Customs Union: Dynamic Effects and Theory | International Economics

In this article we will discuss about:- 1. Dynamic Effects of Customs Union 2. Theory of Customs Union as the Theory of Second Best 3. Intra-Industry Trade and Customs Union.

Dynamic Effects of Customs Union:

The static effects of customs union are- (i) trade- creation and (ii) trade-diversion. The static effects are basically concerned with reallocation of production and consumption. In fact the formation of the customs union initiates a process of structural and technical readjustments, on the one hand, amongst the member countries and, on the other, among the non-member countries.

Such long-lasting dynamic effects of customs union have been greatly emphasised by the writers like T. Scitovsky, B. Belassa and W.M. Corden.

The dynamic effects of customs union are as follows:

1. Increased Competition:

The most significant dynamic effect of customs union is the increase in intensity of competition within the union. Earlier in the sheltered markets, the monopolistic and oligopolistic industries had become sluggish and complacent. After the formation of customs union, as they are exposed to competition from rival firms within the union, they have to operate in the most efficient way or face the risk of elimination.

All the firms, earlier operating below their optimum productive capacity, make efforts to expand production in order to cater to the demand from an expanded market and to minimise their costs. Competition also stimulates the managerial efficiency and induces the industries to utilize new technology.

The customs union must take care that collusion and market-sharing arrangements, which had earlier restricted competition at the national level, should not restrict competition at the union level. In this direction, the member countries should enforce anti­trust legislation throughout the customs union.

2. Economies of Scale:

When a customs union is formed, expansion in the size of market, increased competition, increased specialisation and consequent enlargement of plant size lead to the emergence of internal and external economies of scale. This is evident from the experience of the countries of European Community (EC). The formation of EC resulted in economies of scale due to reduction in the range of differentiated products, increase in production run, pooling of skilled labour, capital resources, research and management.

3. Stimulus to Investment:

The expansion of market and more intensified competition stimulates investment activity. The need for introducing new techniques and accelerated depreciation of the existing plants and equipment step up greatly the rate of investment. In addition, there is also strong stimulus to foreign investment. Many non-member countries set up their plants in the territory of union members so that their products can evade the tariff barriers.

Such industrial units are called as tariff factories. The massive United States investments in Europe after 1955 were probably on account of the American desire of not to be excluded from the rapidly expanding market of EC.

4. Movement of Productive Factors:

After the formation of customs union, or more particularly, the common market, there is free movement of labour, capital and enterprise within the entire region of the common market. This ensures the optimal utilization of resources, increase in factor productivity and consequent rise in the growth rate of the economies of all the countries in the union.

5. Technological Advance:

As a customs union is formed, expansion in the size of market, greater competition, need for increasing the scale of production and achieving higher factor productivity, make the firms and industries develop very strong urge to imitate, to innovate and to make commercial application of technical, scientific and managerial innovations.

There is strong stimulus to research for making improvements in the production techniques, processes of production and quality of products. The intense technological developments tend to push up the rate of economic growth.

6. Improvements in the Terms of Trade:

The formation of the customs union results in raising of external tariffs against the outside world and consequent reduction in imports from abroad. This tends to raise the bargaining power of the union members against the rest-of-the-world. The improvement in the terms of trade brings about also an improvement in the balance of payments position of the member countries.  

7. Reduction of Risk and Uncertainty:

The foreign transactions often involve high degree of risk. The complexity of trade regulations, unilateral changes by countries in the tariff and non-tariff trade restraints and foreign exchange regulations create much uncertainty. The economic integration reduces to a significant extent, risk and uncertainty particularly in respect of the inter-member transactions.

It is on account of these dynamic benefits that the West European countries and the countries of certain other regions deemed it appropriate to organise themselves into some form of economic integration. The recent empirical studies seem to indicate that the dynamic gains of customs unions are five to six times larger than the static gains.

Theory of Customs Union as the Theory of Second Best:

The maximisation of welfare can be possible only under the conditions of free international trade. The Pareto-optimality conditions can be valid only under perfect competition and unrestricted international trade. If a customs union is formed, there is a violation of Pareto-optimality conditions.

In a customs union, there is no doubt elimination of tariff restrictions and it is a movement towards freer trade, yet there may be certain imperfections in the expanded market of customs union on account of the existence of oligopolies and product differentiation.

The rigidities exist on account of diverse monetary and fiscal policies, unless integration assumes the most advanced form of economic union. In addition, the maintenance of high external tariffs amounts to sheltering of inefficient industries within the union. It means the process of production, despite integration, is not likely to become ideal. The formation of the customs union does not necessarily maximise welfare.

In certain situations, it may result in a net loss in welfare. Therefore, the customs union is not consistent with Pareto-optimality. It is rather concerned with Pareto-non-optimal or sub-optimal trade situation.

The theory of customs union is a half-way house between free trade and protection. From this consideration, the theory of customs union can be treated as a theory of the second best.

Intra-Industry Trade and Customs Union:

A number of empirical studies, related to intra- industry trade have indicated that a considerable part of trade among the members of European Community (EC) is of the nature of intra-industry trade. No doubt, many models of intra-industry trade have been developed but a few attempts have been made to relate it to the customs union.

However, a simple model, based on Neo-Chamberlinian model of intra-industry was developed by W. Ethier and H. Horn in 1984. This model attempted to explain the possibility of trade creation gains from intra- industry trade due to integration.

In this model, it is assumed that two countries A and B, before forming customs union produce homogeneous commodity, food and a differentiated product, say machinery. The different variants of manufactured product (machinery) are imperfect substitutes for one another. The production in their case is governed by increasing returns to scale. Both countries A and B export their own varieties of manufactured products to each other as well as to the rest-of-the-world (W).

The rest- of-the-world produces food only. The production of food is governed by constant returns to scale. Countries A and B import food from rest of the world. The two countries before forming the customs unions were having the same tariff on the import of food and manufactured products. There was no restriction by the rest-of-the-world on the import of manufactures.

After the formation of customs union by A and B, the existing tariff on the import of food becomes the common external tariff. Since member countries of customs union did not import manufactures earlier from the rest-of-the-world and they exported varieties of manufactured product (machinery) to each other, there would be no trade diversion after the formation of customs union.

The trade creation effect, however, would be present. The two countries will be able to secure gain due to trade creation as consumers of each country will have duty free access to a greater variety of goods. The consumption of larger variety of goods will definitely increase the level of welfare.