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Customs union theory - the static and dynamic effects of integration Distinguish between static and dynamic effects Static effects occur in the short run within a given time period. Dynamic effects occur in the long run over a series of time periods. Eg A SS & DD represents consumer and producer behaviour for a given time. Illustrating the effect of, say a tariff and analysing the impact in on welfare is known as comparative static analysis Explain trade creation and trade diversion Trade creation The replacement of expensive domestic production by cheaper imports from more efficient partner countries Trade diversion The replacement of cheaper initial imports from lower cost producers outside the union to less efficient producers in member countries Illustrate the static effect of joining a customs union Assume the UK is not a member of a customs union: SW represents the world supply of a good. If the UK imposes a tariff = P3-P1 on imports, Q4 is exchanged of which Q3 is supplied by domestic firms and Q4-Q3 is imported The UK now joins a customs union whose common external tariff (CET) is just P2-P1. Q5 is now consumed of which Q2 is supplied domestically and Q5-Q2 imported Economic integration results in a trade creation effect: Q3-Q2 is now supplied by cheaper imports from more efficient member countries. Note: Consumers gain from increased consumption (Q5-Q4) Domestic producers lose from lower output (Q3-Q2) Government tax receipts from tariffs falls by area C Assess the trade creation and diversion effects of joining a customs union The static cost and benefits of economic integration can be assessed using supply and demand analysis. S1 represent the supply of a good, say, lamb from an efficient producer, say, New Zealand (NZ). S2 is the EU supply for lamb – nb the EU is a less efficient producer Before joining the customs union, the UK imposes a tariff of t. The UK price of imported NZ lamb rises from P1 to P3 and lamb imported from the EU to P4. The price of lamb in the UK is now P3 and UK consumers buy Q2 lamb: Q1 from domestic firms with Q2- Q1 imported from NZ. No lamb is imported form the EU. The UK now joins the EU and tariffs on EU imports are removed but remain in place for NZ lamb. The UK price of lamb falls to P2. UK consumers buy Q4 lamb: Q3 from domestic firms with Q4-Q3 imported from the EU. No lamb is now imported from NZ. Economic integration results in both a trade creation and a trade diversion effect. |