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

The case is studied where several 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 the 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 some countries' welfare decrease, while the trade creation effect will result in all countries' welfare decreasing. Therefore, the conclusion is drawn that there is no incentive to form and maintain a customs union.