3.4 (HL): Pros and cons of a customs union

1. 3.4 (HL): Pros and cons of a customs union P 314 – 316

2. Learning Objectives • In a customs union, explain and illustrate the concepts of: • trade creation and • trade diversion • Explain gains from economies of scale.

3. Price of Steel Deadweight loss D F Recall: The Effects of a Tariff... Domestic supply A B Price with tariff C E Tariff Price without tariff World price G Imports with tariff Domestic demand Q1S Q2S Q2D Q1D 0 Quantity of Steel Imports without tariff

4. Price of Steel Regained efficiency and consumer surplus Trade Creation:How an FTA, CU, promotestrade Domestic supply Price before joining FTA or union Tariff removed Other FTA member’s price Domestic demand Q1S Q2S Q2D Q1D 0 Quantity of Steel Regained Imports without tariff

5. The good news is… Imports will increase – which we call “trade creation”. Production of a good will transfer from high-cost producers to lower-cost producers. Comparative advantage is promoted, resulting in an overall gain in economic efficiency.

6. But when joining a customs union… The disadvantage occurs when imports from countries that were not subject to tariffs – but now are because they are outside the union – become more expensive than imports from fellow union members. When imports become more expensive due to trade barriers, an overall loss in welfare will occur.

7. Price of Steel Deadweight loss Trade Diversion:How a customs union restricts trade Domestic supply Customs Union Member’s Price Tariff on non-member Import Price before joining union Non-union member’s price Restricted Imports Domestic demand Q1S Q2S Q2D Q1D 0 Quantity of Steel Imports without tariff on non-union member

8. The Bad news… Imports will decrease – which we call “trade diversion”. Production of a good will transfer from low-cost producers to higher-cost producers. Comparative advantage is discouraged, resulting in an overall loss in economic efficiency.

9. Recall: 1.5 E economies of scale Different forms of economic integration allow member countries to gain from economies of scale – reduced average costs as output is increased – due to increased efficiency gains, specialisation, division of labour and commercial advantage. All due to increased exports.