Customs Union

A customs union (CU) 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 CUs 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:

• 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.
• A common external policy towards non-member countries
  This means that all the non-member countries face a common trade policy for all the member countries, usually in the form of a fixed tariff. 
  It is relevant to note that 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.
• Countries act as a group during all trade negotiations and agreements
• A high degree of economic integration
• It is third out of seven in the stages of economic integration 
  The seven stages of economic integration are 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.

Historical background of customs unions

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.

Therefore, it was only a matter of time before groups of states or nations began to work together to enhance trade and protect their interests.

One of the first customs unions was the Zollverein, a coalition between German states established in 1834. The timeline of the consolidation of this union is described below.

• 1818
  Prussia eliminated all internal customs dues and proclaimed its willingness to adopt free-trade policies with its neighboring states.
• 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.
• 1829
  Palatinate joined the southern German union
• 1834
  The Zollverein was established to form a union of eighteen states
• 1854
  Two more states, Hanover and Oldenburg, joined the union
• 1867
  Schleswig-Holstein, the two Mecklenburg, Lauenburg, and Lübeck joined the union
• 1888
  Hamburg and Bremen were the last two states in Germany to adhere to the union.

Examples

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

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

Advantages

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 (all the countries of the union and the existing domestic market). 

This leads to potential economic growth along with the ability to utilize economies of scale.

Economies of scale are when a producer's long-run average total costs decrease over a larger quantity. With a larger market and a likely increase in exports, producers can avail economies of scale.

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) hoping to increase their market base.

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 can create new employment opportunities.

6. Trade Creation and Trade Diversion

Trade creation is when more efficient member countries export to less efficient member countries, improving the allocation of scarce resources. 

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 prevents trade distortions that could be caused by the member countries importing or exporting goods with lower tariffs, thus putting other members with higher tariffs at a disadvantage.

Disadvantages

The disadvantages are:

1. Loss of Sovereignty

Within a customs union, all the member countries negotiate and decide on trade agreements together. 

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 likely to receive equal revenues from tariffs. Therefore, some countries may benefit more than others. On the other hand, in the case of losses, some countries may be worse affected than others.  

3. Hampers Goal of Global Liberalization

With the creation of these strong trade blocs, the interests of member countries are highly prioritized with little to no concern about the interests of the non-member countries. 

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

CUs favor domestic producers and lead to trade diversion. As a result, more efficient non-member producers export less, leading to an overall decrease in efficiency and a misallocation of resources. 

5. Disagreements

It is often difficult to set an external policy as different countries benefit differently from it. 

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.

Comparison to other trading blocs

Comparison is:

a) customs union and a free trade area

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:

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

Differences:

• Member countries within a CU 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 CU is a higher degree of economic integration than an FTA.

b) 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:

• 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:

• 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 CU.
• Common markets are usually more efficient due to the flow of factors of production.
• A common market is a higher degree of economic integration than a CU.
• A common market requires greater policy coordination. Policies on unemployment, for example, can impact other member countries.

Researched and Authored by Kiara

Reviewed and edited by Parul Gupta | LinkedIn

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