The Major Differences Between A Free Trade Area And A Customs Union Course Work Example

Introduction

A free trade area has been used to describe the regional market that eliminates most, if not all, trade barriers between the trading partners such as quotas, barriers, and preferences on the flow of the services and goods traded between the member countries (Plante, 2004). Nevertheless, in the free trade areas, members negotiate trade agreements separately with the countries that are not members of the free trade area. A customs union on the other hand, refers to the trade agreement where a group of countries charges a common set of tariffs and quotas to external countries. This refers to a higher level of economic integration as compared to the free trade area, but less than the common market structures. The latter also allows for the free movement of resources between the member countries.

This paper identifies the major differences between a customs union and a free trade area considering the European Union as a customs union and the 1994 North American Free Trade Agreement between the United States, Canada and Mexico, also referred to as NAFTA as a free trade area.

Free Trade Areas

A free trade area has been associated with the countries that seek to embark on economic integration, especially for the countries that are unable or unwilling to engage in higher levels of economic integrations such as customs union, economic unions, common markets or political and economic unions. A free trade area can be limited to some sectors in the economic integration, thereby retaining a higher level of control at the national level as well as preventing exposure to competition from the other sectors (Damanpour, 2000, p. 56). However, this economic integration ensures that every country practices and independent trade policy, especially in the treatment of third countries. Nevertheless, the members of the free trade area have to agree upon the rules of origin in order to determine the specific products that can be transferred within the integration duty free. For instance, in the 1994 North American Free Trade Agreement between the United States, Canada and Mexico, a product must be significantly transformed in order to ensure that a change in the classification of tariffs occurs (Kujawa, Kim, & Kim, 1993). Alternatively, the product must have at least 50 percent or 62.5 percent for cars member country content in order to qualify for the duty free transfer within the free trade area.

However, complex and extensive provisions apply in determining the documentation and how such content is arrived at especially across the borders of these member countries. The tariffs imposed on a product could be circumvented if there were no such rules of origin within the free trade area, thereby landing the products in the lower duty jurisdiction and later transferred duty free to the higher tariff member country. Consequently, the free trade area border controls are important for the trade among the member countries. Additionally, the arguments over the interpretation of the rules of origin can result into delays and disputes among these member countries. These restrictive effects of the rules of origin in the free trade areas have led to some economic observations. For instance, it has been reported that some Canadian producers have at times resorted to paying the relevant duties instead of incurring the costs of proving origin (Kujawa, Kim, & Kim, 1993).

Customs Union

Two or more countries might decide to agree to remove all the essential restrictions on mutual trade between them, and set up a common system of import quotas and tariffs concerning non-member countries. The adoption of joint quotas and common external tariffs ensures that a closer cooperation occurs among the member countries with regard to the non-member imports sharing of customs revenues collected. In this case, the rules of origin are unnecessary (Sherov-Ignatyev, 2012, p. 175). Consequently, the existence of a common external tariff ensures that the imports into the customs union area face similar tariffs in every member country of the customs union. Therefore, the transshipment incentives for imports between member countries do not exist. The common external tariffs effectively create destination neutrality for the imports into the customs union.

Generally, both the customs union and free trade agreements entail that, the member countries in these economic integrations remain as nation states (Abrego, Riezman, & Whalley, 2005, p. 118). Nevertheless, while considering the historical contexts of these agreements and integrations, some slight differences appear between these agreements. For instance, the European Community for Coal and Steel and the German Zollverein are some of the successful examples of the customs unions. The German Zollverein preceded the formation of Germany in 1870. The former, however, a sectoral customs union created in 1951, was not expected to be a antecedent of the resultant European political union (The EU).

Both the customs union and the free trade area have a distinguishing characteristic with significant implications to the economic integration. The characteristic features of the free trade area include the different and independent external tariffs in every member country and the existence of the rules of origin. On the other hand, the customs union has a distinctive feature of the existence of common external tariffs applied on third countries. Nevertheless, both economic integrations ensure that all or most of the trade barriers between the member countries are eliminated.

These significant differences between the economic integration methods have economic and political effects. The rules of origin create incentives for the producers to buy higher cost inputs from the member countries in order to accomplish the origin requirements, thereby resulting in trade diversion. It also lend the member states to lobbying by interest groups, which seek protection favors from foreign competitors through the demand for severe rules of origin favoring the component suppliers from member states over the competing firms from the third countries. It also distorts production since different price inputs in different member countries resulting from different tariff schedules. Economists also consider the rules of origin to apply bureaucratic surveillance and additional costs for the member countries.

The common external tariffs used in the customs union also have economic effects. The negotiations carried out at the government to government levels eliminate the participations of the individuals lobbies (Facchini, Silva, & Willmann, 2012). Additionally, since the common external tariff cannot be renegotiated, common trade and commercial policies would limit the efforts to increase non-tariff barriers. The common external tariff has an advantage over the rules f origin since it is relatively easy to implement and has simply administrative measures. Moreover, the input costs in the customs union would remain the same among the member states resulting from the tariffs, thereby promoting competition and efficiency.

The free trade area agreements are viewed to possess limited sovereignty compromise among the member states both in political and economic fronts. It is therefore valid to conclude that the customs union comes with more economic benefits and political advantages over the free trade areas. Some of these benefits of the former include more competition and positive scale effects, reduced role for individual lobbyists seeking external protection, increased negotiation and market power against the outsiders, simplified access for new members and trans-border trade arrangements between the member states. The political advantages of the common external tariffs in the customs union include core complex negotiations and deeper integration, which increases the harmonization pressure. Therefore, considering the two forms of economic integration, the customs union has more advantages to the member countries than the free trade agreements.

References:

Plante, D.J. 2004, Sustainable development and the North American Free Trade Agreement: A Polanyian interpretation, The University of Utah.
Kujawa, D., Kim, S.H. & Kim, H. 1993, “A North American Free-Trade Agreement: The first step toward one America”, Multinational Business Review, vol. 1, no. 2, pp. 12.
Damanpour, F. 2000, “North American free trade agreement with a focus on the U.S. states participation and Mexico”, Managerial Finance, vol. 26, no. 1, pp. 53-71.
Sherov-Ignatyev, V. 2012, “Customs Unions of Commodity-Exporting Countries: An Answer To Some Challenges Of Globalization?”, Institute for Business & Finance Research, Hilo, pp. 175.
The EU is not a free trade area but a customs union: until we understand the difference, the debate about our membership is meaningless 2012, London.
Facchini, G., Silva, P. & Willmann, G. 2012, The Customs Unions Issue: Why do We Observe so Few of Them?, Social Science Research Network, Rochester.
Abrego, L., Riezman, R. & Whalley, J. 2005, “Computation and the Theory of Customs Unions”, CESifo Economic Studies, vol. 51, no. 1, pp. 117-132.
Mitchell, K.E. 2006, Europeanizing unions: Trade union adaptation to European integration, Princeton University.

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