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An Exploration Of The Traditional Customs Union Theory And The Static And Dynamic Effects Of Economic Integration

| January 12, 2017

Introduction

The benefits gained from regional integration are widely documented in literature and have been known since the time of classical economists (Oslington, 2013). Regional integration has become the subject of great interest due to the perceived benefits of preferential trade arrangements such as customs union, free trade area, and common market among many others.This paper will focus explicitly on customs unions, exploring the traditional customs union theory introduced by prof. Jacob Viner. The paper starts by defining customs union and then examines Viner’s framework of trade creation and trade-diversion effects.

It is important to first define customs union and introduce the theory of customs union. In general, tariff systems often tend to discriminate either between commodities or between countries. Commodity discrimination occurs where different commodities are subjected to different rates of duty whereas country discrimination occurs where different countries are subjected to different rates of duty on the same commodity (Lipsey, 1960). The theory of customs union is defined by the latter part which involves geographical discrimination by imposition of external tariffs to imports from non-member states.

As defined by (Clausing, 2000), a customs union is a form of preferential trade arrangement that involves a tariff-free market access between member countries while imports from non-member countries are subjected to a common external tariff.  Customs union have for a long time formed the basis for regional integration. This has primarily been driven by the perceived trade benefits for having such trade agreements between member countries. Some of the best-known customs unions include the Benelux formed by Belgium, Luxembourg and Netherlands; Zollverein which was formed by German states; and the EEC which was established by several states including France, Belgium and Italy, and is now widely recognized as the EU (Strielkowski, 2013). Other examples of customs unions are the Mercosur and the Andean Community (Hannam, 2014).

Viner’s framework of trade creation and trade-diversion effects.

Any useful literature exploring the welfare effects of custom union formation must commence with the appreciation of the traditional Vinerian orthodoxy which is based on two important considerations: trade creation and trade diversion effects. The Vinerian orthodoxy has been the driving force behind the huge volume of literature exploring the welfare effects of economic integration.

For a long time, the perceived trade gains of customs unions had provided the rationale for regional integration (Jovanovic, 1998). Such regional agreements were viewed as good in terms of the welfare benefits. However, following the work of Viner Jacob, this proposition turned out to be incorrect. Using the concepts of trade creation and trade diversion, Jacob Viner argued that regional trade agreements did not necessarily result trade gains in spite of elimination of trade barriers (Ambrego & Riezman 2003; Lipsey 2006).

Suppose that two countries A and B agree to form a customs union with country C remaining outside the union. If prior to the formation of customs union, country A was importing from country C which is a low cost producer. With the union formed, A chooses to import from country B which is a high cost producer. In this case, the welfare is lowered despite the benefits of a tariff-free market as trade is diverted from a low cost producer to a high cost producer (Ambrego & Riezman 2003; Lipsey 2006). However, if a union was formed between A and C, then trade will be created and the welfare will increase.

Using these static concepts, Professor Viner concluded that such regional agreements can only be beneficial to partner countries if it leads to trade in commodities which were not previously traded (trade creation) (Corden, 1972). Whereas if the union was trade diverting by shifting locus of production from low-cost third country to higher-cost partner country, then the effects are most likely to be detrimental for both partner countries and the rest of the world as well (Chipman, 1998 & Lipsey, 2006).

Since the publication of his seminal work in 1950, many economists have been interested in pursuing the impact of these two effects on world welfare. His work has been the driving force behind later subsequent literature examining the impact of regional trade agreements on welfare.

Subsequent empirical work

Much of the empirical literature on customs union formation has been motivated by the work of Viner (1950). Prior to Vinerian orthodoxy, it had been customary to recognize customs union as always increasing welfare. The classical economic theory behind the formation customs union was the presumption that higher degree of economic integration was beneficial (Jonavonic 1998). Customs union formation was viewed as a step closer to free trade liberalization hence was seen as increasing world welfare. Viner’s seminal contributions proved this argument to be incorrect.

However, Viner’s seminal contributions were challenged by Meade (1955) on grounds that the orthodoxy overlooked some of the benefits resulting in trade-diverting unions such as the benefits arising from substitution in consumption (Chipman, 1998). Lipsey (1957) and Gehrels (1956) criticized the Viner’s work over the same issue. These authors argued that preference considerations had to be taken into account when making determinations of the welfare gains and losses (Chipman, 1998). Dissatisfaction with the Vinerian orthodoxy led to the development of other approaches that yielded clear propositions including the general theory of the second best and the terms of trade-volume approach.

It is important to note that the traditional Vinerian orthodoxy was based on two simplifying assumptions:

  • Constant costs of production (Nicholls, 1993)
  • Fixed proportions in consumptions (Nicholls, 1993).

Meade (1956), Lipsey (1957) and Gehrels (1956) extended Viner’s basic model by relaxing the assumption of zero price elasticity’s of demand (Lee, 1978: p.248). This allowed for the determination of welfare effects with consideration of the changes in composition of consumption. Kemp (1969), Michaely (1965) and Vanek (1965) relaxed the assumption of constant costs.

What is missing from traditional customs union theory?

Besides these limitations, the traditional Vinerian orthodoxy seem to be missing important dynamic aspects which are crucial in determination of the welfare effect. The traditional customs union theory seems to concentrate more on trade creation and trade diversion effects that are likely to be trivial, ignoring those that are crucial in determining the net gains/losses from integration.

Pro-competitive effect

One particular aspect missing is the pro-competitive effect. For example, many small countries will tend to have a few large firms that may collude and raise prices at the expense of consumers. Forming customs union and ensuring a tariff free market will increase the degree of competition and force domestic firms to price more in line with marginal cost (Jovanovic, 1998). This pro-competitive effect will encourage them to reduce inefficiency and force them to price in line with marginal costs, thereby leading reducing the prices to consumers. This pro-competitive effect make it increasingly difficult for these firms to charge margins in excess of marginal costs (Josic & Josic, 2013)

In this regard, Baldwin & Venables (1995) emphasize the importance of pro-competitive effect and even suggest that regional integration amplifies the pro-competitive effect compared to global integration. Formation of customs union create a large market and subjects producers to new forms of competition. Increase in competition forces the firms to be reduce the levels of x-inefficiency and to price in line with marginal cost in order to gain a new market share.

Economies of scale

Another criticism of the traditional customs union theory lies in its failure to allow for economies of scale (Corden, 1972). Viner’s analysis fails to incorporate the effect of economies of scale. It is a fact that regional integration leads to the formation of larger markets which allows firms to exploit greater economies of scale. Customs union formation will therefore lead to the exploitation of greater economies of scale, thereby driving down the costs. With the tariff barriers removed, nationally-scaled firms may benefit greater economies of scale from the larger single market created (Cakmak & Yilmaz, 2008). Economies of scale will allow these union producers to achieve an optimum scale of production, increase their efficiencies and decrease the average production costs as well as the prices to consumers (Ginsberg, 2010: 95)

Technology spill overs

Yet another aspect missing in the traditional customs union theory are the larger effects of technological advances.  The productivity and innovative abilities of nationally scaled firms may further be enhanced by technology spillovers (Cakmak & Yilmaz, 2008). Research and development programs may help in improving technological innovations. There is a greater potential for technological innovation where such unions exist.

Accumulation or growth effects

Furthermore, given that integration leads to increased efficiency, it is also more likely to induce greater investment. This additional investment may lead to medium-term growth effect in some countries and can even improve long-run growth rates where the additional investment is associated with faster technical progress (Josie & Josie, 2013). From an investment perspective, foreign direct investment will be particularly important in boosting domestic growth.

Arguments for and agents removing all tariffs

Indeed there appears to be a number of justifiable reasons for customs union formation. A member country’s welfare as well as the world’s welfare can be raised if tariffs are reduced under such customs unions. However, the greatest benefits would be achieved by complete removal of the tariffs compared to mere reduction of these tariffs. The removal of all trade barriers will without doubt yield significant benefits in terms of reducing monopoly power, improving terms of trade, increasing efficiency, and improving technological innovations through technology spill-overs among many others.

In fact, customs union theory fails to justify or rather explain the need for customs union formation since complete removal of all trade barriers could have all the benefits without incurring potential losses associated with joining customs unions (Jovanovic, 1998). The welfare of a member country is less likely to be raised by a mere reduction in tariffs compared to complete removal. A free trade agreement would therefore tend to have more welfare benefits than a customs union since trade creation is merely dependent on removal of tariff barriers (Clausing, 2000).

However, Krueger (1997) points out that free trade agreements may not necessarily yield greater benefits than a customs union and even argues that it can generate additional welfare costs which would otherwise not have been incurred under a customs union. In fact, Krueger (1997) argues that a customs union will always remain superior to a free trade agreement. This points to the need for further analysis of the benefits and costs associated with Free trade agreements and customs unions formation.

Conclusion

Based on this analysis, this paper concludes that the static concepts of trade creation and diversion cannot appropriately measure the welfare effects of regional integration. Even though Viner seminal contributions points out that consumer welfare may increase due to tariff reductions while welfare cost may accrue from tariff discrimination of customs union, these static effects are trivial when considering the welfare effects of integration. The traditional customs union theory seem to ignore dynamic effects that are crucial in determining the net gains/losses from integration such as the pro-competitive effect, growth effect, economies of scale, and reduction of x-inefficiencies and monopoly power among many others

A prime example can be seen with the European Union, a single market that has had important consequences both within and outside Europe. Following the EU’s single market program, there is now a greater awareness of the importance of formation of customs union and of the value of removing tariff barriers. The EU is not only the largest single importer and exporter, but is also the world’s largest and richest economic entity (Ginsberg, 2010: p.96). The gains associated with joining the union far outweigh the economic risks/costs. The EU is currently planning to expand its reach other European nations. Preferential trading agreements seem to be growing more rapidly, both in size and number.

Reference

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