Page 239 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

Unit 21 : Static and Dynamic Effects of a Custom Union and Free Trade Organization

circumstances the benefits of joining the CU would depend to a considerable extent on the height and Notes
structure of each of the countries external tariff compared to that of the Customs Union external
tariff. While in practice a Customs Union external tariff may not be in place at present, for purposes
of analysis, the Russian tariff is a good proxy of the Customs Union external tariff that had been
negotiated and will be used for the discussion in this unit. If a country such as Armenia or the Kyrgyz
Republic with lower external tariffs were to substitute the Russian tariff for its own tariff structure, it
would increase its unweighted average tariff to 13-14 percent (see table 2). More importantly, assuming
that following accession of new members, the common external tariff is not changed, the Russian
tariff exhibits considerably more dispersion compared with the tariff for some of the countries (typically
between 0 and 30 percent),3 meaning that for selected highly protected products in Russia, the tariff
would increase significantly. For other countries, adopting the common external tariff would mean
actually reducing their average tariff.
Starting with Jacob Viner (1950), international trade economists typically analyze preferential trade
arrangements, whether members of a FTA or a CU, in terms of trade creation and trade diversion.
Trade creation in a product occurs, when additional imports come from partner countries which
displace sales of inefficient domestic producers and these imports are at least as cheap as imports
from non-partner countries. Trade creation results in improved welfare for the importing country
for much the same reasons as increased trade improves a country's welfare. On the other hand, trade
diversion occurs when suppliers in the rest of the world (who continue to face tariffs) are more
efficient than partner suppliers, but additional partner country imports displace the more efficient
suppliers. Trade diversion is typically (but not necessarily) welfare reducing since the home country
must pay more to import the product from the less efficient partner country suppliers.
Although the general theory of regional trading arrangements is quite ambiguous in its conclusions,
we believe some definitive conclusions are possible with respect to the specific customs union under
consideration, at least for some of the CIS countries. Since the partner countries in the potential
customs union already have tariff free access to the other CIS markets under the Free Trade Agreement,
prices in these countries' markets cannot fall as a result of the customs union, i.e., there will be little
welfare gain from trade creation. Whatever trade creation would occur, would come from third country
suppliers in those products where the current external tariff in the country is higher than that of the
Customs Union external tariff. Since welfare costs from a tariff increase with the square of the tariff
rate, net welfare effects are little impacted by reductions in tariffs by a few percentage points say,
from ten to seven percent. Rather what is crucial to the welfare effects are the changes that involve
significant tariff increases.

Countries with Lower Tariffs Than in the Customs Union
Prospective partner country suppliers will have the potential, under the higher tariffs of the customs
union, to raise prices to consumers in other CIS countries by the amount of the tariff preference over
rest of world imports. In the model we present in the appendix, we assume that they will do so. A
principal reason we believe they will do so is our judgment that advocates of the customs union
propose it as a means of expanding protection for inefficient domestic industries throughout the CIS.
That is, the customs union is an import substitution strategy for inefficient industries, where the
structure of the tariff is high in those industries that exist in the customs union, especially in Russia.
In the appendix, we elaborate some additional reasons why we believe they will do so. Thus, a key
assumption of our model is that prospective members of the customs union face upward sloping
supply curves from partner country suppliers who will raise prices by the extent of the tariff.
Moreover, since these countries have tariff free access to markets of the members of the customs
union and to Russia in particular, the exporters from a CIS country joining the CU will not obtain
improved access to the Russian market, which is by far the dominant market in the customs union.
Thus, for countries like the Kyrgyz Republic and Armenia with already liberal external tariffs or
others like Georgia and Moldova which are also pursuing generally liberal trade policies and assuming
the common external tariff is not changed following their accession, the usual tradeoffs that must be
considered in the evaluation of a preferential trade arrangement (trade diversion versus improved
access and trade creation) do not apply. Thus, the CU would virtually result in pure trade diversion.

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