The entire analysis of customs unions applies to common markets too. Due to the free mobility of factors of production in a common market, the effects of a customs union are, however, substantially enriched. The effects on a more efficient allocation of resources (improvements in the locational advantages for business) are due to the free factor flow from low to high productivity businesses within the common market.
Apart from factor mobility, a condition for the integration of factor markets is the non-discrimination of factors originating in the partner countries. In this situation, factors respond to signals which include demand, higher productivity and returns within a common market. Integration of factor markets will be encountered as mobility of labour and mobility of capital in separate sections which follow.
A customs union involves product market integration. A common market adds to that development integration of factor markets. It is expected that the free flow of factors within the bloc will improve the allocation of resources over the one achieved in either a free trade area or a customs union. The neo-classical Hecksher-Ohlin trade theory concludes that a country with a rich supply of labour may either export labour-intensive goods or import capital and export labour, under the assumption that technology is the same in all countries. In either case the country is equally well off.
Let us assume a model which consists of two countries A and B, two final goods X and Y and two factors of production K and L, respectively. Suppose further that factor mobility is perfect within each country, but prohibited between countries. If there are no barriers to trade; and no distortions; and if technology is the same and freely accessible to both countries; and if production functions are homogeneous of the first degree; and if both goods are produced in both countries; and isoquants intersect only once (there is no factor intensity reversal), then free trade in goods will equalize relative prices in goods. This will equalize both relative factor prices and their returns between countries A and B, respectively. This stringent situation is illustrated in Figure 3.1.