STATIC AND

DYNAMIC EFFECTS
OF CUSTOMS UNION –
PART 2
THE GENERAL EQUILIBRIUM APPROACH TO CUSTOMS UNION
• The general equilibrium theory of customs has been developed by many
economists
•THE LIPSEY MODEL : FIXED PROPORTION CONSUMPTION
• Viner’s partial equilibrium leads to the conclusion that trade diversion is welfare
decreasing.
•Lipsey first demonstrates how trade diversion leads to a loss in welfare in general
equilibrium terms.
ASSUMPTIONS
For this analysis he makes the following assumptions :
1. There are three countries : the home country (H), the partner country (P), and the
rest of the world (W).
2. H is the smallest of the three countries with the highest cost structure.
3. W has the lowest cost structure.
4. There are two commodities X and Y.
5. H specialises in the production of only Y.
6. P specialises in the production of X.
7. W specialises in the production of X.
8. The two commodities are consumed in some fixed proportion independent of the
structure of relative prices.
9. The supply of X and Y commodities is perfectly elastic.
10. Both commodities are produced under constant returns to scale.
THE MODEL
•Given these assumptions, trade diversion will always lead to a loss in welfare.
•This is illustrated in Fig. 2 where OH indicates country H’s total production of
commodity Y.
•It imports OW of X from country W in exchange for OH.
•The line HW shows the terms of trade at which countries H and W will exchange
the two commodities X and Y.
•The fixed proportion in which X and Y are consumed in country H is shown by the
slope of the ray OR. which is the income and price consumption line for all prices
and incomes.
• In the pre-customs union situation, country H’s equilibrium will be at point E where
OR.and HW intersect.
• H will consume OG of Y and export GH of Y in exchange for GE of X.
• The equilibrium at E will be maintained so long as the trade between H and W
continues at the terms of trade shown by HW irrespective of a tariff.
Figure 2
•Suppose country H forms a trade-diverting customs union with country P.
•This means that H must buy her imports of X at a higher price than she was paying
before the union was formed.
•The new terms of trade are shown by the line HP. H’s equilibrium is now at point K
where OR.and HP intersect.
•H will consume less of both commodities : she will consume OF of Y (less than
OG) and export FH (more than GH) in exchange for FK of X (less than GE).
•Thus country H’s welfare has unambiguously diminished as a result of trade
diversion.
•After demonstrating how trade diversion leads to diminution in welfare in general
equilibrium terms, Lipsey criticises Viner for assuming fixed proportion in the
consumption of the two commodities independent of the structure of relative prices.
•As a matter of fact, a customs union necessarily leads to changes in the relative
prices of the two traded commodities.
• Their pattern of consumption would also change.
• Consequently, imports from the union partner would increase and the consumption
of the domestically consumed commodity would decline.
•Thus goods would not be consumed in fixed proportions, as assumed by Viner.
THE LIPSEY MODEL : INTER-COMMODITY SUBSTITUTION
•After criticising Viner for neglecting the substitution effect in consumption, Lipsey
shows that trade diversion may have two opposite welfare effects on country H :
• (1) after the customs union is formed, it will have to pay a higher price for importing
X from country P as compared to country W; and
• (2) there being no tariff duty on the import of X from country P, its domestic price will
fall. This will increase its consumption due to its substitution for Y.
•In order to show the importance of the substitution effect in consumption, Lipsey
drops the Vinerian assumption that commodities are consumed in fixed proportions.
•In Fig. 3, OH is country H’s total production of commodity Y and OW of X in country
W.
•The slope of the line HW indicates the terms of trade between commodities X and Y
when H is trading with country W.
•The free-trade equilibrium position is at point E where a community indifference
curve CI1 is tangent to the line HW.
Figure 3
•E is also the consumption point.
•Now in the pre-union situation if country H imposes a tariff on imports of X from
country W. the relative prices change.
• They are indicated by the slope of the domestic price line TT.
•The new equilibrium point is D where a lower community indifference curve CI2 is
tangent to the price line TT.
•The effect of the tariff has been to reduce the consumption of the imported
commodity X which is cheaper and substitute it by increased consumption of the
domestic commodity Y.
•There is loss in welfare because point D lies on a lower community indifference
curve CI2 after the imposition of an import tariff.
•The terms of the trade HW have been assumed not to have been affected by the
tariff as both points E and D lie on the HW line.
•Under the circumstances, it is beneficial for country H to form a trade-diverting
customs union with another country P and thereby increase its welfare.
•To show this, construct a line through H tangent to the community indifference
curve CI2 to meet the X-axis at point P.
•When country H forms a trade-diverting customs union with country P, it
exchanges OH of Y for OP of X.
•The new terms of trade are represented by the line HP, which shows worsening of
H’s terms of trade.
•But it need not lead to a decrease in consumers’ welfare in country H.
• In fact, welfare remains unchanged because they are still on the same community
indifference curve CI2.
• When the terms of trade are given by the line HP, it will be the price ratio in H’s
home market.
•At this price ratio, X becomes cheaper than at the tariff-inclusive price ratio TT.
•Therefore, consumers in country H will substitute more of X for Y in consumption
and move from point D to K on the same community indifference curve CI2.
•This demonstrates that if substitution in consumption takes place, it implies that a
customs union can lead to an improvement in welfare even if it is of a trade-
diverting nature.
ITS CRITICISMS
•Lipsey’s general equilibrium model has been criticised by Bhagwati and others on
the following grounds :
•1. Jagdish Bhagwati has challenged Lipsey’s interpretation of Viner that a trade-
diverting customs union reduces welfare when commodities are consumed in fixed
proportions irrespective of relative prices.
• Bhagwati argues that fixed proportions in consumption are not a sufficient
condition for the Vinerian proposition.
•According to him, a trade-diverting union reduces welfare not because of the
constancy of the consumption pattern but because of the constancy of the level of
imports.
•He points out that Viner implicitly assumes constant level of imports rather than
fixed proportions proportions in the consumption pattern.
• It is under the former assumption that a trade-diverting customs union is welfare
reducing.
• 2. The controversy over the issue whether a trade-diverting customs union leads to
a loss or gain in welfare is a sham one.
•The controversy arises from the meaning attached to trade diversion.
•On the one hand, it means diversion of trade from a lower-cost country (W) to a
higher-cost partner country (P).
• On the other hand, it refers to the creation of new trade between the home country
(H) and the partner country (P) resulting from first, the adjustment in country H’s
consumption; and second, the replacement of the home country’s (H) production by
the partner’s (P) production.
•The confusion arises when these two aspects are kept separate.
•On this basis, trade diversion leads to a loss in welfare and trade creation to a gain
in welfare.
•The net welfare effect of a customs union depends upon which of these two effects
is stronger, as shown by the difference between the sum of the two triangles (a + b)
and the rectangle (c) in Fig. 1.*
THE VANEK MODEL
The general equilibrium approach to the theory of customs union has been developed
by Vanek in terms of the offer curves :
ASSUMPTIONS
This analysis is based on the following assumptions :
1. There are two countries called the home country (H) and the partner country (P)
which form the customs union.
2. There is a third country W which represents the rest of the world.
3. Each country produces, consumes and trades two commodities, X and Y.
4. Commodity X is the exportable commodity of H.
5. Commodity Y is the exportable commodity of P.
6. Country W exports commodity Y.
7. Neither commodity is inferior in any country at any relative prices or income level.
8. Both countries H and P trade with each other before the formation of the customs
union. 9. No tariff or obstacle to trade exists.
10. There is free trade.
Figure 4
•Given these assumptions, the pre-customs union trade situation between country H
and P is shown by their offer curves OH and OP respectively in Fig. 4.
•After the formation of customs union between these countries, the trade relation
between the union and country W has been shown by Vanek in terms of an excess
offer curve, OU in the figure.
• This curve shows the various quantities of X which the customs union is willing to
trade with the quantities of Y offered by country W under different terms of trade.
•The trade relations between the union and country W and how the excess offer
curve is drawn are explained as under.
•first, take OT terms of trade where the trade between the two countries H and P is
balanced at point E.
•In this situation, the customs union will not trade with country W.
•The trade between them is zero. Hence the starting point of the excess offer curve
is O, the point of origin in Fig. 4
•second, take another terms of trade line OT1 where country P is willing to trade at
point A on its offer curve OP and country H at point B on its offer curve OH.
•In this situation, there is an excess offer of good X by country H as compared with
country P in exchange for a larger quantity of Y.
• The distance AB on the terms of trade line OT1 measures the excess offer of good
X for good Y. Now measure OK = AB along the OT1 curve.
•This point K is the second point on the excess offer curve of the union, after the first
point O explained earlier.
•Similarly, the distance CD on the terms of trade line OT2 when measured from the
origin gives the third point R on the union excess offer curve (OR.= CD).
•By drawing more terms of trade lines, further points can be obtained on the excess
offer curve.
•When all such points O, K, R, etc. are joined by a line from the origin, we get the
excess offer curve OU.
• This curve shows the excess offer of good X for Y by the union member taken
together (H +P) in their trade with country W.
•The excess offer curve OU of the customs union is placed alongwith the offer curve
OW of the rest of the world (country W., in Fig. 5 .
•OT is the terms of trade line between the two on which E is their equilibrium trade
point where the markets for both goods X and Y are cleared in the union (H + P
countries) and the rest of the world (country W) under conditions of free trade.
Figure 5
•But under the customs union theory the trade relation between the union and the
rest of the world are not on the basis of free trade.
•A common external tariff is imposed by the union against the third country W.
•So OU1 is the excess offer curve of the customs union reflecting the common
external tariff on the imports of Y from country W.
•The new trade equilibrium is established at point E1 between the union offer curve
OU1 and the rest of the world curve OW.
•As a result of the shift in equilibrium position from E to E1, there is an improvement
in the terms of trade of the customs union with country W. Or, there is a worsening of
W's terms of trade in relation to the union.
• If the union raises the common external tariff further, its excess offer curve will shift
to the left from OU1 to OU2 and the new equilibrium point with country W will be E2.
•The shifting of the equilibrium from E1 to E2 shows not only improvement in the
terms of trade of union but also discrimination against country W leading to
reduction in its trade with the latter.
•This is shown in Fig. 5 when exports of X from the union to W fall by X1X2 as
against the fall in imports of Y by Y1Y2 from W.
•The extent of discrimination against W will depend upon the size of the common
external tariff.
•The greater the common external tariff, the greater will be the discrimination
against the rest of the world (W).