TRADE CREATION

The Trade creation effect refers to the increased output by members of a trade block as a result of
the adoption of free trade between them.

It occurs when some domestic production in a nation that is a member of the customs union is
replaced by lower-cost imports from another member nation assuming that all economic
resources are fully employed before and after formation of the customs union.

A trade-creating customs union can increase the national welfare in the aspects of production
welfare and consumption welfare from the comparative advantages. Specialization and
economies of scale increase the productive efficiency of member countries. Trade will result into
higher world welfare gain as well as an increase in consumer surplus as it increases the welfare
of non-members of the union because some of the increase in its real income spills over into
increased imports from the rest of world.

For example: before the formation of the Customs Union and under its own tariff umbrella,
Luxembourg were importing from the United States at a price of $3.50 per shell. Luxembourg`s
entry into the customs union results in it dropping all the tariffs against Germany. Facing a lower
import price of $3.25, Luxembourg increases its consumption of grain by three shells, therefore
welfare gained.

Illustration of a Trade-Creating Customs Union

Price ($)

Grains (Bushels)
Explanation of the above Illustration

 The sum of triangles “a” and “b” is the overall trade creation effect.
 The welfare associated with the increase in consumption is equal to triangle “b”
 For production (output) is triangle “a”
 With Tariff, the nation’s production surplus increases while the consumer surplus
decreases, the deadweight loss is the total of protection effect and consumption effect.
And it reduces the national welfare.
 The formation of a customs union, no tariff, it can increase the national welfare, it is the
total of protection effect and consumption effect.

TRADE DIVERSION

Generally implies a welfare loss. It occurs when lower-cost imports from outside the customs
union are replaced by higher cost imports from a union member. Trade diversion reduces welfare
because it shifts production from more efficient producers outside the customs union to less
efficient producers inside the union.

Trade diversion worsens the international allocation of resources and shifts production away
from comparative advantage. In the end, a trade-diverting customs union results in both trade
creation and trade diversion. Whether a trade-diverting customs union can increase or reduce the
welfare of union members, depending on the relative strength of these two opposing forces.
While the non-members can be expected to decline because their economic resources can only be
utilized less efficiently than before trade was diverted away from them.

Illustration of the Trade Diverting Customs Union

Grains (Bushels)
Explanations of the above Illustration

Although the total volume of trade under the customs union, part of this trade (10 bushels) has
been diverted from a lower-cost supplier (United States) to a higher cost supplier (Germany)

- The increase in the cost of obtaining these 10 bushels of imported grains equals area C
from the illustration, and this is the welfare loss to Luxembourg as well as to the world as
a whole.
- If (a+b) i.e. trade creation, is greater than area C (trade diversion) the customs union will
increase the welfare of its members as well as the rest of the world. That is to say if the
positive trade creation effect more than offsets the negative trade diversion effect.

The success of customs union depends on the factors contributing to trade creation and diversion.
Several factors that bear on the relative size of these effects can be identified;

 Kinds of nations that tend to benefit from a custom union. Nations whose pre-union
economies are quite competitive are likely to benefit from trade creation because the
formation of formation of union offers greater opportunity for specialization in
production.
 The larger the size and the greater the number of nations in the union, the greater the
gains are likely to be because there is a greater possibility that the world`s low cost
producers will be union members.
 In extreme case in which the can exist only trade creation, no trade diversion.
 In addition, the scope for trade diversion is smaller when the customs union`s common
external tariff is lower rather than higher. Because a lower tariff allows greater trade to
take place with non-member nations, there will be less replacement of cheaper imports
from non-member nations by relatively high-cost imports from member within the
union.

Therefore A trade-creating customs union leads only to trade creation and un-equivocally
increases the welfare of members and non-members. Also it leads to trade creation and trade
diversion, can increase or reduce the welfare of members and will reduce the welfare of the rest
of the world.
REFERENCES

Robert J. Carbaugh, “Global Economics” 13th Edition

Lipsey & Crystal (2004), “Economics” 10th Edition, Oxford University Press

Judith Piggott & Mark Cook (1993), International Business Economics (A European
Perspective), Longman Group UK Ltd.

Li Yumei, International Economics {Power Point Slides}, Economics & Management School of
Southwest University