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Country A is a small country considering joining a free trade area for trade in good...

Country A is a small country considering joining a free trade area for trade in good X. The cost of importing a unit of good X from countries that would not be members of the potential group is $10 per unit. The cost of importing a unit of good X from countries that would be members of the potential group is $20 per unit. Currently, country A applies a $5 per unit tariff on imports of good X from all sources. If the free trade group forms, will there be any trade creation? Any trade diversion? Why? Illustrate and explain your answer with the aid of a diagram

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Answer #1

Yes, there is a trade diversion. Trade diversion is where trade with a low cost country outside a trade bloc is influenced by a higher cost products supplied from within.

Low cost imports are replaced with high cost imports due to trade bloc.

As shown in the figure below, earlier with tariff, price was $10 to import good X. The imports were Q4-Q1, now trade bloc is formed and hence prices of imports gone up to $20, the imports will decrease to Q3-Q2. Domestic producers will now get higher prices and they will supply more.

Govt. loses its revenue while domestic producers gain and domestic consumers lose.

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