Momin A.

Qureshi BSc (Hons) (Econ) The University of Buckingham

In what way do the welfare effects of the EU customs union differ from free trade? There are several major differences between the welfare effects brought on by customs union and free trade. The case with the EU customs union is not any different from any other customs union in terms of welfare effects (compared with free trade). Therefore, for the purpose of this paper, we will look at customs union and free trade in general. To better understand the differences, we need to understand how a customs union differs from free trade and/or vice versa. Free trade and customs union both are basically a type of trade bloc. Jeffrey Schott describes trade bloc as an association of countries that reduces intra-regional barriers to trade in goods (and sometimes services, investment and capital as well) .1 It basically means that regional barriers to trade (tariffs and non-tariff barriers) are reduced or eliminated among the participating states. Non-tariff barriers may include import quotas, special licenses, unreasonable standards for the quality of goods, bureaucratic delays at customs, export restrictions, limiting the activities of state trading, export subsidies, countervailing duties, technical barriers to trade, sanitary and phytosanitary measures and rules of origin2. As far as differences are concerned, there are several between the two types of trade blocs mentioned above. Free trade and customs union are both unique but fundamentally the same as customs union is a restricted form of free trade. The main features of free trade are: supporting and protecting (a) the trade of goods without taxes (including tariffs) or other trade barriers (e.g., quotas on imports or subsidies for producers); (b) trade in services without taxes or other trade barriers; (c) the absence of trade-distorting policies (such as taxes, subsidies, regulations, or laws) that give some firms, households, or factors of production an advantage over others; (d) free access to markets; (e) free access to market information; (f) efforts against firms trying to distort markets through monopoly or oligopoly power; (g) the free movement of labour between and within countries; and (h) the free movement of capital between and within nations.3 In the case of a customs union, and how its both different from and similar to free trade is the fact that it does consist of a free trade area but with a common external tariff i.e. member states (of a union) agree to the same tariff rates on imports coming into the community from other parts of the world.4 This means that customs duties, import quotas, preferences or other non-tariff barriers to trade apply to all goods entering the area, regardless of which country within the area they are entering from. Simply put, a custom union is a union of countries where they trade freely among themselves as is the case with free trade, however in terms of trade with states that arent part of the union, they have a common tariff which basically means trade barrier apply to non-member states.

Regarding welfare effects, it is understandable that free international trade is beneficial to everybody involved in it due to comparative advantage. Comparative advantage according to the U.S. Bureau of Labor (Labour) Statistics is one nation's opportunity cost of producing an item being less than another nation's opportunity cost of producing that item.5 This basically means that despite a nation being more efficient than another in terms of producing one good, the difference in the opportunity cost makes it profitable for any nation as long as the opportunity cost is lower for them in producing that good. Looking at Figure 0 below, we can see that Country B has an absolute advantage over Country A i.e. Country B can produce both pottery and grain more efficiently than Country A per man-hour. However, we can see that Country A has a lower opportunity cost to produce pottery per man hour compared with Country B which shows that Country A has comparative advantage over Country B in producing pottery. This basically means that trade between Country A and Country B will be beneficial for both of them due to the fact that country A has an opportunity cost of 3 units of grain for producing pottery, while for Country B its 9.

Figure 0:

Output/Man Hour Country A Units of Pottery Units of Grain 6 3 Country B 9 12

As far as the welfare effects brought on by customs union and free trade are concerned and how they differ from each other, we need to understand the welfare effects of each individually. This could be better understood diagrammatically, Figure 1 shows the example of a country that wasnt involved in international trade and the effects of when it started to freely trade with the world.

Figure 1:

From the above diagram we can see that at point x, Country A receives Q1 quantity of grain at price P1. In this case there is autarky i.e. the country is not involved in international trade. However, we can also see that PW i.e. world price of grain is much lower than P1 which is what country A is paying. Well assume that country A then starts to trade with the world which will mean that country A will now pay PW for grain as thats the world price. As far as quantity is concerned, since the price has fallen which means domestic producers will have to sell at cheaper prices than before, the domestically supplied quantity of grain has fallen from Q1 to Q3. This would mean that to keep up with the quantity demanded of grain at PW, country A will have to have total quantity of grain at Q2 which means it will have to import Q2-Q3 from the world. From these changes we can do a comparison of before and after and see how it has impacted welfare. We can see that consumer surplus has increased from DP1X to DPWY and the producer surplus has fallen from SP1X to SPWZ. This shows that triangle XYZ has been gained which is of course a welfare gain. It should also be noted that for the above diagram PW=SW i.e. the world price of grain equals to the world supply of grain due to it being assumed that country A trading with the world will have no effect in terms of world price or supply of grain. The second diagram below assumes the very same situation but with an imposition of a tariff.

Figure 2:

For the above diagram well assume the exact same situation as Figure 1, however with an introduction of a tariff and the impact it might have on welfare. We can see that there is now a tariff imposition on PW i.e. world price of grain which means that consumers will have to pay more than they would have had there been no tariff and the tariff also implies that the government will have an increase in revenue i.e. tariff revenue. The welfare effects as seen from the diagram are that firstly the consumer surplus has fallen which is the area 1+2+3+4 compared with when there was no tariff as they have to pay price PW+t instead of PW. Producer surplus has increased by 1 due to the fact that the price has gone up. This implies that Q3 was the domestic grain supply when there wasnt a tariff, however since the producer surplus has gone up and the price has gone up, so has the domestic quantity supplied from Q3 to Q5. This also implies that due to the increase in domestic supply and overall decrease in demand and the imposition of a tariff, the quantity imported has fallen from Q2-Q3 to Q4Q5. This also means that triangle 2 and 4 are both deadweight losses as they were previously consumer surplus but now since the imposition of tariff they arent allocated to anything. Rectangle 3 represents revenue that is generated due to the imposition of tariff, it can be calculated as total imports*tariff=tariff revenue. The total welfare effect therefore can be calculated as -1-2-3-4+1+3= -2-4 (total welfare loss). This basically shows that going from free trade to having a tariff would have a welfare loss (2 & 3).

Both figure 1 and 2 are relevant to free trade and show the welfare effects of free trade. We can understand from both the figures that when there was a state of autarky in Country A, it was worse off than a country that was involved in free trade due to the welfare gains of free trade. We can also see from Figure 2 that international trade has welfare gains when it is absolutely free but has a welfare loss when trade has an imposition of a tariff. It should also be noted for Figure 2 that if a state has autarky but starts to trade with the world but imposes a tariff, itll still have welfare gains as long as PW+t(world price plus tariff) is lower than domestic price. Customs union on the other hand which is a controlled form of free trade has different welfare effects than what can be seen in Figure 1 and Figure 2. To better understand them, Figure 3 below needs to be analyzed.

Figure 3:

For Figure 3, well assume that there are two countries (one of which can also be replaced to represent the world), one of which the country in question (here on known as Country X) will form a customs union with. Well assume the two countries are France and America and PF and PA represents the price of grain in the respective countries and +t represents tariff. We can clearly see that if there is free trade, Country X will be better off trading with America as it is offering the cheapest selling price of grain. In fact, even with an imposition of a tariff, trading with America will still be

better for Country X as its cheaper than the domestic price which for the purpose of the this paper well assume it does. However, if we assume that Country X then forms a customs union with France, it will mean that the trade between them becomes free i.e. free from tariffs and non-tariff barriers. This would firstly mean that price of grain falls to PF and the domestic supply falls to Q4. As the demand is higher at PF, Q5-Q4 will be imported from France. Compared with the previous situation i.e. buying from America with a tariff, we can see that now country X has a consumer surplus represented by area 1+2+3+4, however in terms of producer surplus, theres a loss of area 1. We can also see that now due to a customs union with France, Country X will have a fall in tariff revenue represented by area 3+5. The net welfare effect is +1+2+3+4-1-3-5 = +2+4-5 meaning that there is a gain of area 2 and 4 however a loss of area 5. This means that if area 5 is greater than area 2+4, there is an overall welfare loss and vice versa and if area 5 is equal to 2+4, then the welfare effect is neutral. Area 2+4 according to Jacob Viner represents trade creation i.e. free trade effect brought about by abolishing tariff within a customs union, allowing import of goods from a member of the customs union who produces more cheaply than domestically.6 What can be gathered from the analysis of the different diagrams above for free trade and customs union is the fact that free trade will always have welfare gains (only of course if PW is lower than domestic price) due to world trade and comparative advantage. However in the case of a customs union, it might not always be the case. We can see in Figure 3 that forming a customs union could either have welfare gains or welfare losses, all depending on the size of areas 2, 4 and 5. It should also be noted that customs unions promote trade diversion as well i.e. trade being diverted from a more efficient exporter to a less efficient one.7 From Figure 3, we can see that trade is being diverted from USA to France due to the customs union as USA is clearly the more efficient producer. We can also see that had there been completely free trade in Figure 3, the net welfare effect would be a gain and compared with customs union would be far greater if area 2+4 was greater than 5. Therefore, it is safe to say that free trade will always have welfare gains and in most cases greater than customs unions.

Bibliography:

1. Schott, Jeffrey. "The World Economy." World Economy. n. page. Print. 2. Tingle, Rachel. "The Economic Theory of Integration and EU Customs Union in Practice."
The University of Buckingham. . Lecture. 3. Kluyver, Cornelis. Fundamentals of Global Strategy. Print. 4. "EU Facts: EU External Trade Policy." CIVITAS. N.p.. Web. <http://www.civitas.org.uk/eufacts/FSEXR/EC6.htm>.

5. United States. Department of Labor. Web. <http://www.bls.gov/bls/glossary.htm 6. Viner, Jacob. The Customs Union Issue. Print. 7. Tingle, Rachel. "The Economic Theory of Integration and EU Customs Union in Practice."
The University of Buckingham. . Lecture.