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IAI Actuarial Core Principles · Business Economics · Globalisation and multinational business

A customs union is formed. Country A previously imported steel from Country C (non-member) at Rs 900 per tonne with no tariff. After A joins the union, a common external tariff of 20% on C's steel applies, and A now imports from partner B at Rs 1,000 per tonne tariff-free. Which statement is correct?

This is trade diversion. Country A moves its steel purchases from non-member C, the cheaper source at Rs 900, to member B at Rs 1,000 because the common tariff makes C cost Rs 1,080. Buying from a higher-cost producer is the inefficiency, costing Rs 100 per tonne.

  1. ATrade creation occurs because A now buys from the cheapest world producer
  2. BTrade diversion occurs because A switches from a lower-cost to a higher-cost source, and this is a welfare loss from that switchCorrect
  3. CNeither occurs because the price paid rose by only Rs 100
  4. DTrade creation occurs because B's price is below C's tariff-inclusive price of Rs 1,080
  5. Trade diversion occurs because imports from C rise

Explanation

C's true cost is Rs 900 while B's is Rs 1,000. Joining the union shifts A's purchases from the lower-cost non-member to the higher-cost member, which is trade diversion and involves a resource cost of Rs 100 per tonne. The tariff-inclusive price of Rs 1,080 explains why B wins, but it does not make the shift efficient. Imports from C fall, not rise.

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