The assumptions of Jacob Viner's theory of customs unions

Journal of International Economics 6 (1976) 75-93. 0 North-Holland Publishing Company

THE ASSUMPTIONS OF JACOB VINEIPS THEORY OF CUSTOMS UNIONS Michael MICHAELY* 7% Hebrew

University,

Jerusalem, Israel

Received June 1974, revised version receivedJrine 1975 The paper starts by presenting a method for the decomposition of the impact of a customs union into the familiar trade-diversion, trade-creationand consumption effects. This is used as a framework within which Wner’s original customs-union analysis is investigated. The issues examined are whether Viner’s analysis indeed makes the assumptions about production and eonsumption which are attributed to it by conventional wisdom; whether the assumptions Viner did make were consistent; and the possible explanations of Viner’s analytical course. The investigation is supported by referencesto Viner’sanalytic contributions beyond the sphere of customs unions.

1. Introduction

The analysis of the welfare!effect of a customs union originates with chapter IV (‘The economics of customs unions’) in Jacob Vi&r’s (195Q) The Customs Union Issue. Viner’s discussion there is expressed in a rather intuitive manner, lacking a precise specification! of the analytical model and its basic assumptions. Consequently, possible misinterpretations of Viner’s position have been accepted as conventional wisdom. The purpose of this paper is to investigate this issue more thoroughly than has been done before; and to examine Viner’s position on this subject in light of his earlier analytic contributions. The discussion will be divided into four sections. First, a brief restatement will be presented of the skeleton of th? welfare analysis of a customs union from a single country’s viewpoint. This will serve as a convenient framework within which the model attributed to Viner will be presented (in the second section). The third and fourth sections will then examine, respectively, the basic assumptions about production and consumption alleged to be Viner’s. 2. Tbe welfare impact of a customs union’ The world is assumed to consist of three countries. A, the homt,: country, enters into a customs union *withcountry B, according to which tariffs on the *I am indebted to my colleagues IHaimBark&and Don Patinkin for helpful comments. ‘This section draws heavily on the presentationin Michaely(1976).

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trade between A and B are completely abolished; whereas the tariff on A’s imports from C, the third country, is left intact at its pre-union level, Home country A is assumed to be ‘small’ in comparison with both foreign countries B and C; that is, foreign s;:pply prices are not affected by the size of A’s trade supply curves are of infinite elasticity. Two goods are produced (actually or potentially) at increasing costs - the transformation curve between the two is convex. The impact of the customs union on A’s welfare may be decomposed into three elements: a trade-creation effect, a trade-diversion e&t, and a consumption effect: the distinction between ,the first two terms is, of course, the essence of Viner’s innovation.2 These elements may be visualized by means of the presentation in fig. 1. PQ is the home-country’s transformation curve between the two goods X and M. Point A would have been the autaaky position. At free-trade prices, imports of A4from country C would be cheaper (in terms of X) than imports from country B or from the production price of M in the home country under autarky.’ The price ratio between X and M in trade with C is represented by the slope of exchange line cc, and the price in trade with B by the slope of exchange line bb. With free trade, home Froduction would be at point I;. Trade would be with country C, at the price prevailing in the latter. Line cc would represent the home country3 budget-restraint, with trade of X for A4 taking place, at the price indicated by cc, and consumption would be somewhere on this line to the left of production point 4’.With a (nonprohibitive) tariff on good M, the home price of the good is represented by the slope of line tt; the difference between it and the slope of cc representing the tariff rate. Production will take place at point E. Trade will still be maintained with C, at the price prevailing in it, and the consumption locus will be somewhere to the left of E on c’c’ (parallel to cc), which is the economy’s cum-tariff budget-restraint line. Suppose now that an ejfictiue customs union between A and I3 is established. This will make A’s home price of imports of M from B lower than the (cumtariff) price of M in its purchase from C. Trade with C will stop, and trade with B will take place instead. The new production point will be G, where marginal costs of producing M at home are equal to its price in trade with .B(the latter is expressed, we recall, by the slope of bb). Line bb now becomes the economy’s budget restraint. T&Bade with B will take place frorl production point G leftward, 5~ that the post-union consumption locus is somewhere to the left of G on bb. The iatroduction of the union has thus led to three forms of substitution. ;IIna recent exchange with Bhagwati, Johnson (1974) has argued that Viner’s trade-creation effect incorporatesalso t!le third element, namely, the consumption effect. The quotation from Viner used by Johnson to demonstrate this does not seem to lend support to this contention. But this issue will be discussed extensively later in this paper. Bhagwati’s response (1974) may also be consulted. 31f imports are cheaper in B, the union partner, the establishment of a union would be simply a move from a restricted trade to free trade. The particular features of a customs union, in distinction from a comprehensive,uniform tariffabolition, would then be lost. F

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One is the replacement of trade with C by trade with B: the ‘trade-diversion’. Another is a movement in the home country from the production of M to the production of X; that is, a replacement of domestic production of the import good by imports from the partner country: the ‘trade-creation’. The third form of substitution is in consumption. Trade creation increases welfare by replacing relatively dear home production by cheaper imports. SO does the substitution in consumption which follows the elimination of the gap between prices faced by the consumer and by the economy. Trade diversion, on the other hand, lowers welfare by shifting imports from a relatively cheap to a relatively dear source. H,efus now consider the welfare implications of those effects in terms of units of good X.4 Suppose the pre-union consumption locus tc be at point D. After the establishment of the union, with the shift of trade to a more expensive source of imports, the country would have to possess the basket c.Cgoods R, rather than E, in order to reach consumption basket D by means of trade (with country B, along the line b’b’). The distance ER may thus be designated the trade-di’version efict, in terms of X, on production - a negative welfare impact. On the other hand, the @o&union shift of production from E to C makes the goods available to the economy equivalent (by way of trade with II) to combination 7’, rather than E. The distance ETis the trade-creationeffect of the union on production, and it is positive in its welfare impact. The net outcome of these two changes the distance TR - may be termed the net production e&ct of the union on welfare, and it could be either positive or negative. In the case demonstrated in fig. 1 the net production effect is negative. But had D been contained within bb, rather than being above it as it is shown in the diagram, the net production effect would have been positive: it would show an amount of X which could be taken away from the economy and still enable it to acquire the same basket of goods as before the union. In this case the net production effect alone overlooking, that is, the impact of the union on consumption - would imply an increase of welfare. To this now has to be added the impact on welfare via consumption. Had the economy actually possessed the basket R, it would be in a better position than before the unit.? :’ with this basket the economy could still, by trade with B, reach consumption locus D, as before the union, But, with the change in home prices, consumers would prefer another consumption locus cn b’b’, which would ,hence be preferable tcr D - representing; that is, a higher welfare. The line b”b”, originating in S, is constructed so as to allow the best consumption basket available on it. to leave consumers just as well off as consumption basket D. The distance RS is thus a measure of the consumptionefict of the union on welfare, and it must always be positive. If the net production effect is ne41ndoing this, we sh& employ the Hicksian ‘equivaientvariation.* The ‘economy’is treated here as if it were a singleconsumer.But the same analytical method could easily be shown to be admissible, and the same conclusions 10 follow, for an economy with many consumers and with the ‘compensationprinciple’applied.

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gative - Tis to the left of R - the combined effect of production and consumption may still be positive. Graphically, this combined effect is represented by the distance ST. If S is to the left of r, the total effect of the union is an increase of welfare; whereas if S is to the right of I’, welfare is reduced by the union. The distance STmeasures, in terms of units of X, what could be taken away from the economy, when welfare is raised by the union, or what would have to be added to it, when welfare is lowered, to leave the economy’s welfare on its pre-union level.

3. Vbe.r% allegedmodel of a cnstomsanion We shall now contrast the foregoing presentation with Viner’s implied model, as it is conventionally understood. One major difference between the analysis carried out above and that attributed to Viner is that the latter assumes mutant rather than increasing costs in production; that is, Viner’s transformation curve is a straight line. This is described by means of fig. 2. The transformation curve between goods X and A4 is again represented by PQ, which is now a straight line. In autarky, the production and consumption locus in the home country is at point H, and the slope of PQ represents the price ratio between the two goods. Under free trade, the economy will fully specialize in the production of X, exchanging some of it for M in trade with country C. Production will then be at point Q, and cc will be the country’s budget restraint, the consumption locus being somewhere on it. With a uniform tariff imposed on the imports of M, only two situations are possible: either the tariff is prohibitive, in which case production and consump tion are at autarky point H; or it is not, in which case the home country still specializes completely in the production of X and buys M from the cheapest foreign source, namely country C. Production is thus, in the latter case, still at point Q and consumption somewhere along cc, althotgh closer to Q (that is, containing a larger quantity of X and a smaller quantity of 44) than under free trade. Assume now a nonprohibitivetariff, and introduce an effective cuStoms union with country B (that is, again, an elimination of the tariff on imports of M from B which will make these imports cheaper than either the home production cost of the good or of the cum-tariff price of imports from, the third country, C). Production will remain at Q, with X being sold to B for M at the price indicated by the slope of bb, and consumption will be somewhere on bb. This re:placement of A’s trade with C by trade with B is Viner’s trade diversim. It is obviously a factor leading to a welfare loss since the post-union budget-restraint line bb is wholly contained within the pre-union line cc. Suppose t’fiepre-union consumption is at point D. Following the union, a quantity of OR of X, rather than OQ, will he required to make this consumption again possible (by trading with B,

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at its price, along line b’b’). The distance QR thus measures, in terms of units of good X, the loss from Viner’s trade diversion. With a pre-union prohibitive tariff, on the other hand, the pre-union consumption (and production) point would be the autarky position H. After the union, production will move to Q: the country will completely specialize in the production of X. Exchange of X for M will now take place with B, and consumption will be on budget-restraint line bb. This replacement of home production of A4 by trade is Viner’s trade creation, and it clearly represents a welfare gain, H being below budgetrestraint line bb. With the union, the amount OT would be sufficient to insure, by trade with B along line b”b”, the consumption of H; whereas before the union, at the home country’s prices, consumption H was worth OQ units of X. Distance QT is thus a measure of the welfare gain, in terms of units of X, originating from Viner’s trade creation. A primary difference thus appears between this model, allegedly Viner’s model, and the former one. Here, with straight-line transformation curves, it is no longer true that trade creation and trade diversion occur shxmltaneously, as elements working in offsetting directions. The whole of the ‘net production effect’ consists either of trade creation or of trade diversion, the former taking place under a preunion position of autarky, the latter under a pre-union position of trade and specialization. The effect on home production could be only one of two possibilities: with trade-diversion, no change at all in domestic production will occur; and with trade creation, production will change :fromits autarky position to full specialization in the export good. The other primary element in which Viner’s alleged analysis differs from the preceding one is in its abstraction from the consumption effect. Take the case of trade diversion. The welfare production loss, we have seen, is QR in fig. 2. If, however, OR of X is avilable to the economy in the post-union situation. it will be on a higher welfare level than at the pre-union position D. With the change in home prices from those indicated by the slope of tt (the cum-tariff price before the union) to those represented by 6’6 (or bb), consumers would prefer another consumption basket, although D is still an open possibility. Budget-restraint line b”b”, originating at S, is sc!ected so that the best consumption possibility on it providesjust the same welt:ve level as the basket D. Distance RSis thus the. consumption effect on the welfare of the union in terms of good X, an element of welfare gain. Similarly, a consumption effect will exist in the case of trade creation. With trade creation, both the production and the consumption effects will operate in the same direction, to increase welfare. In the trade-diversion case, on the other hand, the positive consumption effect tends to offset the negative production effect. In fig. 2, the positive effect SR is offset against the negative effect QR, and there is no a priori way to determine which of the two is stronger. In other words, welfare may improve with the trade-diverting union - as, of course, it must in the trade-creal:ing one. In Viner’s analysis, this

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possibility is ruled out, the consumption effect having been overlooked altogether. To sum up, Viner’s analysis differs, allegedly, from the more general model in two primary ways: First, due to the assumption of constant costs and straightline transformation curves, it allows only for either trade creation or trade diversion, with complete specialization in the former case and with no change in the home production in the latter case; and second, it abstracts from the consumption e:ffect.In the following two sections, these two basic features attributed to Viner’s model will be examined, starting with the production side. 4. The eost~ of pmdmtion On the cost side as well as on the demand side, the just-presented interpretation of Viner’s model is mainly due to Meade’s (1955) The Theory of Customs Unions. Describing Viner’s method and inferences, Meade states: ‘The procedure . . . is most suitable where all elasticities of demand are zero and all elasticities of supply are infinite’ (p. 35). ‘Let us turn to certain criticisms of Professor Viner’s basic analysis which result from the fact that supply curves are not normally of infinite elasticity’ -as they are assumed to be, Meade implies in the next sentence, in the ‘economic model . . . constructed by Viner’ (p. 44). While the first reference merely suggests that infinite supply elasticities that is, constant costs, or straight-line transformation curves - are a ‘suitable’ framework for Viner’s analysis, the latter quote states more firmly that such an assumption is actually made by Viner. And it is in this form that Viner’s customsunion model has been subsequently presented and interpreted in the literat.ure. Meade’s description of Viner’s argument by means of arithmetical eaamples (1955, p. 33), which assume constant costs, is repeated in Lipsey’s well-known survey (1960, p. 497) as an illustration of Viner’s position. In a later survey, Corden states flatly that ‘Viner also assumed constant costs in the three countries’ (1965, p. 53). Krauss, to cite a more recent example, submits in his survey of the theory that ‘Viner’s analysis is based on a number of simplifying assumptions fixed proportions in consumption and constant costs in particular. . . , These assumptions have formed the basis of considerable criticism’ (1972, p. 414). It may be best to start the examination of what Viner actually assumed by what he him.selfhad to say many years later in his letter to Corden, motivated by Corden’s afore-mentioned survey : 6 ‘1 have been repeatedly on record since 1938as regarding increasing cost as the one generally prevailing (static) pattern of costs relative to output, and if there is even the slightest implication in anything I wrote in The Customs

‘This letter is published in the present issue (pp. 107408). I am indebted to W.M. Corden for making the letter available for use in the present context.

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Union ISSWof an assumption of constant costs, I wogld certainly like to have it identified, so that I could engage in what I would regard as due penance.’ The most salient section in Viner’s development of his analysis is the following: ‘There will be commodities . . . which one of the members of G-e customs union will now newly import from the other but which it formerly did not import at all because the price of the protected domestic product was lower than the price at any foreign source plus the duty. This shift in the locus of production as between the two countries is a’shift from a high-cost to a lowercost point, a shift which the free-trader can properly approve, . . . There will be other commodities which one of the members of the customs union will now newly import from the other whereas before the customs unicn it imported them from a third country, because that was the cheapest possible source of supply even after payment of duty. The shift in the locus of production is now not as between the two member countries but as between a low-cost third country and the other, high-cost, member country. This is a shift of the type which the protectionist approves. . . .’ (1950, p. 43). ’ Nothing is said here explicitly about the nature of the cost curve. References to a ‘high-cost’ or a ‘low-cost’ country, here and elsewhere in Viner’s analysis, could conceivably apply to the marginal costs at the point of production before the establishment of the union. This does not necessarily imply that’rr.arginal costs are constant - they could conceivably increase. But increasing costs would be inconsistent with Viner’s analysis: in the Insket for any single commodity, either trade creation or trade diversion is assumed to have taken place. This, we have noted, follows directly from an assumption of constant costs (straight-line transfomation curves); whereas increasing costs and convex transformation curves would. give rise in principle to both trade creation and trade diversion in the market for any single good. It must therefore be concluded that the sharp categorization which Viner makes implies an assumption of constant costs. Contrast this inevitable conclusion with the following statement which Viner makes only two pages later: has here been assumed hitherto that in so far as a.customs union has el%ects on trade these must be either trade-creating or trade-diverting effects. This would be true if as output of any industry in a particular country increases over the long run relative to the national economy as a whole, its molney costs of production per unit relative to the general level of money costs also tended to rise. Economists are generally agreed, however, that there are firms, and consequently also industries, where this rule does not hoId, but instead unit costs decrease as output expands’ (1950, p. 45). ‘It

From here Viner goes on to analyze the likelihood of decreasing costs and the effect of this possibility on welfare in a trade-diverting customs union, a

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discussion which is immaterial for our present purpose. What matters in this context is that not only does Viner not mention the state of constant costs, but an explicit assumption of a general state of increasing costs is made. From the reference to ‘firms’ and ‘industries’ one may have suspected that a pattialequilibrium context is assumed here. But in his criticism of others, Viner strongly implies his own analysis to be a general-equilibrium one: others are said to reach conclusions different from Viner’s by, inter alia, ‘applying the standard techniques of partial-equilibrium analysis, traditionally applied to the analysis of the determination of prices of particular commodities taken one at a time, to foreign trade as a whole and to the tariff problem where its findings are either totally without significance or of totally indeterminable significance’ (1950, p. 53). Moreover, Viner’s defence of increasing costs as a general rule runs strictly along general-equilibrium lines: ‘To expand, the industry must draw away from other industries increased amounts of the resources it uses, and consequently must pay higher prices per unit for resources of the type which it uses more heavily than does industry at large, and must reduce the extent to which it uses them relative to other types of resources, thus bringing into operation the law of diminishing returns’ (1950, p. 47). This, of course, is basically the explanation of the convexity of the transformation curve by the differences in factor intensities among industries, Furthermore, Viner presented his analysis as dealing with ‘the consequences of the removal, as the result of customs union, of duties which previously had operated effectively as a barrier, partial or cmzplet~, to import’ (1950, p. 43; italics added). But when the consumption effect is disregarded, as it is in Viner’s analysis, a tariff cannot act as a ‘partial’ barrier to trade in a constant-cost situation: there, it is either ineffective, or it leads to an autarky position and is a ‘complete’ barrier to trade. The reference to the ‘partial’ barrier thus suggests an increasing-cost setting. A basic inconsistency is thus revealed. 30th explicitly and, on one occasion, implicitly, Viner assumes in his customs-union analysis increasing costs and convex transformation cdrves, rather than constant costs and straight-line transformation curves. On the other hand, his statement that a union could be either trade creating or trade diverting, rather than one which in general involves both impacts in the market for any single good, could be true only if constant costs are assumed. Viner was certainly correct in arguing, further along in his letter to Corden, that he could not be taken to have regularly assumed a constant cost world: nothing of the sort could be expected from the author of ‘Cost curves and supply curves’. Viner’s dedication to an increasing-costs world is not complete, however, in his writings on international trade theory, even beyond the customsunion analysis: the record there is mixed.

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The basic source for Viner’s conceptual framework in a trade-determination, general-equilibrium context is, of course, his Studies (1937). At one point there, in the discussion of ‘Increasing and decreasing costs”, increasing costs and a convex transformation curve are explicitly postulated : ‘Under increasing costs, both (all) commodities can conceivably be produced simultaneously under equilibrium conditions in both (all) countries. When trade is carried to the equilibrium paint under increasing Costs, i.e. to the point whe::e each country is fully exploiting the possible gains from trade, the ratios of marginal real costs as between the two (all) countries will be the same for all commodities being simultaneously produced in both (all) of these countries, and it will be the comparative differences in the marginal costs which would result if the existing trade were altered in volume or direction, rather than any prevailing difference in actual marginal costs, which would explain the existing trade’ (1937, p. 472). A similar argument appears later on (p. 565) in the discussion of gains from trade. Against this evidence stands the indirect inference from Viner’s strong defense of the clisssical real cost doctrine, in which constant costs were assumed. Increasing costs would depend on difrerences in factor proportions among goods, and would require a model in which factor substitution exists in- the production of each good. In his section on ‘Variable proportions of the factors and comparative real costs’ (1937 pp. 508-516), Viner does not in fact discuss the issue of the .relationship between changes in quantities of production of the various goods, relative prices of goods and of factors, and changes in factor proportions. Th.e section is devoted, instead, to the question of whether some ‘real’ costs may be representative of total costs. In at least one prace in this discussion, constant costs may be inferred from an implied assumption of fixed factor proportions: . . . where it can be shown that all of the technical coefficients of domestic production of a particular commodity are hipaer than thz corresponding technical coe!Ricients of the export commodities in exchaslge for which the commodity in question would be obtained under fret trade . . .’ (1937, p. 151). ‘

Also, note the following statement, from a paper written at about the same time as the Studies. It says that under conditions which assure a given world price, ‘

the total excess in the aggregate money cost of production in (a country) of the commodities whose domestic production is dependent on the tariff over what these quantities would cost at their prevailing world prices free of duty is an approximate measure, in terms of money, of the aggregate economic burden of the tariff, which does not call for substantial correction downwards* (1936, p. 167). . . .

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Beside the inference from such a statement for the consumption effect, which will be pointed out later, it clearly implies a situation of constant costs. Thus it appears that Viner’s concept of the nature of costs in international trade is ambiguous and inconsistent. This may reflect a general dichotomy between price theory and international trade theory, especially in its normative application, in the tradition of Ricardo and Marshall, whose closed-economy price models assumed increasing costs while their international-trade price determination assumed constant costs.’ In Viner’s analysis of customs unions this ambiguity, or incosiistency, actually turns into an error: there, as we have seen, Viner assumes explicitly increasing costs, but infers the effects of a customs union which would actually arise only in a constant-cost situation. 5. The

consumption effect

Viner’s position with respect to the consumption effect of a customs union, unlike his treatment of costs, is unambiguous: he consistently overlooks this element in his analysis. Indeed, he shows no trace of awareness of the welfare effect of substitution in consumption. The issue to be examined here is not, therefore, whether the consumption effect was neglected or not, but rather the possible sources or interpretations of such neglect. The conventional reading of Viner’s position runs as follows: Viner reached his welfare conclusions on the basis of production effects alone, abstracting from consumption. Such procedure would be warranted if no substitution in consumption takes place - goods are consumed in fixed proportion. Ergo, Viner implicitly assumed fixed Froportions in consumption. This interpretation starts with Meade who, we recall, states that Viner’s analysis is ‘most suitable where all elasticities of demand are zero, and all elasticities of supply are infinite’ (1955, p. 36). This is a tentative, carefully-hedged statement: Meade does not maintain that Viner actually assumed, even implicitly, zero demand elasticities, that is, fixed proportions and no substitution in consumption, but only that such an assumption would be consistent with Viner’s conclusions. In addition, Meade ties the ‘suitability’ of this assumption with the assumption of infinite elasticities of supply, that is, with constant costs. In the subsequent literature, however, Meadz’s caution has been shed. Thus, to cite the aforementioned surveys, Lipsey states that ‘Viner’s analysis implicitly assumed that commodities are consumed in some fixed proportion which is independent of the structure of relative prices’ (1960, p. 499). Corden maintains that ‘Viner ignored ccnsumption effects, and assumed that commodities were consumed in fixed proportions, unaffected by changes in relative prices brought about by the customs union’ (1965, pp, 52-53). And Krauss argues that ‘the traditional interpretation holds that Viner abstracted from consumption effects, which is another way of saying ‘1 am indebted to H. Barkai for this observation.

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that he assumed fixed proportions in consumption’ (1972, p. 414, fn. 4) (of course a non sequitur). Apparently the only exception to this reading of Viner is the aforementioned analysis of Bhagwati (1971), where it is shown that fixed consumption coefficients would not lead to Viner’s welfare conclusions in an increasing-cost setting. Hence, the fixed coefficients assumption is insufficient (nor is it necessary). Instead, Bhagwati suggests an assumption of fixed imports, which would be sufficient to lead to Viner’s results under alternative assumptions about the nature of costs. Like Meade, Bhagwati presents his interpretation as a mere possibility, rather than as an inevitable implication. But it is not a very plausible one, as Bhagwati appears to agree. Its superiority over the tied consumption coefficients would depend on the assumption of an increasing-cost model and, as we have seen, although Viner did as,sume increasing costs, his conclusions would be correct only for a constant-costs model. Further, as has been pointed out by Bhagwati anct in a comment by IKirman (1973), the assumption of fixed imports would in turn require other assumptions, such as negative income elasticities, which are rather odd and which are never hinted at or implied in Viner’s analysis. Recognizing this, Bhagwati believes that while his interpretation of Viner’s model is a possibility, it is probably most likely that Viner simply ‘had not thought through this question completely’ (1973, p. 895). In other words, Viner did not give himself a full account of the consumption effect and did not integrate the consumption facet into his model. Viner himself, on the occasion noted earlier (1965, letter to Corden), maintains that: ‘I did not assume, explicitly or by WWC~OUS implication, “that commodities were consumed in fixed proportions, unaffected by changes in relative prices brought about by the customs union.” If this is nevertheless a necessary implication of something I did say, I would regard it as a monstrous lapse on my part, but would ask where precisely I was guilty of this lapse. Viner further argues in that letter that (1) he did have a consumptionsubstitution effect in mind; but (2) did not mention it explicitly both because it was familiar and because it would only keinforce conclusioris derived from cost considerations alone. As to the last point, it is obviously incorrect. As we have seen - pointing this out was, of course, one of Meade’s major advances over Viner’s ana&sisthe welfare effect of consumption substitution would indeed reinforce the welfare effect derived from the cost side in the case of trade creation; but with trade diversion the two effects work in opposite directions.’ This justification of a’%is statementholds only in a two-good world. With many goods, the consumptionsubstitution effect may turn out to be negative as well as positive, and may thus tend to either reinforce or offsetthe welfare impact of prodluctionin both trade creation and trade diversion. See Lipsey (1960, pp. 501-502).

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Viner’s neglect of explicit recognition of consumption must therefore be dismissed. Nor is it likely that Viner’s reader could have been expected to be that ftiliar with the consumption-substitution effect on’welfare. It is true that consumption analysis has been introduced into the international trade literature in the early 193Os,in the contributions of Leontief and Lerner; and certainly the consumption-substitution effect was the cornerstone of Samuelson’s demonstration in 1938 of the superiority of trade over autarky. But despite this, the consumption effect was absent from the conventional international trade theory of Viner’s generation, which Viner probably had i.n mind in his reference in the letter to ‘general “free-trade” theorizing*. Thus, Haberler’s (1936) Theory ofIn?ernational Trade, the classic exposition of trade theory at that time, contains no mention of consumption substitution throughout his elaboration of the advantages of free trade. And while Viner strongly differed, of course, with Haberler’s analysis of costs, he did not seem to notice the absence of consumption analysis. Indeed, the examination of Viner’s own work would show a consistent disregard of the consumption effect. The neglect of the welfare impact of substitution in consumption is strongly indicated in his statement in a long footnote in his customs-union book: ‘The import duty on a particular commodity may be so high in one of the countries that it is prohibitive of import, but domestic production may be impossible or excessively costly, so that there is no consumption. Upon formation of the customs union, the commodity in question may be imported from the other member country. . . . The original duty thus served as a sumptuary measure rather than as a protective or revenue measure. Whether the removal of a sumptuary measure is of benefit for the country particularly concerned as potential consumer is not a type of question which the economist has any special capacity to answer’ (1950, p. 43, fn. 4). Here is a case where substitution in consumption is clearly assumed: the consumption of the good OLIhand rises from zero to some positive amount when its price falls. Yet, Viner not only refuses to draw welfare implications from thi.s substitution, but even argues that the economist is n.ot qualified to draw such implication:;. Viner may be given some benefit of the doubt from the fact that he refers to .a ‘sumptuary’ measure, indicating perhaps some spec8i.c attributes of the good in question, to which some special social norms are applied and in the consideration of which the economist has no ‘special capacity’. But a strong presumption that Viner refused to attribute welfare implications to substitution in consumption is certainly upheld by this reference. This is further supporTed by the examination of Viner’s basic theoretical framework in the Studies. Viner describes in the following way the approach of the classics to trade and welfare, alrd the extent of his agreement with them:

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‘They recognized, of course, that the economic process involved choice between products as well as choice between activities, but they treatedchoice between products as an income phenomenon and not as a cost phenomenon. When dealing with costs, they assumed income to remain constant, and examined the means by which it could be procured at the minimum cost. When dealing with income, they assumed cost to remain constant and examined the means by which income could be maximized. That this was the only possible, or even the best, procedure, whether with respect to terminology or to mode of analysis, there would be no point in insisting upon, since there is always a choice of terms and of methods of analysis, and which is chosen is often determined mainly by some intellectual fashion of the moment. While there were imperfections in their doctrine, the only one I see which can conceivably be attributable to their technique was . . . their unsatisfactory method of handling land services (or, in general, services supposed not to involve real costs) as a factor in production’ (1937, p. 492). One may believe that the reference to ‘choice between products’ indicates the incorporation of substitution in consumption in welfare considerations. But in everything which follows this reference, there is no awareness of the impact of such substitution. It is certainly not involved in the distinction between the ‘cost approach’ and the ‘income approach’. The latter has nothing to do with substitution in consumption, and is in fact little more than a change in ‘terminology’ from the ‘cost approach’, as Viner himself indicates in the passage just quoted and in the following quote: ‘The classical school . . . attacked welfare problems from the point of view of how the outgo necessary to obtain a given unit of income could be minimized . a . They also,. . . dealt with problems of welfare . . . from the income angle, from the point of view of maxi&ing the: total income from a given outgo in terms of real cost. . . . The two approaches are complementary, rather than contradictory. Provided every element affecting relative prices is given proper consideration, it does not matter, except on purely terminological considerations, whether they arc treated as costs or as foregone incomes’ (1937, p. 518). # Instead of asking what the minimum (Yeal’) cost is at which a given income may be achieved, the ‘income’ approach poses the reverse question of ,what the maximum income is which could be achieved witfi a given cost. This is indeed the same question, as Viner maintains. And this discussion of Viner, which was meant to support the ‘real-cost’ against the ‘opportunity-cost’ doctrine, has thus no relevance to substitution in consumption. Viner does make the claim that the income approach adds a new welfare element: ‘The case for free trade can be still further strengthened by resort to analysis from the side of income instead of cost, as will be shown in the next

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section of this chapter and in the next chapter.’ (1937, p. 515). But it is difficult to find this element in his further discussion. and there is no indication that substitution iI1 consumption is involved. There are only two instances where such substitution may have been hinted at. One is a brief discussion of Malthus, starting as follows: ‘Malthus held that the gain from trade consisted of the “increased value which results from exchanging what is wanted less for what is wanted more;” foreign trade, “by giving us commodities much better suited to our wants and tastes than those v;hich had been sent away, bad decidedly increased the exchangeable value of our possessions, our means of enjoyment, and our wealth” ’ (1937, p. 524). But in Viner’s analysis of this position of Malthus, no mention is made of substitution in consumption; Viner heads, instead, in an entirely different direction. The other possible latent appearance of substitution in consumption is made in Viner’s own devdopment of the concept of the ‘utility terms of trade index’: ‘The amount of gain from trade depends, however, not only on the amount of foreign goods obtained per unit of real cost involved in the production of the export commodities, but also on the relative desirability of the import commodities as compared to the commodities which could have been produced for home consumption with the productive resources now devoted to production for export. To take account of changes in the relative desirability of the import-commodities . . . it would be necessary to incorporate in the “real cost of trade index” an index of the relative average utility per unit of imported commodities . * .‘. (1937, p. 560). Even here, the most likely interpretation of Viner’s position is that he is considering only the welfare effect of changes in demand, but not of substitution in consumption with a given demand pattern for goods. And this is the only page in the close to seventy pages devoted to the chapter on ‘Maximization of real income’ (1937, pp. 527-593) in which Viner gets close to a consumption effect. On the other hand, several instances point out quite clearly that Viner altogather disregards substitution in consumption as a welfare element. Thus, we , find the statement : ‘Free trade therefore always makes more commodities available, and unless it results in an impairment of the distribution of real income substantial enough to offset the increase in quantity of goods available, free trade always operates to increase the national real income’ (1937, p, 534). The increased income, or gain from trade, is clearly equated here with an upward movement of the economy’s budget restraint; and while income distribution is recognized as relevant in the welfare evaluation of the impact of trade, the consumption effect is entirely absent. On the same page, a discussion of the

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me:2ns to overcome possible adverse effects of trade on income distribution, applied to the Cobden Treaty, runs as follows: ‘But the French government, could have brought it about that the Cobden Treaty should not result in a reduction in wine consumption in France . . . by levying special income taxes on the class which consumed cotton goods relatively most heavily and using the proceeds to subsidize the class which consumed wine relatively more heavily, or by levying internal consumption taxes on cottons (at lower r&es than the effective amount of the import dutieswhich had been removedland usingthe proceeds as a subsidy to domestic wine consumption, or by some other stratagem of this general character, designed to offset an undesired effect of the reduction of duties on the distribution of the national income’ $1937,p. 534). Viner appears here to regard as equal, from the welfare point of view, a compensation scheme which works through direct income transfers and one which works through the prices of goods and which tends, of course, to cancel the favourable consumption effect of the tariff reduction. This, again, could probably not be interpreted in any way other than a complete neglect of the consumption effect. Nor is this neglect confined to the Studies. In an earlier work, we find the following statement: ‘There are only two sound economic arguments for free trade, one positive and one negative, but they suffice. The positive argument is that the fact of trade establishes an overwhelming presumption that the commodities obtained from abroad in exchange for exports are so obtained at lower economic costs than that which the domestic production of their equivalent would entail’(1931, p. 10). Clearly, no mention of the consumption effect. Then, in 1936, we find the statement quoted earlier (p. 85) about the measurement of the ‘aggregate economic burden’ of the tariff, in which substitution in consumption is by implication disregarded. In the same article, Winersays: ‘For the country levying the tariff, the burden of long-run protection consists primarily of the excess of the costs at which the protected commodities are produced at home over the cost at which, under free import, they could have been obtained from abroad in exchange for exports. l%otection will in addition tend to alter the distribution of the national real income . . .9. (1936, p. 116). Once more, the burden of the tariff is just its production effect. In the papers devoted to the specific issue of tariff discrimination (1924, 1931) there is likewise no mention of the consumption effect.’ The only passage which may gIt may be noted that in these discussions of the most&wored nation clause just the-trade diversion effect is recognized; it is only in The Customs Union Issue that the possibility of trade creation is also admitted. But Viner had apparently formulated the theory as it appeared in the book many years earlier - as isevident, for instance, from Patinkh’s notes of Vtiaer’s tradecourse in Chicago in 1943.

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conceivably be interpreted as recognizing, by implication, a consumption effect, is the following one from a 1947paper:

‘Any departure from equality of treatment involves a deviation from the weighty economic principle that imports shall come from their lowest-price sources and that exports shall go to the most eager markets. The trade which is forced into bilateral channels, moreover, will ordinarily be not only economically inferior to the multilateral trade which it displaces but less in volume’ (1947, p. 355). Even here, though, it would require much leniency to argue that the last sentence reflects a conscious recognition of the welfare effect of substitution in consumption. In sum, thus, the weight of the evidence clearly suggests that in his analysis of customs unions, Viner’s disregard of the consumption effect of the establishment of the union was due neither to any specific assumption about the nature of this effect, nor to a decision to concentrate only on the production effect while regarding it as only part of the anaiysis. It was rather due, it seems, to Viner’s lack of awareness of the effect of trade and of tariffs on welfare through substitution in consumption. Viner did use indifference curves; he even was a pioneer in applying this tool to welfare analysis in international trade (1937, p. 521, fn. 8). On the other hand, he did not formally use the tool of a budget-restraint line. But all his welfare conclusions are derived essentially from changes in this budget-restraint, or availability, line. He never used the indifference-curve tool to show how welfare could change - by substitution in consumption - when the economy’s budget restraint is given.’ * This focus on production possibilities and the neglect of consumption substitution may perhaps be attributed to Viner’s preoccupation with real costs in international trade; but this would be sheer conjecture. l”Subsequentto his customs union study,though, Viner does explicitly recognke the welfare effect of consumption substitution: ‘Even if [occupational] mobility were zero, and the volume and structure of national production were therefore unaffected by free trade, there would still be gain from the wider range of choice available tc purchasers of what to buy with their income’ (1952, p. 55). I am indebted to A. Collery for drawing my attention to this reference.

References Bhagwati, J.N., 1971, Trade-diverting customs unions and welfare improvement: A clarification, Economic Journal 8 1,580-587. Bhagwati, J.N., 1973, A reply to Professor Kirman, Economic Journai 83,895-897. Bhagwati, J.N., 1974, Reply to Professor Johnson, unpublished (available from author on request). Corden, WM., 1965, Recent developments in the theory of international trade, Special Papers in International Economics, No. 7 (Princeton Urziversity,Princeton, NJ).

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Johnson, H.G., 1974, Trade-diverting czlstoms u.nion: A comment, Economic Journal 84, 618-621. Kirman, A.P., 1973, Trade diverting customs unions and welfare improvement: A comment, Economic Journal 83,890-894. Krauss, M.B., 1972, Recent developments in customs union theory: An interpretive survey, Journal of Economic Literature 10,413-436. Lipsey, R.G., 1960, The theory of customs unions: A general survey, Economic Journal 70, 496-513. Meade, J.E., 1955,The theory of customs unions (North-Holland, Amsterdam). Micha~:ly,M,, 1976,The theory of commercial policy: Trade and protection, forthcoming. Viner, J., 1924, The most-favored nation clause in American commercial treaties, Journal of Political Economy, reprinted (1951) in International Economics (The Free Press, Glencoe) 17-39. Viner J., 1931, The most-favored nation clause, Index, reprinted in International Economics, ibid., 94-108. Viner J., 1936, Memoranda on commercial policy, reprinted in International Economics, ibid., 161-177. Viner, J., (19371,Studies in the theory of international trade (Harper and Brothers, New York). Viner, J., 1947, Conflicts of principle in drafting a trade charter, Foreign Affairs, reprinted in International Economics, op. cit., 351-366. Vines. J., 1950, The customs union issue (Carnegie Endowment for International Peace, New York). Viner, J., 1952, International trade and economic development (The Free Press, Glencoe). Viner, J., 1965, A letter to W.M. Corden, Journal of International Economics 6, no. 1,107-108.

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