The article attempts to consider the impact of a customs union formed between two small countries embedded in the global economy and trading in intermediates, in terms of a general equilibrium framework. It shows that with such a union both countries will gain, although there will be asymmetric effect on wage inequality. However, with higher capital stock the significance of the formation of customs union will be undermined. It also shows that perfect international capital mobility will lead to finite changes in the economy, shutting down the less capital intensive unskilled export sector in each country, which in turn makes the bilateral union irrelevant. Further tariff reduction will increase inequality in both countries. We have also considered the welfare effects of formation of customs union in the form of tariff cut and such a tariff reduction unequivocally improves welfare of the customs union irrespective of small country and large country assumptions, without any intra-union income transfer.
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