The authors construct a model of customs unions in which countries charge optimal tariffs. Customs unions internalize the externality that exists whenever two countries import the same good. Also, customs unions make several countries into one large unit with more market power. Big customs unions can improve their members' welfare relative to the free trade. The authors' model of customs unions separates the effects of tariff reduction from the effects of policy coordination. The movement from Nash equilibrium to a free trade association improves global resource allocations. Moving from a free trade association to a full customs union has ambiguous resource allocation effects.
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Kennan et al. (1990) studied this question.
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