economic

union. n the fnay schedules

doption countries.difference
structure importsduties countries.
amongst markets. tariffs)forms
international 1.
abolition Further,
involve A A
of (tariffs)
from customs ofAll Forms R E
commonly only a customs against
the
In of
between
the
themselves free among countries
trade econonmic
economic 26
customs
of leviedunion certain of
all onenon-member latter non-member a
commodity
restrictions customs but area integration in Economic
integrated union case,duties in is
trade an cachrefers integration countries the
however,
adopted agreement modern
may union amongst
countries. individual to
fiscal on orcountries. be the arnd have world
a
the feweither the byand them, are:
group discrimination come
Integration
monetary
and
movement
commodities
limited
member
al
the
l
membersfree-trade is, a It
between

thus, members
the
at
country

countries
is
of free
trade
()
into not
existencefollow
do
CustUniomsTheory
on The of
goods or follow also same free against
policies. atmay it area a
referred
countries is time, of to areas, uniform
such
and the different maintainwhich
most, be that, groupofa others. as
Suchfactorscomplete. establishing (1)
while while in as
to
have customs removal
discriminatory
The
a ofdiscriminatory the the nations any
complete abolished most of
production a A tradingformer External level
complete common union, trade
limited abolishalto
l of important
union with thereTariff. tariff all and barrierstrade
customs
union individual
tariff
as tariffs
iswell non-member is againsttariff (iii)forms policy.
known a A
consists
as union
common
notable customs
against barriers common(especiallb.
ofSeveral
other such
asthe

1Otowards Shittingwhiçhproduction beFurther, unionrefersProduction

De onEffect and
distribution nwtheconomic
transferred increase the trade of barriers.
However, at
tariffs, trade Assuming () We
contributors
Sèodevelopment. Union 2. Case. markets.
Customs analysis freely.
so move amongst
member
freethe the The
the freer thwoulde elimination to
Consumption may, discriminate
and
The The The ourselv as Theory
the equiptoEconomists formationThe
cost production ofoutput and obiect It theory
atradepromote fromgoods expansion so
creation" distribution of relations is, TheoryPureof Following
of movement
ofpart that, static thus,
cconomic may thus, The of commonand which of
of this Customs
trade within
of accordingthe ofand the conditions, dichotomise cause against atheorycustoms of
Effect. within customs a
theory. Ives the have, is
the mutual
from tariffs gain size of and special supposed countrics. of of
and the ineficient welfare. of tradition, goods Union
creased trade"trade even
income imports the with however, a
a economies deals
ion union.
high-cost trade toand market of union union caseHowever,unions an
common
the between Viner the a to among
analytical
to other diversion" betweenchange from is ofwith webe
focused
Under
trade between principles economic may to the the is too
casily
efficient
barriers of for contends give theory Meade, a member the
market,
source non-member tend
in branch
een and scale,certain the and thepreferential effects framework extendable
take
will their common
union of member effects effects within rate to however,
isation utilisation, wil that alter ofLipsey of countries,
comparative
to thereby
commodities international of tariff attention
up
the members. a permit ofthe of consumption of geographically
countries. here market,
lower countries
discriminatory production member
economic treatment and which to implies
nion customs theory. the
increasing only on but
thercby, Lancaster can cases the cconomic
among cost advantage, member the all
and mayowing countries discrimination. As Viner be
a
source, Thus, effect unions growth, and such, to customs instítution the highest
the the loweringcountries increase, discriminatory
imports used of
factors
a the tariffs. production also and free
integration
ide
member constitutes trade to of into: leading the in degree
efficiency
so the a and Vanke dealing uniontrade of of
that, which Trade customs (i) tariff from have
es. creating the elimination
to Production consequently to member their are
customsproduction
areas
in of
untrics the
costsspecialise alteration patern,
structure charges with its permits
interdependence
of in creationunion the
aresources turn share general
any
movementeffect, and production. tcountries
he prominent union,
se is permits of
depends Effect, in and in specific too not
likely prices in intereffect interms trade in form can only
377
by wil the the the the its the
 Internatlonal Economics The Theory of Customs Union
378 tarifNbythe:union members against
commonexternal the members'
adoption ofa former so that, Y

theremovalof
tariffs within andcompetitive strength of the
decrease the countrics would rise. Similarly. the imports
union mcmbers' D
379

outside countricsdeclinewhilethosefrom member their cxports are mostly diverted to their fellow
as outside
fromoutsidewill countrics will also declinemovement of trade. Moreover,
Cxports to outside of thc free diversification Countries may
of trade from outside
imports
account
constituent countries, on from union members. Such
to as "trade
diversion effect." counttrade
ries
Under
alsorestrict their customs union is referred commodities is stimulated;
constituent countries in the
inefficient domestic
prouction of certain hence, the
as a detrimcntal effect on productive
to
diversion cffect, the
resources are not
optimally used This cftect as suchuneconomically
shifted
from lower r cost effisources)
(outside ciency.
when productionis movement away from free trade.
Further, underthis effect
sources), itleads to a D
(union explicit with the help of aA
to higher cost
mcaning of trade creationand diversion
can be made numerical M.
M
M, M,
The Figure 26.1: Trade
Cxample:
countriesA, Band C. In
producing commodity X. let us assume that. Creation and Diversion Effects
Suppose, there are three Further, we may assume that.Aimposes a tariff Consumption Effect
10, 8and9per unit. a tariff ofR2on their
ime
their respective costs are Likewise, B and C also impose The formation of a
and C.
of 4 on imports from B
of any trade between these
as
countries, each one would find
increase in the welfare of customs
union also leads to an
this case, there will be least possibility customs uni the expansion of
production. Now suppose Aand Ccombine in a retained for the outside world. member nations. When tariffs consurmption,
are removed within thethereby, an
costlier than home C as there is no the
imports Then Awill import the product from Com member countries pre-union price structure is modified union and
impose a uniform external tariff of3. (which is cheaper than domestic cost - i 10). And. Awil hat efficiency of much cheaper than before as to make import of
within the union, So it will get Xat 9 goods
is enhanced. When the compared to that from outside countries,
not import fromB becauseit willcost Rs.
11 8+3 tariff). This is, thus, a case
of trade cret consumption
low aggregate price for imports trom residents of amember Country have to so
cost source
- higher cost)
where the place of production is moved (from A's 10 cost efficiency is increased.
to a lower
surplus rises, which obviously unionanmember (due to the abolition of tariffs), the pay a
(country C- wherecost is 9 per unit), so that, production represents increase in the comunity welfare. consumers'
1.50per unit and B and
Needless to say that, the consumption effect
On the other hand, if we assume that Aimposes originally a tariff of B at 9.50.Now, ifA countries to member countries. incorporate trade diversion from non-member
Cimpose a tariff of 2 per unit on their imports.Then Awould import from
and C combine in a customs union and impose an external tariff of 1.80. Then A
will import from Diagrammatic
union can be exposedExposition:
This theory of trade creation and trade
Cat 9 and stop buying from B as it would cost 9.80 now. This situation represents trade with the help of a diragram of a partial diversion of customs
diversion since, production is shifted from alow-cost source-country B, to a high-cost source 26.1. equilibrium framework, as in Figure
country C, hence, a decline in production efficiency is visualised. In Figure 26.1, DD and SS are
country A's demand and supply curves of
Briefly, thus, trade creation efect leads to the efficient reallocation of productive resources supply curve of commodity Xat the price OB is assumed commodity X. B's
to be perfectly clastic, thus, represented by
resulting in an increase in production whereas, trade diversion effect alters the resources in an BB. Similarly, price OC, Cs supply curve is
represented by CC.
ineficient way which causes adecrease in the productive efficiency. Apparently, the total production Suppose country A imposes a tariff of BT on imports from Band C. Hence, the respective
effect of the customs union depends on the difference between the trade creating and trade diverting
tariff lines are TT and T'T' against the import from country B. In the absence of
effects. A'positive' difference means an increase,while a 'negative' difference implies a decrease trade, the domestic
in world production. price of X in country A would be OT", as determined by the intersection of domestic demand and
supply. But, when trade takes place, Awill import M,M, from country B at OT price and Cwould
be out ofA's market, since its pre-tariff price is higher than that of B. It is obvious, that A will
Produce OM, amount domestically. In this situation, the dome_tic price of Xwould be OT, and the
etfective supply curve would be kindked-line SLQ0, implying that OM, would be produced domestically
and the rest (M,M,) would be imported. Thus, OM, would be the total consumption of A at thi
Price OT.Because of import tariff, the government of country Awill fetch a tariffrevenue:
 380
welfare gain amounts is by OM, the trade This curve,
the
as resource trade amount Cxpand. MM, Hence costthe onlOM,yeffectSince. The MJeffected.Consumption
M, Tr ade COunttory price tor while surpl us the
plus It MMHN areaformation
the
neimport
t A Similarly,amount domestic total to Thus,withe OM,. ofnow the Now LFKQ cconomic Ihe CT
The creation. creation, JR import, and
effects goes to saving M,M,IJ. cost welfare trade Consumption of
that trade M,M, C. tariff
Csupplics Suppose, producer's consumer
Hence, x
net
without the for under to ta l wil
after a of
The + MM,
consumption area the utilitySimilarly, of can cost. When ofthe gaincreation, the suppliedof bese is, creation is, Xthe thus, BT DÌT welfare
trade
of
th e customs Thus, producing gai n lowering trade exceeds, up
to
th e thbet
us, w een domestic is
kink at
retaincd is A +
s 'sLFKQ =
be now surplus
accrues point ion effectreferredformatiA on
saying additional
NHÌ.
price and SLTsurplus, in
demandenjoyed regarded this is expands creation format inpricmeans
creation union the tamount
he realised
(at is by so J and OM, suppl y e 0C C country
gain) isthat consumption triangle to due of forei g n on t an fo rm accruing
expansion againscustt oms
le vel
curve by home) country to by price is isthe of to C of Le, it
(MM, which i.e.,
the import. the the as a
under
measured net M,MHÌ. consumption an (M, M ) fromconsumption MM, due
wor t bwhi lsuppl
e cust
y o ms (m ember
as a curve
MM, woul d A
is
Thus,
residents increase JRL M,M,
A fr o m source,
to + the cust o ms imports les
is to
customs trade
effectrepresents is saving of this
the in whic h product
0Tiolneading curve union trade MM)
countries)
ta kcs
more also than union, of measurcount
cd ry
creation
by additional Onof of in
of
imported
commodity effect. met is OC to to atcreat ising uni o n, th
import;
an place fal from A
union the 4 process
the fo
commodity rm economic
trade in
effect .
i m
toport more
composed
0Cpri c e OT'price at
to B.so by is
traingleswelfare
depends other the
pronouncement
from by greater cheaply
causes has trade before. J, 0A, hence, Athat the DQT
consumer'additional
s creation net X of further from cffect so so woul d al s um and
hand, welfare saving C; is trade increased. of creat io n the th at (w hen
country itthen tariffs
onJRI.
gain X denoted demand, international production domest
than ic of
suppl y total the
consumption the expands also country i m port s C
ratherimport customs domestic
the and (i.e., surplus
import produces toreal
due in
by
creation.
cost. The
and
imported between Aisfrboumy B
wilM producer's ta rif
of
lowing NHÌ. sum
in resources has Athe fromhence, produce thantoproducer expansion trade curve now International
Economies
countryA the It In tr ade fro m effect union production wi l 4 revenue, s
total price AI and I surplus
The (M,M,) production toareaproductioncan C.the in diversion would import fromCrather
factors: a welfare pay under be Hence, before. than C. plus between
of welfare they
extent net ofonl y seen
consumption Butcould
consumption
A
of be B).from
than are CConsumer's is
have from
is beyond trade have SJH. abolished SLT
productton gain. country the MM. contract M,fall
of gainmeasured OM, effect M,MRJ
supply that effect at
produce and A Thus,
thes
to After Thus, home. this from been Total from the in
- pay
to of A. the of the to C.

aboutthe union customs athatwelfare andformation, unionin Catdiversi

Rnmnensated if same The
o n. s ry. went the
exportcount B-divtheertdivedersion the trade (i.e.,
formation tradeThe tariff: () () Theory
the trade toarea When
isBut overall follows, It where, W=a -b Evidently, nroceeds is quantum (low-cost es It (üi)
beneficial, one union
roductior
possible
due
stands stands diverting that
That
amount
payments an A's
Hence,
A M, M ,K F
country
fromeffectsabolitionof creation follows
when
and
The and The The of
thing to W by the customs th e ed Customs
effects the thus, measures the are is diverted
from off creation the willbeing thus, Jevel clasticity clasticity
will for for the
country to
have source)
customs of
formation etfects.illustration).
net our lost proceeds
FKQL plu s A most also
while is
certain not of that net net
gains say, equalcollector,tariff was
increased the pre-union
greater that the of Unlon
welfare but to
efficient be (or (or
necessarily th e loss gain net to 0 to union, customs effect, if,
trade when ToConsumers,worse isthe when M,M,NR theto importing
C-(high-cost
at
larger. pre-union
than in
the the
effects as union of caused
resulting welfare puteffect consumer's the by tariff
the slopc) slopc)
diversionregards the a toreign which rate imports producerA thus,Similarly,f our
isexceeds in off tradeFKRN, for union, illustration,
is one)
of lead customs
adverse. by gain, formalistic a of than obviously BT,
M,M,
causes higher. the
tariff. of of
a trade from a on the
exporters the the
production,
customs is to customs diversion
surplus which same i.e.,fromsource). from which
to the
not. an union. diversion. b, trade accountbetore, a an triangles demandsupply
It w equal B, relatively tend
increase welfare country
improvement may,
Nevertheless,
union wil creation, manner,union of takes quantity
riserepresents amounted meant its Cinstead JRL curve curve
that therefore, If, since to
residents The to
however, be reduced which just area extent produce less gain
in the postive, is the place, of in and A's of of
assessing thus: the import. ofto tends Supply the the
FKQL. a efficient
from welfare.
trade
noeconomic in be b difference price partially
loss a
the deadredistribution had of
NHÌ
countrycountry
M, M KF trade B. an to
a
creation concluded exceeds implying of
producer' s to showing be and
thepriori (OC tariff Thus, But, pay Hence, one. adverse But,
offsets weight diversion larger demand for for
probable between instead import only. the the In there
judgementarising welfare. a,
thereby, revenue tarifi trade oureffect the the
that wil w this loss
surplus ofimport from the
of loss. payments due haveincome illustration,
is is is welfare curves given given
production from the its
OT is falls to price M,M, when also the:
be an trade to commodity; commodity:
can formation negative increase -before
not But,
within the are
a creating entirely its and
payC-
the equal trade gains of
be
customs trade for trade
flatter 381
cftects made net the the the after
of so in to is
 wil
advanced greatergrowthgrowthcost-ratios
of the welfare,
not With
Common account situation, dilovwersiaon of Thgre cater rcallocation resources.of crcation. trade
trade
In member magni tude products mosretspcct one would
low-cost betwocn staunderted as : host ofa 382
be
countries,
degree of
so regard intra-union diversion sin
and Marketce view of the
tarif
would improvement
Level
4. gain
has
It 3. cfi i
2.c i e nt It uniopportunity
o n
high. intra-union
of wi th ofloweramount in count ric s
for
be en Size:
of Dif erences of tothus,
protectoredfol ows member more othcrsourcs for
betheOn custos
1. of
factors
bencficial, cioConmpltram-uepnimloemnnteanrytarity
totrade all the export of the
The count ric s
Hence, th(ECM)
e tarifs be individual ended trade
union diversion trade; tradeeffect. high asize foregoing ofexportmarket
underdeveloped a
minsimised Tariffs: contin size lowest of may union.
were creation, offorming inindustcost rics that thosc supply. for hand, have In
perhaps of this proportion The countries would imposed More wor ld 's
these in
is success
points,
tradeoutside when high trade member
th at theProduction the a
of uniiton may c onomi and
as It asses ing to
no ratherperhaps recent be by cnough. product iin
v cl
e u si o n th er cby uni on custo ms
a source
pr ior grc at e r substitution
the
be
substantial countries,
countries
than years. pre-union
forming
of hig hly we
may outside
the
diverted a
the low creation nation within tothe othprers,cntbcts wcenperhaps considercd. the
wil it
because
trade
benefit cause maycreation of the istrade union
ECM
of
On successful this say,
for nations.
uni on
from common Further isefñci
wil
rises ency ofa providing the union,
number resulting
and Cost s :
Th e
a
custthe oms degroe thatso Cocfmaprtpineogtduciitivnegnes
,
wider rival causc probable
The
outside also tarif after efiected with the union. a a impact
may much said
be
complementarity
empirically
other amongst
are
instance,
in
minimise is the
the rather ofopportunitics
smal l
opportunitisrcallorccatalliocatn hon
largergreater union, ofgrcater onomics, vry most
be
experienced hand,
that
increasing
competitive that
nations raised throughrelative
format i o n than ries
market would competitiveness producing
the the trade d1ferent significant
custorms the
of of
a
trade evidenced count tor of of
be grcater creation the
visualised since them, a
diversion
by of
EFTA
and
customs
the member
totradeagainst custoexpansi
of
ms
associ
o n
a ti o n
an for size,
a
dif erence
by
the resourprooductsParpatiotnitcerimpats ing
substitution
products ofvery factors union
their members has productive
economies
bywith
diversion outside customs
union in mor e gai
wi
of
nt h wil of
by the union
nations
customs union
in favourable determineand in bethe may similar inas eficicncy,
ofconnection productive inon
such and trade union. experienced the not the large, towards
directed member less
between goods,
Economies:
thisEconomlcs
International
like effect:nations.pre-union if of cost effected. be
unions. trade is ofincrease muchefficiency with wil union size two the
ratios
patternscfficicnt
largely EFTA the occurrence
the
provides
of bi g nations high-cost
creation scope
different European befor.
Moreover, the mayproductive
market.
with anda slow arate ecs in tradetariffs nations.
bring
between
goods,
of
direction. A maybe
of for and on thie the the with and\east:
union
of a

I. through improved, ore countries

may may
full income and
tegration, See,
Mayes
GNP Ph Pm Where,
MLog 6. be
to employment 5. more e
advancement
technology.
A
market,
of
This advocat
producted.ivity. rcompet
under: as
lasting
enovatei.tion. 3. The
Theory
= = = Imports
customs As enhanced,
M= the
the As When
ofresearch large It follo ws 2.
It incrcasc The
1.
in formation
process. The
Dynamic
= = investments,
New D.G., the the the the
has country
balance improve, result
whenits
a member industrial may would Thus,the of
b,
unions been productive induce Perhaps, because Th e Customs
York: "The error gross price price t or thin
e generate In
b,suggested which the of the countries protected fact, Effects
St.
Problem them.national in of Log can ofsupply customs generallarger
enterprisesrapid
a for ofmarginal the
of
a Union
Martin's home imports payments efficiency thiseconomiesa
th
customse
(Pm/Ph) be is size
marked industries, or of customs
Press, the
of
product product estimated by the ofunion,standardcapital would technological reason of
chief
exports incfiicient
Quantitative D.Gposition mports
rise, will correlation of market
Customs
union
1982, + formation improves alone, union
supplier trom a of scaletherefore,
b, by find and
p. Log usingMayes, may them tomember living thatso advancement. it a and firms caused produces the
32. these as feasible customs
GNP are face byadustmentUnions
Estimation in and
and saving
between
the the also the countries is
country' s
acceleration result
a accelerate
the
+u directimprove. world
following reduced. common forced many
may and union the challenges. creation
of of the dynamic of
For, to
Integration price market. Ofareterms
welfare.
Increase creation worthwhile for SiZe rate improve the
simple course,
curtailed, of with
underdeveloped of of
effect
When ofeconomic the the of customs
growth
So a effectsworld
Effects," trade which of their they
model: this to
economies
of or
qustoms expansionspend market in
economic the kind against
its grOwth, would countries. efficiency.
of
of have union the
International
termsbargaining of more countries memberand to
enableunion, leads world to
benefit
non-member attainment in th e innovate
integration of size
on cconomies isit
to
Economic trade national
them degree intcnse
wilpower of may long- a 383
are be of to ne be of and
384
advantagesof
major
economicitegration through

specialisation
Custons LCuniOnOomnics are The Theory of Customs Unlon

If thesc two countries. A 385

following facilitated by the and B,
intend
In
short, the
Usuallyclaimed Productivity: ()
to
Duc
greatercountries
member custons union. introduces a concept of
relation between a
Cxcess
number offer or
of terms of
to form a
union,
cxcess reciprocal then for the sake of analysis, Vanck
would bc offered and
demanded, jointly countries deTmand
tradc ratios and the
the curve. Excess offer curve is a
Improred moreefticientinEnlarged Market: Customs union enlarges
1. tendstobe implies production of output on
a the size Figure 26.2, an excess offer
curve ot two
by two amount of two goods ( and ) that
(A and B) to and
production
Economies of
to
Scale duc countries.
member
This
larger scaleof, offer curves. If the
international
will be no excess demand or offer
countries
trade of Aand B is A and Bis
constructed
from athird country. In
from their respective
2.
the
exportsofthe
marketforeconomiesof
scale. union
enablesthe
member countries to of trade line OE, the excess offer O(A+
for
product exactly balanced
either Xor Yby A at OE terms of trade, there
zero and so itandmustBcombined Hence, for terms
customs B) will be
mav lead to a favourable
reaping the
of
Trade:
Improved Terms theglobal
The
market
which in terms trade.have a If, however, the terms of
trade line moves pass through the origin.
expansionofstrade of the member betweenA and B will not be to 0G (when A
3.
bargaining
strengthin
GNP: With
rise. countries their for OY, of Yfrom B: but Bis balanced. Because, Awould be willingbecomes
willing to offer more expensive) trade
to offer OX, of Xin exchange
grcater Growthof tendsto only OY, of Bin
Rateof product(GNP) of Yby country Bis not sufficient
4.Higher
grossnational Union Y(or offer of X) is then
denoted by
to match the
the segment GT ondemand for it exchange for
by country A. OX,
Such
of X. Thus, the offer
growthrate of Theorem of CCustoms Origin Onow yields point G, a point of the 0G. The distance GT excess dermand for
measured from the
Equilibrium points of the. locus (C+ B) will be
O excess offer curves of
General analysis of customs unions in
terms of general obtained. This curve shows countries sA and B. Similarly, all
4. comprehensive countries Aand B under customs
union are willing to offer how much exports the two
propounded atechniqueof offercurves. importsfrom the outside world offer at different price ratios
Vanckhas
byusingthe (i) (country C). in exchange for
equilibrium theory
B,two countries
forming a customs unjon; v
in
commodiv country Crepresenting (B)
(i) Aand
He assumes: specialisingin
commodity XandB
world:(ii) means of their COMMODITY
Y (A+B)
theoutside
betweenAand
Bmay be shown by offer curves as in
The pre-union trade
Figure24.2. offer curve, the equilibriumterms of trade line is OE.
offer curve and OB B's
OA being A's

(B
T
Y Ya
COMMODITY(A+B)

X
COMMODITY X (A)
Figure 26.3: Determination of Terms of Trade in
Customs Union
Now, a complete three-country trade equilibrium can easily be obtained by plotting the offer
curve OC of country C against the excess offer curve 0(A + B) of two union countries (A and
X
B) taken together. This has been illustrated in Figure 26.3.
Xb Xa (A) ON termns of trade are thus, determined, which brings out equilibirum of trade in all the three
COMMODITY X countries.
Figure 26.2: Derivation of Excess Offer Curve
The discussion in this section draws heavily from Vanek's statement in his book 'nternational Trade.
The effect of establishing a customs union on the terms of trade may be seen with the help of
a diagram as in Figure 26.4.
 equilibrium B customs two of of
and improvement 386
the If, countriestarifs customs In
offer however, union, on Figure
terms in imports
uni o n.
curve A
the with and 26.4, COMMODITY Y
EXPORTABLES OF c ofthese Thus, B)
trade
of terms the Bby O4° Figure
country are two removal under the the and
of
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