Customs unions, trade creation and diversion, and optimum currency areas

Countries can cooperate on trade to different depths. Each step down the ladder keeps everything above it and adds something. Click through the six, and look at what each one adds.

The two steps examiners mix up are the second and the third. In a free trade area, members remove tariffs on each other and each keeps its own tariff on outsiders. JNU 2015 asks what most free trade agreements are designed to do, and the key is to eliminate tariffs. In a customs union, members also adopt one common external tariff. A free trade area has a leak: a good from outside can enter through the member with the lowest tariff and then move freely, so members write rules of origin to stop it. A customs union does not need them, which is its advantage, and it costs each member the freedom to set its own tariff.

Integration among developing countries has a history of its own. UGC NET 2024 asks which of the Central American Common Market, the Caribbean Free Trade Association and the Latin American Free Trade Association were attempts at integration among developing countries. All three.

Free trade is best, and a union moves a country toward it, so a customs union must help? Jacob Viner showed it need not. A union lowers tariffs only on its members, and a discriminatory cut can go either way. It has two effects, with opposite signs.

Trade creation is the good effect. Cheaper goods from a partner replace costlier home production, and buyers consume more at the lower price. Some domestic production is replaced by lower-cost imports from a member, which is exactly what UGC NET 2025 calls a trade-creating customs union. Trade diversion is the bad effect. A partner, now tariff-free, displaces a cheaper supplier from outside, whose goods still pay the tariff. The country pays more for what it was already importing.

The market below has a world price of ₹20, a home tariff of ₹5, and a partner whose cost is higher than the world’s. Move the partner’s price. The green triangles are creation and the red rectangle is diversion.

With the partner at ₹22, creation is 18 and diversion 40: a net loss of 22. The partner would have to be below ₹21.34 for the country to gain. With no substitution, if buyers and producers cannot change their quantities, creation is zero and the loss is the whole diversion, 40 here: no consumption and production substitution, the answer to the opening question.

What favours gains, as rules of thumb: a partner whose costs are near the world’s, high tariffs before the union (so there is a lot to create), and member industries that compete with each other, not ones that make different things. What favours losses: a high-cost partner, and a low tariff to begin with, so little is created and much is diverted. Note the lesson of the second best: removing some distortions need not improve welfare when others remain.

The far end of the ladder replaces the exchange rate with a single currency. What do you lose? When a shock hits one region and not the others, a separate currency can depreciate to cushion it. Inside a union that cushion is gone. The theory of optimum currency areas asks when the loss is small enough to accept. It was pioneered by Robert Mundell in 1961 (UOH 2019).

Mundell’s answer was factor mobility. If workers can move freely from the hit region to the others, or its wages can fall, the region recovers without an exchange rate. CUET 2020 states it: in an optimum currency area, internal and external balance can be achieved through the mobility of factors. Later writers added more tests: how open the economies are to each other (McKinnon), how diversified their production is, so shocks are less likely to hit one region (Kenen), and whether a central budget transfers money to the hit region. The lab shows Mundell’s test.

What the lab shows: with mobility and wages both low, a union leaves a region stuck, and a separate floating currency solves the same shock within a year or two. That is why economists asked whether Europe was an optimum currency area when the euro began. The Maastricht Treaty provided for the common currency of the European Community (UOH 2016), and it was a political decision first, with the test of mobility applied afterwards.

The link to the previous page: a currency union is the extreme of a fixed rate, and a member has given up independent monetary policy (JNU 2017). See the trilemma page.

Two UGC NET June 2026 questions ask for bloc years, and we left them out of the practice sets. One keys SAARC to 1981 and NAFTA to 1992, but SAARC’s charter was adopted in December 1985 and NAFTA took effect on 1 January 1994 (it was signed in 1992). The other asks for the order of founding of ASEAN, the EU, SAARC and NAFTA, and the key depends on whether the EU is dated from the Treaty of Rome in 1957 or from Maastricht in 1993, which the question does not say. If you meet either in a paper, work from the dates in the table and the most likely reading.

Read on 6 October 2026. The customs union of 1968: the European Union’s history, 1960 to 69. Maastricht, the single market and the euro: history, 1990 to 99. NAFTA and the USMCA: the Congressional Research Service report R44981. ASEAN: the Bangkok Declaration on asean.org. SAARC: IDSA fact sheet. The model numbers are stylised, from the tariffs page.