Customs Unions and Free Trade Areas

Abstract

This technical note lays out the welfare analysis of free trade areas and customs unions with trade creation and trade diversion. It also discusses some of their advantages and disadvantages.

Excerpt

UVA-G-0624

Rev. April 26, 2010

CUstoms Unions and free Trade Areas

The North American Free Trade Agreement (NAFTA) may well be the best-known free trade agreement (FTA), and the European Union is probably the best-known customs union (CU); however, there exist many more FTAs and CUs. As a matter of fact, there has been a steady increase in preferential trade agreements such as FTAs and CUs in recent years. In 2009, there were more than 200 preferential trade agreements for the 153 members of the World Trade Organization (WTO). In itself, this is an amazing statistic. It raises the question of why the number of preferential agreements has mushroomed and whether these preferential tariff regimes are beneficial in the end. In this note, we first describe some features of CUs and FTAs, before we turn to a welfare analysis that offers some surprising results: CUs and FTAs may actually make a country worse off in some cases.

Customs Unions and Free Trade Areas

CUs and FTAs are, themselves, a bit of an anomaly because they violate a basic principle of the WTO. Indeed, at the heart of the WTO's charter is a clause of nondiscrimination. A member of the WTO agrees to treat all other countries as well as it treats its most favored nation (MFN), which is why tariffs are referred to as MFN tariffs. CUs and FTAs are a clear legal exception to the MFN principle because they bestow preferential treatment to a limited group of countries in trade-related matters. A set of countries decides to entirely remove the internal tariffs on trade among themselves, even as they maintain nonzero tariffs with the rest of the world.

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Keywords: trade liberalization, FTA, FTAs, CUs, CU, protectionism, welfare analysis