(A) Define "Trade Creation" in the Context of the Formation

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The Answer is (a) Trade creation refers to the situation where the formation of a customs union leads to an increase in overall trade and production of goods within the member countries, resulting in a more efficient allocation of resources and higher overall welfare. This occurs when the customs union allows for the elimination of tariffs and other trade barriers between member countries, leading to the production of goods in the most efficient locations and the consumption of goods at lower prices.

In the context of a small home country, the formation of a pure trade-creating customs union can enhance the country's well-being by allowing for the importation of goods at lower prices, leading to an increase in consumer surplus. This can be illustrated using a demand/supply diagram, where the removal of tariffs shifts the supply curve to the right, leading to a decrease in the price of the imported good and an increase in consumer surplus. Additionally, the increase in trade and production within the customs union can lead to economies of scale and increased efficiency, further enhancing the country's well-being.

Factors that would be conducive to a greater gain from trade creation include a larger reduction in tariffs, a greater similarity in production capabilities and consumer preferences among member countries, and the presence of complementarity in production processes among member countries.

(b) Trade diversion refers to the situation where the formation of a customs union leads to a shift in trade from more efficient non-member countries to less efficient member countries, resulting in a decrease in overall welfare. This occurs when the customs union imposes tariffs and other trade barriers on imports from non-member countries, leading to the production and consumption of goods in less efficient locations and at higher prices.

In the context of a small home country, the movement from a situation of a uniform tariff on imports to a trade-diverting customs union with one particular country can affect consumer and producer surplus and government revenue. This can be illustrated using a demand/supply diagram, where the imposition of tariffs on imports from non-member countries shifts the supply curve to the left, leading to an increase in the price of the imported good and a decrease in consumer surplus. Additionally, the trade diversion can lead to a decrease in government revenue from tariffs on imports from non-member countries.

We cannot be sure that welfare in the home country will rise under a trade-diverting customs union because the increase in consumer and producer surplus from trade diversion may be offset by the decrease in consumer and producer surplus from the less efficient production and consumption of goods within the customs union. Under general conditions, it would be likely that a trade-diverting customs union would injure welfare in the home country if the member country has a comparative disadvantage in the production of the good in question, and if the non-member countries have a comparative advantage in the production of the good. Additionally, if the trade diversion leads to a decrease in overall trade and production, it can lead to a decrease in overall welfare.

(A) Define "Trade Creation" in the Context of the Formation

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