A Static Analysis of The Customs Union Issue
RG Lipsey
Economic Journal Vol 70 Sept – Dec 1960 p497
If country A levied a Tariff of 100%, it would be enough to protect its domestic market that is producing commodity X. If A formed a customs union with B it would only have to pay 26s instead of 35s., this is trade creation. Now before the existence of the customs union A would have had to pay a tariff on goods imported from B and C, she would always buy goods from C as they are produced at the cheaper price. However with the formation of the customs union with B, the tariff which was say 50% is waived, and A will buy from B as opposed to C who is producing the good more efficiently. This is how Viner described trade diversion, trade is being diverted from a lower to a higher real cost source. What this means is that B is sufficiently tariff protected to eliminate competition from C which will secure A’s market for B’s inefficient industry. However A and B are both producing the product inefficiently and a customs union is formed then B will capture the union market at the expense of A, this is trade creation which results from trade diversion. Viner always regarded trade creation as good and trade diversion bad.
“Where the trade creating force is predominant, one of the members at least must benefit, both may benefit, the combined two must have a net benefit, and the world at large benefits; but only the outside world loses, in the short run at least, and can gain in the long run only as a result of the general diffusion of the increased prosperity of the customs union area. Where the trade diverting effect is predominant, one at least of the member countries is bound to be injured, both maybe injured, the two combined will suffer a net injury, and there will be an injury to the outside world and the world at large”.
Jacob Viner: The Customs Union Issue
If you refer to Fig 2 below, assume that the supply from the producers in the rest of the world is fully elastic at Pw. Also assume that Country A is the high cost producer where it wants to capture its home market by a large tariff. Country B produces at a lower cost and only has a low tariff. Suppose now that A and B form a customs union which has a common external tariff t*, this is determined by an averaging of the two tariffs. Supply and demand settles at Pcu. Now country A will buy all its imports BE from B as Pcu is lower than Pwt*t, production in country A is now OaB and country B then produces ObE’ and of this exports B’E’ equal to BE in country A.
Fig 2: Trade and Production Effects of a Customs Union for Countries A and B
Cou