Brother Bryson

Marriott School
 Jean Monet, Robert Schumann, Walter
Hallstein and others dreamed, at the end of
WWII and centuries of war in Europe, of a
new era.
What if Europeans quit shooting at each
other and begin to focus more on doing
business with each other.
Trade and investment might make old
political enemies new business partners
 If business went well, perhaps European nations
could become more united.
Could the day come when there would be a
United States of Europe, with all states living in
harmony and peace?
So the effort began in 1950 with the establishment
of the European Coal and Steel Community.
See p. 221, Pugel and Lindert, for EU development
1. The basic concept:
Freedom for many
economic agents to
buy and sell beyond
national frontiers
This freedom is often
retracted by policymakers,
who in the pursuit of special
interests construct trade
barriers opposed to the
general, social interest.
 Originally, tariffs
were imposed to
raise tariff revenues.

Later, legislatures
were approached for
politically expedient
protection of
domestic industry.
Once such barriers are in place, they are not
easily removed.
Integration means removing barriers strictly on
a regional basis. Integration is not a return to
free trade.
 Germany, Italy,
United
Kingdom
ECSC Less-efficient
Tariff partners
walls
Trade flows

U.S., Japan,
Other world-
class producers
 Germany, Italy,
United Less-efficient
Kingdom partners

EU Tariff Trade diversion:

U.S., Japan, Walls
Trade shifts from
Other world-
world to
class producers
community
partners
 Germany, Italy,
United Less-efficient
Kingdom partners

Trade flows
EU Tariff
U.S., Japan, Walls
Other world- Trade creation: Trade
class producers
expands within the
integrated community
Types of capitalist integration:

A. The free trade area.

A set of partners in a given region.
Members eliminate trade barriers among themselves
each member maintains its own set of (usually tariff)
barriers against imports from non-member countries
B. Customs union.
Regional membership
Members eliminate barriers
among themselves
But also establish a common
external tariff
C. Common Market.
To the customs union
tariff arrangements,
this form adds full
freedom of movement
to production factors
D. Economic Union.
Like customs union, plus
harmonization of member
countries economic (especially
monetary) policies.
We will limit our analysis to the customs
union. Consider a protected industry
before the customs union is formed. . .

We return to the simple theory of a tariff,

imposed as a tax added on to the world
price
 $
S Pt = the domestic price after
the imposition of tariffs.
Pw = the world market price,
Pt A
or what our citizens would pay
B
Pw if industry were not protected.
D

X
0
The domestic market price (intersection of S and D) which would
hold without any international trade is substantially higher than
the world market price.
$
S
The domestic price

Pt The market shown obviously

Pw belongs to a country with a
D comparative disadvantage in
X
this industry.
0
 This country finds the world
price too damaging to domestic
$ producers.
S

At the world price, domestic

A firms produce 0q1 and enjoy
B
revenues Pw(ql)
Pw
D From world producers, we import
ql-M1, and their revenues are
X
0 q1 M1 Pw(ql-M1).
 The consumer surplus enjoyed
$ before the tariff
S
is reduced when the tariff is
imposed.
Pt A
Losses are the strip.
B
Pw
D

0
X
q1 q2 M2 M1
 Naturally, with the higher, tariff
price, the producer gains less
$
S
than the consumer loses.
The producer begins with this
producer surplus
Pt A
B
Pw And when the price rises and his
D
output increases to q2, producer
0
X surplus increases also.
q1 q2 M2 M1
 After the tariff is imposed, our
$ total imports fall from q1M1
S

to q2-M2.
Pt A
B
Pw
D

0
X
q1 q2 M2 M1
 Consider the same industry.

$
S Partner countries are now
permitted to send their goods
to us without tariffs.

Pt E But their price, Pcp, although

Pcp F lower than our domestic price,
Pw is higher than the world
D market price.

X
0 M M M M
 Before the customs union,
imports were MM. They were
limited, because price Pt
$ included the tariff
S

.
Pt E These imports came from
a b c' d
Pcp
c
F more efficient producers in
Pw
world markets, who would
D have been willing to sell at Pw.

X
0 M' M M M'
Integration has two important phenomena. The
first: TRADE CREATION
$
S

As the price falls from Pt to

Pcp, total imports increase
Pt E
from MM
Pcp F
to M'M'
D

X
0 M' M M M'
Note: the tariff is still in effect, so the
price is still Pt for countries outside this
community.
But at this high price, hardly anyone in
the country is willing to purchase from
this general world market, even though its
producers are more effective than those of
our country or of our customs union
partners.
Pcp is not a price which incorporates a
tariff. It is simply the price of our
integration partners. They can produce
more cheaply than we can at Pt, but there
commodities are more costly to produce
than the best producers in the world
market.
 As the price went down from
Pt to Pcp there is a world net
welfare gain (of consumer
$ surplus) of b and d.
S
The area e represents a loss of
producer surplus, but this is
offset by an equal consumer
Pt E surplus gain.
ea b c' d
Pcp F c is consumer surplus which
Pw c
was formerly (at Pt) tariff
D
revenues.
X
0 M' M M M'
 Pcp increases imports to
M'M.
$
S

Before integration, at Pt,

Pt
Pcp
Pw
D all imports, MM, came from
X
world trade. None of it came
0 M' M M M' from partner countries at Pt.
 After the customs union, all
trade comes from new partner
countries.

$
S
Tariff barriers remain in
place for non-members.
Pt E
Pcp F
Pw
D Tariffs divert trade from
X
them to our new partners.
0 M' M M M'
 Trade diversion brings a
deadweight loss of c.

$
S This represents the
increased cost of getting MM
E
produced in the less efficient
Pt
Pcp
c'
c F partner countries.
Pw
D At Pt, c was collected as
X tariff revenue (along with c').
0 M' M M M'
After economic
integration, import costs are
in blue.
We$ lose the former tariff $
S
revenues, c.
Our consumers gain a, b,
c and d.
a b c' d
These areas are increased c

CS, shown in red. D

X
0 0
 In summary: the custom
union brings
P
a gain of a and b,
a loss of c, the sum paid
Pcp a
c
b
for higher partner
countries production costs.
Q At Pt, c was tariff
0
 The relative sizes of these gains depend on:

P The elasticities of S
and D (the slopes of
Pt the curves).
Pcp (Elastic or flat curves
imply greater trade
creation.)
Imports
0 Q
The relative sizes of these gains depend on:
1. elasticities, the flatness of the curves.

Imports Imports
Q
The relative sizes of these gains depend on:
1. elasticities, the flatness of the curves,
2. The cost differences between domestic partners and
world producers.
Gains are greatest when the difference is great
between home and partner and small between partner
and world.
(The partner country is much more efficient than
we are, and nearly as efficient as the worlds best
producers.)
Gains are greatest when the difference is
small between partner and world.
great between partner countries and us.

c c
The dynamic effects of customs unions

The static effects of customs unions (as we

have seen: a + b - c) may be small as a
fraction of the total national income,
but dynamic effects are very important.
The dynamic effects of customs unions include:
1. Economies of scale (similar to having a
large internal market).
To serve a large market, firms can begin
to expand, if they have economies of scale,
the very process of expansion causes their
unit production costs to fall, increasing
their competitiveness in global and
domestic markets.
The dynamic effects of customs unions include:

2. Stimulus of competition

Large companies now less

protected must compete
Small companies must
merge, combine, become
efficient
The dynamic effects of customs unions include:
3. Stimulus to invest.
to take advantage of export
opportunities, or
to meet new import
competition.