A customs union is an association of two or more countries to encourage trade. The countries making such an arrangement agree to eliminate tariffs and other restrictive regulations on trade among them. It is a discriminating trade arrangement since the liberalisation only includes the countries that are members of the customs union and they formulate and administer a common foreign trade policy in regard to tariffs and other trade restrictions against third countries.
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 1940's. Belgium, France, Italy, Luxembourg, the Netherlands and West Germany set up the EU in 1957.
Customs union theory builds on relatively 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. It has both positive and negative welfare effects, compared to a situation in which every member state practices protectionism. Therefore no conclusion can be drawn in advance as to the net welfare result of a customs union. It must be mentioned that some alternative theories have appeared which try to give an economic explanation of protectionism including customs unions but these shall not be discussed here.
In this essay I will start by looking at a small country in a small customs union. I will assess its effects on trade creation, trade diversion and trade expansion. This will be followed by the incidence of positive and negative effects of a customs union. I will then proceed to look at a large customs union in the world economy and link it to the terms of trade. Long term restructuring effects will be discussed, then the effects of 1992, and finally I will assess customs unions in relation to the EU and GATT.
A Small Country in a Small Customs Union
As already mentioned, the term `orthodox customs union theory' is due to the relatively strict assumptions of this theory, i.e. perfect competition in the commodity market and factor markets, perfect factor mobility within individual countries but not among the countries, foreign trade equilibrium and full employment. The opportunity cost in production is reflected in the relative commodity prices in each country and transport costs are not included since tariffs are assumed to be the only kind of international trade barrier.
Here I will look at a partial equilibrium model for a good X. It is a situation in which the small home country (H) forms a customs union with a small partner country (P). dH and sH indicate the home country's demand and supply of good X. sP and sW indicate the perfectly elastic supply by the partner country and the world.
Initially H imposes a non-discriminating specific tariff (T) on its imports, implying that the import supply curve is sW + T. Country H now consumes quantity O(1), where quantity O(2) is supplied by the home producers and quantity (2)(1) imported from the world producers. The creation of the customs union between country H and P will mean that the supply curve of country H will be sP. The price in the home market then decreases to pP. From this it can be seen that domestic production decreases from O(2) to O(4) while domestic consumption increases from O(1) to O(3). The imports of country H now also increase to (4)(3) and are no longer bought from the world producer but from the partner country at a price of pP.
Effects on Trade
To discover whether this new situation of a customs union has led to trade creation, trade diversion, trade expansion or a combination of the three, it is necessary to define them. Trade creation will occur when there is a shift from a higher cost to a lower cost producer, i.e. in country H demand will shift from the expensive protected domestic product to the cheaper product from the partner country, implying a shift from a less efficient to a more efficient producer. This is the case in the diagram and is shown by the area (4)(2). Trade diversion will occur when imports from the efficient or cheap world producer are replaced with imports from a less efficient and higher cost partner country. That country's product can be sold more cheaply in the home country than the world's products because the customs union imposes a protective tariff on the imports from the world, while leaving the imports of the partner country tariff free. This is also the case in our diagram and can be seen by the change from (2)(1) to (4)(3). Finally, trade expansion will occur if the lower market price in country H stimulates total domestic demand which will be satisfied by foreign trade. In our diagram the increase in total consumption can be seen by the area (1)(3).
The total welfare effects to H are also illustrated in this diagram. The increase in consumer surplus is equal to the areas (1)+(2)+(3)+(4). The decrease in producer surplus is area (1). The tariff revenue equal to areas (3)+(5) disappears. Areas (1) and (3) are internal redistribution from domestic producers and the government to the consumers. Hence the trade creation effect of the customs union is the sum of (2) and (4), and the trade diversion effect is equal to area (5). The question of whether the customs union leads to a welfare gain or loss cannot be answered unless we have further information about the relative sizes of the areas (2), (4) and (5). It can be said with accuracy that the larger the price elasticity and the difference between pH and pP, the larger the gain in welfare resulting from the trade creation effect and the larger the difference between pP and pW, the larger will be the size of the trade diversion effect of a customs union.
Determinants of gains from Customs Unions
Various factors exist which influence the occurrence of negative and positive effects of a customs union. I will mention five of the most important, the first being the production structure. Two countries can be complementary or competitive. If either country is a potential competitor of the other, specialisation in the products which either country can make best and cheapest is probable, and the advantages of a customs union are likely to be relatively important. The opposite is true if the production structures are complementary. The second factor is the size of the union. The more and the larger the countries participating in the customs union, the larger is its share in the total world trade and the smaller the risk of trade diversion. The third factor has to do with the level of the tariffs. If the initial tariffs of the trade partners are higher, the inefficiencies will probably be worse and the welfare effects of the abolition of the tariffs will be greater. Also the introduction of high tariffs against the world producers will reduce the positive effects. The fourth factor is transportation and transaction costs. For increased trade we will need efficient transport systems, the lack of which will replace tariffs as an obstacle for further specialisation. Clerical procedures at the frontier and linguistic differences in Europe also tend to make transaction costs higher. Finally, the advantages of forming a customs union are greater if member countries can respond more flexibly to new prospects.
A large Customs Union in the World Economy and Terms of Trade
Assuming the customs union is large there are two considerable implications for the total welfare of the customs union. The larger the customs union, the larger the possibility that the most efficient producers of various goods will be inside the customs union and hence, the smaller the potential for trade diverting effects. Secondly, when the large customs union fixes it's common external tariff rate then the possibility of it affecting its external terms of trade is increased and thus it can obtain an additional welfare gain.
So far I have assumed that the terms of trade relative to world producers will not be affected by the creation of a customs union but for a large customs union like the EU this assumption is not appropriate. For a large customs union a general tariff imposed on imports can lead to gains in the terms of trade which exceed the negative welfare effects resulting from a decrease in imports to the benefit of the domestic production. This is the rationale for the optimal tariff rates. I will illustrate this in a diagram.
In the initial situation the member states practice free trade on their own. Initial equilibrium is where the demand curve for imports of the potential customs union cuts the world export supply curve; imports being O(1) and price being pWo. With the formation of the customs union the optimal volume of imports from the world producers will be O(2) where the marginal cost of imports (sW) equal the marginal import utility measured along the demand curve for imports dCU. The optimal tariff rate for the union is therefore tCU. The creation of this customs union leads to an increase in the home market price to pCU and a decrease in the world price of good X from pWo to pW1.
There is a reduction in the import consumer surplus inside the customs union (area (1)+(2)) and the export producer surplus of the world is reduced by area (3)+(4). The total tariff revenue (1)+(3) accrues to the customs union. In this case the customs union has a trade diverting effect and there is a global efficiency and welfare loss of areas (2)+(4). Since the tariff rate tCU is optimal the customs union achieves a net welfare gain since efficiency loss (2) is less than the welfare gain resulting from the improvement in the terms of trade on the quantity of imports O(2), i.e. area (3).
Long Term Restructuring Effects
Restructuring or dynamic effects occur with the creation of a customs union because firms, workers and governments react to new situations and adapt the structure of production and the economy. 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. An establishment which can produce larger quantities cheaper than smaller ones and is constrained in its outlets by a market of limited size, would profit from the extension of the market, for example, by a customs union. The justification for the creation of a customs union on the point of economies of scale depends on the net effect for the entire customs union and their division between the partners.
Advantages of a customs union internal to the company depend on the size of the company, its growth rate and its learning curve. The larger the company the more efficient is its production and the stronger is its negotiating position. They are also more able to build up stable market positions in export countries. The growth rate of companies tends to have a positive effect on efficiency. Fast-growing firms have the most up to date machinery etc. but they tend to be less flexible in their response to entirely new markets. The learning curve indicates that companies learn to produce more efficiently by the production of greater numbers. Expansion permits producers to offer products of higher quality that are better adapted to specific consumer needs and demand will increase. Also, when a customs union puts a company in a better position, the positive influence is not confined to that company but extends to all related suppliers and buyers. That effect will be greater the better the various parts of the economy are equipped to respond to the impulse.
As barriers such as tariffs, quotas etc. are eliminated, domestic producers have to reduce their price to the level of the partner country. Excess profits will disappear and inefficiencies like overstaffing will have to be reduced. Consumers gain from these price reductions as they obtain more goods at lower prices and producers offset the loss by price reductions.
High Stakes for Europe: The 1992 Challenge
In the integrated Community market post-1992 a dramatically new environment awaits consumers and producers alike. The removal of a whole range of non-tariff barriers, i.e. government protection in procurement markets and a plethora of differing product standards leads to an immediate downward impact on costs. More substantial gains will be generated by completion of the EU internal market. There will be a new and pervasive competitive climate and firms can exploit new opportunities and make better use of available resources.
There are four major consequences which are expected from the combined impact of the removal of barriers and the subsequent boost to competition:
* a significant reduction in costs through the reorganisation of business and economies of scale
* improved efficiency within companies due to the downward pressure on costs due to more competitive markets
* new patterns of competition since real comparative advantages will play a determining role in market success
* increased innovation because new business products will be generated by the dynamics of the internal market.
These effects will be spread over differing time spans but the overall effect will be an increase in the competitiveness of business and the general economic welfare of the consumer.
The consumer will no longer be confronted with enormous price differences depending on their country of residence, as is the case in today's Community. Due to the reduction in costs, the level of this price will be on the downward journey. The consumer will also be faced with a wider choice as a result of market integration and increased competition leading to differentiating products as well as economies of scale.
1992 has led to the end of firms relying on the national soft option. Those who are able to scale up their performance to the demands of increased competition, will have an outlook for sales and profits which is dynamic but for others profits will be clearly squeezed by Europe's competitive renewal.
Strengthening European competitivity leads to the reconquest of the European market, but failure to do so will not mean that the challenges of the European market will not be mastered. They will, but not by the Europeans.
EU, GATT and Customs Unions
The basis of the EU according to Article IX of the Treaty of Rome is a customs union. Articles XII to XXIX give a detailed description of phasing out the internal tariff rates and establishing common external tariffs. In July 1968 a customs union for industrial goods had been realised. The idea of the customs union was to establish a totally free internal commodity market in the EU. This goal has still not been fully realised due to the use of non-tariff trade barriers such as technical trade barriers, government subsidies, etc. which became increasingly important in the 1970s.
Customs unions are discriminating trade arrangements and hence violate the rules of GATT. Under GATT's `principle of most favoured nation' member countries have to give each other the same favourable treatment that they give to any other country. Customs unions between a limited number of countries is a clear violation of the principle, but Article XXIV of the GATT treaty gives the right to form regional customs unions if certain conditions are satisfied because the overall aim of GATT is to promote international trade. When GATT was created in 1947, it was the widespread belief that customs unions were a step closer to free trade and it was not until later that it became clear that customs unions could in fact be a form of protectionism.
The creation of a customs union has some positive and some negative welfare effects. It can only be well founded in economic terms if the former exceeds the latter. The welfare effects of the customs union as a whole are uncertain. Only if it is possible for a customs union to affect the external terms of trade through the optimal tariff is it possible for the union to achieve a gain in net welfare.
In relation to the short term effects which affect consumers, producers and governments, customs unions tend to have more positive effects as production structures are more competitive, initial tariffs are higher and also, as customs unions are larger transaction costs are lower. Competition and economies of scale are long term effects and are better reasons for creating customs unions.
Cecchini, P (1988) The European Challenge 1992
El Agraa, A (1981) Theory of Customs Unions
Henderson, W (1959) The Zollverein
Molle, W (1990) The Economics of European Integration
Nielson, H (1992) An Economic Analysis of the EC
Palmer, J (1989) 1992 and Beyond
Yannopoulos, G (1988) Customs Unions and Trade ConflictsGATT and the EC: The case of Agriculture