International Trade
Customs unions

Although the ideas of trade creation and trade diversion date back to the early 1950s, theoretical models of customs unions in a full general equilibrium framework have typically assumed a predetermined trade pattern that remains unaffected by policy. This rules out by assumption Viner's original insight: that the formation of a customs union will switch the source of import supply. Such models' results are also highly sensitive to the choice from the many possible assumptions about the trade pattern.
In Discussion Paper No. 605, Research Fellow Anthony Venables develops a full general equilibrium model in which the trade pattern is endogenous. His model of a customs union has a three-dimensional continuum of product types; so each of the three `countries' the two forming the union and the rest of the world can have a distinct comparative advantage. The formation of the union switches the sources of supply for some product types consumed in each economy. Such changes take the form of trade creation, where products previously produced domestically are now imported from the partner country; trade diversion, where products previously imported from the rest of the world are imported from the partner country; and trade modification, where some products previously produced domestically are imported from the rest of the world as a result of general equilibrium effects.
Venables develops a graphical device to illustrate these effects and evaluate their welfare consequences. He then uses it to derive three types of results. First, free trade within the union and an `optimal tariff' on external trade the reciprocal of the rest of the world's export supply elasticity form the first-best, optimal policy. If either the internal or the external tariff is set above its optimal value, the second-best response is to raise the value of the other. Second, reducing the internal tariff will certainly raise welfare if the external tariff either lies within a range of possible optimal values or is accompanied by a reduction in the external tariff that holds demand for a union member's factor of production unchanged. Investigating both marginal and nonmarginal tariff changes indicates that a reduction in the internal tariff may also raise welfare in other cases, depending on the restrictions placed on admissible patterns of consumer demand. Finally, if the external tariff is held constant relative to the rest of the world's export supply elasticity, increases in the latter will ensure that marginal reductions to lower levels of the internal tariff produce welfare gains because of their terms-of-trade effect.

A Customs Union with a Continuum of Products
Anthony J Venables

Discussion Paper No. 605, December 1991 (IT)