Lecture 2 - The economics of a regional trade grouping

Question 1

What are the benefits and drawbacks of a tariff?

Answer 1

A tariff is a tax on imports:
- It helps home producers increase their share of the home market (more employment in this sector)
- It generates revenue for the government
- It makes imports more expensive to consumers

Question 2

Explain the origin of the European union

Answer 2

The European union is a customs union:
Under the Treaty of Rome the member states of the European economic community agreed to form a customs union called the European Union Customs Union (EUCU)

Question 3

What are the effects of the removal of tariffs and quotas between member countries in a customs union

Answer 3

The removal of tariffs and quotas should increase trade between the member countries as:
- Imports are cheaper to home consumers
- Exports are cheaper to partner’s consumers

Question 4

Is the extra trade created by a CU economically beneficial for the member countries?

Answer 4

Whether or not the extra trade is beneficial for member countries depends on whether the extra trade is new trade - trade creation (TC) or whether trade is diverted away from non-member countries - trade diversion (TD)

Question 5

Explain Jacob Viner’s CU model

Answer 5

• The world is made up of 3 countries: a home/partner and a rest of the world country
• There is one good so there is partial equilibrium and we ignore any interactions with other markets
• There is a given supply price for the good from each source which is unaffected by quantity
• The demand for the good in the home country is given and is not affected by changes in the supply price
• The focus is on the cost of supply: switching to a lower cost source is beneficial, to a higher cost source is harmful

Question 6

What do TC and TD both do for member countries?

Answer 6

TC and TD involve an increase in trade for member countries but their economic implications are different, especially costs of production as stated by Jacob Viner

Question 7

What are some of the benefits of trade creation?

Answer 7

Trade creation is beneficial because:
- Production is switched to a lower cost source
- consumers pay lower prices
- There is no loss of revenue to the government

Question 7

Explain the changes in costs of production due to trade creation (TC)

Answer 7

With trade creation consumers switch from high cost home production to lower cost partner production because the tariff on imports from the partner country is scrapped

Question 8

What are some drawbacks of trade creation?

Answer 8

It is assumed that workers and machines are flexible and can be switched to new jobs in export industries which may not always be true

Question 9

Explain the changes in costs of production due to trade diversion (TD)

Answer 9

With trade diversion consumers switch from lower cost rest of the world production to higher cost partner production because the tariff is scrapped on imports from partners but not on imports from the rest of the world

Question 10

What are the drawbacks of trade diversion?

Answer 10

Trade diversion is harmful because:
- production moves to a higher cost source (inefficient use of the world’s resources)
- governments lose tariff revenue