The Customs Union and the Theory of Second Best

Abstract

THE STUDY OF the customs union or free trade area is of great relevance, both from the practical point of view of international trade policies, and from the theoretical point of view of second best theory. The basic model in the economics of the customs union is that of two commodities and three countries-the home country, the partner country, and the foreign country (the rest of the world).2 By assuming infinite elasticity of foreign and partner supply and the nonexistence of tariffs imposed by the foreign and partner countries, it can easily be shown that the welfare of the home country is increased by the trade creation effect and diminished by the trade diversion effect, of the home country's granting a discriminatory elimination of its tariff on imports from the partner, while retaining its tariff on those from the foreign country.3 An optimum tariff rate for the home country on imports from its partner country can be calculated from the comparison of these two effects, i.e., in terms of the change of consumers' surplus of the home country. Such a rate is optimal simultaneously from the points of view of the home country, of the customs union (the home and partner countries), and of the world (three countries), since the welfare of the partner and foreign countries remains unchanged. The assumption of infinite elasticity of foreign supply is, however, inappropriate for this problem, since under this assumption there is no incentive for the home country to impose a tariff on its imports from the foreign country. Free trade should be considered the best solution and there is no place for arguing the optimal rate of tariff, i.e., a second best solution. Moreover, the assumption of the nonexistence of tariffs imposed by the foreign country cannot be considered realistic if the home country imposes a tariff on imports from the foreign country. If one drops the assumption of an infinitely elastic foreign supply and or that of no foreign tariff, one must solve the problem of the comparison of gains and losses of different countries. Optimality from the point of view of the customs union or of the world should, therefore, necessarily be that