The formation of custom unions can be beneficial to its member countries because of the new volume of trade created, but the net welfare effect depends on whether it leads to trade creation or trade diversion. Explain and discuss this statement ‘Customs union’ is the form of economic integration, which allows no tariffs or other barriers on trade among members (as in free trade area), and in addition it adopts a common commercial policy toward the outside world (such as the setting of common tariff rates). The most famous example is the European Union (EU). Trade creation occurs when some domestic production in a union is replaced by lower-cost imports from another member nation. This increases specialization in production and welfare in the CU. A trade-creating customs union also increases the welfare of nonmembers because some of the increase in its real income spills over into increased imports from the rest of the world.
Trade diversion occurs when lower-cost imports from outside the customs union are replaced by higher-cost imports from another union member. By itself, this reduces welfare because it shifts production from comparative advantage. A trade-diverting customs union leads to both trade creation and trade diversion, and can increase or reduce welfare, depending on the relative strength of these two opposing forces.
Three conditions/ situations when a nation may gain increased Welfare as a member of a Customs Union. * The more competitive rather than complementary are the economies of member nations. There are then greater opportunities for specialization in production and trade creation with the formation of the customs union. Thus, a custom union is more likely to increase welfare if formed by two competitive industrial nations rather than by an industrial nation and an agricultural nation. * The closer geographically are the members of the custom unions. Then transportation costs...
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