How to Calculate the Net Welfare Effect of a Customs Union
The net welfare effect of a customs union equals the trade creation gain minus the trade diversion loss, both measured in dollars off the import diagram.
The Customs Union Welfare formula
Calculator
Enter the world price, the partner price, the tariff and imports before and after to get the net welfare effect.
What the cheapest supplier outside the union charges per unit.
What the partner charges per unit, before any tariff is added.
Charged on every import, partner and non-partner alike.
Quantity imported at the old tariff-inclusive price.
Quantity imported once the lower partner price applies.
Creation minus diversion leaves $40,000, which is what the union is worth to this country on these numbers.
- Domestic price before the union
- $16
- Trade creation gain
- $120,000
- Trade diversion loss
- $80,000
- Tariff revenue given up
- $240,000
- Verdict
- Net welfare gain
Buyers paid the world price plus the tariff, $16, and the union drops that to the partner's price, a fall of $4.
The lower price expands imports, and the two triangles that expansion opens up are worth $120,000.
The units already being imported now come from a dearer supplier, costing the country $80,000 in real resources.
The treasury stops collecting $240,000. Consumers pick up most of it through the lower price, and the rest is the diversion loss.
Extra trade is worth more than the cost of switching to a dearer supplier, so joining raises welfare.
How to calculate Customs Union Welfare, step by step
- 1Find the domestic price before the union. Imports came from the cheapest outside supplier and paid the tariff, so the starting domestic price is the world price plus the per-unit tariff.
- 2Find the price after the union. Inside the union the partner ships duty free, so the domestic price falls to the partner's price whenever that price sits below the old tariff-inclusive price.
- 3Measure trade creation. The lower price expands imports. The gain is the two triangles under the demand and supply curves: ½ × the price fall × the rise in imports.
- 4Measure trade diversion. Units the country was already importing now come from the dearer partner. Multiply the old import volume by the gap between the partner price and the world price.
- 5Subtract to get the net effect. Net welfare = trade creation gain − trade diversion loss. A positive answer means the union left the country better off.
Worked example: Customs Union Welfare
A country charges a $6 per unit tariff. The cheapest outside supplier sells at $10 and the future partner sells at $12, so before the union imports came from the outside supplier at $10 + $6 = $16 and ran at 40,000 units. Joining removes the tariff on the partner alone, the domestic price falls to $12, and imports rise to 100,000 units. Trade creation gain = ½ × $4 × (100,000 − 40,000) = $120,000. Trade diversion loss = 40,000 × ($12 − $10) = $80,000, the part of the $240,000 of forgone tariff revenue that no consumer picks up. Net welfare = $120,000 − $80,000 = a gain of $40,000.
Customs Union Welfare questions
Why is trade diversion a loss when consumers pay less?
Consumers do pay less, but on the units already being imported that saving is money the government used to collect as tariff revenue. Those units now use up $12 of real resources each instead of $10, and the extra $2 goes to the partner's producers rather than the treasury.
Can a customs union leave a member worse off?
Yes. If the country was already importing a large volume and the partner is much dearer than the outside supplier, the diversion loss outweighs the creation gain and net welfare falls. That is why the theory says a customs union is not automatically a step toward free trade.
What makes trade creation more likely to win?
A high starting tariff, demand and supply that respond strongly to the price fall, and a partner whose costs sit close to the world price. Each of those makes imports expand a lot while the resource cost of switching supplier stays small.
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