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Trade Creation and Trade Diversion

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Mostly in the international trades, trade diversion arises as a result of one business being able to offer importation into a particular country at a lower production cost than the other business competitors. The diagram shows that before the UK joined EC, the importation price from New Zealand was P1 and UK consumed Q1 to produce Q2. That is as per New Zealand's tariffs. However, on joining the EC, it is able to enjoy the EC free price tariff price of P2, which is above the tariff-free price P3 of New Zealand.

Therefore, to state the losses and gains in welfare, there is a rise in consumer extra in area 1+2+3+4. In the producer in area 1, there is a reduction in the surplus of the producer. Finally, there will also be a loss of the government revenue tariff of area 3. In countries involved in both trade creation and trade diversion, there are several differences realized before the trade creation and after the trade creation. To start with, trade creation eliminates trade barriers between the member countries thus encouraging the trade between the member countries, therefore, discouraging the trade between the non-member one.

Before trade creation, this phenomenon is not realized. To add on that, after trade creations, member countries are free to exploit and freely trade with members of their choice. The member countries can also import goods at a lower cost thus enabling them to produce goods and services at a lower cost. Nevertheless, before trade creation, no country is allowed to trade freely with its country of choice. This ends up in higher costs of production that result from higher importation cost (Laine, 2011).

Moreover, prior to trade creation, every country works as individual imposing different tariffs on various countries to protect their industries. After trade creation, all member countries within the union have standardized tariffs. Another difference is that, after trade creation, once a union is formed, all members agree to eliminate all tariffs between them. As a result of these zero tariffs on imports, consumer demand raises thus leading to another trade creation.

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