In the previous chapter, we developed in some detail the basic economics of PTAs. In particular, we argued that clear-cut answers with respect to the welfare impact of the formation of trading blocs between nations can rarely be obtained. A singular and important exception is the well-known result relating to CUs, stated independently by Kemp (1964) and Vanek (1965) and proved subsequently by Ohyama (1972) and Kemp and Wan (1976): Starting from a situation with an arbitrary structure of trade barriers, if two or more countries freeze their net external trade vector with the rest of the world through a set of common external tariffs and eliminate the barriers to internal trade (implying the formation of a CU), the welfare of the CU as a whole necessarily improves (weakly) and that of the rest of the world does not fall. A Pareto-improving PTA may thus be achieved. The Kemp–Wan construction offers a way to sidestep the complexities and ambiguities inherent in the analysis of PTAs and it has, therefore, played an important role in shaping the way that economists think about issues relating to the design and implementation of PTAs.

This chapter first discusses in detail this classic solution to the problem of designing welfare-improving CUs provided by Kemp and Wan (1976).