Question

Use appropriate theory and 3 diagrams to compare trade creation/trade diversion effects in three cases for an industry in a small open economy – a member of a trade bloc:

1. The industry in the rest of the wold is more efficient than within the block;
2. The industry in the rest of the wold is less efficient than within the block; and
3. The industry in a small open economy is more efficient than in both the rest of the bloc and the rest of the wold.

Answer 1

In this solution, we try to compare trade diversion and trade creation in three cases for an industry in a small open economy. The comparison uses a partial equilibrium framework in which we consider the effects of trade liberalization with respect to a representative industry. Afterwards we explain the results from the representative industry cases.

There are three countries in the world in an open small economy. Three countries are A, B and C. All the three have demand and supply for similar goods in the representative industry.

Countries A and B will exist in a free trade area. We will assume that country A is a small country in an international markets which means that it takes international prices as given. Countries B and C are assumed to be large countries. Thus country A can export or import as much of a product as desired with countries B and C at whatever price prevails in those markets.

Note: Trade diversion and creation can occur regardless of whether a preferential trade agreement, a free trade area or a customs union is formed. For convenience we'll refer to the arrangement as a free trade area (FTA)

Trade Diversion:

It means free trade area diverts trade, away from amore efficient supplier outside the FTA, towards a less efficient supplier within the FTA.It can be understood through the following diagram-

CountryA P- D' D2

The above diagram shows the case that trade diversion is harmful if a country joins a FTA. It shows the supply and demand curves for country A. P^B and P^C represent the free trade supply prices of the good from country B and C, respectively. Note that country C is assumed capable of supplying the product at a lower price than country B.

Free Trade Area Effects on:

County A S2 si D1 D

If conditions were different, however, the national welfare change could be positive. Consider the diagram. This diagram differs from the one above only in that the free trade supply price offered by country B, P^B, is lower and closer to country C's free trade supply price P^C. The description above concerning the pre- and post-FTA equilibria remains the same and trade diversion still occurs. Thus, trade diversion may be, but is not necessarily, welfare-reducing.

Trade Creation:

Country A

The above diagram displays a case of trade creation. The graph shows the supply and demand curves for country A. P^B and P^C represent the free trade supply prices of the good from country's B and C respectively. Note that country C is assumed capable of supplying the product at a lower price than country B.

In a nutshell, a trade diversion occurs when a FTA shifts imports from a more efficient supplier to a less efficient supplier which causes a reduction in national welfare. Although the economy also benefits through the elimination of the domestic distortions, if these benefits are smaller than the supplier efficiency loss, then national welfare falls. In general, the only way to assure that trade liberalization will lead to efficiency improvements is if a country removes its trade barriers against all countries.