The Theory of Customs Unions: Trade Diversion and Welfare Richard G. sey Economica, New Series, Vol. 24, No. 93. (Feb., 1957), pp. 40-46, Stable URL http: flinksjstor-org/sici%sici= 13-0427%28195702%292% 3A24%3A93%3C40% 3A TTOCUTS 3E2.0.CO%3B2-9 Economica is currently published by The London School of Economies and Political Science: Your use of the ISTOR archive indicates your acceptance of JSTOR’s Terms and Conditions of Use, available at bhupulwww.jstororg/about/terms.hunl. JSTOR’s Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of « journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial us. Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at bhupulhwww jstor.org/journalslonschool htm Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed page of such transmission, JSTOR is an independent not-for-profit organization dedicated to ereating and preserving a digital archive of scholarly journals. For more information regarding JSTOR, please contact support @jstor.org, hupulwww.jstor.ore/ Thu Nov 9 13:20:24 2006[repRUARY The Theory of Customs Unions : Trade Diversion and Welfare* By Ricuanb G. Lursey In his book The Customs Union Issue Professor Viner draws the distinction between the trade-creating and the trade-diverting effects of a customs union. In any theory of customs unions this must be a fundamental distinction. However, after defining the two terms, Professor Viner goes on to conclude that, in some sense, trade creation may be said to be a‘ good thing ’ and trade diversion a * bad thing '.* ‘When a customs union is formed, relative prices in the domestic markets of the member countries are changed because the tariffS on some imports are removed. These price changes are likely to have two important initial effects. First, they may influence the world location of production in the several ways carefully analysed by Viner. Secondly, they will have a parallel effect on the location of world con- sumption. Usually one would expect to find the union members increasing their consumption of each other's products while reducing imports from the rest of the world.? Changes of the first type will be classified under the general heading, production effects of union, and changes of the second type as consumption effects of union. It must be emphasised that even if world production is fixed, a customs union will cause some changes in patterns of consumption due to changes in relative prices in the domestic markets of the member countries. ‘The consumption effec, therefore, may operate even if there is no production effect. ‘The proposition that a change brought about by a customs union is, in general, good or bad necessarily implies a welfare judgement. But the effect of a customs union on welfare must be a combination of + Tam greatly indebted to Mr, K. Klappholz, Doctor H. Makower and Professor J.E, Meade for their many valuable comments and suggestions. the relevant passage from Viner is as follows "There willbe commodities, however, which one of the members ofthe customs ‘union will now newiy import from the other but which it former Gk not import ‘tall because the price of the protected domestic product was lower thar the price at any foreig source plus the duty. ‘This shift in the locus of production ES etre te oe cous 2 St om a highost to lovers oi {shift which the free trader can proper ‘There will be olber commodities which one of the members ofthe customs ‘union will now newly import from the olher whereas before the castors Union imported them from a thied country, because that was the cheapest possible Sour of supply even ater poyment Of the duty The shift in the leas Of Producto i now not a tetnger the two ener eouotis Dut ss between is a shit which the protectionist ‘who understands the Tope of sown doctrine can proper approve. Wie, Jacob, The Custons Union Isue, Catnogie Endowment for International Peace, New York, 1980, p. 43). tales notin the oxginal ® ut tis i not necessarily so." Soe note 1, page 42 below, 01957] THE THEORY OF CUSTOMS UNIONS 4 its effects on the location, and hence the cost of world production ‘and on the location, and hence the * utility’, of world consumption. In this paper it will be shown that when consumption effects are allowed for, the simple conclusions that trade creation is * good’ and trade diversion is * bad” are no longer valid. Although the distinction between trade creation and trade diversion is fundamental for classify- ing the changes in production consequent on the formation of a customs union, it is not one on which welfare conclusions can be based. 1 ‘The problem of the welfare effects of trade diversion will be isolated by using an extremely simple model. The model will be used to show that an increase in welfare may follow from the formation of a customs union which results solely in the diversion of trade from lower—to higher—cost sources of supply. Furthermore, it will be shown that this welfare gain may be enjoyed by the country whose import trade is diverted, by the customs union area considered as a unit and by the world as a whole. ‘The analysis will be based on the following simple model : The world is divided into three counties, A, B, and C. The effects of vari ous trade policies on the welfare of country A only is first considered, ‘A is a small country whose inhabitants consume two commodities, wheat and clothing. A specialises in the production of wheat and ‘obtains her clothing by means of international trade. Being small, she cannot influence the price of clothing in terms of wheat. Country C offers clothing at a lower wheat price than does B, so that, in the absence of country-discriminating tariffs, A will trade with C, exporting wheat in return for clothing. It is assumed that A levies a tariff on imports but that the rate is not high enough to protect a domestic clothing industry, so that she purchases her clothing from C. Now let country A form a customs union with country B, as a result of which B replaces C as the supplier of clothing to A. B is a higher cost producer of clothing than is C but her price without the tariff is Tess than C’s price with the tariff. Hence, the union causes trade diver- sion, A’s trade being diverted from C to B. Indifference curves are used in the analysis but the conclusions reached do not depend on the assumption of a unique community welfare function, For this reason it is first assumed that in country A there is only one consumer, whose indifference map is, ipso facto, country ‘A’s community indifference map. Later the analysis is extended to a community of more than one individual. Diagram I illustrates the conditions existing in country A. OD measures A’s production of wheat. The price ratio between wheat and clothing when trade is with C is shown by the slope of the price line DE. The free-trade equilibrium position is at point G. It is assumed that A levies a tariff on clothing imports of EF per cent. If OF2 OONOMICA [repruary. the tariff revenue were destroyed, the new equilibrium would be at H where an indifference curve is tangent to the domestic price line, DF. However, if the usual assumption is made that the tariff revenue is returned to the consumer, then the point of final equilibrium must be located on DE. It will be where an indifference curve has a slope ‘equal to that of DF at the point where it cuts DE. In Diagram I the ‘equilibrium is at point K, where the curve through that point is tangent to D'F which is drawn parallel to DF. At this point itis impossible for the consumer to trade along his domestic price line D'F’ and reach ‘a higher indifference curve.* The tariff has the expected result of lowering imports of clothing and raising consumption of domestic wheat. Ttis assumed that A now forms a trade-diverting customs union with country B. The line indicating the terms of trade with B must lie Clothing “If nether wheat nor clothing is an inferior good, the point K. mus ie between (G and Hin relation tothe clothing a jt wil be noted that, projected (othe axes, D’F” would have a Y intercept bow the point D. TRE mdtrates the Yat hat whatever bund of wheat aad the consumer may be consuming at K, it will appear to him that he could {fade alls Clothing for more whest than ther sn exstene. This iusto resus fom the fact that thei makes the price of wheat, apps the consumer lowe than the pic Bt wich the tw commode can infact traded in the internation1987) ‘THE THEORY OF CUSTOMS UNIONS a between DE and DF.1 Since there, is no tariff levied on A-B trade, the equilibrium position must be located on the price-consumption line WHGZ. The effects of the union on country A’s welfare may now be considered. In Diagram J, starting from the point D, draw a line tangential to the indifference curve I” (the curve through K) and extend it to cut the clothing axis at some point V. The slope of this line DV indicates terms of trade with country B which leave A as well off as when trade was with country C. If A oblains any terms of trade with B worse than DE but better than DV, the trade-diverting customs union must result in an increase in A's welfare. If she obtains any terms of trade better than DF but worse than DY, trade diversion will occur but it will result in a loss of welfare for A? "It can be concluded, therefore, that country A might gain by entering a customs union whose sole production effect was to divert her import trade from lower—to higher—cost sources of supply. ‘The above conclusion may not have an immediate common-sense appeal, yet the explanation is easily seen with the help of a diagram. ‘The possibility stems from the fact that whenever imports are subject to.a tariff, the position of equilibrium must be one where an indifference curve cuts (nor is tangent to) the international price line. From this it follows that there will exist an area where indifference curves higher than the one achieved at equilibrium lie below the international price line. In Diagram I this is the area above 1" but below DE. As Jong as the final equilibrium position lies within this area, trade carried ‘on in the absence of tariffs, at terms of trade worse than those indicated by DE, will increase welfare, In a verbal statement this possibility may be explained by referring to the two opposing effects of the trade- diverting customs union. First, A shifts her purchases from a lower— toa higher—cost source of supply. It now becomes necessary to export a larger quantity of goods in order to obtain any given quantity of imports. Second, the divergence between domestic and international prices is eliminated when the union is formed. The removal of the tariff has the effect of allowing the consumer in A to adjust his purchases * by assumption, 8s pree of clothing in terms of wheat is higher than C's pros ine musts fo the let of DE. Hlonever, # trade diversion i fo Oar, ‘The Dingram ko ilusrates the eet of the customs union onthe volume 1 trade Sinos Kiet between Gn 1 in elation to the clothing sa oe i, page 2 above) and sine the posteunion equiotum peint mist be lcsted Ppiceconsumption line, WHGZ, between the points Gand H, i folios thot A's Import of clothing may either eke orfslas sau of the teade-dverting ‘stone non, “the conclusion represents but another application of the genersl theory of second best to proplem of international ide Sees Lipsey, Re (ly and Laneseter, Kein, "The Soneral theory of Second Best", The eve of Eoonomte Sate Vai" XXiv, No.1, 986-37. The tadeaiverson problem ty infty 2 ery imp ication of the theory of multiplayer second-best opis (op. it, Section %). Gheen the existence of price distortion by tari, the meximization of production {Sin longer newesarty “An inficlent* production solution may provide aneficlent wellare {fe Diagram T, welfare is incresed by moving from point K to some point Below BE)“ BCONOMICA, [resruary to a domestic price ratio which now is equal to the rate at which wheat can be transformed into clothing by means of international trade. The final welfare effect of the trade-diverting customs union must be the net effect of these two opposing tendencies ; the first working to lower welfare and the second to raise it If, to take a limiting case as an example, country B's price of clothing exceeds country C’s price by only an infinitesimal amount, then the union would allow A to return to a position only an_ infinitesimal distance below the free trade position, G. In this case the only effect operating is the consumption one and the trade-diverting customs union raises welfare virtually to the free trade level. un It must now be shown that the conclusions reached do not depend fon the existence of a unique community indifference map for country A. This will be done by considering a case where country A is a community of two individuals. Diagram Il is a repetition of Diagram I, all the lettering is the same except that the distribution of income in terms of wheat is shown by OD’ for consumer I and by OD” for consumer I (OD' + OD’=OD in Diagram 1). For cach individual the free-trade equilibrium position will be at the point where the inter- national price line, DE, is tangent to one of his indifference curves. Similary, when a tariff is placed on imported clothing, each consumer will move to an equilibrium position (K’ and K’’) which will satisfy the conditions for the location of the point K in Diagram 1 Once allowance is made for the existence of more than one consumer in country A, two problems arise in connection with the trade-diverting, ‘customs union between A and B. First, there will be some prices of clothing which will permit one consumer to reach an indifference curve A word of warning sbout the prsent model: The two-commesity model is «Smpiieation adopted fr the present aalyns where iti desired to demonstrate only te possi tat tnde-dhersion may rae the welfare of «singe county Snd of te world,” Further anasnis bad on So simple a mods ight lead to the fosiston tat the dns tt ssa wor ate ware, Ti no portant peculiarity Of he present models tae country A has only one import For ang detaieg analysis of the consumption fot, a threecommontty model Is reauired. “Consider, for exirple a eane where country A produces commodity X ‘ite import sorimodty ¥ som country Band commodiy 2 from country C- ‘Now if Xtorms a eustoms union wth country B the consumption elect on welfare E complex. This fo even ir hore is nether tre creation nor trae diversion, 0 that A continues to buy ¥ from Band Z trom C. In this cut, the fnoval of {iets rons imports of ¥ changes two price eto ‘On the one had A's domestic ‘ce ato botwcon and Y irmade eqat fo the ate at which these Wo commodtes Bin be transformed ino eachother by means of inernationa! trade. On the other fund: the domestic price rato between and Zi now mae fo diverge for the fateof transformation by international tade- “The XY change works to fae Mreffare wile the ¥-Zebange works fo lower't. The consumption eft on weirs Show the netfee ofthese fo opposing tendencies. {his fe no the place for a detaled discussion ofthis example, ‘The ease is mene tioned oniy to show that's tmoncommodity model obscures many of the most inpors fant problgns inthe theory of customs tnion-_An example ofthis (pe fs snalsed in'some detail in ©" Lipsy & Lancaster, op. et, Section V‘THE THEORY OF CUSTOMS UNIONS 45 1957] I sauinsuod Buryyo19 d 4 I 4awnsuod Buryi019 d 4 ye2uM yeoum 1 Wvaovid46 BCONOMICA [remruary higher than the one he achieved at K while the other consumer is forced to a curve lower than the one he attained at K. Such a price is shown by the lines D’P and DP in Diagram I! Thus, the clear distinction between gains and losses disappears as there will be some prices for which some consumers gain while others lose. Second, the union may cause a redistribution of wheat income? such that one consumer always suffers a reduction in welfare. However, there will always be some prices of clothing higher than the one offered by country C which will allow all consumers to reach higher indifference ccurves than the ones they achieved when trade was with C. Therefore, the conclusion still stands that a country may form a trade-diverting customs union and yet gain an increase in welfare in the sense that every consumer moves to a higher indifference curve. Wu Finally, it may be objected that in considering the welfare of only one country, a parochial point of view has been adopted. The objection ‘would run somewhat as follows: Surprising though itis that one country can increase its welfare by forming a trade-diverting customs union, the world as a whole must surely sulfer a loss when this occurs.* The complex problem of how to measure changes in world welfare when there are many countries, each pursuing a different tariff policy, cannot be discussed in a short paper. However, for the present argument, it is sufficient to show that a case is possible where there is no doubi that world welfare is raised by the creation of a trade-diverting customs union, ‘Assume that B and C, the two countries that constitute the rest of the world in the previous model, are both large and that each produces ‘wheat and clothing under conditions of constant rates of transformation, B and C levy prohibitive tariffs on trade with each other so that the only trade before the union is that between A and C. But C produces ‘both wheat and clothing and, therefore, trade is carried on at a relative rice which is equal to her domestic price ratio. After the union is formed, A trades with country B.C suffers no loss from the elimination of the trade to which she was indifferent in any case. Country B con+ tinues to produce both wheat and clothing so that she gains nothing. from the new trade with A. Thus, all the gains from trade accrue to ‘A both before and after the union. If the trade-diverting customs union raises A’s welfare—and this possibility has already been demon- strated—then it raises the world’s welfare. London School of Economics. + DP and D'P have identical slopes indicating some single price facing both "PES: the points D’ and D* may shift after the union is formed. 2 *Siynere the trade-diverting elect is predominant, one at least of the member countries is bourd to be injured, both may be injured, the two combined will suet ‘{netinjury, and there willbe injury to the outside world and to the world at large.” Viner, 0. ity p44.