Pareto‐optimal Delegation in Customs Unions*

Abstract

Abstract.Customs unions constitute agreements to engage in free intra-union trade and to levy common external tariffs on trade with non-members. Existing theoretical models do not agree on how the common external tariffs are chosen; different, somewhat ad hoc choice rules have been employed. In this paper, a model of customs union formation is developed in which the Pareto principle and the assumption of unanimity are used to construct a mechanism for the choice of common external tariffs. The model is structured as a three-stage game in which union members select common external tariffs that yield utility outcomes that are Pareto optimal and dominate the stand-alone alternative. Numerical examples are use to demonstrate the wide range in the nature of these outcomes. Our results are discussed in relation to the delegation principle developed by Gatsios and Karp and to modeling approaches reported in the customs unions literature. The paper emphasizes the importance of modeling the formation of the customs union agreement.Acknowledgement. We thank, without implicating, Ken Binmore, Arja Turunen-Red and Ian Wooton for valuable comments on earlier drafts of this paper. Woodland wishes to acknowledge the Þnancial support of an Australian Research Council research grant. Melatos gratefully acknowledges the Ronald Henderson Research Foundation for Þnancial support.

Common External Tariff Choice in Core Customs Unions*

“…Indeed, it is often the case that complete delegation does not reside in the Pareto‐optimal set at all. This merely reinforces the point made by Melatos and Woodland (2007a), although in the framework adopted here countries have access to a significantly wider range of options with regards coalition formation. Further, it suggests that the complete delegation arguments advanced by Gatsios and Karp and Syropoulos are only part of the story.…”

“…Delegation in the sense of Gatsios and Karp and Syropoulos may be characterized as being “complete” in that one member assumes total authority over the choice of CET. Recently, Melatos and Woodland (2007a) have generalized the concept of delegation to account for the more realistic case in which members share authority over CET choice. They show that a Pareto‐efficient customs union may require members to share authority over CET choice.…”

“…We compare the CETs that would be chosen if one of the members was given complete authority with the range of CETs that are Pareto‐optimal for those customs unions in the core. Following Melatos and Woodland (2007a), if any part of the Pareto‐optimal range lies between the CETs chosen by the two members, we say that there is “partial” delegation. If any part of the Pareto‐optimal range lies beyond the CETs chosen by the two members then there is “super”‐delegation with one of the members taking an aggressive role.…”

“…In Figure 1, it turns out that the union member characterized by a relatively low elasticity of substitution in consumption is always the one that can induce the lowest rest‐of‐world tariff. Thus, authority over common external tariff choice is delegated (and, in the words of Melatos and Woodland, 2007a, often “super‐delegated”) to this member. Likewise, in Figure 2, the union member with the larger export endowment can induce the nonmember to levy a lower tariff on customs union exports.…”

“…3 3 In cases of super‐delegation, the small weight can be negative. See Melatos and Woodland (2007a) for more detail. …”