Domestic demand and
supply in Country A .
Parameters of Country
A's domestic supply.
Parameters of Country
A's domestic demand.
Initial (pre-union) tariff
level in Country A (use
the spinner to control).
World price (use the
spinner to control). The
same price applies to
both countries.
Equilibrium prices and
quantities in Country A
pre-union.
Equilibrium prices and
quantities Country A
with the union in place.
Welfare levels for
Welfare levels for
Common external tariff Country A with the
Country A in the pre-
used by the union (use union in place (select
union state (select the
spinner to control). the boxes to the the
boxes to see the areas
areas graphed).
Domestic demand and
supply in Country B.
Parameters of Country
B's domestic demand.
Initial (pre-union) tariff in
Country B (use the
spinner to control).
Parameters of Country
B's domestic supply.
Equilibrium prices and
quantities in Country B
pre-union.
Equilibrium prices and
quantities in Foreign
with the export tax in
place.
Welfare levels for
Welfare levels for
Country A with the
Country A in the pre-
union in place (select
union state (select the
the boxes to the the
boxes to see the areas
areas graphed).
Simulation of the Effect of a Customs Un
Domestic Demand Domestic Supply World Supply
Domestic Price Customs Union Price Total Demand
180
160
140
120
Price
Price
100
80
60
40
20
0
0 10 20 30 40 50 60 70 80 90
Quantity
Country A
Inverse Demand Inverse Supply
Intercept 120.0 Intercept 10.0
Slope -2.0 Slope 2.0
Initial Tariff (%) 100.0 1000.0 World Price 200.0 20.0
A Tariff Ridden Equilibrium Show Graph
Domestic Price 40.0 Consumer Surplus 1600.0
Quantity Demanded 40.0 Producer Surplus 225.0
Quantity Supplied 15.0 Government Revenue 500.0
Excess Demand 25.0 Total Surplus 2325.0
Show Graph A and B Customs Union
Common External Tariff 350.0 3500.0
Union Price 85.0 Consumer Surplus 306.3
Quantity Demanded 17.5 Producer Surplus 1406.3
Quantity Supplied 37.5 Government Revenue 0.0
Excess Supply 20.0 Total Surplus 1712.5
e Effect of a Customs Union
Domestic Demand Domestic Supply World Supply
Domestic Price Customs Union Price Total Supply
180
160
140
120
Price
100
80
60
40
20
0
0 10 20 30 40 50 60 70 80 90
Quantity
Country B
Inverse Demand Inverse Supply
Intercept 180.0 Intercept 30.0
Slope -2.0 Slope 2.0
Initial Tariff (%) 375.0 3750.0 World Price 20.0
B Tariff Ridden Equilibrium Show Graph
Domestic Price 95.0 Consumer Surplus 1806.3
Quantity Demanded 42.5 Producer Surplus 1056.3
Quantity Supplied 32.5 Government Revenue 750.0
Excess Demand 10.0 Total Surplus 3612.5
d B Customs Union Show Graph
Union Price 85.0 Consumer Surplus 2256.3
Quantity Demanded 47.5 Producer Surplus 756.3
Quantity Supplied 27.5 Government Revenue 0.0
Excess Demand 20.0 Total Surplus 3012.5
Exercises
1. Initial Tariffs
In a customs union the economies agree to charge zero tariffs on internal trade, and a common tariff on external
trade. The consequence is (generally) a switch of trade from internal to external sources, and an increase in the
total amount of trade that takes place. The welfare effects associated with the changes are called trade diversion
(negative) and trade creation (positive), respectively. The main purpose of this sheet is to analyze the factors
that increase trade creation and/or decrease trade diversion. We begin with the initial level of protection in the
partner countries. Try increasing the initial tariffs in cell AE34 and/or AO34. As you do so, keep an eye on
changes in the total surplus in the equilibrium before the union (cells AI42 and AS42) and after the formation of
the union (cells AI52 and AS52). You should notice that total surplus falls in the tariff ridden equilibrium, while it
2. Common External Tariff
The common external tariff (cell AE47) is the tariff applied to non-members by both economies after the formation
of the union. If the tariff is set high enough, imports from outside the union will be excluded and prices will be
determined within the union. As the CET falls below 325, B will begin to import from the ROW as well as country A.
This hurts country A, but increases efficiency in country B. If the tariff falls below 274 the union as a whole is
actually better off (the customs union increases union efficiency). If the tariff falls below 238, imports from the rest
of the world will be higher than in the initial equilibrium. Such a union must be net trade creating, and beneficial
3. Partner Efficiency
In this sheet, A exports to B in the union. A is relatively efficient in the sense that its autarky price is lower than
that of B. The more efficient the exporting economy, the less the scope for trade diversion. To see this try
lowering the intercept of the inverse supply curve of country A (cell AI32) and/or decreasing the slope of the
inverse supply (cell AI33). Either of these changes represents an increase in production efficiency in A. This, of
course, raises producer surplus in country A in any scenario, but it also has the effect of improving the union
outcome for both countries. Why? For A, the increase in efficiency reduces the amount that it imports pre-
union, and increases the amount it exports post-union, so the gains from the union expand. For country B, the
4. World Prices
Consider a small rise or fall in the world price (cell AI34). An increase in the world price makes the customs union
relatively more attractive for both economies. Why? The higher world price means less initial trade, which
increases the scope for trade creation and decreases the scope for trade diversion. As the world price is lowered,
the opposite happens, and the customs union becomes less attractive. In general then, falls in the world price
are costly for a union with a binding CET because they raise the opportunity cost of the union. In a sense this is
closely related to the efficiency issue, since falling world prices decrease the relative productivity (ceteris
paribus) of the partners. If the world price falls enough, the CET will cease to fully insulate the union, and then