Customs unions

customs unions

A customs union is an agreement between member countries to trade freely with each other and impose common tariffs on non-members (called ‘third parties’) – referred to a CETs (common external tariffs).

The existence of a CET means that a customs union imposes more constraints on its members than 'looser' types of free trade agreements that only bring down barriers to members without requiring the acceptance of a CET.

As of 2020 there were 16 customs unions operating in the global economy as notified to the WTO, with the two most well-known ones the customs union of the EU, formed in 1968, and Mercosur, which is South America’s equivalent, formed in 1991 as a free trade area, and which became a customs unions in 1995.

Being a member of a customs union confirms the following advantages on members:

Tariff free trade

Trade between members is free of tariffs, and this should create an increase in trade between members. Tariffs add a cost to production and as prices rise demand contracts – hence removing a tariff reduces production costs and leads to an expansion of demand.

Reduced costs of trade

A customs union also means that some (but not all) of the costly and time-consuming border controls, bureaucracy, and customs checks in are not required, although checks on standards and quality can still be made. In the EU, it was only with the creation of the Single European Market in 1993 trade borders were finally removed along with the need for border checks.

Economies of scale

Increased trade means increased production and the ability to exploit economies of scale. This can reduce firms’ costs and make them more competitive when exporting outside the customs union.

Welfare gains

There are likely to be net welfare gains from the removal of tariffs between members (though these may be offset by the tariffs imposed against non-members.) As a result of increased trade, members are likely to increase their GDP and create jobs.

customs unions

Negotiations

In terms of trade policy, while a member cannot negotiate its own trade policy is may benefit from negotiations undertaken collectively by the union.

However, set against these benefits are the following disadvantages:

Loss of sovereignty

Members must use the same external tariff, and hence there is a loss of economic sovereignty to determine trade policy, although there is often some flexibility for particular members.

Unable to support industries

Members will not be able to support declining industries or infant industries by putting up protective barriers (unless agreed by the union).

Trade diversion

Trade diversion can arise, as members lose the benefit of trading freely with more efficient third-parties. This can raise prices and reduce economic welfare.

Unequal distribution of revenue

Although countries that collect tariff revenues will typically retain an amount to cover administration costs (20% for the EU), the remainder may not be distributed in a 'fair' between members.


Trade agreements

What is included in a trade agreement?

Trade deals
Exchange rates

What determines exchange rates?

Exchange rates
Tariffs

What are the costs and benefits of tariffs?

Tariffs

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