By signing of the Treaty Rome under the name of European Economic Community in 1957, the European Community (EC) was established as a customs union. It abolished all tariffs and quotas between member countries, and imposed a common external tariff on outside imports. By the end of 1992, the Single European Market has been finally established, it removed other non-tariff barriers .since then commodities, capital and labour are able to move freely between member countries.
In 1973 the EC also formed a free trade area (FTA) in manufactures with the remaining members of the European Free Trade Area (EFTA). The FTA removed all barriers to trade in manufactures between member countries. However members of the EFTA retained their own tariff level on imports from countries outside of the EC and EFTA. An FTA agreement was established to control and limit free trade status to member countries’ products, in order to avoid imports with lowest external tariff coming through member countries within an FTA.
With the experience of European integration, it is crucial to discuss and study the topic free trade based on customs union and FTA. In this essay we will be focusing on both dynamic and static effects of customs union which is closely related with European integration; also some problems of the customs union theory will be outlined with empirical evidences.
Perhaps it is helpful to begin with some basis. At first, it is helpful to understand several questions. What is economic integration? What levels does it include? How important is customs union? The economic integration is a term describes how different aspects between economies are combined. There it is shown that if countries cooperate and set zero tariffs against each other, then both countries are likely to benefit relative to the case when both countries attempt to secure short-term advantages by setting optimal tariffs. This is just one advantage of cooperation. Benefits may also accrue to countries that liberalize labor and capital movements across borders, who coordinate fiscal policies and resource allocation towards agriculture and other sectors and who coordinate their monetary policies.
There are various levels in economic integration; normally they are partitioned into 5 levels: FTA (e.g. NFATA), customs union, common market, economic union, total integration. Customs union is a typical form of economic integration. With the exception of a FTA, other forms of economic integration are gradually formed based on customs union by expanding its field or content. Therefore, in theory, to analyse the economic impact on economic integration, mostly economists take custom union as the study object.
Before we move on the discussion of dynamic and static effects of customs union, it is necessary to compare customs union with FTA. As we mentioned above, customs union is a higher level comparing with FTA. In general, two or more countries agreeing to establish free trade can do so in one of two ways. They can establish a FTA, in which each country’s goods can be shipped to the other without tariffs, but in which the countries set tariffs against the outside world independently. Alternatively they can establish a customs union, in which a group of countries agree to eliminate tariffs between themselves and set a common external tariff on imports from the rest of the world. The European Union represents such an arrangement. With a customs union, all member countries must be able to agree on tariff rates across many different import industries.
There are two kinds of effects of customs unions, static and dynamic. The static effects relate to the impact of the establishment of the customs union on welfare. The analysis in this instance focuses on a comparison of the welfare of a country or groups of countries before and after the establishment of the customs union; thus the analysis is one of comparative statics. The dynamic effects focus on the impact the customs union on the rate of output growth of a country or countries in the medium term2 Many analysts have noted (Winters 1996) that supporters of customs unions and other regional preferential arrangements frequently find that the static welfare effects are typically small and possibly negative.
Firstly, we are concentrating on the static welfare effects. Viner( 1950 ) pointed out that it included an element of greater discrimination between member countries and non-member countries. He distinguished two aspects of the situation: trade creation and trade division.
Trade creation occurs when a customs union is formed; the member countries establish a free trade zone amongst themselves and a common external tariff on non-member countries. As a result, the member countries establish greater trading ties between themselves now that protectionist barriers such as tariffs, quotas, and non-tariff barriers such as subsidies have been eliminated. The result is an increase in trade among member countries in the good or service of each nation’s comparative advantage.
Trade diversion occurs when a country applies the same tariff to all countries, it will always import from the most efficient producer, since the more efficient country will provide the goods at a lower price. With the establishment of a free trade agreement, that may not be the case. If the agreement is signed with a less-efficient country, it may well be that their products become cheaper in the importing market than those from the more-efficient country, since there are taxes for only one of them. Consequently, after the establishment of the agreement, the importing country would acquire products from a higher-cost producer, instead of the low-cost producer from which it was importing until then.
The numerical example underlying can be used to illustrate how customs union is generally working. As we can see price for home, partner and rest of world (RoW) are assumed respectively: 50, 40, and 30. The case one is focusing on trade creation process. Suppose tariff is 30, before formation of the customs union, 50 is optimal price because after tariff, products from partner and RoW are not competitive anymore. However diverting situation would be showed up if a customs union is formed. Now the price of partner’s products is even lower than domestic production. Shall we take a look another case of trade diversion. The process is the same, firstly we set a tariff=15, and then we pick up the respective optimal prices (red circled) in both pre-customs union and post-customs union circumstances.
The diagram above is help understand the static welfare effects of customs union. This is going to explain some questions you might have when we discussed by using numerical example. Before the formation of the customs union, all import s come from the rest of the world as they are the cheapest. The price on the home market is OP2 (P1 + P1P2, P1 is the world price; P1P2 is the tariff). Consumers purchase is OQ3, and the output of domestic producers is OQ4. Q4Q3 is imported from the rest of the world, requiring a foreign-exchange expenditure of ADQ3Q4 and providing a tariff revenue of BCDA.
If a customs union is formed, the tariff is removed on the partner’s goods but not on those from the rest of the world and thus goods from the partner country appear cheaper at OP3. If P3 is less than P2, prices on the domestic market will be decrease. All imports are then acquired from the partner country and are greater at Q6Q5. Therefore, there is a diversion in the purchase of imports of Q4Q3 from non-members to the partner country. There is also a trade creation of Q6Q4, which is now supplied by the partner country instead of domestic producers. In addition there is an increase in consumption of Q3Q5, which is supplied by the partner country. The gain in consumer surplus and the loss in producer surplus due to lower price are P2CEP3 and P2BFP3 respectively. There is also a loss in tariff revenue of ABCD. Therefore the net gain is x + y – z. Here z stands for the cost of trade diversion. x and y are the familiar efficiency gains obtained from the reduction in tariffs.
A customs union would not only provide static effects, but there are some dynamic effects would be also brought to member countries. Since a customs union is established, it has created a good condition for member countries to export products to each other. All domestic markets of member countries composed of a unified regional market. This expansion on the scope of the market expedited the development of production. Therefore producers can continue to enlarge their production scale, lower there production costs and enjoy the benefit of the economies of scale.
The establishment of a customs union among member countries promoted the competitiveness of enterprises. Before a customs union formed, several firms dominated the domestic market acquiring monopoly profits. By forming a customs union, firms not only face competition from domestic market, but also foreign market. To succeed or at least survive, firms would have to improve production efficiency, increase the input on research and development, increase the adoption of new technology and constantly try to reduce the cost of production. Consequently it will lead to improve economic efficiency and promote technological progress.
Moreover, the establishment of the Customs Union will help to attract foreign investment. If a customs union is formed, the products from non-member countries will be discriminated. To avoid this kind of adverse effect of a customs union, non-member countries would divert their production and marketing to the country in which they target for, in order to bypass the unification of tariff and non-tariff barriers. Therefore a great amount of foreign direct investment will be attracted from non-member countries.
Nevertheless, some negative effects are also existed. Firstly the establishment of a customs union led to the formation of new monopolies. Unless there are more new members to join the customs union, otherwise the resulting slow technological progress will be intensified. Secondly the establishment of a customs union may be widening the economic gap between different regions in member countries. If a customs union is formed, the regional capital will flow gradually to a better investment environment. Without the effective policies, the gap between backward and advanced area will be distinctly.
Is customs union theory perfect? Is there any problem of customs union? The answer is obvious. The major problem of customs union is implementation. One example here is helpful to understand. A cargo that is unloaded at Marseilles or Rotterdam must pay duties there, but will not face any additional charges if it then goes by truck to Munich. To make this simple system work, however, the countries must agree on tariff rates: the duty must be the same whether the cargo is unloaded at Marseilles, Rotterdam, or, for that matter, Hamburg, because otherwise importers would choose the point of entry that minimized their fees. So a customs union requires that Germany, France, Netherlands, and all the other countries agree to charge the same tariffs. This can not be done easily.
In conclusion although the economic integration based on customs union is hard to implement and achieve. However , with the belief that economic unity would help cement the postwar political alliance between European democracies, the EU has become a supranational and intergovernmental union of 27 democratic member states, with a GDP of 13,400,000 million USD (2005). EU member states have agreed a programme called the Lisbon Strategy which aims at making “the EU the world’s most dynamic and competitive economy” by 2010.
Reference and bibliography
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R Baldwin & C Wyplosz, (2003) “the Economics of the European integration”, 7th edition, McGraw Hill Press.
P Krugman & M Obstfeld, (2006) “International Economics”, 7th edition, Addison Wesley Press.
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Sachs, Jeffrey and Andrew Warner (1995), “Economic reform and the Process of Global Integration,” in W. Brainard and G. Perry (eds.) Brookings Papers on Economic Activity, pp. 1-117.
Mike Walsh, lecture notes, “the International Economic Integration”