Regional trading agreements have proliferated greatly over the last decade, making study of the implications of economic integration more relevant than ever. This sheet is designed to explore the implications of the formation of a customs union between two economies that are small relative to the rest of the world, but large relative to one another. It is partial equilibrium with linear demands and supplies, and requires no special add-ins. The sheet should work in any version of Excel. Cells in white represent model parameters, which can be changed to simulate various scenarios. Spinners control the policy instruments smoothly. The selection boxes allow the user to control the elements that appear in the graphs, including the welfare measures. The calculations depict the initial tariff-ridden equilibria for each economy, and the customs union equilibrium. The sheet is described further in Oladi and Gilbert (2006).
In a customs union the economies agree to charge zero tariffs on internal trade, and a common tariff on external trade. The consequence is (generally) a switch of trade from internal to external sources, and an increase in the total amount of trade that takes place. The welfare effects associated with the changes are called trade diversion (negative) and trade creation (positive), respectively. The main purpose of this sheet is to analyze the factors that increase trade creation and/or decrease trade diversion. We begin with the initial level of protection in the partner countries. Try increasing the initial tariffs in cell AE34 and/or AO34. As you do so, keep an eye on changes in the total surplus in the equilibrium before the union (cells AI42 and AS42) and after the formation of the union (cells AI52 and AS52). You should notice that total surplus falls in the tariff ridden equilibrium, while it remains constant in the union equilibrium. Hence, the union becomes more attractive by comparison. The reason is that the higher the initial tariffs, the less trade is initially taking place. Hence, the less scope for trade diversion and the more scope for trade creation.
Common External Tariff
The common external tariff (cell AE47) is the tariff applied to non-members by both economies after the formation of the union. If the tariff is set high enough, imports from outside the union will be excluded and prices will be determined within the union. As the CET falls below 325, B will begin to import from the ROW as well as country A. This hurts country A, but increases efficiency in country B. If the tariff falls below 274 the union as a whole is actually better off (the customs union increases union efficiency). If the tariff falls below 238, imports from the rest of the world will be higher than in the initial equilibrium. Such a union must be net trade creating, and beneficial from the world perspective (see Kemp and Wan, 1976). If the CET falls below 100 (i.e., country A's initial tariff), A will begin to import also, and efficiency will increase. Efficiency is maximized with the CET at 0 (i.e., free trade for both economies).
In this sheet, A exports to B in the union. A is relatively efficient in the sense that its autarky price is lower than that of B. The more efficient the exporting economy, the less the scope for trade diversion. To see this try lowering the intercept of the inverse supply curve of country A (cell AI32) and/or decreasing the slope of the inverse supply (cell AI33). Either of these changes represents an increase in production efficiency in A. This, of course, raises producer surplus in country A in any scenario, but it also has the effect of improving the union outcome for both countries. Why? For A, the increase in efficiency reduces the amount that it imports pre-union, and increases the amount it exports post-union, so the gains from the union expand. For country B, the lower price reduces the trade diversion and increases the trade creation. Hence, when forming a union, the more efficient the partner countries, the better.
Consider a small rise or fall in the world price (cell AI34). An increase in the world price makes the customs union relatively more attractive for both economies. Why? The higher world price means less initial trade, which increases the scope for trade creation and decreases the scope for trade diversion. As the world price is lowered, the opposite happens, and the customs union becomes less attractive. In general then, falls in the world price are costly for a union with a binding CET because they raise the opportunity cost of the union. In a sense this is closely related to the efficiency issue, since falling world prices decrease the relative productivity (ceteris paribus) of the partners. If the world price falls enough, the CET will cease to fully insulate the union, and then price falls begin to raise welfare for importing countries as the price of imports from the rest of the world falls.