The effects of the customs union on the country's welfare level relative to its position under tariffs is shown in Table 3.
When countries form a customs union they take the average tariff rate as the tariff rate of the union.
Next, we assume that country 1 holds the tariff rate at its optimal level of 6.2 percent, and that countries 2 and 3 form a customs union by setting the common external tariff rate at its optimal level of 19.2 percent.
Point L is the trading point before the customs union. Country A's import quota is allocated between country U (OZ[prime] of good Y) and country D (ON[prime] of good Y).
Point V will be the trading point after the customs union. Country A will import OV[prime] of good Y.
However, the welfare of country A could increase, decrease, or remain the same after it joins a customs union.(8) Figure III shows the case in which country A's welfare is decreased after it joins the customs union.(9) Before the customs union, country A already imports OZ[prime] of good Y from country U at the terms of trade measured by line OT.
The price of good X in country A is lowered from [P'.sub.1] to [P'.sub.2] after the customs union. At [P'.sub.2], country A imports [P'.sub.2]b of good X.
The welfare effects of joining the customs union are as follows.
Next, assume that country A chooses to make an appropriate non-preferential tariff reduction rather than to join the customs union. This non-preferential tariff reduction would bring the price of good X in country A down from [P'.sub.1] to [P'.sub.2] as the customs union.
The welfare of a tariff-imposing country could increase, decrease, or remain the same after it joins a customs union. However, the welfare of a quota-imposing country will always increase after it joins a customs union.
1 The diversion of initial trade from a lower-cost source to a higher-cost source is the trade diversion effect of a customs union. The creation of new trade between the home country and the partner country is the trade creation effect of a customs union |Chacholiades, op.