CUSTOMS UNION

a trade agreement by which a group of countries charges a common set of tariffs to the rest of the world while allowing free trade among themselves. It is a partial form of economic integration, intermediate between free trade zones, which allow mutual free trade but lack a common tariff system, and common markets, which, in addition to the common tariffs, also allow free movement of resources such as capital and labour between members. It has long been recognized that tariff barriers generally reduce the quantity of trade between nations. Under most circumstances this reduction in trade protects certain domestic producers, but it also translates into higher costs for consumers on both sides. Many governments seem to recognize this problem by trying to strike a balance between protecting politically favoured producers and reducing consumer costs. Customs unions, along with other forms of partial economic integration, are one way to try to achieve that balance. In free trade zones several countries agree to drop tariff barriers to each other's goods in the hope that each will capture at least as much of the gains from trading as they face in losses for some domestic producers. A serious flaw in the free trade zone approach is the absence of common external tariffs. Since the countries may differ in the tariff barriers presented to the outside world, importers will ship through low-tariff countries, even if the cost is higher for fuel, labour, etc. Such roundabout shipping methods are unnecessarily wasteful. The solution is to agree on a common set of tariffs so that shippers can concentrate on transportation costs instead of evading tariffs. A free trade zone and common tariffs is a customs union. While the common external tariffs levied by a customs union avoid the problem of wasteful shipping patterns, they do not solve the problem of wasteful production, a problem sometimes referred to as trade diversion. For example, a country presents a given tariff to all other countries for a given good; if trade occurs at all, it will ideally be in goods produced by the lowest-cost foreign producer. The quantity of trade will not be as high as it would be if there were no tariff at all, and too much of the good may be produced domestically at a higher cost, but at least the incremental goods bought from the foreign producer will have been efficiently produced. However, by selectively lowering tariffs to partners in a free trade zone or customs union, the home country may allow a partner's producers to sell the good at a lower price, even if they have higher production costs than the outsider. The net effect is to reduce trade with the efficient, low-cost producer. The increased volume of trade from a customs union is sometimes referred to as trade creation. Other forms of economic integration include common markets, economic unions, and federations. Common markets allow free passage of labour, capital, and other productive resources in addition to making provisions for no internal tariffs on goods and a common set of external tariffs. Economic unions closely coordinate national economic policies of members. Federations such as the United States or the Swiss Federation coordinate policy generally through the agency of the federal government. Well-known customs unions include the Zollverein (q.v.), a 19th century organization formed by several German states under Prussian leadership, and the European Economic Community, which passed through a customs union stage on the path to fuller economic integration.