Whenever countries set up a Free Trade Area, they abolish all restrictions on trade among themselves and

Correct — A, (a) They establish a common external tariff on imports from outside countries.

The Commission's key completes the stem with the COMMON EXTERNAL TARIFF, and that instrument is what this item is worth learning for. Take it properly.

A common external tariff is a single schedule of duties that every member of a bloc applies to goods arriving from outside it. Adopting one has four large consequences.

THE BLOC BECOMES ONE CUSTOMS TERRITORY TO THE OUTSIDE WORLD. A consignment from a third country pays the same duty whichever member's port it lands at, so from the exporter's point of view the bloc is a single market with a single frontier. NO ROUTING ADVANTAGE, AND SO NO NEED TO POLICE ORIGIN INTERNALLY. Where every member charges the same external duty, there is nothing to gain by landing goods in one member and moving them to another, so goods can circulate freely inside the bloc once they have cleared its frontier. A COMMON COMMERCIAL POLICY BECOMES NECESSARY. No member can alter its duties on outsiders by itself, so trade negotiations with third countries have to be conducted for the bloc as a whole. This is a real transfer of sovereignty over trade policy and it is the main political cost of the arrangement. THE CUSTOMS REVENUE HAS TO BE SHARED. Duty is collected where goods enter, but the goods may be consumed anywhere in the bloc, so a revenue-sharing formula is required. The Southern African Customs Union has one of the oldest and most consequential of these.

Blocs that operate a common external tariff include the European Union, MERCOSUR and the Southern African Customs Union.

It is worth being precise about where the standard taxonomy of economic integration places this instrument, because the vocabulary is examined as well as the mechanism. The usual sequence runs: FREE TRADE AREA, then CUSTOMS UNION, then COMMON MARKET, then ECONOMIC UNION. Each stage adds one thing to the stage before it — the first removes barriers between members, the second adds a common external tariff, the third adds free movement of labour and capital, the fourth adds harmonised economic policy and often a single currency. On that sequence the common external tariff is the feature that identifies a customs union, and the World Trade Organization's own text draws the line in the same place. GATT Article XXIV:8(a)(ii) requires that in a customs union 'substantially the same duties and other regulations of commerce are applied by each of the members of the union to the trade of territories not included in the union'; Article XXIV:8(b) defines a free-trade area purely as a group of customs territories in which duties and other restrictive regulations of commerce 'are eliminated on substantially all the trade between the constituent territories', and says nothing about their duties on outsiders.

So carry both halves out of this item: what a common external tariff does, which is what the keyed option names, and where the four-stage taxonomy and the GATT text put it. A candidate sitting this paper answers to the Commission's key.

The stem ends on the conjunction 'and' with no punctuation, so each option is a full clause completing it, which is why every option repeats its own subject.

Why the others are wrong

• (b)They abolish all restrictions on imports from outside countries — This is wrong on any account of regional integration. Abolishing all restrictions on imports from OUTSIDE countries would be unilateral free trade, and it would destroy the whole point of the arrangement: a regional agreement works by giving members better access to each other's markets than outsiders have, and if outsiders faced no barriers at all there would be no preference left to give. It would also make the agreement pointless under the world trading rules, since GATT Article XXIV exists precisely as an exception permitting members to discriminate in each other's favour against the most-favoured-nation obligation. No free trade area or customs union has ever removed its external barriers altogether.
• (c)They abolish all restrictions on imports from other Free Trade Areas — This misdirects the preference to the wrong recipients. The liberalisation in any regional agreement runs between the members of THAT agreement — the parties who negotiated it and accepted reciprocal obligations. The members of some other bloc are third countries, and they get no benefit unless a separate agreement is made with them. Blocs do sometimes negotiate with each other, and the resulting bloc-to-bloc arrangement is itself a new agreement with its own schedules and its own timetable; it is not an automatic consequence of both sides being free trade areas. The option trades on a vague sense that free-trading groups must be open to one another.
• (d)Each country maintains its own set of tariffs and quotas on imports from outside countries — The Commission's key does not take this option. What the option describes is the arrangement set out in GATT Article XXIV:8(b), which defines a free-trade area solely by the elimination of duties and other restrictive regulations of commerce on substantially all the trade between the members, and imposes no requirement about the duties they apply to outsiders — the requirement of 'substantially the same duties' on non-members appears in Article XXIV:8(a)(ii), which is the definition of a customs union. The mechanism worth learning from this option is what follows when members DO keep separate external tariffs: the arrangement needs RULES OF ORIGIN. If member A charges 5 per cent on an imported good and member B charges 25 per cent, an importer would land the goods in A, pay 5 per cent, and move them duty-free into B — an evasion called TRADE DEFLECTION. To prevent it, agreements of this kind confine duty-free internal treatment to goods ORIGINATING in a member, and then run to long annexes defining what originating means: a change of tariff heading, a minimum percentage of regional value content, or a specified processing operation. Those annexes are often the most heavily negotiated part of such an agreement. The European Free Trade Association and the North American agreement work this way; the European Union and the Southern African Customs Union instead operate a common external tariff.

REGIONAL ECONOMIC INTEGRATION is conventionally set out as a ladder, each rung adding one element to the one below.

FREE TRADE AREA — barriers to trade between members removed. CUSTOMS UNION — the above, plus a common external tariff on non-members. COMMON MARKET — the above, plus free movement of factors of production, that is labour and capital. ECONOMIC UNION — the above, plus harmonised or unified economic policy, and often a single currency. COMPLETE ECONOMIC INTEGRATION — a single economic authority binding on all members.

WHY THE COMMON EXTERNAL TARIFF IS THE PIVOT of the ladder is worth understanding, because it explains the shape of the whole subject. Without one, the members' external duties differ, so goods entering through the lowest-duty member could be moved on to the rest — trade deflection — and the arrangement must therefore restrict its internal preference to goods ORIGINATING in a member, which requires rules of origin, certificates and customs checks at internal frontiers. With a common external tariff, that whole apparatus becomes unnecessary inside the bloc, but the members lose the power to set their own trade policy towards the rest of the world. The trade-off is between administrative simplicity inside and sovereignty outside.

THE WELFARE ECONOMICS, from Jacob Viner's analysis of customs unions, is what descriptive questions ask about. Preferential integration has two opposite effects. TRADE CREATION — a member's high-cost domestic production is displaced by a partner's lower-cost production. Resources move to where they are used better, and this raises welfare. TRADE DIVERSION — imports shift away from an efficient non-member, which still faces the tariff, to a less efficient member, which no longer does. Production moves to where it is used worse, and this lowers welfare. Whether a bloc is beneficial depends on which effect dominates, which is why a preferential agreement is not automatically a step towards free trade.

THE LEGAL FRAME. The most-favoured-nation obligation in GATT Article I requires a member to extend any advantage granted to one member to all. Regional agreements plainly breach it, and Article XXIV is the exception that permits them, subject to conditions — the barriers must be eliminated on substantially all the trade between the parties, and the arrangement must not raise barriers to outsiders above the level obtaining before. India is party to a South Asian Free Trade Area and to a free-trade agreement with the ASEAN countries, among others.

Key facts

• A common external tariff is a single schedule of duties applied by every member of a bloc to goods from outside it; the European Union, MERCOSUR and the Southern African Customs Union operate one.
• A common external tariff makes the bloc one customs territory for outsiders, removes any advantage from routing imports through a low-tariff member, requires a common commercial policy, and requires a formula for sharing customs revenue.
• GATT Article XXIV:8(a)(ii) requires that in a customs union 'substantially the same duties and other regulations of commerce are applied by each of the members of the union to the trade of territories not included in the union'.
• GATT Article XXIV:8(b) defines a free-trade area as a group of customs territories in which duties and other restrictive regulations of commerce are eliminated on substantially all the trade between the constituent territories.
• The conventional ladder of integration: free trade area, customs union, common market, economic union, complete economic integration — each adding one element to the previous stage.
• Where members keep separate external tariffs, rules of origin are needed to prevent trade deflection — importing through the lowest-tariff member and moving the goods on duty-free.
• Jacob Viner's analysis: preferential integration produces trade creation, which raises welfare, and trade diversion, which lowers it; the net effect decides whether a bloc is beneficial.
• Article XXIV is an exception to the most-favoured-nation obligation in GATT Article I, which is what makes discriminatory regional agreements lawful.

Common traps

• Reading the stem's first half as the whole question. The internal liberalisation is given; everything turns on the treatment of non-members.
• Supposing a bloc removes barriers against outsiders as well. That would leave no preference at all and would defeat the purpose of the agreement.
• Supposing that preferences extend automatically to the members of other blocs. They are third countries unless a separate agreement is made.
• Learning the labels of the integration ladder without the mechanism. The reason a common external tariff matters is that it removes the need for rules of origin inside the bloc.

• practice — not a real PYQ

  Rules of origin are necessary in a free-trade agreement principally in order to prevent

  • (a)dumping by member countries
  • (b)trade deflection through the member with the lowest external tariff
  • (c)the imposition of anti-dumping duties by non-members
  • (d)currency manipulation among the members

  Answer(b) trade deflection through the member with the lowest external tariff — where members keep separate external duties, goods could be landed in the cheapest member and moved on duty-free to the rest. Rules of origin confine internal duty-free treatment to goods originating in a member, and are unnecessary where a common external tariff makes every entry point equivalent.

• practice — not a real PYQ

  Trade diversion, in the analysis of preferential trading arrangements, refers to a shift of imports from

  • (a)a high-cost domestic producer to a lower-cost partner country
  • (b)an efficient non-member to a less efficient member country
  • (c)manufactured goods to primary commodities
  • (d)a member country to the world market

  Answer(b) an efficient non-member to a less efficient member country — the non-member still faces the tariff while the member no longer does, so production shifts to a higher-cost source and welfare falls. Option (a) describes trade creation, which raises welfare; whether a bloc is beneficial depends on which effect dominates.