The Social Science Encyclopedia, Second Edition
A customs union is a form of regional economic integration where countries join together to eliminate all barriers to their mutual trade while imposing common restrictions to trade from non-member states. Customs unions therefore imply preferential or discriminatory trade policy which conflicts with one of the basic tenets of the GATT (General Agreement on Tariffs and Trade). However, the GATT permits customs unions (Article XXIV) if they entail the removal of trade restrictions on most of the trade between members and if the average restrictiveness of external trade barriers does not increase.
In the late 1940s when the GATT was created it was generally felt that since customs unions represented a movement towards the goal of global free trade they would be economically beneficial. In the 1950s this favourable economic view was undermined by the development of the theory of second best in which the analysis of customs unions played a prominent role. Since customs unions involve the movement from one distorted allocation of resources (trade restrictions on all sources of imports) to another (trade restrictions on certain sources of imports) there can be no presumption that economic welfare will increase.
The principal contribution to the analysis of customs unions was provided by Viner (1950) who introduced the concepts of ‘trade creation’ and ‘trade diversion’. Trade creation arises when demand which was formerly satisfied by domestic production is met by imports from a more efficient partner, leading to a saving in the real cost of satisfying a given level of demand. Trade diversion arises if the removal of internal trade restrictions results in demand which was previously satisfied by imports from the rest of the world being met by imports from the comparatively less efficient partner. There is a real cost in terms of the tariff revenue forgone.
Whether a customs union is beneficial for a particular member depends upon whether on balance trade creation exceeds trade diversion. A beneficial consumption effect was later identified; the more efficiently produced output from the partner is provided at a lower price thus enabling a greater level of consumption.
Since joining a customs union may reduce welfare, why do countries not remove trade barriers to all sources of imports? The benefits of trade creation are maximized and there is no trade diversion. One answer is that countries join customs unions for non-economic reasons; for example, a desire to increase the size of the industrial sector can be satisfied at a lower cost inside a union. Alternatively there may be economic benefits which were ignored by Viner. There may be gains from the exploitation of economies of scale, improvements in the terms of trade, greater efficiency stimulated by greater competition, increased innovation and faster growth. Further, unilateral tariff reduction directly affects only a country’s imports. For that country’s exports to increase it must encourage others to reduce their tariffs.
Paul Brenton
University of Birmingham
Reference
Viner, J. (1950) The Customs Union Issue, New York.
Further reading
Robson, P. (1987) The Economics of International Integration, London
See also: GATT; international trade.
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