff
revenues - area pwTH*AB - is partly compensated by consumer surplus)
→ the effect on H is ambiguous: (1) + (2) + (3)

• P satisfies its demand OPQP by importing OPQP from the rest of the world (max indirect
trade deflection); the Government gains the revenue on the imported goods (4)
• Producers export OPE to Home: ΔPS = 5
→ the effect for P is unambiguously positive (4 + 5)
Note that we observe price discrimination: price pP in P and price pFTA in H
Country Country
p “Home” “Partner”
DH SH p
DP

SP
TH SH,FTA
1 2
SH+P pFTA
pFTA 5
pP 3 TP= pP 4
pw Sw pw Sw
OH C A B D q OP QP E q
The Economics of Customs Unions
 CUs – Intro
• In CUs, participating countries, apart from abolishing all trade restrictions among themselves,
also relinquish their ability of independently fix their tariffs towards the rest of the world in
favor of a Common External Tariff (CET)

→ the CET will be fixed at a level convenient for each member of the CU

• Once the CET is established, P cannot freely supply its production to H because it cannot
import from the RoW at its own tariff, only at the CET

→ P will only be willing to export to H its excess supply (which is positive as long as CET > P P)

both in H and P (case 1)

Prohibitive tariff
only in P (case 2)
 Case 1

Hypotheses:
• Let’s consider two countries: home (H) and partner (P)
• Prohibitive tariff TH in H: OHQH is domestically produced and consumed, no imports from RoW
• Prohibitive tariff TP in P; OPQP is domestically produced and consumed, with no imports from
RoW

Country Country
“Home” “Partner”
p
DH SH p
DP

TH = pH
SP
TP= pP
pw Sw pw Sw
OH q OP QP
q
QH
 Case 1
Then:
• A customs unions is formed: goods can freely circulate between H and P
• The trade policies of countries are common: a Common External Tariff (CET) is adopted w.r.t.
imports from RoW, such that TH < CET < TP (tariff averaging). No indirect trade deflection, so
no need of rules of origin. An agreement ensures the apportionment of customs revenues to each
country
• We consider a CET ensuring autarky of the integrated area (more on this in the next slide).
• H has access to P’s excess demand MP (P cannot import from RoW at pw as in the FTAs, but it
can import only at CET), so we can draw the supply SH+ MP …
• …and the effective supply under the CU (SHCU), which takes into account that P can supply up to
its excess of supply at all prices above pP
• The equilibrium free-trade price between H and P is exactly @ the CET. Country H’s demand of
imports from country P is represented by the quantity CD.
• P exports to H only its excess supply FE=CD. P satisfies its domestic demand OPF by producing
such quantity domestically.

p
DH SH Country p Country
DP
“Home” “Partner”

TH = pH
SH+ MP SH,CU SP
pP TP= pP
pw Sw pw Sw
OH C q OP q
QH D F QP E
 NOTICE
• We decided to set the CET exactly at the equilibrium free-trade price between members, for
simplicity.

• CET could be above it and nothing would change in our graph in terms of imports and exports.

• CET could be below it...what would happen then?

• Part of H’s demand for imports would be satisfied by the RoW, i.e. H would be importing from
both P (CD = FE, with no tariffs) and RoW (DE, subject to a tariff).

• So, the CET we have chosen in the previous one is the minimum one ensuring autarky of the
integrated area.

p
DH SH Country p Country
DP
“Home” “Partner”

TH = pH
SH+ MP SH,CU SP
pP TP= pP
pw Sw pw Sw
OH C D QH E q OP q
F QP E
 Case 1 – Welfare Analysis
HOME
• Before the CU:
Home’s consumption = Home’s production = OHQH
• After the CU is created:
Home’s consumption = OHD = OHC (domestic supply) + CD (imports from P)
ΔCS = A + B + C ΔPS = - A
ΔWH = A + B + C - A = B + C Internal price raises in P
and goes down in H.
Consumers are better off
PARTNER in H and worse off in P.
• Before the CU: Producers are worse off
Partner’s consumption = Partner’s production = OQP in H and better off in P.
• After the CU is created:
Partner’s production OPE = OPF (domestic consumption) + FE (exports to H)
ΔCS = - D ΔPS = D + E
ΔWP = - D + D + E = E

p Country Country
DH SH p
“Home” DP “Partner”

TH = pH
A
SH+ MP SH,CU SP
B C
pP TP= pP D E

pw Sw pw Sw
q OP q
OH C QH D F QP E
 Case 2

Hypotheses:
• Let’s consider two countries: home (H) and partner (P)
• Non prohibitive tariff TH in H: OHA is domestically produced, OHB is domestically consumed
and AB is imported from RoW
• Prohibitive tariff TP in P; OPQP is domestically produced and consumed, with no imports from
RoW

Country Country
“Home” “Partner”
p
DH SH p
DP

SP
TH
TP= pP
pw Sw pw Sw
OH q OP QP q
A B
 Case 2
Then:
• A customs unions is formed: goods can freely circulate between H and P
• The trade policies of countries are common: a Common External Tariff (CET) is adopted w.r.t.
imports from RoW, such that TH < CET < TP (tariff averaging)
• H has access to P’s excess demand MP (P cannot import from RoW at pw as in the FTAs, but it
can import only at CET), so we can draw the supply SH+ MP …
• …and the effective supply under the CU (SHCU), which takes into account that P can supply up to
its excess of supply at all prices above pP
• At the price CET, country H’s demand of imports from country P is represented by the quantity
CD. H experiences trade diversion: now, it imports from P (before, the partner was RoW)
• P exports to H only its excess supply FE=CD. P satisfies its domestic demand OPF by producing
such quantity domestically

Country Country
p “Home” “Partner”
DH SH p
DP

TH SH+ MP SP
pP SH,CU TP= pP
pw Sw pw Sw
OH C A BD q OP q
F QP E
 Case 2 – Welfare Analysis

HOME
• Before the CU:
Home’s consumption = OHB; Home’s production = OHA; Home’s import from RoW = AB
After the CU is created:
Home’s consumption = OHD ; Home’s production = OHC; Home’s import from RoW = CD
ΔCS = A + B + C + D ΔGS = - C - E Internal price raises in P
ΔPS = - A and goes down in H.
ΔWH = A + B + C + D - A - C - E = B + D - E Consumers are better off
Negative
in H and worse off P.
TRADE
CREATION welfare effect Producers are worse off
PARTNER due to TRADE in H and better off in P.
• Before the CU: DIVERSION
Government in H loses
Partner’s consumption = Partner’s production = OQP tariff revenues
• After the CU is created:
Partner’s production OPE = OPF (domestic consumption) + FE (exports to H)
ΔCS = - F ΔPS = F + G
ΔWP = - F + F + G = G
p Country Country
DH SH p
“Home” DP “Partner”

TH SH+ MP SP
A B C D
pP E
SH,CU TP= pP F G

pw Sw pw Sw
OH C A B D q OP F QP E q
Free Trade Areas vs. Customs Unions (compare case FTA3 to CU2)

FTA
Under standard
assumptions
(perfect competition, small
countries, etc…….),
Free Trade Areas...

….are normally more efficient than Customs Unions  In H trade creation effects (1 and 2)
are clearly larger under FTA (top) than
CU CU (bottom) agreements, while trade
diversion (3) is smaller (than E). This
is because CET>pFTA

 In P the FTA generates only positive

effects (indirect trade deflection 4)
with no reallocation of resources,
while the CU yields a positive effect
but a redistribution of resources from
consumers to producers (F)

The RoW improves its access to members countries’ markets under FTA (P starts importing the quantity
EQP>AB previously imported by H), while the situation is worse under CU (imports AB from H are
substituted with EF produced in P, which stays close to international markets).
 Discussion: FTAs vs. CU: which one to choose?
• NAFTA (North American Free Trade Area, i.e. US, Canada, Mexico) is shaped as a FTA. In fact, Mexico and
Canada are allowed to have a FTA with the European Union, with rules of origin protecting NAFTA from EU
exports.

• The European Union is shaped as a Customs Union (since 1969, after its creation in the 1957 Treaty of Rome)

• The EU-Turkey trade relations are shaped as a Customs Union since year 1995

• The EU-Korea trade relations are shaped as a FTA as of 2014

• We have shown that under standard assumptions FTAs are more efficient than Customs Unions

• Why the EU founding countries have chosen to create a Customs Union ?

• Why the US have chosen to create a FTA with Mexico and Canada? Why the EU has opted for a FTA rather than a
CU with Korea?

From a transaction-costs perspective:

1. Customs Unions however imply a political cost of negotiations, which grows with the size and heterogeneity of
the CU, thus generating a trade-off with different optimal solutions depending on the specific case

2. Customs unions can generate greater welfare effects for member countries by increasing their bargaining
power on the global stage (i.e. removal of the “small country” hypothesis), leading to favourable trade
agreements.
 Benefits of CU

• Why did the EU choose to be a Customs Union and not a Free Trade Area?

• One of the reasons is that with an FTA the EU would remain a union of "small" countries
with independent tariffs and independent trade policies. . A CU allows them to play as one
single player at the table of international trade negotiations (eg the WTO). In this position
the EU would get more bargaining power if it is a CU than a FTA. If it is a CU it can
threaten the rest of the world to raise CET credibly. Why this should be credible?

• Because, as a CU, the EU becomes a "large country" and might gain by charging a
moderate tariff unilaterally. This gain makes the threat credible. At the bargaining table
for tariff reductions, a credible threat would lead third countries to reduce their tariffs too.
 Economies of Scale in Customs Unions

Hypotheses:
• Let’s consider two countries: home (H) and partner (P)
• A homogeneous good is produced in the two countries H and P at declining average costs (AC
curve), with P more efficient than H (ACP is always lower than ACH) => e.g. steel; or a
differentiated good => cars
• Because of the shape of supply (cost) curves, the minimal tariff that can be sustained at
equilibrium is the prohibitive one (no imports from RoW). Hence country H internally produces
and consumes OHA at price TH, while country P internally produces and consumes OPQ at price TP.

DH
Country p p Country
“Home” DP “Partner”

TH
Tp
ACH
ACP
pw Sw pw Sw
OH A q OP Q q
 Economies of Scale in Customs Unions

Then:
• A customs unions is formed: goods can freely circulate between H and P
• The trade policies of countries are common: a Common External Tariff (CET) is adopted w.r.
to imports from RoW. An agreement ensures the apportionment of customs revenues to each
country
• When the CU is formed, the most efficient producer (P) attracts all the demand of country H
=> DP+DH
• At the price CET, H imports the quantity OHA’ from P, which consumes the quantity OPQ’ and
produces the quantity OPX

DH
Country p p Country
“Home” DP “Partner”

TH
Tp DP+ DH
CET ACH CET
ACP
pw Sw pw Sw
OH A A’ q OP Q Q’ X q
 Economies of Scale in Customs Unions

Welfare effects:
• H gains from the CU since its consumers can now buy the good at price CET<TH => trade
creation (1) + (2)
• At CET, consumers in P demand OPQ’>OPQ at a lower price, hence experiencing the cost
reduction (3) + (4), while producers produce OPX>OPQ, hence the country also gains in terms of
employment (it produces more → more workers needed)
•Notice: we cannot compute Producer Surplus (PS) as the relevant curve depicted here is the AC,
not the MC!

DH
Country p p Country
“Home” DP “Partner”

TH
Tp DP+ DH
1 2 CET 3 4
CET ACH
ACP
pw Sw pw Sw
OH A A’ q OP Q Q’ X q
 Economies of Scale in Customs Unions
Some practical caveats
1. If country H is not producing the good before the CU but only importing from RoW at pW,
then the CET will imply a negative trade diversion to a more expensive source of imports
(country P).

2. If instead country P is not producing the good before the CU, there will be a production
reversal from H to P. Consumers in H will benefit from trade creation, but those in P will
suffer from “trade suppression”, as cheap imports from RoW are replaced by less efficient
internal production.

3. We might observe “perverse specialization” if a large, though less efficient, captures the
whole market just due to a market-size advantage...
…. do we need a social planner then? Would she/he be able to identify the most efficient
producers?
 Trade diversion

Initially, country H is not producing the good (TH is not prohibitive) but it is importing from RoW
at pW; Country P is producing the good (TP is prohibitive).

Then, with a CU:

• consumers in H consume OB;
• consumers in P consume OC;
• P exports CD=OB to H.

DH
Country p p Country
DP DP+ DH “Partner”
“Home”
TH
TP
ACH
CET CET ACP
pw Sw pw Sw
O A B q Q C D
O q

OB = CD
 Trade diversion – welfare effects

• Country H was importing from RoW at pW, then with a CU: consumers gain 1+2, the Government
loses 1+3 → net effect is 2 – 3

• Net/trade effects: a negative trade diversion (3) due to a more expensive source of imports
(country P), but still a positive trade creation (2 consumption effect)

• In country P, a cost reduction (4+5) → consumers in P can consume more at a lower price, because
of the lower production cost (recall: economies of scale)

DH
Country p p DP Country
DP+ DH
“Home” “Partner”
T
H
TP
1 ACH
2 CET 4 5
CET ACP
pw 3 pw
Sw Sw
O A B q Q C D
O q

OB = CD
 Trade suppression
Initially, country H is producing the good (TH is prohibitive); Country P is not producing the good and
is importing OQ from the RoW at Pw (TP is zero).

With the CU
• Consumers in H will consume OB (imports from P);
• Consumers in P will consume OC
• P exports CD = OB to H

DH
Country p p DP DP+ DH Country
“Home”
T “Partner”
H
ACH
CET CET ACP
pw Sw pw Sw
O A B q C Q D
O q

OB = CD
 Trade suppression – welfare effects

• Country H was producing the good (TH is prohibitive); Country P was not producing the good and
was importing OQ from the RoW at Pw + tariff = TP.
• With the CU, Consumers in H gain 1+2; Consumers in P gain 4+5, the Government loses 4+6 →
net welfare effect is 5 - 6.

• Net/trade effect: in H, trade creation (1+2); in P trade creation (5, consumption effect) and
“trade suppression” (6), as cheap imports from RoW are replaced by less efficient internal
production.

DH
Country p p Country
DP DP+ DH “Partner”
“Home”
T
H
1 2 ACH TP
CET 4 5
CET ACP
pw 6
pw Sw Sw
O A B q Q C D
O q

OB = CD
 Perverse specialization

• We might observe “perverse specialization” if a large, though less efficient, captures the whole
market just due to a market-size advantage.
• Assume that country H is less efficient but larger than Country P (see AC and D)
• If consumers prefer to buy the cheapest good, then consumers in Partner will buy in Home (TH <
TP): the producer in Partner stops its activity.
• The additional production in Home slightly reduces the ACH. The beneficial effects in Home and
Partner could be larger if P were the only producer.
• Differently from other cases, the starting price (TH and TP) is not properly signalling the efficiency
level of the producer.

DH
Country p DH + DP p Country
“Home” DP “Partner”

T TP
ACH CET
CETH
ACP
pw Sw pw Sw
O A C q O Q B q
From Customs Unions to the Common Market

• In a model of Customs Unions with economies of scale, net effects are overall positive but
we “ignore” the loss of surplus accruing to producers in H.

• We suppose in fact that producers in H will shift their production processes to another
good in which H has a comparative advantage (the analysis here considers only one good
at the time)

• Alternatively, we can suppose that producers in H can move their production in P => then
rules have to be written for allowing a movement of factors of production (labour and
capital)

=> a Common Market, with 4 fundamental freedoms, “naturally” follows a Customs Union
where economies of scale are relevant