Consequences Of The Customs Union Theory

998 Words 4 Pages
To what extend have the predictions of the customs union theory been supported by the empirical evidence in Europe? What are the problems of empirically testing customs union theory?

Since the end of the second world war, there has been many forms of economic integration proposed and implemented. In order for us to understand a customs union, we must understand what it means to be in a free trade area which is the first level of economic integration. A free trade area is where member countries remove tariffs and quotas between themselves, but retain whatever restrictions each member chooses with non-member countries (Sloman, 2012). The 1957 Treaty of Rome committed EU members to a free-trade area but also to a customs union (Baldwin et al,
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A customs union (CU) was initially regarded as a move towards free trade of goods and services coupled with a common external tariff. Viner (1950) was a pioneer for CU analysis and concluded that the combination of free trade and protectionist measures could result in trade creation (TC) and/or trade diversion (TD). Trade creation is the replacement of expensive domestic production by cheaper imports from a partner and trade diversion is the replacement of cheaper initial imports from the outside world by more expensive imports from a partner (El-Agraa, 1989). An example of trade creation can be seen in table 1 below, where you’re buying from a more efficient producer within the CU, moving from home production to importing from a partner. Table 2 shows trade diversion as it would be more beneficial to import from outside the CU, however, due to protectionist tariffs, it becomes cheaper to import from within the CU. Therefore, moving from a more efficient producer to a less efficient producer. Viner argued that TC is a good aspect of CU theory while TD is harmful, therefore in order to understand whether CU theory can be supported by empirical evidence in Europe, is reliant on the relative strength of these two …show more content…
The curves and show the supply and demand of Poland. Prior to joining the customs union, Poland had to pay a tariff in order to trade with EU countries, indicating that Poland traded at a price of P1. From figure 1 we can infer that at this price of P1, Poland would produce at Q2 and consume at Q3, where the price level meets the supply and demand curve respectively. Therefore, Poland would import Q3 – Q2. However, as Poland becomes a part of the customs union, tariffs are removed with the free movement of goods and services between partner countries. The price level decreases to P2 which causes production to fall to Q1 and consumption to rise to Q4, demonstrating an increase in imports of Q4 – Q1. This implicates trade has been created. In order to determine the relative strength of trade creation we have to analyse the welfare effects. Figure 1 also illustrates the gain in welfare from a decrease in price from P1 to P2. Area 1 + 2 + 3 + 4 is the increase in Polish consumer surplus while area 1 is the profit lost by domestic firms by competing within the customs union and area 3 is the loss of tariff revenue the government has had to give up. This leaves a net

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