A Static Analysis of The Customs Union Issue
Country A Country B
Source: The Economics of European Integration by W Molle p98
If initially, country A was protected, then there is a positive outcome, the new trade flow BE exists between countries A and B and CD is trade diversion as it replaces the imports that would have otherwise come from C. BC is trade creation and DE is trade expansion, so as BC + DE is larger than CD in this case, there is a positive outcome. However this is not the case if country A started from a free Trade situation, as trade would have been lessened by AB on the producer side and by EF on the consumer side, so BE is being diverted from the most efficient country C to the higher cost country B. If country B started from free trade, the common tariff will stop the trade that may have existed between country B and country C, which means that there will be less trade creation and expansion as the less efficient producers of B take over from the more efficient C. If country B was initially tariff protected then there will be no trade effects as there were no imports flowing into country B .
To get and idea of the magnitude of the welfare aspect refer to fig 3 below and assume that the customs union price is Pcu.
Fig 3: Welfare Effects Of A Trade Diverting Customs Union
Country A Country B
Source: The Economics of European Integration by W Molle p100
For country A’s production, trade creation is represented by the blue Ä KRL trade expansion or consumption is [next page]