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

Which of the following is a likely trade diversion effect when a customs union is formed?

Trade diversion means imports switch from a lower-cost non-member to a higher-cost member because the member's goods avoid the tariff. This misallocates resources. Replacing domestic production with cheaper partner imports is trade creation, which is a different effect.

  1. AConsumers buy more from the lowest-cost world producer
  2. BMembers switch imports from a lower-cost non-member to a higher-cost member now free of tariffsCorrect
  3. CDomestic high-cost production is replaced by cheaper imports from a partner
  4. DTotal world output rises because of specialisation by comparative advantage
  5. Member countries' tariffs on each other rise

Explanation

Trade diversion occurs when tariff-free access makes a higher-cost member's goods cheaper than those of a more efficient non-member that still faces the common external tariff. Replacing domestic high-cost output with cheaper partner imports is trade creation, not diversion.

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