Trade Creation:

Trade creation under  an FTA  implies that imports are sourced  from a more efficient producer within the region, at  times

involving  a shift  of  imports away from-  the rest of the world.  Such  a  shift  is welfare  increasing  in  a member country  of  theFTA. In  the above Figure you should be able  to see  that  if  country  A enters into a FTA with the more  efficient  suppliercountry C,  there will be only trade creation and no diversion.  Another example of trade creating effects, where country A  forms an FTA with country B, is demonstrated in Figure.

The supply and demand curves for country A are displayed in the figure. The supply  prices of  the good from countries B and C, respectively, are  represented by P_B  and P_C.  As assumed earlier, A has a specific tariff t^B  =t^c =  t* set on imports fiom both countries B and C. The tariff raises the domestic supply prices to PTB  and PTC, respectively. The size of  the tariff is denoted by t* =  P_T^B - P^B  =  P_T^C  - P_C. Including the tariffs, the pre-FTA price  in country A (PA) is less than both PTB and PTC, hence the product will not be imported.  Instead country A will meet its domestic demand with its own supply at S¹  =  D¹. If countries A and B form an FTA and A hlly eliminates the tariff on imports from country B, the tB,  becomes zero but tC  remains at t*. The domestic prices of goods  fiom countries B and C become PB  and PTc,  respectively. Since P_B  < P_A,  country A would now  import the product  from country B after the FTA. At the lower domestic price PB,  imports would rise to D₂  - S_2.  It may be noted that trade now  is generated in the post-FTA scenario from an efficient source within the region it is called trade creation.

The net welfare effect for the country A can be assessed aggregating the gains and  losses to  consumers and producers. It has  two positive  dimensions: a positive  production efficiency gain (b) and a positive consumption efficiency gain (c). Thus, an FTA that leads to trade creation implies net welfare gains.

You  should be able to show that the gain would be even larger if country A entered into the FTA with the more efficient supplier country C. The analysis of trade creation and trade diversion can also  be extended to many markets and multiple countries of an FTA. Therefore, the aggregate effects of an FTA can be obtained by summing up the effects across markets and  across countries.  Finally, the net welfare effects are measured by taking both  trade creation and  trade diversion into account.  If  the positive effects from  trade creation  outweigh the  negative effects from trade diversion, the FTA under consideration is said to be welfare improving.

It is for this reason both trade creation and trade diversion  effects need to be combined to assess the welfare-increasing  effects of a customs union or RTA.