If area c is greater than the efficiency losses in areas a and b, then a tariff that encourages additional production of the import-competing good increases the small country's welfare. Using a trade policy to solve the domestic spillover is second best. The government should address the problem directly with a production subsidy to import-competing producers. First, consider a case where the formation of a customs union between Britain and France improves the welfare of the British. The gains from trade creation are shown below graphically.
British producers lose area a, but consumers gain area ab, raising overall welfare by area b.
Instead, consider a case where Britain is worse off after joining the customs union. Overall, Britain will gain from the formation of a customs union if it leads to new trade. Alternatively, Britain will lose if trade within the customs union replaces trade with countries outside the union.