The Formation of Customs Unions and the Effect on Government Policy Objectives

The case is studied where two small countries wanting to set second-best tariffs to maximize objective functions move from the situation where they can set their most appropriate tariffs to the situation where they form a customs union. By dividing the overall effect of forming customs unions into trade diversion, trade creation, and intra-union relative price effects, it is found that the trade diversion effect and intra-union relative price effect will make one country’s welfare decrease, while the trade creation effect will result in a decrease in both countries’ welfare. The conclusion is that there is no incentive to form and maintain a customs union.