CUSTOMS UNIONS,FREE TRADE AREAS and MULTINATIONAL TRADING SYSTEM Onur AKSOY 2010500138

In this paper I will examine the effects of customs unions and free trade areas on the multinational trade. There is a great number of variables due to the complexity and uncertainty of this matter,but I will stick with the basics,try to make a clear definition and demonstrate the effects of the matters to countries. A customs union is an association of two or more countries to encourage trade. The countries making such an arrangement agree to eliminate tariffs and other restrictive regulations on trade among them. It is a discriminating trade arrangement since the liberalisation only includes the countries that are members of the customs union and they formulate and administer a common foreign trade policy in regard to tariffs and other trade restrictions against third countries. The best-known customs unions have included the Zollverein, Benelux and the EEC, now called the EU. The Zollverein was formed by German states in the 1830's. These states became the German nation in 1871. Belgium, the Netherlands and Luxembourg established Benelux in the 1940's. Belgium, France, Italy, Luxembourg, the Netherlands and West Germany set up the EU in 1957. Customs union theory builds on relatively strict assumptions such as perfect competition in commodity and factor markets and hence it is often referred to as orthodox customs union theory. It also only deals with the static welfare effects of a customs union. It has both positive and negative welfare effects, compared to a situation in which every member state practices protectionism. Therefore no conclusion can be drawn in advance as to the net welfare result of a customs union. It must be mentioned that some alternative theories have appeared which try to give an economic explanation of protectionism including customs unions. Various factors exist which influence the occurrence of negative and positive effects of a customs union. I will mention five of the most important, the first being the production structure. Two countries can be complementary or competitive. If either country is a potential competitor of the other, specialisation in the products which either country can make best and cheapest is probable, and the advantages of a customs union are likely to be relatively important. The opposite is true if the production structures are complementary. The second factor is the size of the union. The more and the larger the countries participating in the customs union, the larger is its share in the total world trade and the smaller the risk of trade diversion. The third factor has to do with the level of the tariffs. If the initial tariffs of the trade partners are higher, the inefficiencies will probably be worse and the welfare effects of the abolition of the tariffs will be greater. Also the introduction of high tariffs against the world producers will reduce the positive effects. The fourth factor is transportation and transaction costs. For increased trade we will need efficient transport systems, the lack of which will replace tariffs as an obstacle for further specialisation. Clerical procedures at the frontier and linguistic differences in Europe also

tend to make transaction costs higher. Finally, the advantages of forming a customs union are greater if member countries can respond more flexibly to new prospects. In early work on customs unions, Jacob Viner (1950) showed that even though a customs union represents a reduction of trade barriers, and hence a move towards Pareto optimal global free trade, a customs union may reduce economic welfare if it induces members to import from high-cost rather than from low-cost sources. Franz Gehrels (1956-57), and Richard Lipsey (1957)pointed out that even in this case it is possible that a customs union raises economic welfare if there is sucient substitution in consumption or in production. However, about 20 years later, a more sweeping result was established when Michihiro Ohyama (1972) and Murray Kemp and Henry Wan (1976) demonstrated that it is possible to form customs unions that (a) set their common external taris such that no non-member country is aected (denoted by Jaroslav Vanek (1965) as the compensating external tari ), and that (b) redistribute income between the customs union members so that no member country loses and so that some member country gains from joining the customs union. It is an important corollary to this result, and one stressed by Ohyama, Kemp, and Wan, that global free trade can be reached through sequences of ever-expanding compensating customs unions such that no country in the world ever loses at any stage of any sequence and some country gains. In conclusion,If countries are asymmetric, if, for example, they are of dierent size, it is dicult to obtain global free trade since, as shown already by Harry Johnson (1953) in a two-country model, a sufficiently large country may be able to obtain higher welfare with a tari even if its trade partner retaliates. But then, because global free trade is Pareto optimal, there would exista payment from the country that loses from the tari war to the country that gains from the tari war that does not exceed what the latter country loses in economic welfare from giving up its taris, and that is smaller than what the former country gains from global free trade. The country losing from the tari war is willing to oer that payment, and the country losing from free trade is willing to accept it in return for an agreement to trade freely. If there is existence of one large customs union, there are two considerable implications for the total welfare of the customs union. The larger the customs union, the larger the possibility that the most efficient producers of various goods will be inside the customs union and hence, the smaller the potential for trade diverting effects. Secondly, when the large customs union fixes it's common external tariff rate then the possibility of it affecting its external terms of trade is increased and thus it can obtain an additional welfare gain. As far as the companies concerned, advantages of a customs union internal to the company depend on the size of the company, its growth rate and its learning curve. The larger the company the more efficient is its production and the stronger is its negotiating position. They are also more able to build up stable market positions in export countries. The growth rate of companies tends to have a positive effect on efficiency. Fast-growing firms have the most up to date machinery etc. but they tend to be less flexible in their response to entirely new markets. The learning curve indicates that companies learn to produce more efficiently by the production of greater numbers. Expansion permits producers to offer products of higher quality that are better adapted to specific consumer needs and demand will increase. Also, when a customs

union puts a company in a better position, the positive influence is not confined to that company but extends to all related suppliers and buyers. That effect will be greater the better the various parts of the economy are equipped to respond to the impulse. As barriers such as tariffs, quotas etc. are eliminated, domestic producers have to reduce their price to the level of the partner country. Excess profits will disappear and inefficiencies like over staffing will have to be reduced. Consumers gain from these price reductions as they obtain more goods at lower prices and producers offset the loss by price reductions. Customs unions are discriminating trade arrangements and hence violate the rules of GATT. Under GATT's `principle of most favoured nation' member countries have to give each other the same favourable treatment that they give to any other country. Customs unions between a limited number of countries is a clear violation of the principle, but Article XXIV of the GATT treaty gives the right to form regional customs unions if certain conditions are satisfied because the overall aim of GATT is to promote international trade. When GATT was created in 1947, it was the widespread belief that customs unions were a step closer to free trade and it was not until later that it became clear that customs unions could in fact be a form of protectionism. All in all,the creation of a customs union has some positive and some negative welfare effects. It can only be well founded in economic terms if the former exceeds the latter. The welfare effects of the customs union as a whole are uncertain. Only if it is possible for a customs union to affect the external terms of trade through the optimal tariff is it possible for the union to achieve a gain in net welfare. In relation to the short term effects which affect consumers, producers and governments, customs unions tend to have more positive effects as production structures are more competitive, initial tariffs are higher and also, as customs unions are larger transaction costs are lower. Competition and economies of scale are long term effects and are better reasons for creating customs unions. Free trade areas are part of the broad category of trade arrangements under which member countries grant one another preferential treatment in trade.The process of forming an FTA usually begins with discussions between trading partners to ascertain the feasibility of forming an FTA. If they agree to go forward, then the countries undertake negotiations on what the FTA would look like. At a minimum, participants in an FTA agree to eliminate tariffs and some other nontariff trade barriers and agree to do so over a specific time period. In addition, the partner countries usually agree on rules of origin, that is, a definition of what constitutes a product manufactured within the FTA and, therefore, one that is eligible to receive duty-free and other preferential trade treatment. Rules of origin prevent products from nonmembers entering an FTA market over the lowest tariff wall. Most FTAs also include procedures on the settlement of disputes arising among members and rules on the implementation of border controls, such as product safety certification and sanitary and phytosanitary requirements. Most recent FTAs contain rules on economic activities besides trade in goods, including foreign investment, intellectual property rights protection, treatment of labor and environment, and trade in services. The size and complexity of the FTA will largely reflect the size and complexity of the economic relations among the participating countries. U.S. FTAs with Israel and Jordan are relatively basic, while the NAFTA (the United States, Canada, and Mexico) is very complex. Countries form free trade areas for a number of economic and political reasons. Most basically,

by eliminating tariffs and some nontariff barriers, FTAs permit the products of FTA partners easier access to one anothers markets. The 1989 FTA between the United States and Canada was formed arguably for this purpose. Developed countries have also formed FTAs with developing countries to encourage them toward trade and investment liberalization. FTAs may be used to protect local exporters from losing out to foreign companies that might receive preferential treatment under other FTAs. For example, some supporters of the U.S.-Chile FTA argued that U.S. firms were at a disadvantage vis--vis their Canadian competitors whose exports face no Chilean tariffs under the Canada-Chile FTA. Slow progress in multilateral negotiations has been another impetus for FTAs. For example, when the 1986-1994 Uruguay Round negotiations got bogged down, the impetus for the United States, Mexico, and Canada to form NAFTA seemed to increase. Arguably the surge in FTA formation worldwide in the past few years has been a result of the difficulties encountered in launching and implementing the Doha Development Agenda round of negotiations in the WTO. Political considerations are also a motivation to form FTAs.For instance, The United States formed FTAs with Israel and with Jordan to reaffirm American support of those countries and to strengthen relations with them. The formation of FTAs worldwide raises the question of their impact on the countries included in an FTA and on the rest of the world. It is an issue that economists have long studied and debated. Interest in the issue has peaked at various times in the post-World War II period. The first time was the formation of the European Common Market. Interest has peaked again with the current trends in FTAs. The debate has relied largely on theory since empirical data are scarce save for the experience of the European Union. The debate has also divided economists between those who strongly oppose FTAs as an economically inefficient mechanism and those who support them as a means to build freer trade. Economists usually base their analysis of the impact of FTAs on the concepts of trade creation and trade diversion. These concepts were first developed by economist Jacob Viner in 1950.Viner focused his work on the economic effects of customs unions, but his conclusions have been largely applied to FTAs and other preferential trade arrangements. His analysis was also confined to static (one-time) effects of these arrangements. Trade creation occurs when a member of an FTA replaces domestic production of a good with imports of the good from another member of the FTA, because the formation of the FTA has made it cheaper to import rather than produce domestically. The creation of the trade is said to improve economic welfare within the group because resources are being shifted to more efficient uses. Trade diversion occurs when a member of an FTA switches its import of a good from an efficient nonmember to a less efficient member because the removal of tariffs within the group and the continuation of tariffs on imports from nonmembers make it cheaper to do so. Trade diversion is said to reduce economic welfare because resources are being diverted from an efficient producer to a less efficient producer. In most cases, it appears that FTAs lead to both trade diversion and trade creation with the net effects determined by the structure of the FTA. Therefore, even if two or more countries are moving toward freer trade among themselves in an FTA, the FTA could make those countries and the world as a whole worse off if the FTA diverts more trade than it creates, according to economic theory. Trade policymakers encounter circumstances much more complicated than those depicted in

economic theory. Many functioning and proposed FTAs encompass more than two countries and involve a range of products, both goods and services, making it much more challenging to evaluate their economic impact. To provide an analytical framework, some economists have developed sets of conditions under which, they have concluded, an FTA would create more trade than it diverts. They state that trade creation is likely to exceed trade diversion the larger the tariffs or other trade barriers among members before the FTA is formed; the lower the tariffs and other barriers in trade with nonmembers; the greater the number of countries included in the FTA; the more competitive or the less complementary the economies joining the FTA; and the closer the economic relationship among the members before the FTA was formed. Economists also have determined that, along with the immediate, static effects of trade diversion and creation, FTAs generate long-term dynamic effects that might include the following: increased efficiency of production as producers face increased competition with the removal of trade barriers; economies of scale, that is decreased unit costs of production as producers can have larger production runs since the markets for their goods have been enlarged; and increased foreign investment from outside the FTA as firms seek to locate operations within the borders of the FTA to take advantage of the preferential trade arrangements. Until recently not many FTAs were in operation; therefore, available data on their impact have been limited to the experience of the formation of the European Common Market and subsequently the European Union. Most studies have concluded that the European Community has resulted in more trade creation than trade diversion. However, in some sectors, such as agriculture, the net effect has been trade diversion because the EUs Common Agricultural Policy raised barriers to agricultural trade outside the EU. A basic principle of the General Agreement on Tariffs and Trade (GATT) that is administered by the WTO is the most-favored nation (MFN) principle. Article I of GATT requires that any advantage, favor, privilege, or immunity granted by any contracting party to any product originating in or destined for any other country shall be accorded immediately and unconditionally to the like product originating in or destined for the territories of all other contracting parties. FTAs, by definition, violate the MFN principle, since products of FTA member countries are given preferential treatment over nonmember products. However, the original GATT signatories recognized that FTAs and customs unions, while violating the MFN principle, improve economic welfare of all members, if certain conditions are met to minimize trade diversion.The WTO formed the Committee on Regional Trade Agreements (CRTA) in 1996 to review pending and operating FTAs and customs unions to determine whether they conform to WTO rules under the GATT and the GATS. However, the rules are sufficiently ambiguous as to be subject to continuing debate within the CRTA.Yet, none of the reports of notifications has been completed because CRTA members have not been able to reach a consensus on any of them. Nevertheless, the vast majority of the FTAs have gone into operation. As it can be easily seen above,both customs unions and FTAs have positive and negative effects due to their variable contents.I sincerely hope that every outcome of any trade negotiation or interaction would be in all concerned parties benefits and cause no conflict

between nations and its citizents. 2947 Words References

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