Partial Equilibrium Analysis | Trade Creation and Trade diversion

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The partial equilibrium analysis of customs union was developed by Viner in terms of trade creation and trade diversion.

Friends, in today’s article we are going to know about Partial Equilibrium Analysis (Trade Creation and Trade diversion). So let’s discuss in details. The analysis is based on following assumption –

(i) There are two countries. Say home country (H) and partner country (P). They from customs union.

(ii) There is another country which is called rest of the world (W).

(iii) There is only one good say X.

(iv) There is no transport cost.

(v) Technological changes are absent.

(vi) There is free and unrestricted trade between H and P.

Trade Creation Effect

Trade Creation effect show the favourable impact of customs union on production, price level, consumption level of the trading countries. Trade Creation effect is explained with a diagram.

Here DH and SH are the demand and supply curve of the home country. Sw is the supply curve of the rest of the world. Sp is the supply curve of the partner country. Before the customs union is formed, WT tariff is being imposed on W by country H so that the new supply curve becomes Sw + t.

From the figure it is clear to us that at price OT country H consumes ON, where MN quantity of X imported from W. Country H gets a tariff revenue equal to the area ADKH.

Partial Equilibrium Analysis | Trade Creation and Trade diversion
Suppose country’s H forms a custom union with a country called partner country from W. Thus now country will import good X duty free from country P only and none from country A. This provides following trade creation effects of the customs union for country H.

• Price Effect – From the figure it is clear that OT is the pre customs union price and OP is the post customs union price. Therefore OT – OP = TP is the price effect.

• Consumption Effect – From the figure, it is clear that ON is the pre customs union consumption and OR is the post customs union consumption. Therefore OR – ON = NR is the consumption effect.

• Production effect – From the figure, it is clear that OM is the pre customs union production and OL is the post customs union production. Therefore OM – OL is the production effect.

The production and consumption effects of the trade creation lead to the welfare gain effect for country H. Before customs union, LM was being produced by H at a total cost given by the area AMLB under the supply curve SH.

After customs union LM is imported from country P at a lower total cost given by the area JMLB under the supply curve Sp. Thus AMLB – JMLB = AJB is the production gain effect.

Before customs union the home country consumes ON quantity at price OT. But after customs union it consumes OR at price OP. By consuming NR, more quantity of X the total utility derived by H equal to the area DFRN under the demand curve DH.

Here the cost of additional consumption is FRNE. Thus DFRN – FRNE = DFE is the consumption gain effect.

Trade Diversion Effect

Trade diversion occurs when with the abolition of tariff on the partner country, the home country imports the product from the high cost partner country instead of from the lower cost rest of the world country.

It has two aspects – 1st an increase in the cost of ggod X and Secondly a close in consumer’s surplus. The trade diversion effect is explained in the above figure.

Where in the pre customs union situation H country imports MN quantity of good X from country W at price OT for MN quantity, the consumer in country H pay ADNM.

But the total cost to country W for exporting this quantity is HKNM. Thus ADNM – HKNM = ADKH is the tariff revenue of the government.

Due to formation of customs union country H imports the same quantity MN from the partner country P. Here country H pays equal to the area JENM. Thus the shaded rectangle JEKH represents a welfare loss for country H.

Net Welfare Effect

The net welfare effect can be measured on the basis of welfare gain and welfare loss.

Let,

a = Production gain = AJB

b = Consumption gain = DFE

c = Welfare loss = JEKH

Now, If (a+b) = c, there is net gain nor net loss in country H’s welfare from customs union.

If (a+b) > c, there is net gain in country H’s welfare from customs union.

If (a+b) < c, there is net loss in country H’s welfare from customs union.

Conclusion

So friends, this was the concept of Partial Equilibrium Analysis. Hope you get the full details about it and hope you like this article.

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