The Theory of Customs Unions: Trade Diversion and Welfare

Abstract

In his book The Customs Union Issue Professor Viner draws the distinction between the trade-creating and the trade-diverting effects of a customs union. In any theory of customs unions this must be a fundamental distinction. However, after defining the two terms, Professor Viner goes on to conclude that, in some sense, trade creation may be said to be a ' good thing' and trade diversion a ' bad thing '*2 When a customs union is formed, relative prices in the domiestic markets of the member countries are changed because the tariffs on some imports are removed. These price changes are likely to have two important initial effects. First, they may influence the world location of production in the several ways carefully analysed by Viner. Secondly, they will have a parallel effect on the location of world consumption. Usually one would expect to find the union members increasing their conisumption of each other's products while reducing imports from the rest of the world.3 Changes of the first type will be classified under the general heading, production effects of union, and changes of the second type as consuimption effects of union. It must be emphasised that even if world production is fixed, a customs union will cause some changes in patterns of consumption due to changes in relative prices in the domestic markets of the member counitries. The consumption effect, therefore, may operate even if there is no production effect. The proposition that a change brought about by a customs union is, in general, good or bad necessarily implies a welfare judgement. But the effect of a customs union on welfare must be a combination of