Elaborate the concepts of Trade Creation and Trade Diversion in the contextof Custom Union

Trade creation and trade diversion are two important concepts in the context of a customs union. Let's elaborate on each concept step by step:

1. Trade Creation: Trade creation occurs when a customs union eliminates or reduces trade barriers, such as tariffs or quotas, among its member countries. This leads to an increase in trade between member countries, as they can now trade with each other more freely and at lower costs.

2. Lowering Trade Barriers: The customs union achieves trade creation by harmonizing trade policies and removing barriers to trade, such as tariffs, import quotas, or export subsidies. By doing so, member countries can access each other's markets more easily, leading to increased trade flows.

3. Economic Efficiency: Trade creation is beneficial because it promotes economic efficiency. Member countries can specialize in producing goods and services in which they have a comparative advantage, leading to increased productivity and overall economic growth within the customs union.

4. Example: For instance, let's consider a customs union consisting of Country A and Country B. Before the customs union, both countries had trade barriers in place, such as tariffs on each other's goods. However, after forming the customs union, these trade barriers are eliminated, leading to increased trade between Country A and Country B. This increased trade is known as trade creation.

5. Trade Diversion: On the other hand, trade diversion occurs when a customs union diverts trade away from more efficient non-member countries towards less efficient member countries. This happens when the customs union imposes trade barriers on non-member countries while maintaining preferential treatment for member countries.

6. Diverting Trade: Trade diversion can lead to inefficiencies because it encourages trade between member countries that may not be the most efficient producers. This can result in higher costs and reduced economic welfare compared to trading with more efficient non-member countries.

7. Example: Continuing with the previous example, suppose that before the customs union, Country A imported a certain good from a non-member country, Country C, at a lower cost. However, after forming the customs union, the union imposes higher tariffs on imports from Country C, making it less competitive compared to Country B, a member country. As a result, Country A starts importing the same good from Country B, even though it may be more expensive. This diversion of trade from a more efficient non-member country to a less efficient member country is known as trade diversion.

In summary, trade creation occurs when a customs union eliminates trade barriers among member countries, leading to increased trade and economic efficiency. On the other hand, trade diversion occurs when a customs union diverts trade away from more efficient non-member countries towards less efficient member countries, potentially leading to inefficiencies.