Ways in Which Welfare Effects of the EU Customs Union Differ with Free Trade Area - Example

Ways in which welfare effects of EU customs union differ with free trade area Name: Tutor: Course: Date: Introduction The welfare effects associated with customs union and free trade area have contrasts yet mirror some resemblances. When compared with free trade, the European Union (EU) customs union in terms of welfare effects is similar to other customs union. Nello (2012) describes customs union and Free trade as trade bloc among countries to reduce barriers to intra-regional trading of capital, investment and sometimes services. Common regional barriers to trade are tariffs and non- tariff barriers. Some of the non-tariff barriers include import quotas, export subsidies, export restrictions, special licenses and countervailing duties (El-Agraa & Ardy, 2011). Being unique, customs union and Free trade are similar as the former is a restricted form of the latter. While free trade protects and supports trade of goods without taxes, customs union has common external tariffs from member states with considerable welfare effects. Free trade has no trade barriers and trade distorting polices like laws, regulations, subsidies and taxes. EU customs union members have agreed to a common tariff rate for its members while trading with non-members. This essay compares and contrasts the welfare effects of EU customs union with free trade area. Trading blocs and regional economic integration Countries enter into regional trade agreements to eliminate or reduce trade barriers among some countries but not all. On a multilateral basis, reduction of trade barriers has variations. A group of countries form a free trade area (FTA) when they agree to maintain their own external tariff on imports but eliminate tariffs among themselves on exports to the rest of the world (Nello, 2012). On the other hand, another group of countries may chose to form a customs union where they agree to set a common external tariff on imports but eliminate tariffs among themselves while trading with the rest of the world. A well known FTA is the North American Free Trade Agreement (NAFTA) which is designed to prevent goods imports into member countries with low tariffs then transshipped at very high tariffs by adopting ‘rules of origin’. Conversely, El-Agraa and Ardy (2011) argue that the EU customs union avoided the ‘complex rules of origin’ by introducing the problem of policy coordination. Instead, all member countries in the customs union agree on tariff rates throughout the various import industries. According to Nello (2012) free trade area allows for free access to market information and market information while trying to fight firms that attempt to distort markets using oligopoly or monopoly power. Besides facilitating the movement of capital within and between nations, FTAs also provide free movement of labor. Regardless of the country of entry, non-tariff barriers to trade, preferences, import quotas and customs duties apply in the free trade area. However, customs union members trade freely among themselves (Nello, 2012). This means that trade barrier apply to non-member states trading with union members. Other forms of economic integration are economic union and common markets. European Union is about 55 years old and comprises of 25 countries with a combined GDP larger than the U.S and an estimated population of 372 million people (Ardy & El-Agraa, 2011). In 1951, the EU began working on an agreement to eliminate tariffs and quotas for the steel and coal industries in countries such as West Germany, the Netherlands, Luxembourg, Italy, France and Belgium. This was meant to promote free trade and deter future military conflicts in Europe. While implementing the regional trade agreement has come with benefits and costs, it has increased the amount of trade and reduced trade barriers between the countries involved. Some trade is lost by those countries not part of the agreement. Tariffs and other trade barriers, under multilateral trade negotiations, are reduced for all World Trade Organization (WTO) members. Regional trade agreements involve tariffs and other trade barriers eliminated in some selected countries making it discriminatory (Nello, 2012). The European Union (EU) is the world’s most successful and the largest customs union after an agreement to free trade area and common external tariffs. Establishment of customs unions affects the flow of trade within and outside the new union. Customs unions provide an incentive to increased trade and eliminate barriers to trade among members (El-Agraa & Ardy, 2011). As a result, there will be reduced trade between members and non-members. On the one side, it covers only part of trade through the limited preferential trade agreement. When moving along the continuum, one begins with the free-trade areas and ends up in an economic union. As one moves along the continuum, the levels of economic integration deepen. The EU began walking into economic integration and full economic union by creating a genuinely barrier-free internal market. The union sets a number of conditions for member governments to meet in a bid to create a unified market (Nello, 2012). The individual countries had fulfilled the requirements by 1992 and plans for a single market under the Maastricht Treaty (1992) were developed to engender the Euro (European currency). The separate national currencies were discontinued in January 2002. Each country maintains, in a free-trade area, its own national tariff schedule meaning that member states can different tariffs of the same product. This is an incentive to get product exports to the low-tariff countries and re-export to the high-tariff country duty free with some minor processing (El-Agraa & Ardy, 2011). To avoid trade deflection, free-trade agreements change to customs unions. For instance, when France and Britain form a customs union, there will be tariff reduction on French wine, and if completely removed, the free wine market price 100 franc becomes attractive to the British consumers. In total, British consumers consumes more wine because the average wine prices will have fallen when tariffs will have been removed. Total demand for French wine increases and creates new trade as as a result of union members removing the barriers. In the case of trade expansion within the union, the French wine prices fall than those of Australia and in the open market. Trade is diverted away from the formerly highly efficient Australia in wine making and production because the union will have distorted trade. Potentially, tariff revenue is lost following the diversion of trade from non-member countries (Nello, 2012). Imports from Australia fall following the elimination of tariff revenue on French wine. Alternatively, the customs union gives rise to a net gain or a net loss. Globally, world welfare is affected through freer trade movement under a customs union in two ways that oppose as shown in the diagram below. (Source: Ardy & El-Agraa, 2011) Figure 1: Capital formation in trade diversion As shown in the table above, trade creation increases the welfare effect where consumers in France (home country) buy more total domestically produced cars (q2) from Germany (partner country). Increase in consumption is equivalent to the welfare gain shown in triangle a. Furthermore, the lower-price imports replace the French domestic production (q1 to q2). The production change associated with the welfare gain equals triangle (b) represents a favorable production effect. The sum of the triangles a + c is the overall trade creation effect. On the contrary, customs union in the form of trade diversion is a welfare- decreasing (Nello, 2012). This is because imports from suppliers at low price outside the union are replaced by supplier at higher price within the union. World production, as a result of the customs union, is inefficiently organized. This welfare loss to France and many other nations is indicated by box (c). On the other hand, when trade diversion effect (c) is smaller than trade creation effect (j + h), then, customs union formation will increase its members’ welfare and that of the entire world. Customs union creation with common external tariffs alters the existing trade flow pattern. Before the union, it can be assumed that members protected their own industries by imposing different tariffs on different countries. For example, the tariff imposed before customs union formation between the Netherlands and United Kingdom (UK) was 0-q2, where Q2 to Q3 were imports. This implies that X + Y would be the net welfare loss. (Source: Ardy & El-Agraa, 2011) Figure 2: Welfare gain through trade creation Assuming the diagram above shows the UK welfare effect from importing cheaper upon joining the EU is provided as; =Gained consumer surplus (a + b + c + d), less producer surplus loss (a), less government revenue loss (c), which gives; = b + d as the net welfare gained It will be noted that previously, the UK consumed q3 since it had tariffs on EU imports and paid P2. Now, trade has been gained since it consumes q2. Following the union, the tariff is abandoned and the market share of UK farmers falls to 0-q1, and imports from Denmark increase from q4-q3, to q1 to q2. The welfare gain is X + Y, and the trade created is q3 to q2. On free trade, the welfare effects accrue to participants in one country and one specific market making entry to the free trade area. Presumably, multiple countries and many markets are affected when a free trade area is formed (El-Agraa & Ardy, 2011). The aggregate FTA welfare effects affect a range of markets and countries. Trade that would not have existed is created by free trade area sparking supply from more-efficient product producers. The country’s national welfare, in all cases, is raised through trade creation. Nello (2012) argues that EU member-states maintain completely heterogeneous attitudes as they voluntarily subject themselves to some supra-national authorities on issues of border control, monetary policy, and military integration and alliances. Also, El-Agraa and Ardy (2011) observes that free trade area benefits consumers of a given product in the importing country. Consumer surplus in the market is raised by reducing domestic prices of both domestic substitutes and imported goods. Consequently, producers in the free trade area which their country is importing will likely suffer losses. Producer surplus in the industry is reduced by product price decrease in their domestic market (Nello, 2012). This decrease in price lowers the output of existing firms or cause total shut down. The results of this include decreased payments and profits and loss of employment. FTA induces no loss of revenue where there was no initial tariff revenue or prohibitive initial tariffs. Summing the losses and gains to producers and consumers gives the aggregate welfare effect for the country. Two positive components are the net effect of free trade: positive gain in consumption efficiency and the positive gain in production efficiency (El-Agraa & Ardy, 2011). This means that when an FTA is formed and gives rise to trade creation, it results in gain in net national welfare. When a country entering an FTA has import markets, it leads to trade creation but trade diversion occurs in other markets. Trade diversion is likely to generate national welfare losses while markets with trade creation generate national welfare gains. For FTA to improve national welfare, then the positive effects of trade creation should be more than the trade diversion’s negative effects. The theory of the second best argues that an FTA is welfare improving if it causes more trade creation than trade diversion (Nello, 2012). Moreover, market distortions like a trade policies potentially raise economic efficiency or welfare. The policy change in the case of an FTA could be elimination of trade barriers instead of adding new trade policies. Customs unions are beneficial to the welfare of the world when the quantity of trade diversion is insignificant compared to the amount of trade creation as a result of its formation. When customs union creates trade diversion it decreases world welfare because imports from a supplier at low price outside the union are replaced by a supplier at high price within the union. Owing to the customs union and the imminent zero-tariff, lower priced imports from members, consumers create new trade and increase demand for the goods. For example, in 2007, the removal of bilateral tariffs on food and agricultural products between the EU and Turkey generated economic welfare gains for Turkey amounting to US$72 million (0.01 percent of GDP). On the contrary, if the EU removed bilateral agriculture and food tariffs between Turkey. Then the latter would have to reform its border policies on utilities and services. As a result, the economic welfare of Turkey could likely rise by US$1.2 billion (0.19 percent of GDP). Compared to free trade agreement (FTA), the customs union has brought greater welfare benefits between Turkey and the EU (Nello, 2012). The reason is that customs union negates the need for ‘rules of origin’ (ROOs) on bilateral trade and provides an anchor on applied tariffs for industrial products in Turkey. Under an FTA, exports of Turkey to the EU would have been 3.0-7.2 percent lower due to costs (2-6 percent) associated with rules of origin. At the same time, if ROOs were more restrictive, exports from EU to Turkey would have been 4.2 percent lower had the latter maintained at current levels its MFN tariffs for industrial products. Countries have policy-imposed distortions prior to entering an FTA. These are tariff barriers that apply to goods imports that shift the initial equilibrium to a second-best equilibrium. Some of these distortions are removed upon the formation of the FTAs. Nevertheless, El-Agraa and Ardy (2011) note that other distortions remain to be those applied on non-member countries. With the non-FTA countries, removal of partial tariffs raises substantially the negative effects of remaining tariff barriers. The negative welfare effects outweigh the efficiency improvements within the FTA caused by free trade. The national welfare could fall given the strength of the remaining barriers outside the FTA. For example, when the North American FTA shifts imports to a less-efficient supplier from a more-efficient supplier, it leads to a reduction in national welfare. Yet, the domestic economy may benefit from the elimination of such distortions leading to gain in national welfare where supplier efficiency loss is smaller than the benefits (Nello, 2012). In general, removal of trade barriers against all countries ensures that trade liberalization creates efficiency improvements. Nevertheless, the design flaws in the customs union are being unraveled by the changing global economy (Nello, 2012). The post-1995 period and customs union implementation coincided with tectonic shifts in the global economy and the significant changes in the economic growth model of many EU countries. The period witnessed EU membership expansion eastward and the unprecedented increase in global trade sparked by the rising fortunes of emerging market economies such as China, Brazil and India. This moment was critical for the EU to take mutual advantage of the changing dynamics. On the contrary, customs union is increasingly unable to handle the changing dynamics of global trade integration and changes have to be made for all parties to fully benefit from the dynamic global trading environment. As a customs union, the EU engendered a Common Agricultural Policy (CAP) to subsidize the agricultural sector in the same manner (El-Agraa & Ardy, 2011). Compared to FTAs that handle only trade, customs union of EU member countries facilitate farmers with paid subsidies by the EU and not the respective national governments. At the moment, about half of the EU budget goes to the policy guarantees and farm subsidies to stabilize all farm commodity prices for all the members of the European Union. A variable levy protects farmers from international competition because the EU buys what the farmers are unable to sell on the open market. Farmers from Portugal are subsidized in the same manner those from Belgium. The EU pays subsidies to farmers even as each national government provides revenue to the EU. The tariff rises and vice versa if farm prices within the EU decline. With generous support prices, chronic oversupply of agricultural commodities remains a problem in Europe. To reduce EU losses, dumping on world markets in synonymous to its surplus agricultural commodities (El-Agraa & Ardy, 2011). This creates constant trade frictions between the EU and the US over the common agricultural policy and efficient agricultural commodity producers such as New Zealand, Australia and Canada. For example, when the EU dumps or sells surpluses, countries not only suffer losses in other export markets but also lose exports to the EU. Countries in the FTA demand that the EU reforms the system to be less damaging to other countries under FTA. Conclusion The essay has established that EU customs unions provide an incentive to increased trade and eliminate barriers to trade among members. Countries form a free trade area (FTA) when they agree to maintain their own external tariff on imports but eliminate tariffs among themselves. In the EU customs union, trade creation increases the welfare effect where consumers. Free trade area benefits consumers of a given product in the importing country. Also, producer surplus in the industry is reduced by product price decrease in their domestic market. On the contrary, customs union in the form of trade diversion is a welfare- decreasing where imports from the suppliers at low prices outside the union are replaced by suppliers at high price within the union. FTA induces no loss of revenue but has positive gain in consumption efficiency and the positive gain in production efficiency. The essay found that market distortions like a trade policies potentially raise economic efficiency or welfare. On contrast, customs union creates trade diversion by decreasing world welfare because imports from a low-price supplier outside the union are replaced by highly-priced supplier within the union. This essay shows that the welfare effects of EU customs union and free trade differ in various ways. References El-Agraa, A & Ardy, B. (2011). The European Union: Economics and Policies, 9th Edition. Cambridge University Press. Nello, S.S. (2012). The European Union: Economics, Policies and History. McGraw Hill Companies. Read More