A trade-creating effect and (b) a trade-diversion effect. Although the former might be a gain,

greater losses might be incurred by the latter. Take the example of two countries A and В and

the rest of the world С producing a particular commodity for ￡50, ￡40 and ￡30 respectively. If

the home market of A is protected by a ￡25 tariff on the item, then no one in A will find it

economic to import from В or C. Production in A will occur, at ￡50. If country A then forms a

customs union with B, trade will be created because it is cheaper for A to obtain the commodity

from В than to produce it itself. There is a gain in so far as A is ￡10 better off. On the other

hand, if country /l’s original import duty had been ￡15, trade would then have taken place with

the rest of the world C, despite the tariff, as this would be the least-cost source to A. In this

example, if A forms a customs union with В it will now switch its trade because it can obtain

the commodity for ￡40 from В compared with ￡30 + ￡15 = ￡45 from C. This trade diversion

represents a move away from the optimum of resource allocation, because В is a higher realcost

Source than C. Whether, therefore, a customs union will yield overall gains from shifts in

The location of production will depend on the superiority of trade creation to trade diversion.

However, this type of analysis covers only a part of the problem; many other factors must be