Discuss the conditions that are likely to lead to increased welfare with the formation of customs unions. (10)
Previous studies in economics believed that any movement towards freer trade would also increase welfare, through efficient utilization of world resources and in the end maximize world output and welfare. The basis of this argument suggests that the creation of customs unions allows the movement toward freer trade, which is believed to bring an increase in the welfare of member and non-member nations alike.
In contradiction to this assertion, Viner argued that the formation of a customs union could increase or reduce the welfare of member nations and the rest of the world, depending on the circumstances under which the customs union formation took place. This statement leads to the theory of second best, which states that if all the conditions required to maximize welfare cannot be satisfied, trying to satisfy as many of these conditions as possible will only lead to the second-best position. In such a way that, forming a customs union and removing trade barriers only among the members will not necessarily produce the second-best welfare position. In order for welfare to be maximized the following conditions should be available for trade creation under the formation of customs unions to lead to an increase in welfare. The conditions are elaborated below:
- The higher are the pre-union trade barriers of member countries. There is then a greater probability that the formation of the customs union will create trade among union members rather than divert trade from non-members to members.
- The lower are the customs union’s barriers to trade with the rest of the world. This makes it less likely that the formation of the customs union will lead to costly trade diversion.
- The greater is the number of countries forming the customs union and the larger their size. Under these circumstances, there is a greater probability that low-cost producers fall within the union.
- The more competitive rather than complementary are the economies of member nations. There are then greater opportunities for specialization in production and trade creation with the formation of the customs union. Thus, a customs union is more likely to increase welfare if formed by two competitive industrial nations rather than by an industrial nation and an agricultural (complementary) nation.
- The closer geographically is the members of the customs union. Then transportation costs represent less of an obstacle to trade creation among members.
- The greater is the pre-union trade and economic relationship among potential members of the customs union. This leads to greater opportunities for significant welfare gains as a result of the formation of the customs union.
On this part, Salvatore (2013) concluded by saying that, the EU has had greater success than European Free Trade Association, mainly because the nations that formed the EU, were much more competitive than complementary, we’re also closer in terms of geographically, and had pre-trade.
