A Static Analysis of The Customs Union Issue
is represented by the orange Ä UMN and trade diversion is shown by HLMI, but the production inputs are larger which results in a net gain. In the case of country B, the customs union will cause a rise in price, the consumers get less but have to pay more and that is indicated by Ä VXU. As additional resources were drawn in to produce more of the product, there will also be a production loss Ä RZW, but these costs will surely be outweighed by the extra trade with country A, so country B will benefit in the long run.
Viner’s conclusion was challenged by Cooper and Massell in 1965 when they claimed that the theoretical process involved in determining trade creation and diversion was not useful in the analysis of welfare gain. Firstly they should, before the customs union is formed reduce the tariff level for B and C so it would give the same union price and production, consumption and import changes. Then they should start a customs union from the new price which if you refer back to Fig 3 would be OaPcu, this will ensure that the gains from trade creation ÄKRL and ÄMUN still accrue while the losses from the trade diverting effect will not be there as the new supply curve GKLMN makes sure that imports come from country C at the cost of CDHI. As far as trade creation goes, the new imports will cost less which will lead to gains of KVLH and MNIT. This suggests that an equal tariff reduction policy is more favourable than a customs union as far as world welfare is concerned, the trade diverting effect is eliminated and there is more trade creation. This is reverting back to the concept of a free trade area.
However Aarnt 1968 pointed out that variable terms of trade can make customs unions superior to Cooper and Massell’s alternative which is a rather valid point in terms of the EU and its bargaining power. Wonnacott and Wonnacott 1981 looked at the scenario of the rest of the world also employing tariffs, they looked at the reasons why customs unions are formed and came to the conclusion that as the world is already tariff ridden then a customs union is the best option.
Johnson 1965 came to the conclusion that trade diversion is preferable to trade creation as the supply curve of C becomes more inelastic, although C will lose more, the countries within the union will sacrifice less and less domestic production. He added that both trade creation and trade diversion may lead to greater efficiency through economies of scale. Johnson’s theory is not as accepted as the Viner interpretation on the grounds of conflicting views on the assumptions that he made, the distinctions between social and private costs and benefits .
What we have looked so far is partial equilibrium model which only considers the market for a single good. An extension on the static framework includes a general equilibrium model which [next page]