Factor Mobility and Customs Unions Theory

Abstract

The standard theory of customs unions originated with the pathbreaking work of Viner [11]. Viner draws a distinction between the trade-creating and the trade-diverting effects of customs unions. Trade creation involves a shift of consumption of the importable good from a high-cost domestic producer to a lower-cost foreign producer. Trade diversion, however, involves a switch from the lowest-cost external producers to a higher-cost producer. Viner argues that trade creation improves the home country's welfare and trade diversion dampens it. Viner's analysis was refined by Gehrels [4], Lipsey [8] and Batra [1]. The theory was reexamined in light of unemployment by Yu [12] and in the presence of variable returns to scale by Choi and Yu [3]; Viner's main results were modified accordingly. Underlying the standard theory of customs unions is the assumption that factors are perfectly mobile between industries in a given country. This assumption simplifies the analysis, but cannot be supported by empirical observations. It is notable that the two-sector trade model has been recently extended to accommodate varying degrees of factor mobility. Mussa [10] considered the case in which capital is sector-specific, but labor displays any degree of mobility. Grossman [5] posited capital immobility but allowed perfect labor mobility. Casas [2] studied the implications of labor immobility which gives rise to an endogenous wage differential. Hill and Mendez [6] developed a general model which allows any degree of mobility in both factors. Yu and Parai [14] adopted Casas approach to examine the gains-from-trade issues. This factor-mobility literature has generated many interesting results in the neoclassical trade theory. The implications of factor immobility for the customs union theory, however, remain by and large unexplored.' The purpose of this paper is to make a modest contribution by considering the customs unions theory in the presence of any degree of mobility of both factors. As a secondary contribution, we elucidate how the presence of factor immobility makes the extent of factor price differentials