The difference between a free trade area and a customs union is, in brief, that the first is politically straightforward but an administrative headache, while the second is just the opposite.
Consider first the case of a customs union. Once such a union is established, tariff administration is relatively easy: Goods must pay tariffs when they cross the border of the union, but from then on can be shipped freely between countries. A cargo that is unloaded at Marseilles or Rotterdam must pay duties there, but will not face any additional charges if it then goes by truck to Munich.
To make this simple system work, however, the countries must agree on tariff rates: The duty must be the same whether the cargo is unloaded at Marseilles, Rotterdam, or for that matter Hamburg because otherwise, importers would choose the point of entry that minimized their fees. So a customs union requires that Germany, France, the Netherlands, and all the other countries agree to charge the same tariffs. This is not easily done: Countries are, in effect, ceding part of their sovereignty to a supranational entity, the European Union.
This has been possible in Europe for a variety of reasons, including the belief that economic unity would help cement the post-war political alliance between European democracies.
But elsewhere these conditions are lacking. The three nations that formed NAFTA would find it very difficult to cede control over tariffs to any supranational body; if nothing else, it would be hard to devise an arrangement that would give due weight to U.S. interests without effectively allowing the United States to dictate trade policy to Canada and Mexico. NAFTA, therefore, while it permits Mexican goods to enter the United States without tariffs and vice versa, does not require that Mexico and the United States adopt a common external tariff on goods they import from other countries.
This, however, raises a different problem. Under NAFTA, a shirt made by Mexican workers can be brought into the United States freely. But suppose that the United States wants to maintain high tariffs on shirts imported from other countries, while Mexico does not impose similar tariffs. What is to prevent someone from shipping a shirt from, say, Bangladesh to Mexico, then putting it on a truck bound for Chicago?
The answer is that even though the United States and Mexico may have free trade, goods shipped from Mexico to the United States must still pass through a customs inspection. And they can enter the United States without duty only if they have documents providing that they are in fact Mexican goods, not trans-shipped imports from third countries.
But what is a Mexican shirt? If a shirt comes from Bangladesh, but Mexicans sew on the buttons, does that make it Mexican? Probably not. But if everything except the button were made in Mexico, it probably should be considered Mexican. The point is that administering a free trade area that is not a customs union requires not only that the countries continue to check goods at the border, but that they specify an elaborate set of “rules of origin” that determine whether a good is eligible to cross the border without paying a tariff.
As a result, free trade agreements like NAFTA impose a large burden of paperwork, which may be a significant obstacle to trade even when such trade is in principle free.
Question:
1. From this case, what is the main difference between a free-trade area and a customs union?
2. Why are rules of origin needed for a free-trade area? How might they be protectionist?
