When because of customs union the member countries abolish tarrif the new source of supply are created or a substitution takes place between old source of supply and new source of supply. Such substitution has been called static effects of custom union. The static effects of customs union are two types. They are as:
1. Trade Creation Effects of Customs Union
2. Trade Diversion Effects of Customs Union
These effects are discussed below with partial equilibrium approach.
Trade Creation Effects:
As a result of this effect of customs union the expensive domestic source of supply is replaced by the cheaper source of supply from member country. In other words the customs union cerates a new source of supply. As a result, the domestically produced goods which was protected on the basis of tarrif, its production is reduced. For example before the establishment of EU the producers in
Therefore, if due to customs union the production is shifted from thigh cost source to low cost source the world’s production and trade will increase. Such situation is given the name of “trade creation”. Thus if due to customs union, the cheaper goods become available, the trade will be created which is given the name of trade creation. Because of trade creation world’s resources will be utilised in a better way; goods will become available at lower prices, the specialization will be encouraged. All such will have the effect of increasing world’s welfare. It is so because that such customs union will lead to increase real income of member countries. The increase in incomes will lead to increase the imports of the union or the exports from other countries. Consequently the incomes of exporting countries will increase. Now we explain trade creating effects of customs union.
Here Dx2 and Sx2 are the demand and supply curve of good x in the country-II. In the presence of free trade the Px = 1. If this country-II imposes tarrif on good x equal to 100% the Px rises to 2. At this price the country-II consumes GH of good x. In other words at Px = 2 the demand for x is GH. While at such price the domestic production (supply) is GJ. As a result the imports of x are JH which are being imported form country-I. In such a situation country-II is also earning revenues equal to MJHN. In the presence of free trade SI curve is the supply curve of good x by the country-I which is perfectly elastic. Because of imposition of tarrif by country-II the supply curve of good x becomes S1 + T.
We suppose that the country-II does not import good x form country-III. We suppose that country-I and II integrate into economic union. As a result the tarrif on the imports from country-I is abolished. In this way the price of x will be 1 even in country-II. At such price the good x will be demanded in AB quantity, out of it AC will be produced at home and the amount of imports will be CB. In such situation the country-II will no be getting any revenue. However the consumers have obtained the surplus equal to AGHB which has led to raise the welfare of the consumers. Whereas the area AGJC shows the reduction in the producers surplus. It means that the good x which was being produced in country-II at higher price under the shield of tarrif will not be produced now when custom union is established. As a result the producers surplus will come down. Again the govt. revenue will fall by MJHN. The establishment of custom union has led to reduce the misallocation of resources by the area CJM. The increase in welfare of the consumers has been equal to area NHB. The consumers of country-II are consuming good x more than earlier. Therefore the sum of CJM and NHB shows the static effects of customs union.
2. Trade Diversion Effects:
If because of customs union a member country is getting the goods from the costlier source of union istead of cheaper non-member source, such effects of customs union are given the name of trade diversion effects. It is explained with the help of following table.
Cost of Production
We suppose three countries A, B and C, the cost of producing good x are $50 in A, $40 in B and $30 in C. If country A imposes 100% tarrif the country will not have to import good x from any country and the good x will be supplied form domestic source. If 50% tarrif is imposed on good x it will be imported from country C, as its price in A will be $45. We suppose that country A and B integrate into a custom union. Now the good x will be imported from country B. it is obvious that the imports have been shifted from a cheaper non-member source (country C) to the expensive member source (country B). Such will be against the creation of world trade. This is the reason that they are given the name of ‘Trade Diversion’ effects of customs union. Thus trade diversion effect occurs when goods have to be imported fom less efficient country instead of more efficient country. In this way world trade will not increase. This situation will lead to misallocation of resources. This will contradict the law of comparative cost and international division of labour and specialization would not take place.
The trade creating customs union can come into being because of trade creation and trade diversion. In this way the welfare of members of the union can increase as well as decrease. But this depends upon both trade creation and trade diversion effects.
The trade creating customs union leads to create trade. In this way the welfare of member and non-member countries will increase. Whereas the trade diverting effects of customs union can give rise to both trade creation and trade diversion.
According to Prof. Viner, if assumption of price inelastic demand is relaxed both trade creation and trade diversion effects may arise because of formation of customs union. Then when demand is not perfectly inelastic, the fall in price will result in increasing the consumption. This will be a source of welfare gain. Such consumption gains will increase the gains which would rise due to trade creation. Moreover they will offset the welfare reducing effects of trade diversion. In this way, the trade diverting customs union may lead to an increase in welfare.Net Welfare: We have seen above that trade creation leads to a welfare gain and trade diversion to a welfare loss in country as a result of the formation of customs union. The net welfare effect is the difference between welfare gain and welfare loss. Thus in terms of net welfare effect the trade creation effect predominates, the customs union is made better off or if the trade diversion effect predominates it is made worse off. If the two effects happen to be equal, the gains and losses are equally distributed between members of the union. Consequently the net welfare effect of customs union depends on which of these effects is stronger.