The economic case for membership of a trading bloc

Overview

Customs union and regional development and cohesion transfers exist within an economic union.

What you need to know

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Questions from this subtopic

Each one with the model answer underneath.

1. 1

   What is a customs union, and how does it differ from a free trade area?

   Model answer

   A customs union is a group of countries that abolish tariffs and quotas on trade between themselves and apply a single common external tariff to imports from non-members. A free trade area also removes internal barriers but leaves each member free to set its own external tariff. That difference matters because a free trade area needs rules of origin to stop imports entering through whichever member has the lowest external tariff and then moving on tariff-free, whereas a customs union does not need them because the external tariff is the same everywhere.

2. 2

   What does a single market add on top of a customs union?

   Model answer

   A customs union removes tariffs and quotas on goods; a single market goes further by removing the non-tariff barriers as well, so that goods, services, capital and labour can move as freely between member states as within one. In practice that means harmonised product standards or mutual recognition of national ones, common rules on state aid and public procurement, recognition of professional qualifications, and the removal of customs checks and paperwork at internal frontiers.

3. 3

   Why does membership of a large single market raise the scope for economies of scale?

   Model answer

   A firm confined to a small domestic market can only sell as much as that market absorbs, so its output is capped and its fixed costs are spread thinly. Free access to a market of several hundred million consumers lifts that cap, allowing the firm to expand output and spread research, design, plant and marketing costs over far more units. Long-run average cost falls through technical, purchasing, managerial and marketing economies, which lowers prices for consumers and improves the firm's competitiveness against producers outside the bloc.

4. 4

   Distinguish trade creation from trade diversion.

   Model answer

   Trade creation occurs when the removal of a tariff between members shifts production from a higher-cost domestic producer to a lower-cost producer inside the bloc, so the real resource cost of supplying the good falls and welfare rises. Trade diversion occurs when the removal of the internal tariff shifts production from a lower-cost producer outside the bloc to a higher-cost producer inside it, purely because the outside producer still faces the external tariff, so the real resource cost rises and welfare falls. Whether a customs union is beneficial on balance depends on which of the two effects is larger.

5. 5

   A good costs £110 a unit to produce at home, £100 in a neighbouring country and £90 in the rest of the world. A 30% tariff applies to all imports. Show what consumers buy before and after the home country forms a customs union with the neighbour, and calculate the welfare effect.

   Model answer

   Before the union the tariff-inclusive prices are £130 from the neighbour (£100 × 1.3) and £117 from the rest of the world (£90 × 1.3), against £110 from the domestic producer, so consumers buy domestically at £110 and no tariff revenue is collected. After the union the neighbour's tariff is removed, so its price falls to £100 while the rest of the world remains at £117; consumers now buy from the neighbour at £100. Production has moved from a producer using £110 of resources a unit to one using £100, so the real resource cost falls by £10 a unit; consumers gain £10 a unit and no tariff revenue is lost because none was being collected. This is pure trade creation, with a net national gain of £10 a unit.

6. 6

   A good costs £120 a unit at home, £100 in a neighbouring country and £90 in the rest of the world, and a 20% tariff applies to all imports. Show what happens when the home country forms a customs union with the neighbour and calculate the net national effect.

   Model answer

   Before the union the rest of the world sells at £90 × 1.2 = £108 and the neighbour at £100 × 1.2 = £120, against £120 at home, so consumers import from the rest of the world at £108, of which £18 a unit is tariff revenue to the government and £90 pays the overseas producer. After the union the neighbour supplies tariff-free at £100 while the rest of the world still costs £108, so imports switch to the neighbour. Consumers save £8 a unit but the government loses £18 a unit of tariff revenue, giving a net national loss of £10 a unit. That £10 is exactly the rise in the real resource cost of the good, from £90 to £100, so this is trade diversion.

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