Abstract. This paper considers a general equilibrium model of trade to examine how a move from bilateral trade within a customs union to multilateral free trade affects skilled-unskilled wage inequality within the customs union. It also shows the spillover effects of a reduction in common tariffs on countries outside the union. It is interesting to see that increased liberalization raises skilled-unskilled wage inequality under reasonable conditions within the customs union. Moreover, for the country outside the customs union, export of intermediate product to the customs union rises, accompanied by an increase in income of the capitalists and the wage earners and a decrease in income of the landlords. Also, employment and output in the import competing sector falls while the exportable sector witnesses an increase in employment and output for the country outside the customs union. These results have interesting political-economic implications.

Keywords: customs unions, skilled labour, unskilled wages, protectionism, liberalization, intermediate goods.