CHAPTER 5
ECONOMIC INTEGRATION:
CUSTOMS UNIONS AND
FREE TRADE AREAS
tienht@[Link]
CHAPTER’S OBJECTIVES
Clearly distinguish difference level of international
economic intergration
• Understand the definitions of trade creation and
trade diversion in custom union
• Understand the static and dynamic benefits of
various forms of economic linkage
• Use supply-demand diagrams to analyze welfare
effects of economic integration
• Calculate trade creation, trade diversion and net
welfare changes
Contents
The forms of economic The theories of Other welfare effects of
integration customs unions customs unions
THE FORMS OF ECONOMIC INTEGRATION
Preferential trade agreements
Free trade area (FTA)
Customs Union
Common Market
Economic Union
THE FORMS OF ECONOMIC INTEGRATION
Allow trading partners to
grant preferential terms in
the context of their trade
with each other
Preferential
trade
agreements
Provide low barriers on
trade among the
participating nation
THE FORMS OF ECONOMIC INTEGRATION
Free Trade Area (FTA)
Free trade Free to choose Eliminate all Only need a
among trading policies tariff barriers simple
members with trading organizational
partners control
\
THE FORMS OF ECONOMIC INTEGRATION
Customs Union
Free trade among members
The factors of productions cannot
mobile freely among members
Set common trade policies toward
the rest of the world
THE FORMS OF ECONOMIC INTEGRATION
Common
market
Set
The factors of
Free trade common
productions
among policies
can mobile
members toward the
freely among
rest of the
members
world
Economic Union
Set common
Unifying the The factors of Free trade
Unifying the policies toward
monetary productions among
social policies the rest of the
policies mobile freely members
world
SOME EXAMPLES OF REGIONAL ECONOMIC INTEGRATION
North America
Free Trade
Agreement
European
WTO
Union
Association of
Southeast Asian
Nations
THE THEORIES OF CUSTOMS UNIONS
• The effects of customs unions are measured in terms of trade creation
and trade diversion.
• Analysis method: Compare the gains from trade with and without the
existence of a customs union.
• The formation of the customs union results in two groups of effects:
Ø Statis effects: These effects appear immediately after the
establishment of the customs union
Ø Dynamic effects: This group of effects occurs later on along with the
activities of the customs union
TRADE CREATION
1. Definition
Trade creation refers to the increase in the economic welfare of member nations.
Trade creation occurs when some domestic production in a nation that is a member of
the customs union is replaced by lower-cost imports from another member nation.
2. Example
• Before the formation of the European Union, both the UK and France produce wheat.
The production cost in the UK is higher than in France. The UK did not import wheat
because of the imports tariff.
• After becoming a member of the EU, the UK imports wheat from France because there
is no tariff.
TRADE CREATION
3. Example
• Three countries in the market. Country 1 forms a customs union with
Country 2. Country 3 is a nonmember of this customs union.
• Country 1 is very small compared to Country 2 and 3
• Country 1 imports X
• The domestic supply curve of X: S = 10P – 20
• The domestic demand curve of X: D = -10P + 80
• The price of X at the Country 2 is P2 = 3USD, at the Country 3 is P3 =
3.5USD
TRADE CREATION
P Sd
Dd C1 đánh thuế lên 2 thg còn lại
C1 k có lợi thế
C1 import C2
C1 form custom union
5 Aftẻ forming,
The domestic price before the formation
of the customs union
4
a c The domestic price after the formation
b d of the customs union
3
C1 C2 C3
The free trade price 5 3 3.5
1$ tariff 5 4 4.5
C1 forms a customs
0 union with C2
10 20 30 40 50 Q - 1$ tariff for C3 5 3 4.5
- 0 tariff for C2
The graph indicates the effects of trade creation
TRADE CREATION
Before the formation of the customs union After the formation of the customs union
• C1 applies a nondiscriminatory tariff rate T • The tariff rate between C1 and C2 is: T
= 1USD/1 unit of X =0
• C1 imports from C2 with the price: P = P2 • C1 imports from C2 with the import
+ 1 = 4USD price is: P = P2 = 3USD
• The domestic demand: Qd = 40 • The domestic demand: Qd = 50
• The domestic supply: Qs = 20 • The domestic supply: Qs = 10
• Import volume: 20 • Import volume: 40
TRADE CREATION
The effects of trade creation on the countries:
ü An increase in the consumer surplus: ΔCS = a+b+c+d
ü A reduction in the producer surplus: ΔPS = - a
ü Tariff revenue declines: - c
ü C1 gains benefits: + (b+d)
- b is the domestic save because of a reduction in the production cost
- d is the gains from the increase in consumption
ü C2 receives net static gains as a whole thanks to the export volume growth
TRADE CREATION
4. The effects of trade creation
• Trade creation always increases welfare due to the production shifts from less
domestic producers to more efficient producers.
• Gains more benefits for consumers through a decrease in the commodity price
• A trade-creating customs union leads only to trade creation and increases the
welfare of members and nonmembers.
• The effects of the customs union are greater if the imposed tariff was higher and
the price elasticity of supply and demand in the importing country was greater.
TRADE DIVERSION có creation
Trade diversion is the replacement of the lower-cost imports
from outside the customs union by higher-cost imports from a
Definition union member
Before the formation of the customs union, the UK imports wheat
from the US. After forming a customs union with France, the UK
imports wheat from France although the cost of production in France
Example is higher.
Trade diversion can increase or reduce the welfare of members
Effects
TRADE DIVERSION
Example
• Three countries in the market. Country 1 forms a customs union with
Country 3. Country 2 is a nonmember of this customs union.
• Country 1 is very small compared to Country 2 and 3
• Country 1 imports X
• The domestic supply curve of X: S = 10P – 20
• The domestic demand curve of X: D = -10P + 80
• The price of X at the Country 2 is P2 = 3USD, at the Country 3 is P3 = 3.5USD
TRADE DIVERSION
P
Dd Sd
5
The domestic price before the formation
of the customs union
4
c The domestic price after the formation of the
3.5 a b d customs union
e Price at C2 C1 C2 C3
3 The free trade price 5 3 3.5
1$ tariff 5 4 4.5
C1 forms a customs
Q union with C3
5 4 3.5
0 - 1$ tariff for C2
15 20 40 45 - 0 tariff for C3
The graph indicates the effects of trade diversion
TRADE DIVERSION
Before the formation of the customs After the formation of the customs
union union
• C1 applies a nondiscriminatory tariff • The tariff rate between C1 and C3 is:
rate T = 1USD/1 unit of X T=0
• C1 imports from C2 with the price: P = • C1 imports from C2 with the import
P2 + 1 = 4USD price is: P = P3 = 3.5USD
• The domestic demand: Qd = 40 • The domestic demand: Qd = 45
• The domestic supply: Qs = 20 • The domestic supply: Qs = 15
• Import volume: 20 • Import volume: 30
TRADE DIVERSION
The effects of trade diversion on countries:
ü An increase in the consumer surplus: ΔCS = a+b+c+d
ü A reduction in the producer surplus: ΔPS = - a
ü Tariff revenue declines: - (c + e)
ü The welfare of Country 1 changes: (b + d) - e
- If b + d > e ð C1 increases the welfare
- If b + d < e ð C1 reduces the welfare
OTHER WELFARE EFFECTS OF CUSTOMS UNIONS
The formation of customs unions increase the level
of competition, the monopolistic market is put under
pressure to compete with other competitors
Increase competition
Outsiders set up production facilities
with the customs union to avoid trade
barriers imposed on nonunion products
Stimulus to investment
Competition stimulates the
development and utilization of
new technology
Stimulate technological innovation
Costs can be spread
over a large number of
goods
Achieve economies of scale in production
OTHER WELFARE EFFECTS OF CUSTOMS UNIONS
📄 OTHER BENEFITS OF CUSTOMS UNIONS
Static Benefits:
• Reduce administrative and business costs
• Improve trade conditions of economic integration
• Enhance members' position in bilateral and multilateral trade
negotiations
Dynamic Benefits:
• Enhance competitiveness of member countries
• Benefits from "economies of scale"
• Increase foreign investment attraction
• Promote economic-social reforms
• Promote cooperation in other fields
CONDITIONS FOR INCREASING CUSTOMS UNIONS EFFECTIVENESS
• The higher the tariff levels in member countries before establishing custom union, the higher
the potential for trade creation to outweigh trade diversion
• Geographic proximity enhances integration effectiveness
• The more numerous the member countries and the larger their scale, the higher the potential
for trade creation to outweigh trade diversion.
• The higher the development level, the more similar the countries, and the higher the
competition among member countries, the higher the probability of trade creation
outweighing trade diversion
• The larger the trade volume among members before establishing the customs union, the
smaller the potential for trade creation.
CONDITIONS FOR INCREASING CUSTOMS UNIONS EFFECTIVENESS
Exercise
Given the following data:
Country A B C
Px (USD) 16 12 10
Questions:
a) If Country A imposes a 100% non-discriminatory tariff on imported product X, in this
case, will Country A import product X domestically or from abroad? After that, if Country A
forms a customs union with Country B, what type of customs union will be created? Why?
b) Similarly to question a, but change the tariff to 50%
Thank You