Customs union theory - the static and dynamic
effects of integration

Distinguish between static and dynamic effects

Static effects
occur in the short run within a given time period.
Dynamic effects occur in the long run over a series of time periods. Eg A
SS & DD represents consumer and producer behaviour for a given time.

Illustrating the effect of, say a tariff and analysing the impact in on welfare
is known as
comparative static analysis

Explain trade creation and trade diversion

Trade creation
The replacement of expensive domestic production by
cheaper imports from more efficient partner countries

Trade diversion The replacement of cheaper initial imports from lower cost
producers outside the union to less efficient producers in member countries

Illustrate the static effect of joining a customs union

Assume the UK is not a member of a customs union: SW represents
the world supply of a good.

If the UK imposes a tariff = P3-P1 on imports, Q4 is exchanged of which Q3
is supplied by domestic firms and Q4-Q3 is imported

The UK now joins a customs union whose common external tariff (CET) is
just P2-P1. Q5 is now consumed of which Q2 is supplied
domestically and Q5-Q2 imported

Economic integration results in a
trade creation effect: Q3-Q2 is
now supplied by cheaper imports from more efficient member countries.

Consumers gain from increased consumption (Q5-Q4)
Domestic producers lose from lower output (Q3-Q2)
Government tax receipts from tariffs falls by area C

Assess the trade creation and diversion effects of joining a customs

The static cost and benefits of economic integration can be assessed using
supply and demand analysis.

S1 represent the supply of a good, say, lamb from an efficient producer, say,
New Zealand (NZ). S2 is the EU supply for lamb nb the EU is a less
efficient producer

Before joining the customs union, the UK imposes a tariff of t. The UK price
of imported NZ lamb rises from P1 to P3 and lamb imported from the EU to
P4. The price of lamb in the UK is now P3
and UK consumers buy Q2 lamb: Q1 from domestic firms with Q2- Q1
imported from NZ.
No lamb is imported form the EU.

The UK now joins the EU and tariffs on EU imports are removed but remain in
place for NZ lamb. The UK price of lamb falls to P2. UK consumers buy Q4
lamb: Q3 from domestic firms with Q4-Q3 imported from the EU. No lamb is
now imported from NZ.

Economic integration results in both a
trade creation and a trade
diversion effect.