Countries sometimes band together to form a free trade area or a customs union to promote trade. This often occurs with countries that have common borders. The two types of trade associations are alike in many respects, but have a different approach to how external trade partners are treated.
Internal and External Trade
Both free trade areas and customs unions eliminate most internal trade barriers, such as tariffs and quotas, on goods produced by its members. The basic difference between FTAs and customs unions involves the handling of trade with outside nations or trade groups. Each FTA member sets its own external trade policy. A customs union, on the other hand, imposes uniform tariffs and quotas on external trade for all of its members.
Major FTAs and Customs Unions
NAFTA -- consisting of Canada, the United States, and Mexico -- is a prominent FTA. Goods produced in the United States, for example, may be imported duty-free by Canada and Mexico. However each of the three member countries sets its own trade policy for goods produced by other external countries and customs unions.
The most important customs union is the European Union, made up of 28 countries. Membership in the European Union allows goods produced by Great Britain, for instance, to be imported duty-free by France -- and by all other members of the EU. Goods produced by outside nations or customs unions are subject to the same tariffs and quotas when imported by Britain, France, or any of the other 26 members of the EU.
Complicated but Free
Members of FTAs are free to establish trade pacts with trading partners outside of the FTA. This allows a member to tailor external trade policies to protect certain industries or products, or to take advantage of some characteristic of its economy. However, different external tariff rates among FTA members complicates internal trade of goods produced wholly or partly outside the association.
NAFTA deals with this situation by stipulating rules of origin that determine how these goods are treated within the group.
Simple but Restrictive
The common external trade policy of a customs union paves the way for products imported from outside the union to move more freely between member countries. A widget imported from the United States into Germany pays the EU's Common External Tariff, and then can be shipped to Italy or any of the other 26 EU members tariff-free.
Sometimes, however, a member nation may find the common external trade policy restrictive. It may be forced to charge higher tariffs than it otherwise would.
A customs union member would not be able to negotiate trade deals to take advantage of strong connections with nations outside the union. Great Britain, for example cannot negotiate special terms with Canada or other nations with which it has long-standing trading ties.