A2 Economics 9708: Globalisation, Trade Creation and Trade Diversion

Trevalia is considering joining "the Consortium," a customs union of several neighbouring countries, as part of a wider process of globalisation affecting its economy. Trevalia currently imports a good from Farlow, a low-cost producer outside the Consortium, and could alternatively import the same good from Nearbridge, a Consortium member.

	Farlow (non-member)	Nearbridge (Consortium member)
Underlying production cost per unit	$40	$46
Trevalia's external tariff (applied before joining, to both)	$10	$10
Price Trevalia's consumers pay BEFORE joining the Consortium	$50	$56

(a) Identify TWO causes of globalisation, i.e. factors that have enabled deeper international economic integration between countries in recent decades. [2]

(b) If Trevalia joins the Consortium, it abolishes tariffs on trade with fellow members (such as Nearbridge) while keeping its $10 common external tariff on non-members (such as Farlow). From which country would Trevalia now import this good, and would this switch represent trade creation or trade diversion? Explain your reasoning. [4]

(c) Explain ONE reason why the effect identified in (b) might still be more than offset by other benefits of Trevalia joining the Consortium. [3]

(d) Discuss the extent to which increased trade openness of the kind described above is likely to benefit all groups within Trevalia's economy equally. [3]

Part (a): Two causes of globalisation

Globalisation (the growing economic integration of countries through trade, investment and finance) has been driven by several factors, including:

Trade liberalisation: the progressive reduction of tariffs, quotas and other trade barriers through the World Trade Organization (WTO) and regional trade agreements has made cross-border trade far easier and cheaper than in the past.
Falling transport and communication costs: developments such as containerisation of shipping and the growth of the internet have dramatically reduced the cost and time of moving goods, services, information and capital across borders.

(The growth of multinational companies’ international supply chains, and increased mobility of financial capital following the deregulation of financial markets, are also valid causes.)

Part (b): Trade creation or trade diversion?

Before joining the Consortium, Trevalia’s external tariff of $10 applies to imports from both Farlow and Nearbridge, since neither currently receives preferential treatment:

Farlow: $40+10=50$
Nearbridge: $46+10=56$

Trevalia buys from Farlow, since $50 is cheaper than $56.

After joining the Consortium, the tariff is abolished on trade with fellow members (Nearbridge) but kept on non-members (Farlow):

Farlow (tariff still applies): $40+10=50$
Nearbridge (tariff now removed): $46+0=46$

Since $46<50$ , Trevalia now switches to importing from Nearbridge.

However, Nearbridge’s underlying production cost ($46) is actually higher than Farlow’s ($40). Farlow remains the genuinely more efficient world producer. Trevalia’s switch to Nearbridge happens purely because of the preferential removal of the tariff on fellow Consortium members, not because Nearbridge is truly the lowest-cost producer. This is the definition of trade diversion: trade is diverted away from a more efficient non-member producer towards a less efficient member producer, which tends to reduce economic welfare/efficiency of resource allocation (Trevalia now sources the good from a higher-cost producer than before, and its government also loses the tariff revenue it previously collected on this good).

Part (c): Why the overall effect on Trevalia could still be positive

Trade diversion on this single good is welfare-reducing in isolation, but it is only one part of the overall picture of Consortium membership. Trevalia could still gain overall if:

On other goods, Consortium partners genuinely are the lowest-cost producers, so trade with them replaces more expensive domestic production. Genuine trade creation, which raises welfare and can outweigh the trade diversion identified in (b).
Membership gives Trevalian firms access to a much larger market, allowing them to achieve economies of scale and become more efficient.
Greater competition from Consortium firms could push Trevalian firms to cut costs and innovate.
Tariff-free access to the wider Consortium market could attract more foreign direct investment into Trevalia.

Part (d): Are the benefits of trade openness shared equally?

Increased trade openness is unlikely to benefit every group in Trevalia’s economy to the same extent. Consumers generally gain from cheaper imports (such as the fall in price from $50 to $46 for this good) and greater product choice. Firms and workers in Trevalia’s genuinely competitive, export-oriented industries may also gain from new access to Consortium markets.

However, firms and workers in industries that previously relied on Trevalia’s external tariff for protection, or that simply cannot compete with lower-cost Consortium producers, are likely to lose out, potentially facing falling sales, business closures and job losses (structural unemployment) as production shifts towards more competitive Consortium partners. These losses may also be geographically concentrated, worsening regional inequality within Trevalia.

Judgement: while increased trade openness is likely to raise Trevalia’s aggregate economic welfare in the long run (through lower prices, greater choice, and the dynamic gains discussed in part (c)), the distribution of these gains and losses across different groups and regions is likely to be uneven. Meaning government policy (such as retraining support or regional assistance for those in declining industries) may be needed to ensure the benefits of trade openness are shared more widely.

Final answers

(a) Trade liberalisation and falling transport/communication costs (also acceptable: growth of MNCs, greater capital mobility)
(b) Trevalia switches to Nearbridge; this is trade diversion, since Farlow ($40) remains the truly lower-cost producer than Nearbridge ($46)
(c) Genuine trade creation on other goods, economies of scale, increased competition, or greater inward FDI could outweigh this trade diversion
(d) No. Consumers and competitive exporters gain, but import-competing firms/workers may lose out, so the benefits of trade openness are likely to be distributed unevenly