A Note on Customs Unions vs. Non-Preferential Tariffs

Article excerpt

It has been known that making a non-preferential tariff reduction is always superior to joining a customs union (Cooper and Massell, 1965]. This proposition is based on the assumption that the country concerned is a small country. The purpose of this paper is to show that if the country concerned is a large country, then joining a customs union is not necessarily inferior to making a non-preferential tariff reduction. (1)

The standard three country trade model will be used in this study. Country A is the home country. Country B is the other member of the customs union and country C is the non-member country, representing the rest of the world.

Consider a small country A. In Figure 1, [D.sub.A] is the import demand curve for good X in country A. [S.sub.B] and [S.sub.C] are the export supply curves of countries B and C, respectively. [S.sub.B] and [S.sub.C] are both horizontal lines under the assumption that country A is a small country. The price of good X in country C is assumed to be lower than that in country B.

Suppose that country A initially imposes a non-preferential tariff, T, before a customs union. The price of good X in country A is [P'.sub.1]. Country A imports [P'.sub,1] a of good X from country C at the price [P.sub.1]. [[P.sub.1][P'.sub.1] ab measures the tariff revenue.

Next, suppose that country A joins a customs union with country B. While country A's tariff on imports from country B is eliminated, country A still imposes the same tariff, T, on imports from country C. After the customs union, the price of good X in country A is lowered from [P'.sub.1] to [P'.sub.2]. Country A imports [P.sub.2] C of good X from country B at the price [P'.sub.2]. After joining the customs union, country A gains [[P'.sub.2][P.sub.1] ac (measuring the net changes in consumers' and producers' surpluses), but loses the tariff revenue [P.sub.1][P.sub.2] ab.

However, country A can choose to make an appropriate non-preferential tariff reduction rather than to join the customs union. If country A reduces the non-preferential tariff from T to T', the price of good X in country A will be lowered from [P.sub.1] to [P'.sub.2] as in the customs union. Country A will import [P.sub.2] C of good X from country C at the price [P.sub.1]. As in the customs union, country A gains [[P.sub.2][P'.sub.1] ac after the non-preferential tariff reduction. However, country A's old tariff revenue [[P.sub.1][P'.sub.1] ab is now replaced by the new tariff revenue [P.sub.1][P'.sub.1] ab This shows that making a non-preferential tariff reduction is superior to joining a customs union.

Next, consider the case where country A is a large country. In Figure 2, [D.sub.A] is the import demand curve of country A and [S.sub.B] is the export supply curve of country B. In Figure 3, [S.sub.C] is the export supply curve of country C. [S.sub.B] and [S.sub.C] are both upsloping under the assumption that country A is a large country.

Suppose that country A initially imposes a non-preferential tariff, T, before a customs union. [S'.sub.B] and [S'.sub.C] will be the export supply curves of country B and country C, respectively, after country A imposes the tariff. ([D.sub.A] - [S'.sub.B]) is the net import demand curve of countries A and B before a customs union (i.e., the horizontal difference between [D.sub.A] and [S'.sub.B]).

[S'.sub.C] intersects ([D.sub.A] - [S'.sub.B]) at q. [P'.sub.1] will be the price of good X in country A. At [P'.sub.1], country A imports [P'.sub.1]a of good X. [P'.sub.1]d (= [P.sub.1]e) is imported from country B at the price [P.sub.1] and ad (= [OX.sub.1]) is imported from country C at the price [P.sub.1]. [P.sub.1][P'.sub.1]ac measures the tariff revenue.

Now suppose that country A joins a customs union with country B. ([D.sub.A] - [S.sub.B]) will be the net import demand curve of countries A and B after they form the customs union. While country A's tariff on imports from country B is eliminated, the same tariff, T, is still imposed on imports from country C. …