Customs Union and Free Trade Area Assignments.

Customs union and free trade area assignment

Question 1

A customs union is a type of trade bloc comprising of two or more countries formed to abolish custom restrictions exchanged between member countries as well as set up a uniform tariff policy. European Commission forms a significant example of a customs union. On the other hand, a free trade is a relatively loose type of integration whereby nations basically agree to get rid of tariff and non-tariff barriers between them in order to enhance free trade of goods and services. The European Free Trade Area and the North American Free Trade Area form good examples of free trade areas.

Trade creation, trade diversion and trade deflection form concepts that are employed in distinguishing between the effects of customs union or free trade area creation that may be favourable from those that are unfavorable.

Trade Creation

Trade creation entails a shift in domestic consumer spending from a higher cost domestic source to a lower cost partner, due to the abolition of tariffs on intra-union trade. For instance ; car manufacturers from Western Europe may find and thereafter be able to profit from a much cheaper source of rubber tyres from other nations within the customs union compared to if they were relying on domestic sources with trade restrictions all set. As highlighted by Figure 1 Below ,trade creation leads cheaper supplies and further allowing lower prices for consumer .

Figure 1.

As highlighted by Artis & Nixson (2007), trade creation is a source of benefit as it stimulates the increase intra-trade within customs union. In theory, it is argued to enhance the efficient allocation of limited resources as well as gains in producer and consumer welfare. As highlighted by Figure 2 trade creation caters for consumer welfare through providing low prices.

Figure 2

Trade Diversion

On the other hand, Artis & Nixson (2007) highlights that trade diversion occur if nations come to source their imports from relatively high-cost partner countries. Trade diversion can therefore be described as the shift in domestic spending from a lower cost global source to a higher cost partner source, due to the abolition of tariffs on imports from the partner.

For instance, assuming the most efficient manufacturer of wine globally is Australia-a nation outside the European Commission. Assuming too that prior to membership UK had an identical tariff on wine from any nation, it would therefore import wine from Australia rather than the European Commission. After becoming a member of the EC the abolition of the tariff made the wine cheaper as the tariff remains on the Australian wine (Margetts, 2010).

Consumption is thus switched to the higher cost European Commission wine. This leads to a reduction in global efficiency. As far as UK is concerned it will experience gains as well as losses in welfare. In the diagram below, prior to joining the EC, UK was obtaining wine from Australia at price P1. At this particular price UK consumed Q1, produced Q2 locally, and imported the remaining Q1 – Q2 (Margetts, 2010). On becoming a member of EC it is now possible to consume the European Commission tariff free price of P2 (this is higher than the Australian tariff free price of P3). It is therefore possible to see the welfare gains and losses:

An increase in consumer surplus in areas 1 + 2 + 3 + 4.

A reduction in producer surplus of UK wine producers in area 1.

A loss in government tariff revenue of 3 + 5.

Trade Deflection

Trade deflection is a situation that arises when two or more nations establish a free trade area, and in so doing, they do not have tariffs that are homogeneous to the rest of the world. As a result, this makes it possible for a nation to import certain goods that the other nation previously imported only to turn around and trade the goods with another nation in its free trade area. This situation lowers the amount of government revenue within the consuming nation and may cause decrease in surplus (Riley, 2006). The diagram demonstrates the effect of enforcing a tariff for an importing nation.

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In the case of a free trade situation, an importing nation is consuming QD0 units at a price of P0. The world free trade price is represented by the blue price line, PFT. At this particular price local producers trade QS0 worth of the goods and QD0 -QS0 is imported. If a tariff is forced, the prices rise by the tariff amount. At a new price, P1, the free trade price and the tariff amount, indicated in red, consumers tend to reduce their consumption level of goods to QD1. Domestic or local manufacturers experience a higher profit level, and enhance their level of production to QS1.Imports drop to a level indicated by the red bracket, and which is the difference between QD1 and QS1(Riley, 2006) .

Question 2

Article 101 and 102 are key competition provisions under TFEU, whereby (Articles101) restricts competition and Article 102, restricts dominant position. The two articles bring about the static and dynamic concepts of completion in various ways.

Article 102 through the provision of restricting dominant position of firms, encompasses creation of static competition. Static competition aims at lowering prices and raising costs of providing goods and services as a result the earnings of firms reduce and their assets also reduce. Artis and Nixson (2007) highlight full membership of the EU requires the application EU’S competition policy as a result, in this context when article 102 is applied among EU member states no firm is able to gain dominance in the market when prices are lowered and operational costs are increased. Thus firms will operate at an equalized level.

Article 101 by the provision of restricting competition, encompasses dynamic competition. The main objective of dynamic competition is that it forces firms to compete in completely new ways based on the fact that they require the changing technology at various points of the value. As a result firms are forced to transform their technology in order develop different or unique assets that can assist them bring in new inflow of cash. Artis and Nixson (2007) highlight that; competition policy allows collaboration between firms at the stage of developing new products for an immediate market. As a result the collaboration between firms to come up with products is an indication of firms working towards transforming their technology in order to meet the demand of the market.

One of the major objectives of the formation of the EU was to develop a common market that will assist in free movement of goods, people and services among the members of EU. The introduction of article 101 and 102 within the competition law framework facilitates the development of a common market that is characterized by both static and dynamic phases of competition. This is because through the formation of a single market; firms within the EU operate within the same market forces as proposed by Michael porters five forces. That is firms in the EU framework face the same competition aspects such as potential entrants, suppliers bargaining power, substitutes, buyers bargaining power and industry competition. As a result the formulation of competition policies like article 101 and 102 as an EU regulation, influences companies to compete in both the static and the dynamic faces of competition.

Question 3

One of the main non-tariff barriers that have hindered the development of single market has been competition policies (Hitiris, 2003). Lack of implementation as well as lack of effective competition policies has hindered healthy competition thus hindering the development of single markets. Holmes (1995) highlights, for instance, that the European Community confirmed during the build up to the year 1992 that it would welcome investments from outside. This led to an increase in the number of investments from the Pacific Asia and the United States. Companies were notified that if they invested in any of the European nations, they would have an access to the domestic market of all the others.

However, a number of interesting cases revealed that the rhetoric openness ran ahead of the reality. According to a study by the Organization for Economic Cooperation and Development carried out in the year 1995, the consequences of such ineffective policies has been that the European Community economies have been losing out to the United States and Pacific Asia for foreign direct investment (Holmes,1995).

Inflows of foreign direct investment to the United States, for instance tripled up to $60.07 in the year 1994 from $21.37 billion during the year 1993.This figure marked a six-fold rise from the$9.89 billion of such investment into the United States in the year 1992.Competition policy has therefore been a barrier hindering the development of the single market rather than an enhancement of it.

Another major non-tariff barrier that has hindered the development of a single market has been harmonization. As highlighted by Holmes (1995), harmonization has, for instance, resulted in the EC market being overregulated, over-centralized as well as overprotected. As a result, businesses have been burdened with extra costs, hindering labour markets from working effectively, and as well, stifling the regenerative process of the capitalist system.

Harmonization has also cut consumer choice, giving rise not to a single market, but a uniform one. According to Hitiris (2003), there is a big difference between a single market where consumers are always the king and a uniform one where the EC makes a decision on product determination. Unfortunately it is a uniform market that the European Commission directives, has for instance, been rapidly producing. This has without a doubt formed a major non-tariff barrier that has hindered the development of the single market.

References

Artis, M & Nixson, F, 2007, The Economics of the European Union, Fourth Edition, Chapter 3

Holmes, M, 1995, From Single Market to Single Currency: Evaluating Europe’s Economic Experiment

Hitiris T, 2003, European Union Economics, Fifth Edition, Chapter 3

Riley, Geoff, 2006, Macroeconomics / International Economy: Trade Agreements in the International Economy.

Margetts, S, 2010, Trade Creation and Trade Diversion