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

MFEJ. A non-preferential tariff of rate t' would produce a welfare loss equal to the triangle BCL. The Notes
difference is equal to the area MFEJ which derives from the fact that consumers in country A pay
higher prices to partner country producers than they would have to pay to rest of the world producers.
The area MFEJ would be captured for country A as tariff revenue and not lost to the economy if the
tariff were not preferential. Instead with a the combination Free Trade Agreement and customs union
the area MFEJ is added to the losses of country A, thereby greatly magnifying the losses. The area
MFEJ represents a combination of transfers to partner country suppliers (the area MNEJ) plus
inefficiency (deadweight) losses of using marginally inefficient partner country suppliers (the triangle
NFE). It is necessary to reduce this estimate of the losses by the increase in the terms of trade earned
by exporters from country A on their sales within the PTA. Since the tariff primarily benefits existing
Customs Union members, these gains may be expected to be small.
21.3 Summary

• For small CIS countries, with relatively open trade regimes, joining the Customs Union that has
been established by several CIS members could be economically quite costly. These costs could
be mitigated, but probably not fully offset, if as a consequence of the entry of new members,
both the average level and the dispersion of the previously negotiated external tariff of the
customs union were reduced. For these countries, maintaining an open trade regime without
preferences is the best policy that maximizes welfare and growth prospects. It will also facilitate
entry into the WTO, a key objective for these countries' trade policies.
• Even for the existing customs union members, and for others with more restrictive trade regimes
than those of existing members, preferential arrangements that provide strong incentives to
orient trade towards partners in the former Soviet Union contain significant long term risks.
The main risks are that the preferences (through customs union or free trade arrangements)
lock in traditional technologies and production structures, reduce innovation and competition,
and hence result in inefficient industries that absorb scarce resources that could be better used
elsewhere.
• The discussion has focused on preferences and a specific customs union arrangement among
CIS countries. But it has relevance for preferential arrangements, including customs unions,
that might be considered in the context of other country groupings in the CIS as well as in
transition economies in Eastern Europe, e.g. former Yugoslavia. In this case as well, the main
problems would arise from lack of competition and the absence of dynamic technology. The
discussion is not intended to apply to countries in transition joining the EU, where different
circumstances prevail which improve the prospects for economic benefits.
• The key difference between preferential arrangements among CIS members and other
preferential arrangements (NAFTA, the EU) is that in the latter the markets are large enough to
promote competition and encourage the flow of new technology which increase the probability
that distortions introduced through preferences are more than offset by new trade creation and
the dynamic effects of investment embodying new technology.
• We had advocated preferential arrangements for CIS members as useful transitional devices to
mitigate the severe disruption of trade among the new independent states in the aftermath of
the breakup of the Soviet Union (Michalopoulos and Tarr, 1992; 1994). Although based on
duration of unemployment measures, two years appears to be a sufficient period of adjustment
in market economies,11 there is no standard period for adjustment or transition; and the breakup
of the Soviet Union clearly created unprecedented disruption which may have warranted a
greater adjustment period. The new independent states have had five years to adjust to
international competition. Given the inherited burden of inefficiencies that plagues a sizable
portion of CIS industry, there are serious costs of continuing preferential arrangements
indefinitely, and integrating more closely through a customs union at this time appears ill
advised.

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