CUSTOMS UNIONS AND FREE TRADE AREAS

the rest of the world would be available, so that two equilibrium

prices would exist in the area.

In this case country H would experience only a trade creation

effect (a+c). Country P would incur no excess costs of consumption
or production, but it would enjoy a gain in government revenue,
equal to the hatched area, which would represent an increase in its
national income.

If instead countries H and P formed a customs union (Figure

2.4b), the common external tariff would be effective, with demand
and supply approximately in balance at that level, the price in the
union being a little higher than in the free trade area case. Country
H would experience trade creation. Country P would benefit, on
balance, from its ability to export to country H at a higher price,
but at the cost of adverse production and consumption effects,
denoted by d and e.

A comparison of these two situations shows that in this second

case, just as in the first, the customs union alternative is inferior to
the free trade area arrangement. This conclusion appears to be
generally valid for the alternatives of a tariff-averaging customs union
and a free trade area, irrespective of the particular market conditions
assumed.
These comparisons of a customs union with a free trade area refer
o trade and tariffs with respect to final products. If, as is possible in
a free trade area, tariff disparities also exist on intermediate inputs,
hese differences may give rise to distortions in the area’s pattern of
production at that level. If processing costs were identical, production
in a free trade area would tend to concentrate in the country whose
input tariff was lowest. In general, however, it is not possible to say
whether such tariff disparities would encourage a concentration of
production of inputs in more efficient or less efficient member
countries. In comparing the merits of a customs union with those of
a free trade area, it is clearly necessary to take into account any such
production-distorting effects of a non-harmonized tariff at the input
stage that may upset the relative advantage of a free trade area in
comparison with a customs union.

NOTE

1 These particular definitions of trade creation and trade diversion are

those of Johnson (1962). They differ from those initially employed by
Viner (1950), Meade (1955a) and Lipsey (1960), who have used the

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