Show trade creation and trade diversion on a diagram and say when joining a customs union raises welfare
6 min
4 questions
Key terms
Trade creation
Trade creation is the new trade that follows when joining a trading bloc lets cheaper imports from a partner replace dearer home production and lets buyers buy more.
Trade diversion
Trade diversion is when joining a trading bloc switches imports from a cheaper producer outside the bloc to a dearer producer inside it.
Joining lowers the price from Pt to Pp, and home firms make less
1 of 3
Before joiningImports from the cheapest producer cost Pw plus the tariff, Pt. Home firms supply Q2 and buyers want Q3.
Joining the customs union moves the price down from Pt to Pp, and home firms cut output from Q2 to Q1.
Before joining, every import pays the tariff. The cheapest producer, outside the bloc, sells at the world price Pw, so its goods cost Pt, which is Pw plus the tariff. The future partner's price Pp plus the tariff is higher than Pt, so all imports come from outside.
Once the country joins, the partner's goods enter tariff-free at Pp. Pp is below Pt, so buyers switch to the partner, while goods from outside still pay the tariff and still cost Pt. The domestic price falls to Pp.
Home firms move down their supply curve from Q2 to Q1. The units between Q1 and Q2 cost home firms more than Pp to make; they are now imported from the partner for less. That saving, area A, is trade creation.