A trade economist is analyzing the impact of a new bilateral trade agreement between two countries. The agreement eliminates tariffs and non-tariff barriers on most goods. The economist observes that after the agreement, a significant portion of Country A's imports of automotive parts shifted from Country C (a non-member, historically efficient producer) to Country B (the new trade partner, a less efficient producer). This outcome is best described as an example of:
- ATrade creation, as new trade flows are generated between the partners.
- BTrade diversion, as trade shifts from a more efficient non-member to a less efficient member.
- CComparative advantage, as Country B now has a lower opportunity cost in producing automotive parts.
- DAbsolute advantage, as Country B can now produce automotive parts with fewer resources than Country C.
Show answer & explanationAnswer & explanation
Correct answer: B. Trade diversion, as trade shifts from a more efficient non-member to a less efficient member.
Trade diversion occurs when a free trade agreement causes trade to shift from a more efficient producer outside the agreement to a less efficient producer within the agreement. This happens because the tariff elimination within the bloc makes the less efficient member's goods artificially cheaper than the more efficient non-member's goods, which are still subject to tariffs. This leads to a reduction in overall economic welfare.
Why the other options are wrong
- A. Incorrect. Trade creation involves replacing high-cost domestic production with lower-cost imports from a partner, which improves efficiency. Here, efficiency is lost.
- C. Incorrect. Comparative advantage is about relative opportunity costs. The agreement itself doesn't change fundamental opportunity costs; it changes prices through tariffs.
- D. Incorrect. Absolute advantage refers to producing more with the same resources. The scenario explicitly states Country B is a 'less efficient producer,' implying it does not have an absolute advantage over Country C.
Trade Diversion
A negative outcome of a regional trade agreement where trade shifts from a more efficient, lower-cost producer outside the bloc to a less efficient, higher-cost producer within the bloc.
- Occurs because internal tariffs are eliminated, while external tariffs remain.
- Reduces global efficiency and overall economic welfare.
- Is a potential downside of preferential trading agreements.
Memory trick: Blocs either Create new paths or Divert old ones.