Page 240 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

International Trade and Finance

Notes High tariff protection for such small economies is generally very inefficient and costly. Protection
prevents the transmission of world prices to the economy and thereby prevents market signals from
inducing resource reallocation to areas of comparative advantage in the economy. Experience has
shown that over time, countries with high protection generally grow more slowly than those with
low protection. Moreover, we show in the appendix that increasing an external tariff within the
framework of a customs union with Russia and the other partners for a small CIS country, is much
more costly than simply raising tariffs, without preferential treatment to the customs union members.
In fact, in this example the customs union will be several times more inefficient and costly to the
small country than simply raising tariffs to the rest of the world in a non-preferential manner.
Joining the customs union with a common external tariff such as that previously negotiated is so
costly for several reasons: First, partner country suppliers can raise prices under the tariff protection
they receive from preferential protection. Then for the quantities previously purchased from partner
country suppliers, consumers in member countries with a previously lower external tariff will likely
pay higher prices (excluding the tariffs) to partner country producers than they were paying prior to
participation in the customs union, i.e., there is an adverse terms-of-trade effect on the initial quantities
purchased from partner country suppliers. Second, since rest of world imports are subject to a higher
tariff, there will be a diversion of sales away from rest of the world suppliers toward partner country
suppliers.
This trade diversion entails two costs: (a) since the importing country does not collect any tariff revenue
on imports from partner countries, there is a loss of the tariff revenue on these trade diverting imports;
and (b) excluding the tariff, consumers will have to pay higher prices to partner country suppliers than
they were paying to rest of world suppliers prior to participation in the customs union.
In their comprehensive theoretical treatment, Bhagwati and Panagariya (1996) describe a model in
which partner country suppliers have perfectly elastic supply curves. This situation might be expected
to apply if a country is forming a preferential trade area with a very large market, such as the European
Union or NAFTA, because competition among many suppliers in the large market results in flat
supply curves to the prospective new member country. In this case, there is a much larger likelihood
of the preferential trade area being welfare increasing since the new member will not suffer a terms-
of-trade loss on its purchases from the suppliers from the large market.
Countries with Higher Average Tariffs Than in the Customs Union

For countries with a higher average external tariff than that of the CU, the results are more ambiguous.
On the one hand, in converting to the common external tariff, since the average tariff is lower than in
the home country, there will be a number of products where the external tariff will be reduced.
Then there will be a welfare gain on those products where the external tariff is lowered Because
there will be some trade creation from additional imports from rest of the world Suppliers (partner
country suppliers already have tariff free access due to the FTA so no Additional trade creation is
possible from CIS partners). On the other hand, the negotiated
Tariff of the CU is not uniform; rather it favors production of those products already produced in
the CU. Even in countries with higher average tariffs than in the CU, their tariffs typically favor their
home production. Substitution of the CU tariff will shift the tariff structure so that it favors the
producers of the CU, i.e., tariffs will be high on the products produced in the CU and low on the
products produced in the home country, and it is likely that even in countries with higher average
tariffs, they will have to raise their external tariffs on many products produced in their partner
countries. This will allow partner country producers to charge higher prices under the protection of
higher tariffs on third country producers, a significant welfare loss that is likely to dominate.
A choice available to a country in these circumstances is to lower its tariff on third countries, without
joining the CU. This option offers the gains from the trade creation on the products where the external
tariff is being lowered, without the losses of the trade diversion from having to pay higher prices to
inefficient partner country suppliers.
Russia, Kazakstan and Belarus. Finally, briefly consider the welfare impact on Russia, Kazakstan
and Belarus, the members of the Customs Union which had adopted the common external tariff.

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