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More on tariffs, import quotas, and customs unions.

The welfare of a tariff-imposing country could increase, decrease, or remain the same after it joins a customs union. If the country concerned is a small country, the outcome depends on the welfare-reducing trade diversion effect and welfare-improving trade creation effect of the customs union. In the large country case, the outcome also depends on the terms-of-trade effects of the customs of union [Bhagwati, 1971; Lipsey, 1960]. The welfare of a small, quota-imposing country will always increase after it joins a customs union [Yeh, 1992]. The purpose of this paper is to show that the welfare of a large, quota-imposing country could increase, decrease, or remain the same after it joins a customs union.

The offer curve approach [Meade, 1952] will be used in this study. This paper is divided into two sections. Section I discusses the case in which the country concerned is a small country. Then Section II deals with the case in which the country concerned is a large country.

I. Section I

In Figure I, the vertical axis and horizontal axis measure the importable good Y and exportable good X of the home country A, respectively. OA is the offer curve of country A. OD and OU are the offer curves of foreign countries D and U, respectively. OD and OU are straight lines under the assumption that country A is a small country. OD is steeper than OU because the relative price of good Y in country U is assumed to be higher than that in country D. Point C will be the trading point under free trade.

Suppose that country A imposes a tariff. OA[prime] is the tariff-distorted offer curve of country A which intersects OD at E. Point E is the trading point after the tariff. Country A would import OG of good Y from country D. The domestic price ratio is measured by the slope of the trade indifference curve I at E or by line OE[prime].

Next suppose that country A forms a customs union with country U. While country A's tariff on imports from country U is eliminated, country A still imposes the same tariff on imports from country D. OA intersects OU at H. Point H will be the trading point after the custom union.(1) The domestic price ratio after the custom union is measured by line OU. Country A will import HH[prime] of good Y from country U. The welfare of country A could increase, decrease, or remain the same after the customs union. Figure I shows the case in which the welfare of country A is decreased after the customs union.(2) Country A reaches a lower trade indifference curve [I.sub.t] after the customs union than the trade indifference curve I before the customs union.

Now examine the case in which country A imposes an import quota instead of a tariff. Suppose that country A initially imposes an import quota equal to OG of good Y, which is the amount of imports under the tariff. The offer curve of country A after the import quota is OMG, which intersects OD at E. E is the trading point before the customs union. Country A will import OG of good Y from country D and the domestic price ratio is measured by the slope of the trade indifference curve I at E or by line OE[prime].(3)

Next suppose country A forms a customs union with country U. While country A's import quota on imports from country U is eliminated, the same import quota (OG of good Y) is still imposed on imports from country D. Draw country A's offer curve [Mathematical Expression Omitted] with point E as the origin. Then draw country U's price line [Mathematical Expression Omitted], which is parallel to line OU. Line [Mathematical Expression Omitted] intersects the offer curve [Mathematical Expression Omitted] at K. Point K will be the trading point after the customs union. The domestic price ratio after the customs union is measured by line [Mathematical Expression Omitted].

Country A's total amount of exports is equal to KK[prime] of good X and its total amount of imports is equal to OK[prime] of good Y. However, only GK[prime] of good Y is imported from country U. The remaining OG of good Y is still imported from country D. After the customs union, country A still could import from the lower cost source, country D, so long as the amount of imports does not exceed the import quota OG.

The offer curve [Mathematical Expression Omitted] is derived as follows. In Figure II, the price line is pivoted about point E. Its points of tangency with trade indifference curves will trace out [Mathematical Expression Omitted]. Pick any point lying between C and F on OA, say, point Q. A trade indifference curve is tangent to line OQ at Q. Then draw a line from E and tangent to the trade indifference curve at q. Point q would lie to the left of Q. Next, pick any point lying above C on OA, say, point S. A trade indifference curve is tangent to line OS at S. Then draw a line from E and tangent to the trade indifference curve at s. Point s would lie to the right of S. Connecting points E, q, C, s, ---, one derives the offer curve [Mathematical Expression Omitted].

After the customs union, country A's welfare will be always increased. Country A reaches a higher trade indifference curve [I.sub.q] at the trading point K after the customs union than the trade indifference curve I at the trading point E before the customs union [ILLUSTRATION FOR FIGURE I OMITTED]. Since the amount of imports from country D is the same before and after the customs union, there is no trade diversion effect. Moving up from I to [I.sub.q] is due to the welfare-improving trade creation effect of the customs union.

Moreover, country A will always reach a higher welfare level at the trading point K under the quota preference than at the trading point H under the tariff preference. In other words, country A will be always better off to grant a quota-free entry to the imports from country U after the customs union than to grant a duty-free entry to the imports from country U after the customs union.

II. Section II

In Figure III, OA is the offer curve of the home country A. OD and OU are the offer curves of foreign countries D and U, respectively, which are less-than-perfectly-elastic under the assumption that country A is a large country. The offer curve O (D + U) is the sum of the offer curves OD and OU.(4) Point C is the trading point under free trade.

Suppose that country A imposes a tariff. The tariff-distorted offer curve (not drawn) intersects O (D + U) at L. Point L is the trading point after the tariff. Country A would import ON[prime] of good Y from country D and OZ[prime] of good Y from country U. The domestic price ratio is measured by the slope of the trade indifference curve [Mathematical Expression Omitted] at L.

Next suppose that country A forms a customs union with country U. While country A's tariff on imports from country U is eliminated, country A still imposes the same tariff on imports from country D. OU intersects OA at R. Draw country A's offer curve RA[prime] with point R as the origin.(5) Then draw the tariff distorted offer curve [RA[prime].sub.t]. [RA[prime].sub.t] will intersect country D's offer curve RD[prime] (drawn with point R as its origin) at Q. Point Q will be the trading point after the customs union. The welfare of country A is represented by [Mathematical Expression Omitted].

Now examine the case where country A imposes an import quota instead of a tariff. Suppose that country A initially imposes an import quota equal to OL[prime] of good Y, which is the amount of imports under the tariff. The offer curve of country A after the import quota is OWL[prime], which intersects O (D + U) at L. Point L is the trading point before the customs union. Country A's import quota is allocated between country U (OZ[prime] of good Y) and country D (ON[prime] of good Y). Like the tariff case, the welfare of country A is represented by [Mathematical Expression Omitted].

Next suppose that country A forms a customs union with country U. While country A's import quota on imports from country U is eliminated, the same import quota (ON[prime] of good Y) is still imposed on imports from country D. Draw country U's offer curve [Mathematical Expression Omitted] with point N as the origin.(6) Then draw country A's offer curve [Mathematical Expression Omitted] with point N as the origin.(7)

The offer curves [Mathematical Expression Omitted] and [Mathematical Expression Omitted] intersect at V. Point V will be the trading point after the customs union. Country A will import OV[prime] of good Y. However, only N[prime]V[prime] of good Y is imported from country U. The remaining ON[prime] of good Y, which is equal to the import quota on imports from country D, is still imported from country D. Country A still could import from the lower cost source, country D, so long as the amount of imports does not exceed the import quota. In other words, the trade diversion effect of a customs union never arises.

However, the welfare of country A could increase, decrease, or remain the same after it joins a customs union.(8) Figure III shows the case in which country A's welfare is decreased after it joins the customs union.(9) Before the customs union, country A already imports OZ[prime] of good Y from country U at the terms of trade measured by line OT. After the customs union, country A imports from country U at the less-favorable terms of trade measured by line NV (not drawn). Nevertheless, like the small country case, country A will always reach a higher welfare level at the trading point V under the quota preference than that at the trading point Q under the tariff preference.

In conclusion, the welfare of a small, quota-imposing country will always increase after it joins a customs union because the trade diversion effect of a customs union never takes place. This paper shows that the trade diversion effect of a customs union also never takes place in a large, quota-imposing country. However, the welfare of a large, quota-imposing country could increase, decrease, or remain the same after it joins a customs union. Unlike the case for a small quota-imposing country, a large, quota-imposing country already has some imports from the member country before the customs union. After the customs union, these imports from the member country will be at less favorable terms of trade.

1 Country U's offer curve OU should be steeper than line OE[prime], which measures the domestic price ratio in country A before the customs union. Otherwise, country A will not import good Y from country U after the customs union.

2 The welfare of country A will decrease after the customs union if country U's offer curve OU intersects OA at a point lying between E[prime] and F (the intersection point between OA and I). However, if OU intersects OA at a point lying between C and F, then the welfare of country A will increase after the customs union. In case that OU is tangent to I at F, the welfare of country A will remain the same after the customs union.

3 It is assumed that both before and after the customs union, the government of country A raises the import quota revenue by selling import quota licenses through competitive auctions. Then, like the tariff revenue, the import quota revenue is redistributed to the private sector in the form of lump-sum transfers.

4 The offer curves O (D + U) shows how much good Y and good X countries D and U together would like to export and import, respectively, at different international prices. For example, at the given price ratio measured by line OT, countries D and U would like to export OL[prime] of good Y, which is equal to the sum of OZ[prime] (from country U) and ON[prime] (from country D).

5 The offer curve RA[prime] is derived in the same way as the offer curve [Mathematical Expression Omitted] is derived in Figure II.

6 Country U's offer curve [Mathematical Expression Omitted] will pass through point L. OZ + ON = OL. Therefore, OZ = NL.

7 Country A's offer cure [Mathematical Expression Omitted] is derived in the same way as the offer curve [Mathematical Expression Omitted] is derived in Figure II. The offer curve [Mathematical Expression Omitted] will pass through point C[prime].

8 If country A imposes the full import quota (OL[prime] of good Y) on country D after the customs union, the outcome will be different. In this case, the welfare of country A will always increase after the customs union.

9 If the offer curve [Mathematical Expression Omitted] intersects the offer curve [Mathematical Expression Omitted] at M (the intersection point between [Mathematical Expression Omitted] and [Mathematical Expression Omitted]), then the welfare of country A remains the same after it joins the customs union. If the offer curve [Mathematical Expression Omitted] intersects the offer curve [Mathematical Expression Omitted] at a point to the left of M, then the welfare of country A will increase after it joins the customs union.

REFERENCES

Bhagwati, Jagdish N. "Trade Diverting Customs Unions and Welfare Improvement: A Clarification," Economic Journal, 81, September 1976, pp. 580-7.

Lipsey, Richard. "The Theory of Customs Unions: A General Survey," Economic Journal, 70, September 1960, pp. 496-513.

Meade, James E. A Geometry of International Trade, London, England: George Allen and Unwin, 1952.

Yeh, Yeong-Her. "Tariffs, Import Quotas, and Customs Unions," Atlantic Economic Journal, 20, December 1992, pp. 38-40.
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Author:Yeh, Yeong-Her
Publication:Atlantic Economic Journal
Date:Jun 1, 1996
Words:2349
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