ALEC - Economic Integration, Trade Creation, Trade Diversion

Definitions:

• Trade creation-Trade creation refers to the increase in economic welfare from joining a free trade area, such as a customs union.
• Trade diversion: when tarrifs cause imports to shift from lower cost countries to higher cost countries.
• Economic integration: when countries coordinate trade, fiscal, and/or monetary policy.
• Economic welfare: Level of prosperity or living standards.

Trade creation:

• Benefits:

1. Increase in consumer surplus
2. Increase in welfare
3. Increase in exports

• Problems

1. Decrease in tax revenue
2. Domestic producers will sell less as consumers will buy cheaper imports.

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Graph:

• Domestic producers will sell less as consumer buy cheaper imports (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

Trade diversion:

• Opposite of trade creation

• Problems:

1. The decrease in output of goods and services from a high cost country to a low cost country will cause a decrease in efficiency.
2. This decrease in efficiency causes a decrease in overall output.

Economic integration:

• Assumptions:

1. Both countries cooperate with each other.
2. Zero tarrifs between each country.
3. Fluid movement of inputs and outputs.

• Benefits:

1. Can increase a country's efficiency.
2. Increases a country's welfare.

• Examples:

1. Capital movements across borders
2. Resource allocation towards agriculture
3. NAFTA
4. EU