BUS613: Advanced International Business

As was mentioned earlier, the key difference between a CU and an FTA is the need to adjust the tariff structure applied to third-party suppliers, at least for some members. Countries that join an FTA are not required to change the tariffs they apply to imports from the rest of the world. What will differentiate the effects of a CU from those of an FTA will be the extent to which the external tariff is increased or decreased by a given member with respect to a given good. The net economic effect of a CU crucially depends on how the adjustment of the external tariff affects the degree of discrimination vis-à-vis nonmember countries.

In order to isolate the impact of a CU, it is useful to start with a case in which an FTA is already in place (i.e., trade is already liberalized among the partners) and member countries are considering establishing a customs union by harmonizing their external tariff duties. For ease of presentation, the following discussion assumes that two countries, A and B, are members of an FTA and have decided to form a customs union. Without loss of generality, it will be further assumed that, for a particular good, A has a low tariff and B has a high one. Two possible cases are relevant and are examined here.

One possibility is that the agreed common external tariff (CET) leads to a higher tariff rate for a given CU member (say, country A). The bloc's degree of discrimination is thus enhanced, and the negative impact of trade diversion caused by the FTA is exacerbated. This usually happens when a less advanced member has to implement a CET aimed at protecting the industries of a more developed member. In this case, consumers in country A will lose because they have to pay higher prices for imports from the rest of the world or switch to less efficient suppliers from country B. Despite the higher external tariff, the government in country A could collect less tariff revenues if the higher degree of discrimination leads to a greater propensity for switching the sourcing of imports to duty-free, country B suppliers. Producers of the good in A face less competition from the rest of the world but more competition from B. In fact, the adoption of a high tariff by A effectively extends the protection received by country B producers to country A's markets. These producers may be the only ones to gain from the CU in this scenario. In some cases, and in a more dynamic setting, the expansion of the protected market may lead to some tariff-jumping types of investment in the customs union, motivated by the prospect of taking advantage of the larger, more protected market.

Joining a CU may offer a second possibility to consolidate the existing tariff schedule and adopt a more liberal trade regime. If the establishment of the CU yields a CET that is lower than the pre-CU tariff (say, in country B), the potential for trade diversion is reduced, or even reversed, because there is less potential for switching suppliers. The discriminatory aspect of the FTA is, in a sense, diluted in this case. Starting from an FTA situation, a decrease in B's external tariff would have two effects, both working in the same direction. First, the liberalization will directly increase B's imports from the rest of the world (trade creation). Second, since it effectively dilutes the existing preference margin, it will reduce the attractiveness of sourcing from country A relative to sourcing from the rest of the world (less trade diversion). By reversing the trade diversion caused by the FTA (i.e., by inducing consumers to switch from less efficient suppliers in A to more efficient ones in the rest of the world), country B's tariff reduction will benefit its consumers. It could also help increase government revenues. as dutiable imports from the rest of the world expand (albeit at lower tariffs) and as country B shifts to dutiable imports and away from duty-free imports from A. Domestic producers will face more competition from nonmembers, but this will be offset by consumer gains resulting from lower prices and, potentially, by higher tariff revenues. Although adopting a lower CET may not lead to tariff-jumping investment, the higher returns associated with the more liberal economic environment could attract efficiency-seeking investments. Krueger (1995) has argued that if the CET level is chosen as the union's average tariff for a given commodity, an FTA will not lead to more net trade creation than a CU. Furthermore, as long as the CET is set below the tariff level of the high-cost country, an FTA will not be more welfare enhancing than a CU.

In the actual implementation of a CET, an individual CU member will generally have to increase its external tariffs on certain products while decreasing them on others. The overall impact will depend on the balance. Kemp and Wan (1976) demonstrate the existence of conditions that suffice to ensure that a CU is welfare enhancing. In particular, they show that if the CET is chosen so that trade with the rest of the world is kept unchanged, then following the establishment of a CU, welfare could potentially increase for all parties, including nonmembers, contingent on compensatory transfers. This increase occurs because any additional trade between CU members would be welfare-enhancing trade creation. Although this is an important result, it is a "possibility" and does not guarantee that the existing political-economy equilibrium will be a welfare-enhancing one.