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The Theory of Customs Unions: Trade Diversion and Welfare

Article  in  Economica · February 1957

DOI: 10.2307/2551626

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The Suntory and Toyota International Centres for Economics and Related Disciplines

The Theory of Customs Unions: Trade Diversion and Welfare

Author(s): Richard G. Lipsey
Source: Economica, New Series, Vol. 24, No. 93 (Feb., 1957), pp. 40-46
Published by: Wiley on behalf of The London School of Economics and Political Science and
The Suntory and Toyota International Centres for Economics and Related Disciplines
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 [FEBRUARY

The Theory of Customs Unions:

Trade Diversion and Welfare'
By RICHARD G. LIPSEY

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 con-
sumption. 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

I I am greatly indebted to Mr. K. Klappholz, Doctor H. Makower and Professor

J. E. Meade for their many valuable comments and suggestions.
2 The relevant passage from Viner is as follows
There will be commodities, however, which one of the members of the customs
union will now newly import from the other but which it formerly did not import
at all because the price of the protected domestic product was lower than the
price at any foreign source plus the duty. This shift in the locus of production
as between the two countries is a shift from a high-cost to a lower-cost point,
a shift which the free trader can properly approve...
There will be other commodities which one of the members of the customs
union will now newly import from the other whereas before the customs union
it imported them from a third country, because that was the cheapest possible
source of supply even after payment of the duty. The shift in the locus of
production is now not as between the two member countries but as between
a low-cost third country and the other, high-cost, member country. This
is a shift which the protectionist approves, but it is not one which the free trader
who understands the logic of his owvn doctrine can properly approve. (Viner, Jacob,
The Custonis Union Issue, Carnegie Endowment for International Peace, New
York, 1950, p. 43.) Italics not in the original.
3 But this is not necessarily so. See note 1, page 42 below.
40

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1957] THE THEORY OF CUSTOMS UMONS 41

its effects on the location, and hence the cost of world production
and on the location, and hence the 'utility', of world consumption.
In this paper it will be shown that when consumption effects are
allowed for, the simple conclusions that trade creation is 'good ' and
trade diversion is 'bad' are no longer valid. Although the distinction
between trade creation and trade diversion is fundamental for classify-
ing the changes in production consequent on the formatioon of a customs
union, it is not one on which welfare conclusions can be based.
I

The problem of the welfare effects of trade diversion will be isolated

by using an extremely simple model. The model will be used to show
that an increase in welfare may follow from the formation of a customs
union which results solely in the diversion of trade from lower-to
higher-cost sources of supply. Furthermore, it will be shown that
this welfare gain may be enjoyed by the coutntry whose import trade
is diverted, by the customs union area considered as a unit and by
the world as a whole.
The analysis will be based on the following simple model: The
world is divided into three countries, A, B, and C. The effects of vari-
ous trade policies on the welfare of country A only is first conrsidered.
A is a small country whose inhabitants consume two commodities,
wheat and clothing. A specialises in the production of wheat and
obtains her clothing by means of international trade. Being small,
she cannot in-fluence the price of clothing in terms of wheat. Country
C offers clothing at a lower wheat price than does B, so that, in the
absence of country-discriminating tariffs, A will trade with C, exporting
wheat in return for clothinig. It is assumed that A levies a tariff on
imports but that the rate is not high enough to protect a domestic
clothing industry, so that she purchases her clothing from C. Now
let country A form a customs union with country B, as a result of
which B replaces C as the supplier of clothing to A. B is a higher
cost producer of clothing than is C but her price without the tariff is
less than C's price with the tariff. Hence, the union causes trade diver-
sion, A's trade being diverted from C to B.
Indifference curves are used in the analysis but the conclusions reached
do not depend on the assumption of a unique community welfare
function. For this reason it is first assumed that in country A there
is only one consumer, whose indifference map is, ipso facto, country
A's community indifference map. Later the analysis is extended to
a community of more than one individual.
Diagram I illustrates the conditions existing in country A. OD
measures A's production of wheat. The price ratio between wheat
and clothing when trade is with C is shown by the slope of the price
line DE. The free-trade equilibrium position is at point G. It is
assumed that A levies a tariff on clothing imports of EF per cent. If
OF

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 42 ECONOMICA [FEBRUARY

the tariff revenue were de

where an indifference curve is tangent to the domestic price line, DF.
However, if the usual assumption is made that the tariff revenue is
returned to the consumer, then the point of final equilibrium must
be located on DE. It will be where an indifference curve has a slope
equal to that of DF at the point where it cuts DE. In Diagram I the
equilibrium is at point K, where the curve through that point is tangent
to D'F' which is drawn parallel to DF.' At this point it is impossible
for the consumer to trade along his domestic price line D'F' and reach
a higher indifference curve.2 The tariff has the expected result of
lowering imports of clothing and raising consumption of domestic
wheat.
It is assumed that A now forms a trade-diverting customs union with
country B. The line indicating the terms of trade with B must lie

.DIAGRAM I

D'

KV E
Clothing

If neither wheat nor clothing is an inferior good, the point K must lie between
G and H in relation to the clothing axis.
2 It will be noted that, if projected to the axes, D'F' would have a Y intercept
above the point D. This illustrates the fact that whatever bundle of wheat and
clothing the consumer may be consuming at K, it will appear to him that he could
trade all his clothing for more wheat than there is in existence. This illusion results
from the fact that the tariff makes the price of wheat appear to the consumer lower
than the price at which the two commodities can in fact be traded in the international
market.

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 1957] THE THEORY OF CUSTOMS UNIONS 43

between DE and DF.I Since there, is no tariff levied on A-B trade,

the equilibrium position must be located- on the price-consumption
line WHGZ. The effects of the union on country A's welfare may
now be considered. In Diagram 1, starting from the point D, draw a
line tangential to the indifference curve I" (the curve through K) and
extend it to cut the clothing axis at some point V. The slope of this
line DV indicates terms of trade with counitry B which leave A as well
off as when trade was with country C. If A obtains any terms
of trade with B worse than DE but better than DV, the
trade-diverting customs union must result in an increase in A's
welfare. If she obtains any terms of trade better than DF but worse
than DV, trade diversion will occur but it will result in a loss of welfare
for A.2 It can be concluded, therefore, that country A might gain
by entering a customs union whose sole production effect was to divert
her import trade from lower-to higher-cost sources of supply.
The above conclusion may not have an immediate common-sense
appeaL,3 yet the explanation is easily seen with the help of a diagram
The possibility stems from the fact that whenever imports are subject
to a tariff, the position of equilibrium must be one where an indifference
curve cuts (not is tangent to) the international price line. From
this it follows that there will exist an area where indifference curves
higher than the one achieved at equilibrium lie below the international
price line. In Diagram I this is the area above I' but below DE. As
long as the final equilibrium position lies within this area, trade carried
--on in the absence of tariffs, at terns of trade worse than those indicated
by DE, will increase welfare. In a verbal statement this possibility may
be explained by referring to the two opposing effects of the trade-
diverting customs union. First, A shifts her purchases from a lower-
to a higher-cost source of supply. It now becomes necessary to export
a larger quantity of goods in order to obtain any given quantity of
imports. Second, the divergence between domestic and international
prices is eliminated when the union is formed. The removal of the
tariff has the effect of allowing the consumer in A to adjust his purchases
1 By assumption, B's price of clothing in terms of whe-at is higher than C's price.
Therefore, the line must lie to the left of DE. However, if trade diversion is to occur,
B's clothing price must be less than C's price plus the tariff. Therefore, the linie
rnust lie to the right of DF.
2 The Diagram also illustrates the effect of the customs union on the volume
of A's trade. Since K lies between G and H in relation to the clothing axis (see
note 1, page 42 above) and since the post-union equilibrium point must be located
on the price-consumption line, WHGZ, between the points G and H, it follows
that'A's imports of clothing may either rise or fall as a result of the trade-diverting
customs union.
3 The conclusion represents but another application of the general theory of
second best to problems of international trade. See: Lipsey, R. G., and Lancaster,
Kelvin, " The General Theory of Second Best ", The Review of Economic Studies,
Vol. XXIV, No. 1, 1956-57. The trade-diversion problem is, in fact, a very simple
application of the theory of multiple-layer second-best optima (op. cit., Section X).
Given the existence of price distortion by tariffs, the maximization of production
is no longer necessarily desirable. An 'inefficient' production solution may provide
an efficient welfare solution. (e.g. In Diagram I, welfare is increased by moving
from point K to some point below DE.)

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 44 ECONOMICA [FEBRUARY

to a domestic price ratio which now is equal to the rate at which

wheat can be transformed into clothing by means of interniational
trade. The final welfare effect of the trade-diverting customs union
must be the net effect of these two opposing tendencies ; the first
working to lower welfare and the second to raise it.
If, to take a limiting case as an example, country B's price of clothing
exceeds country C's price by only an infinitesimal amount, then the
union would allow A to return to a position only an infinitesimal
distance below the free trade position, G. In this case the only effect
operating is the consumption one and the trade-diverting customs
union raises welfare virtually to the free trade level.'

II
It must now be shown that the conclusions reached do not depend
on the existence of a unique community indifference map for country
A. This will be done by considering a case where country A is a
community of two individuals. Diagram II is a repetition of Diagram
I, all the lettering is the same except that the distribution of income
in terms of wheat is shown by OD' for consumer I and by OD" for
consumer II (OD' + OD"=OD in Diagram I). For cach individual
the free-trade equilibrium position will be at the point where the inter-
national price line, DE, is tangent to one of his indifference curves.
Similary, when a tariff is placed on imported clothing, each consumer
will move to an equilibrium position (K' and K") which will satisfy
the conditions for the location of the point K in Diagram I.
Once allowance is made for the existence of more than one consumer
in country A, two problems arise in connection with the trade-diverting
customs union between A and B. First, there will be some prices of
clothing which will permit one consumer to reach an indifference curve
1 A word of warning about the present model: The two-commodity model
is a simplification adopted for the present analysis where it is desired to demonstrate
only the possibility that trade diversion may raise the welfare of a single country
and of the world. Further analysis based on so simple a model might lead to the
conclusion that the consumption effect always works to raise welfare. This is not so.
The important peculiarity of the present model is that country A has only one import.
For any detailed analysis of the consumption effect, a three-commodity model is
required. Consider, for example, a case where country A produces commodity X
while importing commodity Y from country B and commodity Z from country C.
Now if A forms a customs union with country B the consumption effect on welfare
is complex. This is so even if there is neither trade creation nor trade diversion,
so that A continues to buy Y from B and Z from C. In this case, the removal of
tariffs from imports of Y changes two price ratios. On the one hand, A's domestic
price ratio between X and Y is made equal to the rate at which these two commodities
can be transformed into each other by means of international trade. On the other
hand, the domestic price ratio between Y and Z is now made to diverge from their
rate of transformation by international trade. The X-Y change works to raise
welfare while the Y-Z change works to lower it. The consumption effect on welfare
is now the net effect of these two opposing tendencies.
This is not the place for a detailed discussion of this example. The case is men-
tioned only to show that a two-commodity model obscures many of the most impor-
tant problems in the theory of customs unions. An example of this type is analysed
in some detail in : Lipsey & Lancaster, op. cit., Section V.

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19571 THE THEORY OF CUSTOMS UNIONS 45

LL

.EE
-c

b~c
() 0
U

0~~~~~

.E E

0 0~~~~~~~~~~~~~~~~~~~

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 46 ECONOMCA [FEBRUARY

higher than the one he achieved at K while the other consumer is

forced to a curve lower than the one he attained at K. Such a price
is shown by the lines D'P and D"P in Diagram II.- Thus, the clear
distinction betweeni gains and losses disappears as there will be some
prices for which some consumers gain while others lose. Second,
the union may cause a redistribution of wheat income2 such that one
consumer always suffers a reduction in welfare. However, there will
always be some prices of clothing higher than the one offered by
country C which will allow all consumers to reach higher indifference
curves than the ones they achieved when trade was with C. Therefore,
the conclusion still stands that a country may form a trade-diverting
customs union and yet gain an increase in welfare in the sense that every
consumer moves to a higher indifference curve.

III

Finally, it may be objected that in considering the welfare of only one

country, a parochial point of view has been adopted. The objection
would run somewhat as follows: Surprising though it is that one country
can increase its welfare by forming a trade-diverting customs union,
the world as a whole must surely suffer a loss when this occurs.3 The
complex problem of how to measure changes in world welfare when
there are many countries, each pursuing a different tariff policy, cannot
be discussed in a short paper. However, for the present argument,
it is sufficient to show that a case is possible where there is no doubt
that world welfare is raised by the creation of a trade-diverting customs
union.
Assume that B and C, the two countries that constitute the rest of
the world in the previous model, are both large and that each produces
wheat and clothing under conditions of constant rates of transformation.
B and C levy prohibitive tariffs on trade with each other so that the
only trade before the union is that between A and C. But C produces
both wheat and clothing and, therefore, trade is carried on at a relative
price which is equal to her domestic price ratio. After the union is
formed, A trades with country B. C suffers no loss from the elimination
of the trade to which she was indifferent in any case. Country B con-
tinues to produce both wheat and clothing so that she gains nothing
from the new trade with A. Thus, all the gains from trade accrue to
A both before and after the union. If the trade-diverting customs
union raises A's welfare-and this possibility has already been demon-
strated-then it raises the world's welfare.

London School of Economics.

I D'P and D"1P have identical slopes indicating some single price facing both
consumers.
2 i.e. the points D' and D" may shift after the union is formed.
3 " Where the trade-diverting effect is predominant, one at least of the member
countries is bound to be injured, both may be injured, the two combined will suffer
a net injury, and there will be injury to the outside world and to the world at large."
Viner, op. cit., p. 44.

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