If any country becomes the member of customs union and the trade diverting effects are faced it would mean that this country will have to pay more price for x, more price for y or more price for both the goods. However, in such situation the domestic consumers will not be paying tarrif. Thus such good will become available cheaper to domestic consumers. They will purchase more of this cheaper good, provided the domestic consumers make substitution. In such situation the welfare of domestic consumers will increase. But to analyse the increase or decrease in welfare we will have to consider the two effects.
(1) The fall in terms of trade which will lead to reduce welfare (2) Increase in welfare of consumers which took place due to fall in price.
Here the basic equilibrium of the economy takes place at A where it is producing good x. Before the formation of union this country used to import good y from country B when the terms of trade is AB. If the trade is free the country will consume at point d. If duty is imposed on good y the terms of trade will be U. Now the consumption takes place at ‘C’ where a lower indifference curve is tangent to it. It is obvious that because of tarrif the consumption of y decreases and that of x increases. In other words there is a substitution of x for y.
Now we suppose that this country forms union with country C. As a result on the one side there will be trade diversion and on the other side, the terms of trade will go against as shown by AC. The country A still produces x at point A. In country A the good y becomes again cheaper as compared with tarrif inclusive price (because of customs union). Now the consumption take place at F where indifference cure (U1U2) is tangetn to AC. The point F lies on the same indifference curve where ‘e’ lies. It shows that level of satisfaction same both before and after customs union.
If there is lesser fall in terms of trade due to customs union, as terms of trade curve lies in between AB and AC, consumer welfare may go up even because of trade diverting effects of customs union. The level of satisfaction may go up from U1 but it will still remain below U2.
Dynamic Effects of Customs Union:
The effects of customs union i-e trade creating, trade diverting, consumption and production effects are concerned with static analysis. As a result of these effects there will be reallocation of resources. However there is no change in resources and technology. Some industries expand, some industries shrink and the goods become available to the members of union at lower prices. But the over all situation remains the same what it was before the formation of customs union.
If due to establishment of customs union a change in resources occurs, technology changes, stock of capital and investment change. All such will be concerned with dynamic effects of customs union.
The dynamic effects of customs union are concerned with the followings:
1. Increase in Competition
2. Economies of Scale
3. Increase in Investment
4. Better use of Resources
All these are discussed as under:
1. Increased Competition: In the absence of customs union, and the presence of tarrif the domestic producers become sluggish. But because of customs union when tarrif walls are removed the domestic producers will have to compete with the members of customs union. As a result, the domestic producers will improve the quality of their products. The skill and technology will be improved. In this way, the domestic goods could also be produced at lower costs leading to welfare of the masses.
2. Economies of Scale: Because of customs union markets are extended giving rise to economies, both internal and external. Under perfect competition all the economies are reaped because here the plants are optimally used. On the other hand, under imperfect competition the plants are un-optimally utilised. Therefore when due to customs union the markets are extended the demand for goods will increase. The plants will be used upto their maximum limit gibing rise to economies. The economies of scale are concerned with costlier and superior machinery, equipments, plants, innovation, invention, research and technology. Before customs union a country is a static. But after customs union when there is a better use of plants the economies of scale are accured.
In addition to internal economies the external economies cal also be reaped with the establishment of customs union. Because of industrial development the skilled labour and efficient managers will become available. Moreover when big industries are setup so many small firms will also come into being. As if automobile industry is established the industries producing spare parts, automobiles, tyres and tubes will also develop. Because of internal and external economies the technology and technical progress will develop. The effects technical development will be concerned with dynamic effects of customs union.
3. Increase in Investment: Because of customs union when markets are extended the investment will increase so that extended markets could be availed of. As after custom union the discriminatory treatment is provided to non-members they are restricted with heavy tarrif. In such situation the foreigners will think to invest when their goods are restricted. As a result, the foreign investment in customs union would increase. This is the reason that the E.U is of big attration for American investors. Therefore the foreign investment in customs union is given the name of “Tarrif Factory”.4. Better Utilization of Resources: Because of the customs union the labour and capital become mobile between the member countries. The labour move to those countries of union where they got higher wages. In the same way, the capital will move in those countries where the interest rate is higher. In this way, so many administrative, technical and institutional changes will occur. They will have their social and political influences. Such all will be concerning with the dynamic effects of customs union.