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
Reducing tariffs on consumer surplus
However, that is not the full story, reducing tariffs has two drawbacks on domestic producers and government tariff revenue.
However, the diagram shows there is a net gain from removing tariff barriers.
- Domestic producers will sell less as consumers buy cheaper imports (decline in producer surplus is shown by area 1)
- Government lose tax revenue (from import tariffs) (shown by area 3)
Net welfare gain
The net welfare gain is equal to area 2+4 (increase in consumer surplus – tariff revenue and producer surplus)
The impact of trade creation will depend upon:
- The elasticity of demand and supply. If demand and supply are inelastic, the net gain will be much lower.
Trade creation from exports
However, there are more potential benefits of reducing tariffs.
If you cut import tariffs, other countries are likely to reciprocate and reduce tariffs on your exports. Therefore, there will also be an extra benefit from increased exports.
The important thing of this analysis is that 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)
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 as the unemployed workers struggle to find jobs in new export industries.