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IAI Actuarial Core Principles · Business Economics · Importance of international trade

A regional trading bloc removes tariffs among its members, and a member country begins importing a product from a partner at a cost of 90, replacing imports from a non-member that cost 80 before the common external tariff. Which term describes this effect, and what is its welfare implication?

This is trade diversion, which lowers welfare. Imports switch from a non-member with a cost of 80 to a partner with a cost of 90, so supply moves from a lower-cost to a higher-cost source. Trade creation would instead replace dearer domestic output with cheaper partner imports.

  1. ATrade creation, which raises welfare because production moves to a more efficient producer
  2. BTrade diversion, which lowers welfare because production moves from a lower-cost to a higher-cost sourceCorrect
  3. CTrade creation, which lowers welfare because the importing country pays more
  4. DTrade diversion, which raises welfare because tariff revenue increases
  5. Terms of trade effect, which has no welfare implication

Explanation

Imports shift from a world-cost source of 80 to a partner source costing 90, so resources are used less efficiently. This is trade diversion, which tends to reduce welfare. Trade creation would involve replacing higher-cost domestic production with cheaper partner imports. Tariff revenue is lost on the diverted imports rather than gained.

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