THE THEORY OF CUSTOMS UNION

THE THEORY OF CUSTOMS UNION 

When two or more countries make a group with a motive of promoting trade amongst themselves, it is called custom union. The member countries agree to remove tariffs and other restrictive regulations on trade among them. It is a trade arrangement which is discriminatory in nature. According to liberalization regime of WTO also liberalization includes only member countries of a custom union. These custom unions together form their trade policy for other countries. 

The most widely known custom union is European Union. It was initially called Zollverein and was created by Bismarck, Benelux and the EEC in 1830s. Earlier Zollverein was formed f the German states. Later these states became a nation called Germany in 1871. In 1940’s, Benelux was formed by the Belgium, France, Italy, Luxemburg, the Netherlands and West Germany in 1957. 

Jacob Viner was the first to discuss the concept of custom union in detail. He studied the impact of formation of custom unions on member countries and studied the impact on trade patterns and resource allocation. Jacob Viner gave two concepts: trade creation and trade diversion in this context. 

(a) He claimed that if custom union is formed then some members who were not importing earlier due to high price will now be importing from others because the price of the protected domestic price of the product will be less than the import price. It will remove protection for domestic producers. It will increase competition and thereby increase efficiency. It will shift the production of commodity from high cost to low cost destination. It is called trade creation by Jacob Viner. 

(b) After the formation of the union, it may be possible that a member country is buying commodities from other member country which it was purchasing from a third nonmember country which was providing it at a low cost even after payment of duties. But now it is buying the same from a member country even at a higher cost. Viner termed it as ‘Trade diversion’. The economic effect of formation of custom unions at global level is sum total of these two effects. If trade creation is dominant and trade diversion is negligible or not so prominent, then making of a custom union will increase overall welfare or aggregate utility at global level. On the contrary, if trade creation is negligible and trade diversion is prominent, then making of a custom union will decrease overall welfare or aggregate utility at global level.