Question

Assume three countries produce commodity X. Country A produces X at a cost of $10; country B produces commodity X at a cost of $8; and country C produces commodity X at a cost of $6.

a). Explain whether trade creation or trade diversion takes place when country A, which initially imposes a nondiscriminatory ad valorem import tariff of 100% on commodity X, forms a customs with country B.

b). Explain whether trade creation or trade diversion takes place when country A, which initially imposes a nondiscriminatory ad valorem import tariff of 50% on commodity X, forms a customs union with country B.

Answer 1

Answer :

a ) Trade creation.

Explanation  

When country A forms customs union with country B , then there will be no tariff on import from country B. So country A will import commodity X from country B because the price of commodity X ( $ 8 ) is cheaper in country B as compared to country A ( $ 10). The country A will not import the commodity X from country C , because the price of commodity X will be $ 12 inclusive of tariff.

b ) Trade diversion

Explanation

Trade diversion takes place when imports from a more efficiently producing country C are switched to a less efficiently producing country B because of the custom union which is made in between country A & country B. It replaces lower price import of commodity X at $ 6 from country C to a higher price import of commodity at $ 8 from country B.