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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