Discuss the potential dynamic welfare gains that can result from the formation of custom Union. (10)
On top of the static welfare effects, the nation’s forming a customs union are likely to receive several important dynamic benefits, and these dynamic benefits result from increased competition, economies of scale, a stimulus to investment, and better utilization of economic resources. These points will further be explained below.
Increased competition
According to the prescribed text, the greatest dynamic benefit from the formation of a customs union is the increased competition. Without foreign competitors, local producers will be enjoying the powers and benefits of monopolistic and oligopolistic markets, and tend to over-charge the consumers, as well as growing sluggish and complacent as there will be protected by the barriers to entry. The creation of customs unions will lead to the elimination of the monopolistic powers and barriers to entry as the foreign producers will have access to the local market. The other benefit that will result from this increased competition includes the benefits of research and development, transfer of technology. Above all, this will lead to a reduction in the cost of production which will be passed to consumers in the form of lower prices. As a result, the consumer surplus will then increase.
Economies of scale
The prescribed text stated that economies of scale are the second possible benefit from the formation of the customs union that will arise from the enlarged market. The formation of customs unions will reduce the range of differentiated products manufactured in each plant and tend to increase the production runs.
Stimulus in investment
The desire to meet the increased demand due to the enlarged market and also the desire to meet the competition will force companies to increase their level of investment. As stated in the prescribed text, the formation of a customs union is likely to spur outsiders to set up production facilities within the customs union to avoid the (discriminatory) trade barriers imposed on nonunion products. These are the so-called tariff factories. The massive investments that U.S. firms made in Europe after 1955 and again after 1986 can be explained by their desire not to be excluded from this rapidly growing market.
Better utilization of economic resources
According to Salvatore, the free movement of factors of production like labor and capital within a custom union, more specifically the common market, will lead to better utilization of the economic resources of the entire community, or the countries in the customs union.
Conclusion
Salvatore went on and said that the dynamic gains from the formation of a customs union are believed to be much greater than the static gains and are very important. The empirical evidence shows that the dynamic gains are five to six times larger than the static gains.
