Activity B

Well done! Now let’s look at a slightly different case. Suppose that instead of forming a customs union with Japan (the low-cost supplier) Australia were to instead form a customs union with the EU (the high-cost supplier).

This will mean that once the customs union has been formed that Australia can choose to import motorcycles from Japan at a price P_J + t or from the EU at a price of P_EU.

Since you have already had a go at this type of analysis, this time you are required to complete the activity without receiving any hints. This is a different case to the one we have already considered so it might take you more than one go to get correct. Good luck!

Well done! Notice that the result you got in Activity B is not the same as in Activity A. It seems that forming the customs union with the EU (the high-cost producer) opens the door to the possibility that the net effect of a customs union on welfare in the motorcycle market could be positive or negative.

In both activities the customs union has a trade creation effect and imports rise by the amount (q₂ - q₁ ) + ( q₄ + q₃). This is a positive thing and the welfare gain associated with reducing the distortionary effect of the common tariff by the area of the two orange triangles.

However the EU, analysed in Activity B, has an additional effect on the motorcycle market. Forming a customs union with the EU has in effect diverted trade away from Japan and toward the EU, or more generally from the low-cost producer to the high-cost producer. This is a negative thing for Australia and the amount of welfare loss is shown in Activity B diagram as the area of the bottom of the two red rectangles.

Overall therefore, whether members of a trade-diverting customs union gain or lose in our static, partial equilibrium framework, depends on the relative sizes of the trade creation and trade diversion effects.