The formation of a customs union also leads to an expansion of consumption, thereby, an increase in the welfare of the member nations.
When tariffs are removed within the union and retained for the outside world, the pre-union price structure is modified to make import of goods from member countries much cheaper than before as compared to that from outside countries, so that efficiency of consumption is enhanced. When the residents of a member country have to pay a low aggregate price for import from union member (due to the abolition of tariffs), the consumers’ surplus rises, which obviously represents an increase in the community welfare.
Needless to say that, the consumption effect incorporate trade diversion from non-member countries to member countries.
Suppose country A imposes a tariff of BT on imports from B and C. Hence, the respective tariff lines are 7Tand T’T’ against the import from country B. In the absence of trade, the domestic price of X in country A would be OT’, as determined by the intersection of domestic demand and supply. But, when trade takes place, A will import M2M3 from country B at OT price and C would be out of A’s market, since its pre-tariff price is higher than that of B. It is obvious, that A will produce OM2 amount domestically. In this situation, the domestic price of .X would be OT, and the effective supply curve would be kindked-line SLQ, implying that OM2 would be produced domestically and the rest (M2M3,) would be imported. Thus, OM3 would be the total consumption of A at this price OT. Because of import tariff, the government of country A will fetch a tariff revenue:
The consumer’s surplus accruing to country A is DQT and the producer’s surplus is SLT. Thus, the economic welfare in country A is measured by the sum total of tariff revenue, consumer’s surplus and producer’s surplus, i.e.,
Now suppose, A and C form a customs union, so that all tariffs between A and C are abolished, while the tariff BT is retained against imports from B. A would then buy from C rather than from B, for now C supplies at price OC which is less than OT price (when it is imported from B). A fall in the price of import, thus, means an expansion of import; hence, country A will now import M1M4 from country C. The domestic price level would also fall to OA, so that domestic production will contract to OM1. Hence, the kink in supply curve takes place at J, so the supply curve would be SJH. Total consumption of X is now OM4, i.e., M3M4 more than before.
Thus, with the formation of a customs union, trade creation and trade diversion have been effected. Trade between A and C (member countries) has increased. The expansion of trade from M2M3 to M1M4 is, thus, referred to as the trade creating effect of customs union between A and C. The total trade creation effect (M1M2 + M3M4) is composed of production effect plus consumption effect. Since after the formation of customs union at OC price domestic producer in A could produce only OM, that is, up to point Jon the supply curve more cheaply than import from C. But beyond this the domestic cost exceeds, so it is worthwhile to import from C rather than to produce at home. Hence JR will be supplied by foreign source, leading to greater international trade than before. Thus, M1M2 amount of trade creation is due to production effect.
Similarly, the lowering of price from OT to OC causes demand, hence, the consumption to expand. Consumption expands by M3M4, which is met by further imports from C. Hence, M3M4, the amount of trade creation, is due to consumption effect.
A welfare gain accrues to country A in this process of trade creation. In production effect of trade creation, the gain is realised from the saving in pronouncement cost. It can be seen that the resource cost of producing (at home) M1M2 of commodity X is denoted by the area under the supply curve M1M2LJ. When this amount (M1M2) is imported from C; country A has to pay only M1M2RJ as the import cost. Thus, the triangle JRL represents the net saving in real resources of country A. This net saving can be regarded as an increase in economic welfare due to the production effect of trade creation. Similarly, the consumption effect of trade creation also produces welfare gain. After the formation of customs union the consumption of commodity X expands in country A from OM3 to OM4. The total utility enjoyed by the residents of A form additional consumption (M2M4) is measured by the area under the demand curve MJAJHQ. On the other hand, the import price they have to pay is M3M4HN for the additional import. Thus, additional consumer’s surplus – a welfare gain – amounts to the area NHQ.
It goes without saying that the net trade creation welfare gain (i.e., sum total of net production gain plus net consumption gain) is measured by the traingles JRL and NHQ. The extent of these welfare effects of trade creation under customs union depends on the following factors:
(i) The elasticity (or the slope) of the supply curve of the country for the given commodity;
(ii) The elasticity (or the slope) of the demand curve of the country for the given commodity; and
(iii) The level of the pre-union tariff.
It follows thus, that if, in our illustration, country A’s supply and demand curves are flatter (i.e., es and ed being greater than one) the triangles JRL and NHQ showing the welfare gains of trade creation will also be larger. Similarly, the welfare gain tends to be larger from the abolition of the tariff, when the pre-union tariff is higher.
The trade creation effect, thus, causes an increase in welfare. But, there is also the trade diversion effects of the customs union, which tend to produce an adverse effect when trade is diverted from the most efficient producer to a relatively less efficient one. In our illustration, after the formation of customs union, A imports from C instead of from B. Hence, trade is diverted from B – (low-cost source) to C – (high-cost source). The extent of trade diversion is M2M3.
When country A was importing M2M3 from B, its residents had to pay the import price equal to the area M2M3KF plus tariff at the rate BT, i.e., equal to area FKQL. But, the tariff proceeds FKQL went to A’s customs collector, which obviously meant just a redistribution of income within the country. Hence, payments to the foreign exporters amounted to M2M3KF only. A have to pay C – exports an amount equal to M2M3NR for the same quantity of import. Thus, import payments for the same quantum have increased by FKRN, which represents a dead weight loss due to the trade diversion. That is to say, when the trade diversion takes place, the producer’s surplus falls and the tariff proceeds are lost but the consumer’s surplus rise which partially offsets this loss. But, its net effect is that the country is worse off than before, since the loss of tariff revenue is not entirely compensated by the gains to consumers, on account of reduced price (OC instead of OT – before union formation, in our illustration).
Evidently, the net welfare effect of a customs union is the difference between its trade creating and trade diverting effects. To put in a formalistic manner, thus:
w = a – b
where, w measures net welfare gain,
a stands for net gain resulting from trade creation,
b stands for net loss caused by trade diversion.
It follows, thus, that when a exceeds b, w will be positive, implying thereby, an increase in welfare due to the formation of the customs union. If, however, b exceeds a, w will be negative so that the overall effects of the union is adverse. It may, therefore, be concluded that the formation of a customs union will not necessarily lead to an improvement in economic welfare.
But one thing is certain as regards production, that the trade creation arising from a customs union is beneficial, while trade diversion is not. Nevertheless, no a priori judgement can be made about the possible production effects of a customs union in assessing the probable production effects of a customs union. In assessing the probable impact of a customs union on productive efficiency, a host of factors may have to be considered. The most significant factors in this connection may be stated as under:
1. Complementarity and Competitiveness of the Participating Economies:
A union between complementary economies producing very different patterns of goods, provides least opportunity for intra-union substitution effecting a reallocation of production between high-cost and low-cost sources of supply. It may perhaps cause a reallocation of resources in a less efficient direction.
On the other hand, a union between rival economies, producing very similar patterns of goods, would be more beneficial, as it presents wider opportunities for the substitution of the products of one union member for those of the other, so that, greater trade creation may be effected.
It thus, follows that the greater the degree of competitiveness of the member nations with respect to protected industries prior to a customs union, the greater will be directed towards the most efficient or lowest cost source within the union.
2. Differences in Production Costs:
The greater the difference in cost ratios between products of countries forming a customs union, the larger would be the gain with the occurrence of trade creation.
The size of the union and the resulting market size, by and large, determine the magnitude of trade creation, thereby, providing opportunities for a more favourable productive reallocation of resources.
It has been contended that inclusion of a number of small countries in customs union may bring greater improvement in world’s productive efficiency rather than an association of two big nations. The gain for the individual member nation rises with the relative expansion in the size of market.
4. Level of Tariffs:
More trade creation is effected through customs union if pre-union tariffs of member countries were high enough. Further after the formation of customs union the trade diversion would be minimised when a low common tariff is raised against outside nations. Moreover, a low tariff in export markets outside the union will also minimise trade diversion effect; for, in this situation, the amount of export trade diverted from outside nations to member nations, will be less on account of lower tariffs imposed by the outside nations.
In view of the foregoing points, we may say, for instance, that a customs union like the European Common Market (ECM) would be highly successful in increasing the productive efficiency and welfare, since all the size countries forming this union are competitive economies with different cost-ratios and with a high proportion of pre-union trade amongst them, and with not much scope for the trade diversion effect.
The success of ECM is empirically evidenced by the increase rate of growth of intra-union trade in recent years. On the other hand, EFTA has experienced a slow growth of intra-union trade; this is perhaps because of complementarity of members of EFTA and a greater degree of trade diversion rather than trade creation experienced by the union.
With regard to underdeveloped countries, it may be said that since their trade is largely with advanced countries, a union of these countries will cause much trade diversion and trade creation will not be so high. Hence, perhaps no substantial benefit may be visualised by such unions.