POSSIBLE GAINS FROM THE FORMATION OF A

CUSTOMS UNION

Reasons for the formation of Customs Union

Static gains: Better allocation of resources

Dynamic gains: Economies of scale etc.

Protectionism

Economic integration is a prerequisite for political integration

Static Gains

Trade creation - Trade diversion

Hard to measure: Economic growth Other factors affecting trade other than CU

Static Gains: Measurement of TC and TD

Standart Approach

Net TC = Total increase in imports by Home country –

the fall in imports from non-members caused by integration

Difficulties: Trade figures are expressed in money terms, so it also shows

the effects of relative prices Non-integration influences must be excluded Choice of dates for comparison (must allow some time)

Static Gains: Measurement of TC and TD

Another Approach

TC= Change in total imports / consumption

TD= Change in imports from non-members / consumption

(Between two years before and after integration)

Static Gains: Measurement of TC and TD

Balassa, 1967: Income elasticities of import demand= M

M = Average annual change in imports

Average annual change in GNP

If M from intra-area Gross trade creation

If M from all sources Trade creation

If M from extra-area Trade diversion

Dynamic Gains Improved terms of trade with the rest of the world

If the formation of the CU does not affect the demand for imports from the rest of the world, the union’s TOT will be unaffected. Otherwise, there will be a tendency for TOT to improve.

Increased capital inflows and increased rate of technological change (increases in quantity and quality of factor inputs)

Reduced uncertainty

Dynamic Gains

Increased competition among firms within the CU (which increases efficiency)

Economies external to the firm which may have a downward influence on both general and specific cost structures

Dynamic Gains

Better allocation of economies of scale for both firms and industries operating below optimum capacity before the integration occurs

Assumptions: Domestic price = cost of imports from W + tariff Homogenous product W produces and supplies to H and P a constant prices H and P is capable of producing at declining average costs

Dynamic Gains

Pre-union possibilities: Production in both H and P Production in one country Production in neither

RISKS

Possible responses by firms in third countries who lose market share as a result of the CU and may seek to fight back.