Customs Union

What Is A Customs Union?

A customs union agreement between two or more countries eliminates trade barriers between member countries and adopts a common policy toward all non-member countries. 

The official definition of customs unions was given by the General Agreement on Tariffs and Trade (GATT) under Article XXIV. 

The purpose of such a union is to facilitate trade between member countries, reduce administrative and financial barriers to trading, and foster economic growth and cooperation.

The main features are the following:

1. Free trade between member countries: This means that all the member countries have removed tariffs and other forms of trade barriers between each other. As a result, goods can move freely across the union.
2. A common external policy towards non-member countries: This means that all non-member countries face a common trade policy for all the member countries, usually in the form of a fixed tariff. Notably, any duty is paid on a good or service at the first point of entry into the union. After this, the good can move within the union with no duty.
3. Countries act as a group during all trade negotiations and agreements
4. A significant level of economic integration characterizes customs unions
5.  classified as one of the stages of economic integration: The seven stages, which may vary in sequence, include a preferential trading area, a free trade area, a customs union, a common market, an economic union, an economic and monetary union, and complete economic integration

Customs Union History

Humans have been trading for thousands of years. Historians estimate that the first forms of trade existed between the Mesopotamian Civilisation and the Indus Valley Civilization around 3000 BC. Ancient civilizations used to trade goods such as spices, textiles, precious stones, and metals.

These different civilizations and territories often developed and solidified friendly trade relations with other civilizations. International trade became increasingly common during the rule of the Persian Empire, the Greek Empire, and the Roman Empire.

Consequently, groups of states or nations eventually began to work together to enhance trade and protect their interests.

Among the early customs unions was the Zollverein, a coalition between German states established in 1834, though other examples predated it, such as the Scandinavian Monetary Union in 1873.

The timeline of the consolidation of this union is described below.

1. 1818: Prussia eliminated all internal customs dues and proclaimed its willingness to adopt free-trade policies with its neighboring states.
2. 1828
   • Prussia and Hesse-Darmstadt signed the first free-trade pact
   • Bavaria and Württemberg in southern Germany formed a union
   • Saxony, the Thuringian states, electoral Hesse, and Nassau in central Germany formed a union.
3. 1829: Palatinate joined the Southern German Union
4. 1834: The Zollverein was established to form a union of eighteen states
5. 1854: Two more states, Hanover and Oldenburg, joined the union
6. 1867: Schleswig-Holstein, the two Mecklenburg, Lauenburg, and Lübeck joined the union
7. 1888: Hamburg and Bremen were the last two states in Germany to adhere to the union.

Customs Union Examples

The most common example is the European Union (EU). The European Union Customs Union (EUCU) consists of 28 countries belonging to the EU and is the largest customs union in the world in terms of economic output.

The table below is an extensive list of various unions. The list may also include extensions of customs unions, such as monetary and economic unions:

Advantages of Custom Unions

The advantages are:

1. Increased Efficiency and Lower Costs

Due to the removal of trade barriers within the union, there is an increase in the competition between the producers in the member states. With no barriers to import or export, domestic producers are no longer protected by external tariffs or quotas. 

As a result, domestic producers have to increase their efficiency to compete with foreign producers.

This results in higher efficiency levels and improved resource allocation as the most efficient producers produce. Additionally, improved efficiency and lower cost of production may translate to the consumers in the form of lower prices and improved quality of products. 

2. Expansion of the Market and Economies of Scale

By removing trade barriers, domestic producers effectively have access to a larger market, including both the countries of the union and the existing domestic market. This leads to potential economic growth and the ability to utilize economies of scale.

Economies of scale occur when a producer experiences a decrease in the long-run average total costs per unit as the quantity produced increases. Producers can avail economies of scale with a larger market and a likely increase in exports.

3. Increased Investment

Firms are more likely to invest in companies belonging to a trade bloc (an agreement between countries to reduce or eliminate trade barriers) as they can operate with greater ease and with fewer barriers. 

The increase in foreign direct investment (FDI) often comes from multinational companies (MNCs), which may seek to expand their market base, among other strategic objectives.

4. Political Stability

When forming a union, the member countries work together to create trade policies that support economic unity. 

With the member countries highly dependent on economic stability, growth, and development, there is less likely to be friction between countries, as the breakdown of the union would result in the breakdown of the countries’ economic systems.

5. Increased Growth

Due to the removal of protectionist trade barriers, there is increased trade within the member countries. This spearheads economic growth, boosts the countries’ gross domestic product, and creates new employment opportunities.

6. Trade Creation and Trade Diversion

Trade creation is when more efficient member countries export to less efficient member countries, contributing to the overall improvement in economic welfare.

Trade diversion, on the other hand, is when more efficient non-member countries export less to member countries because of tariffs or other barriers. This allows smaller and less efficient businesses within the trade bloc to flourish.

7. Reduces Trade Distortions

The common external policy aims to prevent trade distortions that could arise if member countries import or export goods with lower tariffs, potentially disadvantaging other members with higher tariffs.

Disadvantages of Customs Unions

The disadvantages are:

1. Loss of Sovereignty: Within a customs union, member countries collectively coordinate and decide on external trade agreements, limiting individual control over certain economic policies. As a result, an individual member country cannot decide its economic policy by itself. They cannot change trade policies to protect their interests and may be worse off.
2. Unequal Distributions: Countries within a trade bloc are not guaranteed equal benefits from various economic mechanisms, including tariffs. Some countries may benefit more, while others may be adversely affected. On the other hand, in the case of losses, some countries may be worse affected than others.  
3. Hampers Goal of Global Liberalization: Creating strong trade blocs can prioritize the interests of member countries over non-members, potentially affecting overall global trade liberalization. As a result, there is a decrease in the overall global trade liberalization. This goes against the World Trade Organization’s (WTO) principle of non-discrimination among countries.
4. Reduction in Global Efficiency: Customs unions favor domestic producers, leading to trade diversion, where more efficient non-member producers export less, causing a decline in overall efficiency and a misallocation of resources.
5. Disagreements: Setting external policy within a customs union is challenging due to differing benefits among member countries, potentially resulting in disagreements and complications. Disagreements within member countries on the setting of external policy may lead to problems between the countries. With the economies heavily dependent on each other, friction between the countries could be catastrophic.

Customs Union Vs. Other Trading Blocs

Let’s compare the customs union with some other trading blocks:

Customs Union and a Free Trade Area (FTA)

FTA is the most common type of trading bloc in which a group of countries removes or reduces trade barriers between the member countries.

Similarities are:

• Both are trade agreements between two or more countries 
• Both entail free trade between the member countries (no tariffs or trade barriers)

Differences are:

• Member countries within a customs union have a common external policy (such as a common tariff) toward all non-member countries. Countries within an FTA do not have a common external policy and can negotiate their trade deals with non-member countries
• A customs union is generally considered to involve a higher level of economic integration than an FTA

Customs Union and a Common Market/ Economic Union

A common market/ economic union is an agreement between countries that entails free trade, a common external policy, and no restrictions on the movement of any factors of production.

Similarities are:

• Both are trade agreements between two or more countries 
• Both entail free trade between the member countries (no tariffs or trade barriers)
• Both have a common external policy towards all non-member countries

Differences are:

• Member countries of a common market have no restrictions on the movement of any factors of production (human capital, physical capital, etc.). Therefore, workers can move freely across borders. The same does not hold for a customs union
• Common markets are usually more efficient due to the flow of factors of production
• A common market and a customs union represent different degrees of economic integration, with some perspectives suggesting that a common market involves a higher level of integration
• A common market typically involves greater policy coordination, and policies on issues like unemployment can potentially affect other member countries

Researched and Authored by Kiara

Reviewed and edited by Parul Gupta | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Balance of Trade (BOT)
• Barriers to Entry
• Common Market
• Economic Integration
• Trade Barriers