Customs Union: Trade

Creation and Trade Diversion

Presented by
Ishika Saha (Roll No.66)
Saurav Dutta (Roll No.67)
Customs Union

● It is a union or group of countries that apply one common system of

procedures, rules and tariffs for all or almost all their imports and exports.
● The group of countries agrees to eliminate tariffs among themselves and
set a common external tariff on imports from the rest of the world.
● The European Union (EU) represents such an arrangement.
● A customs union avoids the problem of developing complicated rules of
origin.
● With a customs union, all member countries must be able to agree on tariff
rates across many different import industries.
The effects of custom union can be measured in terms of :

1) Trade creation: increase in economic welfare by joining a custom union

dueTrade creation typically leads to increased economic activity and
lower prices for consumers.

2) Trade diversion: a negative impact on the welfare of non-members through

lower market access as well as on members through reduced tariff revenue.

With assumption of fixed resources and technology is given.

Trade Creation
● Trade creation occurs as a result of the formation of a customs union
production of goods takes place in the more efficient member country
instead of taking place in both the countries.

● Trade creation involves the removal of tariffs and its benefits include
getting rid of the disadvantages that comes with tariffs: reducing price,
increasing consumption, increasing imports, decreasing domestic
production and increasing allocative efficiency

● In all cases, trade creation will raise a country’s national welfare.

 Trade Creation: Diagram
• Trade Creation effect show the favourable impact of customs union
on production, price level, consumption level of the trading
countries. Trade Creation effect is explained with a diagram.
• Here DH and SH are the demand and supply curve of the home
country. Sw is the supply curve of the rest of the world. Sp is the
supply curve of the partner country. Before the customs union is
formed, WT tariff is being imposed on W by country H so that the
new supply curve becomes Sw + t.
• From the figure it is clear to us that at price OT country H consumes
ON, where MN quantity of X imported from W. Country H gets a tariff
revenue equal to the area ADKH.
• Suppose country's H forms a custom union with a country called
partner country from W. Thus now country will import good X duty
free from country P only and none from country A. This provides
following trade creation effects of the customs union for country H.
• Price Effect From the figure it is clear that OT is the pre customs union price and OP is the post customs union price.
Therefore OT - OP = TP is the price effect.
• Consumption Effect From the figure, it is clear that ON is the pre customs union consumption and OR is the post
customs union consumption. Therefore OR - ON = NR is the consumption effect.
• Production effect From the figure, it is clear that OM is the pre customs union production and OL is the post customs
union production. Therefore OM OL is the production effect. -
• The production and consumption effects of the trade creation lead to the welfare gain effect for country H. Before
customs union, LM was being produced by H at a total cost given by the area AMLB under the supply curve SH. After
customs union LM is imported from country P at a lower total cost given by the area JMLB under the supply curve Sp.
Thus AMLB – JMLB = AJB is the production gain effect.
• Before customs union the home country consumes ON quantity at price OT. But after customs union it consumes OR
at price OP. By consuming NR, more quantity of X the total utility derived by H equal to the area DFRN under the
demand curve DH. Here the cost of additional consumption is FRNE. Thus DFRN-FRNE =DFE is the consumption
gain effect.
• The net welfare effect can be measured on the basis of welfare gain and welfare loss.
• a = Production gain = AJB
• b Consumption gain = DFE
• c = Welfare loss = JEKH
• Now, If (a+b) = c, there is net gain nor net loss in country H's welfare from customs union.
• If (a+b) > c, there is net gain in country H's welfare from customs union.
• If (a+b) < c, there is net loss in country H's welfare from customs union.
Trade Diversion

● In general, a trade diversion means that a free trade area diverts trade
away from a more-efficient supplier outside the Customs Union and
toward a less-efficient supplier within the Customs Union.
● In some cases, trade diversion will reduce a country’s national welfare, but
in some cases national welfare could improve despite the trade diversion.
 Trade Diversion

● After joining the EU, Spain abolished

tariffs with France, but not NZ.
● Consumers gain an increase in
consumer surplus of areas 1+2+3+4
● Spain producers sell less they only
sell Q1, as they now import more Q4-
Q1.
● The government loses tariff area 3+5
● Consumers gain area 1+2+3+4
● Producers lose area 1
● The net gain is (2+4) – 5
● It is possible area 2+4 can be greater
than 5 – depending on the elasticity
of demand.
Thanks!

Presented by Ishika
(Roll No.66) and
Saurav (Roll No.67)