CFA Level II ExamEconomicsMedium
An economist is analyzing the impact of a newly formed free trade area (FTA) between two previously isolated countries, Alpha and Beta. Before the FTA, Alpha produced good X at a cost of $10 and imported good Y at a cost of $15. Beta produced good Y at a cost of $12 and imported good X at a cost of $18. After the FTA, Alpha begins to import good Y from Beta at a cost of $12, and Beta begins to import good X from Alpha at a cost of $10. Which of the following is the most accurate assessment of the outcome?
- AAlpha experienced trade creation, while Beta experienced trade diversion.
- BAlpha experienced trade diversion, while Beta experienced trade creation.
- CBoth countries experienced trade creation.
- DBoth countries experienced trade diversion.
Show answer & explanationAnswer & explanation
Correct answer: C. Both countries experienced trade creation.
Trade creation occurs when high-cost domestic production is replaced by lower-cost imports from a trade partner. Alpha previously imported Y at $15 but now imports from Beta at $12 (lower cost). Beta previously imported X at $18 but now imports from Alpha at $10 (lower cost). Both are examples of trade creation.
Why the other options are wrong
- A. Both countries are benefiting from lower-cost imports, indicating trade creation for both.
- B. Neither country is importing from a higher-cost source; both are importing from a lower-cost source within the FTA.
- D. Trade diversion involves shifting imports from a lower-cost non-member to a higher-cost member, which is not the case here.
Trade Creation
Trade creation occurs when the formation of a free trade area or customs union leads to imports shifting from a higher-cost domestic producer to a lower-cost producer within the trade bloc.
- Increases economic efficiency and welfare.
- Occurs when internal production is replaced by cheaper imports from a partner.
- Results in a net gain for the importing country and the bloc.
- Driven by comparative advantage within the trade bloc.
- Contrasts with trade diversion, which reduces welfare.
Memory trick: Creation brings better buys, diversion makes you pay the price.