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While a customs union and a free trade area are similar in some ways, they are also different. A customs union represents a higher level of economic integration than a free trade area does.
A free trade area is simply an area in which countries have agreed to trade with one another freely. There are no (or at least not many) tariffs or other trade barriers that impede the flow of goods and services from one country to another. An example of this is the North American Free Trade Agreement (NAFTA). There are essentially no trade barriers between the NAFTA countries.
A customs union is a free trade area. There is free trade between all the countries in a customs union. However, that is not all there is to it. The countries in a customs union also have a common foreign trade policy. They have one set of policies for trading with countries outside the union. They have a common tariff that applies to goods being imported into the customs union. The United States, Canada, and Mexico do not have such a common policy and therefore they are not a customs union.
Customs unions and free trade areas are very similar in terms of the internal arrangements with which member nations agree to trade among each other. Within both the free trade area and customs union, there is an agreement to lower or eliminate obstacles to trade such as tariffs, essentially, taxes imposed on imported goods that arbitrarily raises the cost of those goods to the consumer, thereby making those goods less competitive with domestic sources, import quotas and other protectionist tools used to protect domestic industries from foreign competition. The key distinction between customs unions and free trade areas, however, involves their approach to non-treaty nations. While a customs union, by definition, requires all parties to the agreement to establish identical external tariffs with regard to trade with non-treaty nations (those nations that are not signatories to the agreement), members of a free trade area are free to establish whatever tariff rates with respect to foreign imports from non-signatory nations that they deem necessary or desirable. That creates an uneven playing field with respect to foreign nation/non-signatory countries' ability to circumvent individual country tariffs by focusing on exporting to those nations with the lowest external tariffs.
The European Union is the largest and most productive customs union in existence, although internal strife resulting from vast economic disparities among member states has seriously weakened the EU. Members of the EU have agreed to, among other criteria for membership, maintain a common external tariff system with respect to outside nations. The point of the customs union, in contrast to free trade areas, is that they seek to integrate member states more thoroughly than occurs in the case of the latter category. Free trade areas, like the North American Free Trade Agreement (NAFTA), are less cohesive to the extent that each of the three member nations, the United States, Canada and Mexico, are free to establish tariff policies distinct from each other. NAFTA, basically, lacks the political cohesion that bound the EU before the latter organization spread itself too wide.
A customs union is made up of a free trade area and includes the introduction of the same import quotas, custom duties which apply to imports within the region. What this does is it eradicates re-exporting that would otherwise be practiced by member countries. An example of a customs union is the Southern African Customs Union (SACU).
A free trade agreement on the other hand refers to the eradication of import quotas, tariffs and some if not all trade preferences. An example of free trade area is the ASEAN Free Trade Area (AFTA).
The major difference between a customs union and a free trade area is that in a free trade area there is no common external tariff imposed. This means that they may interact differently with non-members with regards to trade. A customs union seeks to establish a standard of how member countries should interact with non members. This brings the issue of diminished customer choice because the products available may just be from the member countries.
In summary according to Krueger:
"A free trade agreement is preferential arrangement in which tariff rates among members are zero, although external tariffs may be at different rates for different members of the arrangement.
Customs union is an arrangement in which there is zero duty between members on imports of goods and services, and common external tariff."
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