Variable labor supply and the theory of customs union

Abstract

publisher Tokyo This paper reexamines the traditional results of customs union theory in a model where labor supply is variable and wages are taxed. In the absence of wage taxes, trade creation improves welfare while trade diversion may or may not. When the imported good is labor intensive and a complement to leisure in consumption, then variable labor supply increases the welfare gains from trade creation. In the presence of wage taxes, trade creation and trade diversion have ambiguous welfare effects. In this case, the paper identifies conditions under which welfare improves or deteriorates as a result of a trade creating or a trade diverting customs union.