Popular discussions of tax and tariff policies often concentrate on the employment and output effects of these policies. In Discussion Paper No. 38, CEPR Research Fellow Tony Venables shows how changes in the taxation of domestically produced and imported products affects not only patterns of trade and production but also the welfare or satisfaction of consumers.
Venables investigates tax and tariff policy for economies in which there is a "monopolistically competitive' industry whose output is traded internationally. Such an industry contains a number of firms, each of which produces an output slightly different from the outputs of other firms. Because its product possess some qualities which consumers value differently from other outputs, the firm enjoys some degree of market or monopoly power. Venables assumes that production takes place under conditions of increasing returns to scale, and the number of firms in each country is determined by the free entry and exit of firms in response to profits. The resulting equilibrium generally involves intra-industry trade in the differentiated products, as well as trade in other competitively produced goods. Consumers in different countries may have different preferences for goods. This, and the presence of transport costs, means that firms have a larger share of their own home market than of export markets. The firm's mix of products therefore reflects the preferences of home consumers more closely than it does those of consumers in other countries.
Venables considers first the consequences of a single (home) country independently changing taxes on domestic production, imports, and exports of differentiated products. He establishes that if retaliation does not occur, the home country can improve its welfare by employing positive import tariffs, by subsidising its exports, or by subsidising domestic production. These policies work by increasing the number of firms in the home country. The larger number of firms produce a wider range of differentiated products which match home consumers' preferences more closely. The welfare of home consumers rises.
Venables then considers the effect of simultaneous and reciprocated tariff reductions by a number of countries - the formation of a customs union. If the countries are sufficiently similar then the customs union raises welfare in member countries and reduces welfare of non-members. Venables also finds that enlargement of the union raises the welfare of the joining country but may reduce the welfare of existing union members. How does this happen? The number of firms in the joining country may increase. This may cause a reduction in the number of firms in existing member countries, whose consumers will therefore have available a narrower range of goods to satisfy their preferences.
If countries are not sufficiently similar, then formation of a customs union may actually reduce welfare in some of the joining countries. For example, if countries differ in size then large countries will certainly gain from the customs union, but small countries may lose. Trade liberalization, in this framework, will cause production to adjust to meet demand in the large, rather than the small markets. Consumers in the large markets benefit as the mix of differentiated products adjusts to suit their preferences. This suggests that customs unions may be expected to form between countries which are relatively similar, rather than between economies with very different characteristics.

Customs Union, Tariff Reform, and Trade in Differentiated Products
Anthony J Venables

Discussion Paper No. 38, January 1985 (IT)