Question

Q. Taking as an example the free trade agreement between Australia and China:

(a) Explain how the effects of trade creation and trade diversion occur with the formation of a trade bloc.

(b) What factors determine the size of the gains or losses? Explain.

Answer 1

a) Countries belonging to a free trade area freely trade among themselves but have barriers trading with countries outside the free trade area.There are a number of trading blocs like custom union,common market Economic union etc.. Trade creation and trade diversion are direct effects of creation of custom union.Trade creation is increase in trade trade that takes place between member countries of the trading bloc as a result of the forming of the trade bloc.This takes place as removing of trade barriers leads to greater specialization in accordance with the comparative advantage. Thus prices will fall and trade will increase.Trade diversion is decrease in trade as a result of forming the trade bloc as trade with non trading low cost block members is stopped and trade takes place with high cost trading bloc members.Consumers in the union will not be benefited as they will not get cheap international goods.

b)Free trade creates winners and losers but economists are of the view that free trade is gain to the society,The factors that determine gain is elimination of remaining tariffs and barriers to trade , and US employers should continue to outsource workers from foreign countries. Free trade increases the efficiency of production in the economy and gives better choices to consumers. So in the long run gains are more.With free trade the absolute level of output which winner and loser enjoy will increase with winner from free trade gaining more.