Customs Union, Wage Inequality and Welfare in General Equilibrium

Published date01 February 2023
Date01 February 2023
Subject MatterArticles
Customs Union, Wage
Inequality and Welfare
in General Equilibrium*
Sugata Marjit1,2, Sharmi Sen3 and Kausik Gupta3
The article attempts to consider the impact of a customs union formed between
two small countries embedded in the global economy and trading in intermedi-
ates, in terms of a general equilibrium framework. It shows that with such a
union both countries will gain, although there will be asymmetric effect on wage
inequality. However, with higher capital stock the significance of the formation
of customs union will be undermined. It also shows that perfect international
capital mobility will lead to finite changes in the economy, shutting down the less
capital intensive unskilled export sector in each country, which in turn makes the
bilateral union irrelevant. Further tariff reduction will increase inequality in both
countries. We have also considered the welfare effects of formation of customs
union in the form of tariff cut and such a tariff reduction unequivocally improves
welfare of the customs union irrespective of small country and large country
assumptions, without any intra-union income transfer.
JEL Codes: F02, F11, F55, F68
Customs union, intermediate imports, wage inequality, finite change, welfare
Foreign Trade Review
58(1) 45–67, 2023
© 2022 Indian Institute of
Foreign Trade
Reprints and permissions:
DOI: 10.1177/00157325221120623
* This article is a tribute in the memory of the legendary trade theorist Prof Murray Kemp. Sugata
Marjit is personally indebted to Prof Kemp for encouraging mentorship, which helped his work
on virtual trade, when both of them shared the same office during a visit at the City University of
Hong Kong in 2006. Insightful comments from an anonymous referee of the journal have helped
the authors to revise thoroughly the present version of the paper. Kausik Gupta acknowledges
fruitful discussions with Sushobhan Mahata for the welfare section of the paper. However, the usual
disclaimer applies.
1 Indian Institute of Foreign Trade, Kolkata Campus, Kolkata, West Bengal, India.
2 CES-Ifo, Munich, Germany.
3 Department of Economics, University of Calcutta, Kolkata, West Bengal, India.
Corresponding author:
Kausik Gupta, Department of Economics, University of Calcutta, 56A, B.T. Road, Kolkata,
West Bengal 700050, India.
46 Foreign Trade Review 58(1)
The purpose of the article is to explore the possibilities of formation of customs
union along with analysis of the situations when such possibilities are not success-
ful. It also attempts to examine the welfare implications of such possibilities.
Regional economic integration takes place when countries tie among themselves
to form free trade areas or customs union offering members preferential trade
access to each other’s markets.1 As a result of formation of customs union the
member countries enjoy the benefits of trade creation and trade diversion.2 Greater
ties of customs union imply removal of market segmentation and promotion of
economic integration. The interesting question that arises in this context is that
whether formation of customs union retards multilateral free trade or not. Another
important question in this context is that why General Agreement on Tariffs and
Trade (GATT) or World Trade Organization (WTO) have not banned regional
trading agreements (RTAs). It has been argued by various economists that RTAs
may be desirable when multilateral free trade or multilateral bargaining among
countries is less efficient than bilateral trade or bargaining. Thus, the issue of
formation of customs union and also breaking of customs union is an important
and relevant issue in the presence of prescriptions of WTO for a globalized world.
As per GATT–WTO guidelines, a customs union cannot be established
instantly but it should be gradually completed over a reasonable period of time,
which generally does not exceed 10 years. Among the examples of customs union,
the most common example is European Union. It is a trade bloc but it also consists
of countries, which form a customs union, and it is referred to as European Union
Customs Union. Other examples of customs union are Eurasian Customs Union,
Caribbean Community, Central American Common Market and so forth.3 The
literature on customs union is quite wide in its coverage starting from the seminal
works of Kemp and Wan (1976), Lipsey (1957), Ohyama (1972), Viner (1950)
and others to relatively recent works of Goyal and Joshi (2006), Grossman (2016),
Iwasa et al. (2008), Maggi (2014), McLaren (2002), Qi and Shimomura (2009),
Saggi and Yildiz (2010), Sykes (2016), Venables (2001) and so forth.
Grossman (2016) in his work has mentioned that any discussion on incentives
for trade agreements among a few countries must start from the renowned
Ohyama–Kemp–Wan theorem (Kemp & Wan, 1976; Ohyama, 1972). These
authors have shown that a group of countries can form a mutually beneficial cus-
toms union irrespective of the response of the rest of the world (ROW). Kemp and
Wan (1976) have developed a theorem to show that formation of customs union
results in Pareto-improvement in the presence of intra-union income transfer.
Iwasa et al. (2008) and Qi and Shimomura (2009) have generalised the results of
Kemp and Wan (1976) and have shown that formation of customs union causes
Pareto-improvement even in the absence of intra-union income transfer. McLaren
(2002) has argued in favour of ban on free trade area or customs union though
Goyal and Joshi (2006) have adopted a network-formation approach to study the
formation of free trade area or customs union and have referred to them as ‘build-
ing blocks’ towards global free trade. Saggi and Yildiz (2010) and Seidmann
(2009) have considered three-country bargaining models and have argued that ban

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