THEORY OF CUSTOMS UNION:

A customs union is an association of two or more countries to encourage trade. The countries making such an arrangement agree to eliminate tariffs and other restrictive regulations on trade among them. It is a discriminating trade arrangement since the liberalisation only includes the countries that are members of the customs union and they formulate and administer a common foreign trade policy in regard to tariffs and other trade restrictions against third countries.

The best-known customs unions have included the Zollverein, which was created by Bismark, Benelux and the EEC, which later came to be called the EU. The Zollverein was formed by German states in the 1830's. These states became the German nation in 1871. Belgium, the Netherlands and Luxembourg established Benelux in the 1940's. Belgium, France, Italy, Luxembourg, the Netherlands and West Germany set up the EU in 1957. We will discuss about the European case in greater detail in Section 19.5. 

The first systematic analysis of customs union was provided by Jacob Viner. He looked at the situation for a group of countries before and after they joined the union. In what circumstances would countries gain by forming a customs union? How will trade patterns and resource allocation be affected? According to Viner, after the formation of the union, some member would be importing from others but which it formerly did not import because the price of the protected domestic price of the product was lower than the import price. With the formation of the union, protection to domestic industry would be removed. There will be a shift in the locus of production from a high cost to a low cost point. This would be appreciated by those who champion free trade. Viner called this outcome trade creation. There could be a second kind of effect of the formation of customs union, according to Viner. After the formation of the union, there may be commodities which a member would be importing from some other member, which it earlier used to import from a low-cost third country, because that was the cheapest source of supply, even after payment of duty. After the union, this same product may be purchased from another member of the union. The shift of production in this case is not now between two member countries but between a low-cost non-member country and high-cost member country. This kind of effect Viner called trade diversion. 

According to Viner, when trade creation is dominant and trade diversion not so prominent, the formation of the union raises the collective welfare of its members. Some member may experience a loss, but the joint welfare of others will outweigh the loss. Moreover, the non-member countries may experience some welfare loss, but the welfare of the members will outweigh that loss. On the other hand, if trade diversion is dominant, a customs union may reduce the welfare of its members. Viner's analysis had three limitations. First, he did not show how to deal with a trade-off between trade creation and trade diversion. Secondly, he assumed a case of constant returns to scale. Finally, he considered only production effects, and did not analyse consumption effects which modern tariff analysis explicitly brings into 

the picture. Traditional customs union theory builds on relatively strict assumptions such as perfect competition in commodity and factor markets and hence it is often referred to as orthodox customs union theory. It also only deals with the static welfare effects of a customs union. It has both positive and negative welfare effects, compared to a situation in which every member state practices protectionism. Therefore no conclusion can be drawn in advance as to the net welfare result of a customs union. The term ‘orthodox customs union theory' is due to the relatively strict assumptions of this theory, i.e., perfect competition in the commodity market and factor markets, perfect factor mobility within individual countries but not among the countries, foreign trade equilibrium and full employment. The opportunity cost in production is reflected in the relative commodity prices in each country and transport costs are not included since tariffs are assumed to be the only kind of international trade barrier.

Later theories have attempted to deal with these limitations of Viner's theories. Customs union theories can be analysed in the same way as partial equilibrium analysis of the effects of tariffs. We now compare customs union with free trade zones. Both customs union and free trade zones are examples of preferential trading agreements under which member countries apply lower tariffs on each other's goods than on the same goods coming from other countries. In a customs union, the countries must agree on the tariff rates. In a free trade area, on the other hand, each country's goods can be shipped to the other without tariffs, but in which each member country sets tariffs against the outside world independently. The North American Free Trade Agreement (NAFTA) is a free trade agreement between the US, Mexico and Canada. Canada and Mexico need not agree, for example, on tariff rate on electronics goods from Japan. The European Union is a customs union. Free trade area is politically simple but administratively complex while a custom union is the opposite. For example, tariff administration is easy in a customs union. Goods must pay tariffs when they cross the border of the union but can be freely shipped from there onward.