The theory of customs unions is a branch of tariff theory Binder and Vane are the prominent contributors of this theory however Meade Lapse and Lancaster also have their share in its development. The theory deals with the effects of geographically discriminatory charges in trade barriers. It is thus a special case of the theory of international discrimination.

The object of a customs union is to give preferential treatment to imports from member countries and to discriminate against imports from non-member countries. As such, the tariff structure and the economic relations within the union may tend to alter consumption and production pattern, the terms of trade and may cause even a change in the rate of economic growth, and consequently in the growth and distribution of income between and within member countries leading to alteration in the distribution of economic welfare.

We may thus dichotomies the economic effects of customs unions into

(i) Production effect and (ii) consumption effect.

Production effect

Assuming static conditions, Viner contends that the production effect of a customs union depends on the “trade creation” and “trade diversion” effects of discriminatory tariffs. Trade creation effect refers to the expansion of trade between the members countries owing to the elimination of inter union tariffs, so that the size of market for certain commodities may increase, which in turn permits to increase output and gain economies of scale, thereby increasing the efficiency of production. Further elimination of tariffs and other barriers will permit member countries to specialize in the production of goods according to the principles of comparative advantage so, that the resources will be transferred from the inefficient to efficient utilisation thereby lowering the costs and prices which would promote mutual trade between union members. Thus, a trade creating effect, by shifting the production from a high- cost source to a lower cost source, constitutes a movement towards freer trade within the union.

Consumption effect

The formation of a customs union also leads to an expansion of consumption, thereby an increase in the welfare of the member nations. When tariffs are removed within the union and retained for the outside world, the pre union price structure is modified to make import of goods from member counties much cheaper than before as compared to that form outside counties much cheaper than before as compared to that form outside counters so that efficiency of consumption is enhanced. When the residents of a member country have to pay a low aggregate price for imports from union member (due to the abolition of tariffs), the consumers surplus raises which obviously represents and increase in the community welfare.

Needless to say that the consumption effect incorporate trade diversion from non- member counties to member counties.

Diagrammatic exposition: this theory of trade creation and trade diversion of customs union can be exposed with the help of a dire gram of a partial equilibrium framework as in figure.

In figure, DD and SS are country A’s demand and supply curves of commodity X. B’s supply curve of commodity X at the price OB is assumed to be perfectly elastic, thus, represented by BB. Similarly, price OC, Cs supply curve is represented by CC.

Suppose country A imposes a tariff of BT on imports from B and C. Hence, the respective tariff lines are TT and T’T’ against the import form country B. In the absence of trade the domestic price of  X in country A would be OT, as determined by the intersection of domestic demand and supply. But, when trade takes place, A will import MM from country B at OT price and C world be out of A market since its pre-tariff price is higher than that of B. It is obvious that A will produce Om amount domestically in this situation the domestic price of X world be OT and the effective supply curve world be kindled lien SLQ, implying that OM₂ would be produced domestically and the rest (MMM) would be imported. Thus OM would be the total consumption of A at this price OT. Decease of import tariff the government of country A will fetch tariff revenue:

CT × M₂ M₃ = LFKQ

The consumer’s surplus accruing to country A is DQT and the producer’s surplus is SLT. Thus, the economic welfare in country A is measured by the sum total of tariff revenue consumer surplus and producer s surplus.

LFKQ + DQT + SLT

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