Definition of trade creation
Trade creation refers to the increase in economic welfare from joining a free trade area, such as a customs union.
Trade creation will occur when there is a reduction in tariff barriers, leading to lower prices. This switch to lower cost producers will lead to an increase in consumer surplus and economic welfare.
Diagram of trade creation
Removing tariffs, reduces the price of imports from P1 to P2. Quantity bought rises from Q3 to Q4.
Therefore there is an increase in consumer surplus, equal to area 1+2+3+4
In the above diagram, trade creation does have two drawbacks:
- Domestic producers will sell less as consumer buy cheaper imports (decline in producer surplus is shown by area 1)
- Government lose tax revenue (from import tariffs) (shown by area 3)
However, the diagram shows there is a net gain from removing tariff barriers. This area is equal to area 2+4
Note this is just in goods where import tariffs are removed.
The impact of trade creation will depend upon:
- Elasticity of demand and supply. If demand and supply are inelastic, the net gain will be much lower.
Problems of trade creation
Often domestic job losses are more visible, than the gains from cheaper prices. If domestic producers lose out significantly, this may have a higher political impact than slightly lower prices for the majority of the population. It could lead to structural unemployment.
Trade creation from exports
If other countries drop tariffs on your exports, there will be extra benefit from increased exports.
However, this analysis suggests a country can have an increase in economic welfare by cutting import duties – even if they are not reciprocated. (though countries may still hold out for bilateral trade agreements)