VINER’S MODEL OF CUSTOMS UNION

(1)

Lecture 3

Topic 3, Economics of Customs Union

VINER’S MODEL OF CUSTOMS UNION

JEM081

ADVANCED ECONOMICS OF EUROPEAN INTEGRATION:

Microeconomic Aspects

Dr. Wadim Strielkowski IES FSV CUNI

October 7, 2013

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Customs union

• a group of countries among which trade takes

place freely without being restricted by the barriers of tariffs or quotas on trade, and which adopts a

common external tariff - all member countries impose the same tariffs on countries outside the customs union

• the theory of customs union - a good example of the relevance of economic theory for practical economic policies

(4)

Customs unions in European history

• The best-known customs unions have included the Zollverein, Benelux and the EEC, now called the EU.

• The Zollverein was formed by German states in the 1830's. These states became the German nation in 1871.

• Belgium, the Netherlands and Luxembourg established Benelux in the 1944.

• Belgium, France, Italy, Luxembourg, the

Netherlands and West Germany set up the EEC (EU) in 1957.

(5)

Customs unions related to the EU

• EU-Andorra: established in 1991.

• EU-San Marino: established in 2002.

• EU-Turkey: established in 1996.

(6)

Customs unions in the world

• Andean Community (CAN): formed in 1988.

• East African Community (EAC): formed in 2005.

• Customs Union of Belarus, Kazakhstan and Russia:

formed in 2010.

• Israel-Palestinian Authority: formed in 1994.

• Southern Common Market (MERCOSUR): formed in 1991.

• Southern African Customs Union (SACU): formed in 1910 (the oldest still existing CU in the world (RSA, Botswana, Lesotho, Swaziland, Namibia).

• Switzerland-Lichtenstein: formed in 1924.

(7)

Customs unions in economic theory

• Customs union theory builds on strict assumptions such as perfect competition in commodity and

factor markets and hence it is often referred to as orthodox customs union theory

• It also only deals with the static welfare effects of a customs union.

• Customs union has both positive and negative welfare effects, compared to a situation in which every member state is practicing protectionism

• The theory is relatively new (started in 1950)

(8)

Economic theory of customs union

• any economic theory of regional product market integration has to address the question of

economic justification of particular integration

forms (the question whether an arrangement would be superior to the status quo and to participation in world-wide trade liberalisation)

• until the beginning of the 1950s it was commonly held that the customs unions and free trade areas were steps promoting free international trade

• only after pioneering work of Jacob Viner’s

published in 1950 it was realised that customs unions might as well be seen as a step towards protectionism

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Simple model of a customs union

• Elimination of tariffs on imports from member countries

• Adoption of a common external tariff on imports from the rest of the world

• Apportionment of customs revenue according to an agreed formula

(10)

Simple model of a customs union: assumptions

• Pure competition in commodity and factor markets

• Factor mobility within countries but not between them

• No transportation costs

• Tariffs are the only form of trade restrictions

• Prices reflect the opportunity costs of production

• Trade is balanced

• Resources are fully employed

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Viner’s contribution

• Jacob Viner (1892-1970) - Canadian economist, professor at Chicago University and Princeton

University, an international trade theorist; his book The Customs Union Issue introduced the

distinction between the trade-creating and the trade-diverting effects of customs unions

• contribution of Jacob Viner was an introduction of welfare consideration into the theory of

international trade in general and particularly into the theory of customs unions

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Trade creation and trade diversion

• ground-stones of Viner's theory of customs unions are concepts of trade diversion and trade creation effects of different arrangements of regional

integration.

• original Viners’ definition of these concepts was formulated in terms of trade flows:

• trade diversion: switch in trade from less expensive to more expensive producers

• trade creation: switch in trade from more expensive to less expensive producers

(13)

Trade creation and trade diversion

• in 1965 Johnson suggested that the concept of

trade diversion and trade creation should be more precisely defined on the basis of welfare effects rather than in terms of trade flows

• trade creation - welfare change due to the

replacement of higher cost domestic production and/or higher cost imports by lower-cost imports

• trade diversion - welfare change due to the

replacement of imports from a low cost source by imports from a higher cost source

(14)

Trade creation and trade diversion

• in terms of world allocation of resources: trade creation is beneficial to welfare, while trade

diversion worsens allocation

• a customs union is economically justified if it leads to a trade creation, while a customs union

generating a trade diversion leads towards a

deeper protectionism and decrease of efficiency

(15)

Viner’s model - assumptions

• perfect competition in commodity and factors markets,

• perfect factor mobility within the individual countries, but not among the countries,

• full employment and foreign trade equilibrium,

• perfectly price elastic supply on the world market,

• economies and/or diseconomies of scale are not considered

(16)

Viner’s model - assumptions

• transport costs are not considered,

• at least three participants of the trade are

considered; countries A and B, discriminating in trade with the rest of the world, and the world

market,

• a partial equilibrium approach is adopted: one commodity markets are considered,

• customs union formation will not increase the tariff protection.

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Viner’s model – a small country and a big country

• A partial equilibrium model: customs union of a small country and a big country

• two countries:

H (home country)

P (potential partner country)

• world market W

• country H is assumed to be a small country, country P is assumed to be a big country

(18)

Viner’s model – a small country and a big country

• a partial market for one commodity

• let

S_H(p) be a domestic supply function

D_H(p) be domestic demand function for this commodity in the country H

• the supply by the partner country and the world market supply of the commodity is assumed to be perfectly elastic, hence the country H cannot

influence the price

(19)

19

Viner’s model – initial situation of general tariff protection

• let us denote

p_W world price

t non-discriminatory tariff

p_P the price in the partner country P

p_H the closed equilibrium price in the home country

p_W+t tariff protected price in H

• Assume that

p_W < p_P < p_W+t < p_H

• Initial situation: the small country H covers part of its domestic demand by tariff protected import

from the world market and considers formation of customs union with big country P

(20)

Country H in general tariff protection regime (before CU

formation)

TP equilibrium Et

EH

d q

s p

p H

W p +t

W

St(q) Sd(q)

Dd(q)

H

t t

Sw(q)

E_w CE equilibrium

FT equilibrium

d

sw q w q

p

pP

(21)

Welfare before CU formation

• domestic supply of country H is s_t,

domestic demand d_t and import from the world market at the price p_W + t is d_t – s_t

• welfare (shaded area in the graph) including

tariff revenues (d_t - s_t)t

.

p

q

(a)

consumers' surplus in TP

producers' surplus in TP

tariff revenues in TP

Et

E_H

d q s p

p H

W p +t

W

St(q) Sd(q)

Dd(q)

H

t t

Sw(q)

p P

(22)

Viner’s model – customs union with big country P

• assume that country H is considering a possibility of switching from tariff protection to customs

union with the country P

• after the customs union is created the trade inside the union will be tariff free, for the price p_CU = p_P

less than the p_W + t

• will there be a trade creation or trade diversion, welfare improvement for H compared to tariff protection?

(23)

Country H in customs union with big country P (after CU formation)

E

p

s q d q

p

H H

H W

t

t t

sCU d

CU

Scu(q) Sh(q)

St(q) E_CU

p

CU

p

W

+t p

P

=

CU equilibrium

Sw(q) E_w

(24)

Equilibrium in customs union of a small and big country

• comparing to tariff protection:

• effective supply curve for country H in the customs union will be S_CU

• domestic equilibrium supply will decrease from s_t to s_CU

• domestic equilibrium

demand will expand from d_t to d_CU

• the difference d_CU - s_CU

represents the import from the country P

• equilibrium price will decrease from p_W+t to p_P

E E

p

s q d q p

p

H H

H W

t

t t

sCU d

CU

Scu(q) Sh(q)

St(q) E_CU

p

CU

p

W

+t p

P

=

CU equilibrium

Sw(q) E_w

(25)

Welfare effects of customs

union of a small and big country

E

p

s q d q p

p

H H

H W

t

t t

consumers' surplus in CU

producers' surplus in CU

no tariff

revenues in CU

(a) (b) (c) (d)

(e)

sCU d

CU

Scu(q) Sh(q)

St(q) E_CU

p

CU

p

W

+t p

P

=

Sw(q)

(26)

Is customs union more beneficial for country H than tariff protection?

• welfare effects of customs union formation for small country H

• comparing customs union to initial

situation of a general tariff protection regime, is there a welfare gain in

country H?

• Comparing customs union to potential

general free trade regime

(27)

Comparison of welfare in CU and TP

p

q

(a)

consumers' surplus in TP

producers' surplus in TP

tariff revenues in TP

E_t EH

d q s p

p H

W p +t

W

St(q) Sd(q)

Dd(q)

H

t t

Sw(q)

p P

E E

p

s q d q p

p

H H

H W

t

t t

no tariff revenues in CU

(a) (b) (c) (d)

(e)

sCU d

CU

Scu(q) Sh(q)

St(q) E_CU

p

CU

p

W

+t p

P

=

Sw(q)

(28)

Trade creation and trade diversion in CU

• before the union was

created the country H was importing from the world market for lower price than in the customs union with country P

• strictly Vinerian approach classifying such a customs union as purely trade

diverting and, therefore, economically unjustified, is rather misleading and

problematic

E E

p

s q d q p

p

H H

H W

t

t t

no tariff

revenues in CU

(a) (b) (c) (d)

(e)

sCU d

CU

Scu(q) Sh(q)

St(q) E_CU

p

CU

p

W

+t p

P

=

Sw(q)

(29)

Trade creation and trade diversion in CU

• together with trade diversion following from increase of

producers’ price we can observe at the same

time a reduction of the more expensive

domestic production in favor of cheaper

imports from partner's country and decrease of domestic supply

E E

p

s q d q p

p

H H

H W

t

t t

(a) (b) (c) (d)

(e)

sCU d

CU

Scu(q) Sh(q)

St(q) E_CU

p

CU

p

W

+t p

P

=

Sw(q)

(30)

Trade creation and trade diversion in CU

• The total welfare effect for the

country H:

• The decrease of the equilibrium price

from p

_W

+ t to p

_CU

= p

_P

leads to an

increase of

consumers' surplus by the amount equal to regions denoted as (a), (b), (c) and (d)

E E

p

s q d q p

p

H H

H W

t

t t

no tariff

revenues in CU

(a) (b) (c) (d)

(e)

sCU d

CU

Scu(q) Sh(q)

St(q) E_CU

p

CU

p

W

+t p

P

=

Sw(q)

(31)

Trade creation and trade diversion in CU

• At the same time producers' surplus is decreasing by an amount equal to the area (a).

• The government is losing tariff

revenues equal to the regions (c) and (e)

E E

p

s q d q p

p

H H

H W

t

t t

no tariff

revenues in CU

(a) (b) (c) (d) (e)

sCU d

CU

Scu(q) Sh(q)

St(q) E_CU

p

CU

p

W

+t p

P

=

Sw(q)

(32)

Trade creation and trade diversion in CU

• Considering gains and losses we can see that areas (a) and (c) do not represent a gain, they are compensated by losses in producers' surplus and

government tariff

revenues, but only an internal redistribution of welfare between producers and

consumers

E E

p

s q d q p

p

H H

H W

t

t t

no tariff

revenues in CU

(a) (b) (c) (d)

(e)

sCU d

CU

Scu(q) Sh(q)

St(q) E_CU

p

CU

p

W

+t p

P

=

Sw(q)

(33)

Trade creation and trade diversion in CU

• the positive welfare effects of the

customs union for the home country

consists of areas (b) and (d). The trade

creation effect was defined by Johnson as a sum of these two areas, reg (b) + reg (d)

E E

p

s q d q p

p

H H

H W

t

t t

no tariff

revenues in CU

(a) (b) (c) (d)

(e)

sCU d

CU

Scu(q) Sh(q)

St(q) E_CU

p

CU

p

W

+t p

P

=

Sw(q)

(34)

Trade creation and trade diversion in CU

• Negative welfare effect is given by the region (e), the loss of tariff

revenues, used before for welfare redistribution, by Johnson this

represents a trade diversion effect

E E

p

s q d q p

p

H H

H W

t

t t

no tariff

revenues in CU

(a) (b) (c) (d)

(e)

sCU d

CU

Scu(q) Sh(q)

St(q) E_CU

p

CU

p

W

+t p

P

=

Sw(q)

(35)

Trade creation and trade diversion in CU

• the net welfare effect given as

reg(b)+reg(d)-reg(e) indicates, whether the trade creation or the trade diversion prevails in a

particular case of the customs union

E E

p

s q d q p

p

H H

H W

t

t t

no tariff

revenues in CU

(a) (b) (c) (d)

(e)

sCU d

CU

Scu(q) Sh(q)

St(q) E_CU

p

CU

p

W

+t p

P

=

Sw(q)

(36)

Trade creation and trade diversion in CU

• Conclusion: one can make no

general statement about the total

welfare effects of customs unions, an empirical

investigation of

each particular case is necessary

E E

p

s q d q p

p

H H

H W

t

t t

no tariff

revenues in CU

(a) (b) (c) (d)

(e)

sCU d

CU

Scu(q) Sh(q)

St(q) E_CU

p

CU

p

W

+t p

P

=

Sw(q)

(37)

Customs union puzzle: tariff reduction versus customs union

• Let before the customs union formation the tariff is t

₀

and

p

_P

< p+t

₀

< p

_H

then in the customs union with the country P the country H will import from country P instead from world market

• t

₀

will remain to be common external tariff

in the customs union

(38)

Customs union equilibrium

E

p

s q d q

p

H H

H W

t

t t

sCU d

CU

Scu(q) Sh(q)

St(q) E_CU

p

CU

p

W

+t p

P

=

CU equilibrium

Sw(q) E_w

(39)

Customs union equilibrium and welfare

• domestic supply of country H in the customs union will be s_CU, domestic demand will be d_CU and import from P to H will be d_CU – s_CU

• positive trade creation effect: area (b) and (d), negative trade diversion

effect: area (e), total positive effect if

reg(b) + reg(d) > reg(e)

E E

p

s q d q p

p

H H

H W

t

t t

no tariff

revenues in CU

(a) (b) (c) (d)

(e)

sCU d

CU

Scu(q) Sh(q)

St(q) E_CU

p

CU

p

W

+t p

P

=

Sw(q)

(40)

What is better: customs union or tariff reduction

• let us consider situation when country H decides (instead of forming CU with P) reduce unilaterally tariff protection from original level t₀ to the level of price p_P, it means that new tariff t_n is constructed in such a way that t_n=p_P-p_W

• in this case we shall get the same market

equilibrium in country H as in the case of customs union with P: the same domestic supply, domestic demand and import, but import now will come from the world market instead of from country P

• is it better or worse than the customs union with P?

(41)

Tariff reduction equilibrium

q

E

E_H

d q

s p

p H

W W

Sto(q)

Sd(q) Dd(q)

H

Stn(q) W

to

E_tn E_W

Eto equilibrium with tariff to

to to

s

tn dd

tn

Sw(q) p

p +to p +tn

Etn equilibrium with tariff tn

(42)

Customs union puzzle: tariff reduction versus customs union

• in the customs union tariff protection is abolished in internal union trade

and the government does not collect any tariff revenues

• in a new situation with reduced tariff t

_n

government tariff revenues will remain on the level of imports multiplied by

tariff

(43)

Welfare of tariff reduction

q

E

E_H

d q

s p

p H

W W

Sto(q)

Sd(q)

Dd(q)

H

Stn(q) W

to

E_tn

(a) (c)

(e) E_W

Welfare effect of tariff reduction from t0 to tn reg(b)+reg(d)+reg(f)+reg(g)

to to

s

tn dd

tn

Sw(q) p

(d) (b)

(f) (g)

p +to p +tn

(44)

Customs union puzzle: tariff reduction versus customs union

• Welfare gain of country H due to tariff

reduction to t

_n

(compared to the situation of tariff protection with t

₀

) corresponds to the areas (b), (d), (f) and (g)

• (b)+(d) = increase in consumer surplus

minus loss in producers surplus (a) minus decrease of the government tariff revenues (c) from the original imports

• (f)+(g) = increase of government tariff

revenues from extended imports from the

world market

(45)

Welfare in customs union and tariff reduction

E E

p

s q d q p

p

H H

H W

t

t t

(a) (b) (c) (d)

(e)

sCU d

CU

Scu(q) Sh(q)

St(q) E_CU

p

CU

p

W

+t p

P

=

Sw(q)

q

E

E_H

d q s p

p H

W W

Sto(q)

Sd(q)

Dd(q)

H

Stn(q) W

to

E_tn

(a) (c)

(e) E_W

Welfare effect of tariff reduction from t0 to tn reg(b)+reg(d)+reg(f)+reg(g)

to to

stn dd

tn

Sw(q) p

(d) (b)

(f) (g)

p +to p +tn

(46)

Tariff reduction generates more welfare than customs union

• When we compare this result to the welfare effect of customs union with country P, we can conclude that t_n < t_o implies

reg(b)+reg(d)+reg(f)+reg(g)>reg(b)+reg(c)-reg(e)

• the right side of inequality represents welfare effect (for country H) of customs union with country p

and the left side represents welfare effect (for

country H) of original tariff reduction t₀ the level t_n such that p_P = p_W+t_n without entering the customs union with P

(47)

Problems and questions

• why the customs unions are created at all, when the theory indicates that the same production and consumption effect and better welfare effect can be achieved by unilateral tariff reduction?

• do we have incompetent decision makers or there is something missing in the

theory?

• the answers probably should be looked for

in oversimplified structure of the Vinerian's

framework of customs union models

(48)

Some oversimplifications to be removed

• Perfect elasticity of partner's country

supply is a rather strong assumption, that is, perhaps, valid for economic relations between San Marino and Italy, but hardly for non-trivial economies.

• Customs union has usually measurable effects in both (in our simplified two

country model) or all (in a more general

models) participating countries. Hence the

assumption that export from country P to

country H has no influence on price should

be relaxed

(49)

Some oversimplifications to be removed

• Single commodity market assumption is also

rather misleading. Changes in supply, demand and price on one partial market influence also other

partial markets, so multi-commodity analysis can lead to more realistic results

• Vinerian’s models analyze only static effects,

ignoring dynamic effects, such as restructuring, economy of scale etc. Firms faced with increased competition will try to lower their costs to stay in the market and increased technical efficiency due to increased competition can have a welfare effect, exceeding many times the limited static effect.

(50)

Model of a customs union of two small countries on one-commodity

market

• assume as before two countries H and P, and the world market W

• In this case let both countries H and P are small economies, they still face a perfectly elastic world supply curve, but after formation of eventual

customs union of H and P the customs union

supply curve will be the sum of the two domestic supply curves, the customs union demand curve will be the sum of the two domestic demand curves and the customs union equilibrium price will be

different from closed equilibrium prices in the both member countries

(51)

Two small countries supply and demand, closed equilibrium

• let

S

_H

(p) be a supply function in H D

_H

(p) be a demand function in H S

_P

(p) be a supply function in P D

_P

(p) be a demand function in P

• Closed equilibrium (q

_H

,p

_H

) in H

p

_H

: S

_H

(p)=D

_H

(p), q

_H

= S

_H

(p

_H

)=D

_H

(p

_H

) Closed equilibrium (q

_P

,p

_P

) in P

p

_P

: S

_P

(p)=D

_P

(p), q

_P

=S

_P

(p

_P

)=D

_P

(p

_P

)

(52)

Two small countries supply and demand, closed equilibrium

pP pH

pw

COUNTRY H COUNTRY P

EcH

EcP

qH qP

(53)

Two small countries supply and demand, tariff protection

pP pH

pw

COUNTRY H COUNTRY P

EcH

EcP

qH qP pt

dtH stH

EtH

(54)

Customs unions of H and P, joint supply and demand

• Considering customs union of H and P, there will be a free trade among H and P leading to joint equilibrium, and common external tariff for trade protection with

respect of the rest of the world

• Supply in customs union: “sum” of two supply functions, demand in customs union: “sum” of two demand functions

• What means “sum” in our case?

(55)

Sum of supply and demand functions in H and P

p p p p p

H W+t

P W CU

qCU

q d^CU

P P s

P

s^CU CU H q

H d^CU

H

Country H Country P Customs union of

H and P D D

D_P _CU

H

S S

S

H

P CU

(56)

Sum of supply functions

Sum of supply functions in H and P

0 0

0 0 min{ , }

( ) ( )

( )

( ) ( ) max{ , }

SH SP

H SH SP

CU

P SP SH

H P SH SP

if p p p

S p if either p p p

S p

S p or p p p

S p S p if p p p

  

  

 

 



  



(57)

Sum of demand functions in H and P

Sum of demand functions in H and P

0 0

0 max{ , }

( ) ( )

( )

( ) ( ) min{ , }

DH DP

H DP DH

CU

P DH DP

H P DH DP

if p p p

D p if either p p p

D p

D p or p p p

D p D p if p p p

 

  

 

 



  



(58)

Customs union price

Knowing customs union supply and demand function S_CU(p) and D_CU(p), we can calculate equilibrium price of customs union p_CU of small countries H and P as the solution of equation

( ) ( )

CU CU

S p  D p

and comparing it to world price and tariff protected price we can decide whether the customs union of H and P has some justification or not. The necessary condition for welfare increasing customs union of H and P in this case is

CU

<

W

+ t

p p

(59)

Welfare in customs union of two small countries

• country H imports from the country P for the price p_CU and the welfare effects for country H are given by known formula reg(a)+reg(b)-reg(c), i.e. gain in consumers' surplus minus loss of government tariff revenues

• country P is an exclusive exporter into country H and its welfare effect is given by the area (d),

increase in producers' surplus minus decrease of consumers' surplus, which is, under given

assumptions, always positive.

(60)

Welfare in customs union of two small countries

• Then the total welfare effect of customs union for the both countries is reg(a)+reg(b)-

reg(c)+reg(d)

• Taking into account a bit more realistic case of an influence of

customs union on

market equilibrium in both considered

countries, the total balance of welfare changes increases

(a) (b) (c)

(d)

p p

p p p

country H country P

E

H H

W W

P

P CU

+t

q s d^P s sq d d

1 1

HH H H H

2 2

P P

1 1

(61)

EXAMPLE

•

One commodity market in country H with domestic demand and supply functions:

•

A potential partner country: P

•

World price: pW = 4

•

Non-discriminative ad valorem tariff: t = 1

•

Price in partner country: pP = 4.5

20p

- 370

= D (p)

50p +

50 -

= S (p)

H H

(62)

EXAMPLE

• From

• we get closed equilibrium price

• and closed equilibrium quantity

20p -

370

= 50p +

50 -

6 70 =

= 420 p^*

250

= p )

D (

= p )

S (

q^*= _H ^* _H ^*

(63)

EXAMPLE

• Case 1: Welfare of closed equilibrium

– Price of zero demand

– Price of zero supply

18.5

= p 0

= 20p -

370 

1

= p 0

= 50p +

50

- 

(64)

EXAMPLE

– Consumers’ surplus

– Producers’ surplus

– Total welfare in closed equilibrium 1562.5

= 250 6)

- (18.5 2

= 1 CS

625

= 250 1)

- 2(6

= 1 PS

2187.5

= 625 +

1562.5

= PS + CS TW _CE =

(65)

65

EXAMPLE

• Case 2: Tariff Protection

– Tariff protected market price

– Domestic demand

– Domestic supply

– Imports

5

= 1 + 4

= t + p

=

p_t _w

200

= 5

* 50 + 50 -

= p ) S_H( _t

270

= 5

* 20 - 370

= ) p D_H ( _t

70

= 200 -

270

= p )

S ( - p )

D_H ( _t _H _t

(66)

EXAMPLE

– Consumers’ surplus

– Producers’ surplus

– Government tariff revenue

1822.5

= 270 5)

- (18.5 2

= 1 CS

400

= 200 1)

- 2(5

= 1 PS

70

= 1

* 70

= TR

(67)

EXAMPLE

•

Total welfare under tariff protection:

•

Compared to closed equilibrium consumers are gaining, producers are losing, total welfare

effect is positive.

2292.5

= 70 + 400 +

1822.5

= TR + PS + CS TW_TP=

(68)

EXAMPLE

• Case 3: Customs Union of H with P

– Customs Union market price

– Domestic demand

– Domestic supply

– Imports

4.5 p =

p_CU = _P

280

= 4.5

* 20 - 370

= ) p

D_H ( _CU

175

= 4.5

* 50 + 50 -

= ) p

S _H ( _CU

105

= 175 -

280

= p )

S ( - p )

D_H( _CU _H _CU

(69)

EXAMPLE

– Consumers’ surplus

– Producers’ surplus

– Total welfare

1960

= 280 4.5)

- (18.5 2

= 1 CS

306.25

= 175 1)

- 2(4.5

= 1 PS

2266.25

= 306.25 +

1960

= PS + CS TW _CU =

(70)

EXAMPLE

• Welfare effect of CU compared to tariff protection:

• Conclusion: By Viner’s model of customs

union, in this particular case tariff protection is for country H economically more beneficial than customs union.

26.25 -

= 2292.5 -

2266.25

TW = TW -

WE_CU = _CU _TC

(71)

71

Likelihood of gains and losses from customs union

• The larger is the economic area of the CU and the more numerous are the countries of which it is composed, the greater will be the scope for TC.

• It is likely that TC will be greater than TD if

countries joining together in a CU are similar in the range of products they produce before the formation of the union.

– This is because TC occurs through the

replacement of domestic production by more efficient production within the union.

– If future members produce essentially different goods, there will be little scope for such

replacement and, hence, little trade creation.

VINER’S MODEL OF CUSTOMS UNION

Lecture 3

Topic 3, Economics of Customs Union