Trade within the EU

Question 1

What is trade diversion

Answer 1

When CETs are present and prevent trade with the rest of the world Causes trade to switch from low cost supplier outside the CU to a high cost supplier within it

Assumes ROW price + tariffs are still more competitive than domestic producers price

Question 2

What is the trade diversion diagram

Answer 2

Assumes EU producers are less efficient than the rest of world producers

Before customs union –> economy imposes tariff on EU and rest of world goods

After customs union –> EU tariff removed but rest of world tariffs still there –> so EU goods most competitive

Domestic economy supplies 0Q3

Domestic consumers import Q3 - Q4 units from the EU

Welfare gains –> increase in CS A+B+C+X

Welfare losses –> reduced PS by A

Loss of tariff revenue on rest of world goods X+Y

Question 3

What is trade creation

Answer 3

Replaces high cost domestic production with imports from a more efficient source (EU)

Assumes ROW price is more competitive than domestic producers price

Assumes ROW price + tariff is less competitive than domestic producers price

Question 4

What is the trade creation diagram

Answer 4

Before customs union –> assume domestic economy imposes tariff on all imported goods

Pushes up price of EU good and rest of world goods Prices out foreign suppliers

Domestic firms supply Q1

After joining CU –> domestic economy abolish tariffs with the CU Domestic consumers buy good at Peu

Domestic demand increases due to lower EU price Q2-Q3 units imported from CU

Welfare gains –> increase CS A+B+C

Welfare losses –> loss of PS at A

Net welfare gain –> B + C