Customs Union Theory
Customs union theory relates to the perceived gains from the establishment of such a union. These include gains from specialization of production, economies of scale, greater competition, externalities associated with agglomeration, improvement in the terms of trade, an increased rate of growth, and political unification.
Most of the theoretical effort has been put into the first of these, that is, attempting to demonstrate that the establishment of a customs union leads necessarily to an improvement in welfare, along the lines of the gains associated with moving from a state of no trade to free international trade. Such a direct application of the traditional theory regarding the gains from trade would appear to be clear-cut, but it turns out that such a gain cannot be presumed a priori for the establishment of a customs union.
In order to demonstrate this notion, it is important to review the traditional theory as it applies to the costs involved with introducing a tariff on a previously freely traded good. The partial equilibrium analysis for such a situation is presented in Figure 3.1, where D and S are the domestic demand and supply curves, respectively, for the good. The autarky (no trade) price for this good (PA) is relatively "high" compared with the world price (PW), thus demonstrating that the country does not have a comparative advantage in the production of the good. Once again according to standard international trade theory, this is probably due to the fact that the country is relatively insufficiently endowed with the factors of