A Static Analysis of The Customs Union Issue
which considers all markets. In a theoretical frame work Lipsey 1957 considered this scenario using three countries and two goods in the same manner as previously discussed with respect to the three countries, A and B forming a union to stop A trading with C. However Lipsey adopts a slightly different approach in the way that he uses indifference curves in his analysis. This is shown below in fig 3.
Fig 3: Welfare In A Trade Diverting Customs Union
Source: International Economic Integration By M N Jovanovic p34
In a free trade situation A would trade with C and achieve indifference curve II at equilibrium point E, if a non discriminatory tariff was imposed then the price would increase to AT and equilibrium would be achieved at G along I’I’. If now that the government put the tariff money back into the economy then equilibrium must be at point K along AC. If now country A formed a customs union with B, the terms of trade line is AB, now points K and L lie along the same indifference curve I2I2. Although the structure of consumption has changed, the formation of the union has not effected A’s welfare. If point E represents the most favourable point of consumption, the formation of the union will only result in a shift from one second best position L to another sub optimal position K. If this occurs then country A is indifferent as far as welfare is concerned. If A’s terms of trade are worse than OB/OA then a common external tariff will make a worse off and have a negative welfare effect. If those terms are better than OB/OA then trade diversion can be beneficial to country A.
To go one step further, Lipsey developed his model where both goods are produced in the same country and substitution in production is also permitted. This is shown diagrammatically in fig 4 below.
Fig 4: Production and Consumption in Country A Before and After a Tariff
Source: International Economic Integration By M N Jovanovic p35
If country A is initially self sufficient, she will produce at Qa and consume at Ca, this is as both functions are tangential to the price line PA at the same point. If country A started trading in a free trade scenario at a price ratio PP between good X and Good Y then country A will now produce at Q and consume at C, as amount FG of good Y is exported and JK of good X is imported. If country A imposed a non discriminatory tariff on imports, production is at Q2 along the new price line TT and consumption is at C2. If the government decided to put all the tariff money back into the economy then there will be more imports shown by line RR and TT equals tariff revenue remembering that at this stage A is still importing from the most efficient producer C. If now A and B form a customs [next page]