A customs union is a type of intergovernmental agreement involving a particular region composed of a free trade area. Within the region, the countries involved eliminate or reduce the tariff and non-tariff barriers. The involved countries establish a common external trade policy. The main purpose of establishing a custom union is to enjoy better.
According to Adam Smith in his book Wealth of Nations, a country has absolute advantage in producing a good over another country if it can employ few resources to produce that good than the other country. The theory is based on assumptions that labor as the only factor of production, countries are able to trade freely without trade barriers, the factors of production are immobile among different countries, imports are taken care of by the equivalent exports and that production reveals steady returns to scale.
For Example, if by employing equal quantity of labor, Canada can produce 20 tonnes of wheat or 5 tonnes of rice while in China, the same quantity of labor can produce 10 tonnes of wheat or 8 tonnes of rice, it means therefore that Canada has an absolute advantage in the production of wheat while China has an absolute advantage in producing rice. From the above example it therefore means that Canada can get more rice with specialization of its labor in the production of wheat and trading it with Chinese rice. Similarly, China has absolute advantage in production of rice, and can get more wheat by specialization of its labor in the production of rice and trading it with Canadian wheat.
Trading allows a country to specialize in whatever it can produce best by employing few resources thus making them more productive. The theory is therefore based on the assumption that a country is absolutely more efficient in production of a good than other countries and hence it should only produce that good and obtain the rest from other countries which can produce them better. The comparative advantage theory was formulated in 1817 by David Ricardo. According to this theory, despite a country being able to produce various products at minimal cost, countries benefit from as a result of trading with each other due to existence of comparative costs.
The theory argues that a country would gain from trade by importing goods that it has less comparative advantage and export those that it has high comparative advantage. The theory is based on the assumption that there is no transport costs, it only considers two economies producing only two goods, the costs of producing these goods is constant and hence there is no economy of scale, the traded goods are identical, there is perfect mobility of factors of production, there is free trade and hence no trade barriers and both buyers and sellers have perfect knowledge on the availability of cheap goods internationally.
