2 management - School of International Business and ...

161 The Puzzle of Globalization
a common currency. The member states reach the highest level of economic integration by harmo-
nizing the fiscal policy – first of all by establishing a common tax system.
Since the early 1960s the basic model of the customs union [Viner, 1950] has motivated many
economists to test the three effects, namely trade expansion, trade diversion and trade creation.
The first effect is based on the result of the free trade model. The consumers inside the customs
union switch their demand from relative expensive producers in third countries to intra-union
producers who gain competitiveness because of the abolishment of internal tariffs. Intra-union
trade increases but at the same time causes trade diversion. The former import from the cheapest
producer is now discriminated by the common external tariff. With free trade inside the customs
union internal producers with higher costs replace external low cost producers, therefore resulting
in trade diversion. The abolishment of tariffs inside the customs union is accompanied with driv-
ing out of the market less efficient producers and replacing them by imports from more efficient
producers in one of the member states. This effect is called »trade creation«. The welfare effect
of the customs union depends on the relation of the three aforementioned trade effects (Annex,
Figure 8). The probability that the positive effects outbalance the negative effects is increasing
– with the growing number of member states,
– if the common external tariff exceeds the original tariffs to a small amount only,
– if the new internal equilibrium price differs only marginal from the world market price.
Despite the problems of measuring the trade effects of regional trade agreements [Magee, 2008]
empirical studies show evidence that the positive effects of a customs union are higher than a
free trade agreement [e.g. Carbaugh, 2008, pp 272].
Box 3 Effects of the Customs Union