Introduction

• A customs union is a free trade area in which all members shares the same tariffs and quotas when importing from non members.
• this is called a 'common external tariff'.
• Having the same external tariff simplifies the free trade area as there is no need to prove the origin of a product.
• Any tariffs collected at the point goods enter the customs union are shared amongst all members.
  • The country that imports the goods may recieve a larger share as it may incur adminitrative costs when collecting the tariff.

Trade Creation and Diversion

• As tariffs drop between members, the flow of trade will change.
  • More trade will happen between members inside the customs union, while trade with producers on the outside will drop.
• However the total overall trade will increase.
  • This is because the reduction in tariffs will create a drop in prices, leading to higher demand.
  • The increase in total trade is called 'trade creation'.
• Producers outside the customs union will lose out on trade to producers on the inside.
  • Even if the new producer is less efficient at producing the goods, they can take advantage of the reduced tariffs to gain a competitive advantage.
  • This is called 'trade diversion'.

Advantages

• Total trade will increase through trade creation.
• Unlike an FTA, there is no need to prove the origin of a product due to each member sharing the same external tariff.
• The customs union can negotiate trade deals as a whole. This increased buying power can be used as leverage to get a better deal.

Disadvantages

• Members of a customs union are not free to seek independent trade deals.
• They also cannot impose their own tariffs on imports.
  • This makes it difficult to protect a declining industry.
• Members must impose all tariffs outlined by the customs union.
  • For example, the customs union may put a 10% tariff on pineapples.
  • Every member must impose this tariff.
  • For members that do not produce their own pineapples, there is no domestic industry to protect.
  • The only effect of this tariff will be to raise prices for consumers.
• There can also be issues with sharing tariffs fairly.
  • The country that collected the tariff might not get its fair share of the revenue.
• Finally, the reduction in tariffs in trade across the customs union will lead to a loss in revenue, and other taxes may have to rise to compensate.