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Trade Creation: Definition & Effect

Instructor: Brianna Whiting
In this lesson, we will look at trade creation. We will define the term, discuss how the process works and look at the concept in terms of real-life trade transactions before concluding with a summary and a quiz.

A Beginning Look at Trade Creation

Let's imagine that you want to buy a new refrigerator. Since it is a costly purchase, you obviously want to take your time and do some research. You first go store to store and look at floor models. You compare features and, perhaps more importantly, you compare price. After endless searching, you decide to give up the idea of buying a refrigerator, because the prices are too high and it just doesn't seem like it's in the budget.

Feeling disappointed, you look through your mail and stumbled across a sales ad for one of the local stores you had previously visited in your search for a refrigerator. In the ad, the store had one of the models you were interested in for a discounted price that you could actually afford. You immediately rushed to the store, and purchased your new refrigerator. Much like your experience of 'shopping around' to obtain the best price, trade creation focuses on a similar procedure.

Trade Creation Defined

In order to understand how trade creation works, we first need to define it. Trade creation is the creation of an area in which countries can trade goods without restrictions. This area then creates a redirection of the flow of goods to a different country that uses imported goods instead of those produced locally. Since the goods are often obtained for cheaper prices because of the lack of restrictions and tariffs, consumers can purchase the goods at a reduced price.

It is important to point out though, that by importing a cheaper good, trade creation often puts local producers out of business. For example, if China and the U.S. establish a trade creation for computers for a price of $100 per computer, those that locally produce computers in China will lose business. This is because they sell their computers for $130, and consumers would rather pay the cheaper price.

How Does Trade Creation Work?

Now, let's look at the formation of trade creation more deeply. Trade creation begins with a customs union. This is a way for countries to trade without barriers with those that are members. This then creates the desire to increase trade between members and to decrease trade among non-members. Below is an example to better explain how trade creation works.

Let's take the U.S., Germany, and Japan. Each country produces potato chips. However, the U.S. produces potato chips for $5, Germany produces potato chips for $4.50 and Japan produces them for $4. Before a customs union, Japan had a comparative advantage because it produced them the most efficiently for the cheapest price. Prior to creating a customs union, each country may have imposed different tariffs on each of the other countries in order to protect themselves as a nation as well as their local producers.

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