All countries in the modern world do not follow a uniform discriminatory trade policy. Several forms of economic integration have come into existence such as removal of trade barriers (especially tariffs) among certain countries and discrimination against others. The most important forms of such international economic integration are: (i) free trade areas, (ii) customs union, and (iii) common markets.
A free trade area refers to the group of countries which have abolished all tariff barriers amongst themselves but each individual country is free to maintain any level of tariff against other countries.
A customs union is an agreement between members of a group of nations to abolish all custom duties (tariffs) levied in trade amongst them, at the same time, establishing common tariffs against imports from the non-member countries.
It is, thus, also referred to as the External Tariff. A notable difference between a customs union and a free-trade area is that, in the former there is a common structure of custom duties adopted by all the member countries while trading with non-member countries. In the latter case, however, the members follow different discriminatory individual tariff schedules against non-member countries.
Further, a customs union may be either limited or it may be complete. A limited customs union may involve only one commodity or a few commodities at the most, while a complete union consists of the abolition of all restrictions on the movement goods and factors of production as well as the adoption of commonly integrated fiscal and monetary policies. Such a complete union is known as an economic union.
The formation of a common market, however, implies a highest degree of interdependence amongst the member countries. Under the common market, economic integration permits not only the free movement of goods among member countries, but all the factors of production too can move freely.
Economists have, however, focused their attention on the institution of customs union, the analysis of which is supposed to be easily extendable to the cases of free trade areas and common markets. Following the tradition, we too will take up here only the customs union in its general form so as to equip ourselves with an analytical framework which can be used in dealing with any specific case.