2 management - School of International Business and ...

Günter S. Heiduk
This model combines the free trade case and the tariff case. Assume that under free trade
country I imports good x at the world market price p(F). After country I introduces a tariff (t
I (F)) for imports from the world market, the domestic price rises to p(F + t), thus reducing
the imports to x I (F + t) x I (F + t)* = x (CU) x (F + t). At this tariff, country II is not compe-
titive: its price plus tariff exceeds the price plus tariff from other countries (p II + t > p (F +
t)). Finally, country I and II decide to establish a customs union. Now, country II has free
access to the market in country I, but the latter still protects its market against third coun-
tries by keeping the tariff (t I (CU)). The equilibrium within the customs union is achieved
with an import volume of x (CU) x (F + t)) = x I (CU) x I (CU)* = x II (CU) x II (CU)* at the
price p I,II ( CU) . The total trade effect can be divided into:
- trade creation x I (CU) x I (F + t)
- trade expansion x I (F + t)* x I (CU)*
- trade diversion x I (F + t) x I (F + t)*.
The customs union leads to an increase of imports at a lower price, but the total imports
of country I are now exported from country II instead of formerly from third countries. Less
effi cient producers in country II substitute more effi cient producers in third countries. This
effect is characterized as the welfare loss of trade diversion (table below).
Note that the negative welfare effect of trade diversion is shrinking if the difference bet-
ween the free trade price and the price within the customs union is decreasing.
The model of an optimum currency area [Mundell, 1961; McKinnon, 1963, Kenen, 1969] is one
of the main theoretical pillars that form the starting point for integrating the monetary sectors
of countries with different currencies. The empirical relevance is growing, not only because an
increasing number of regional trade agreements have reached a mature stage but also because
the gravity forces in larger regions without institutionalized trade agreements experience the
emergence of a leading currency. The aforementioned founders of the OCA theory addressed
the essential characteristics that determine the supra-national region where exchange rates can
be fi xed and eventually replaced by a common currency. It could also be applied to sub-national
regions demonstrating the opposite policy if the common currency does not fulfi ll the OCA criteria.
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