(a) Define “trade creation” in the context of the formation of a customs union. Then, using a demand/supply diagram of a (small) home country for a good that is produced at home and would be imported if there were no tariff, illustrate and explain how the formation of a pure trade-creating customs union can enhance the country’s well-being. What factors would be conducive to a greater rather than a smaller gain from the trade creation?
(b) Define “trade diversion” in the context of the formation of a customs union. Then, using a demand/supply diagram of a (small) home country for a good that is both produced at home and imported, illustrate and explain how the movement from a situation of a uniform tariff on imports of the good from all countries to a situation of a trade-diverting customs union with one particular country can affect consumer and producer surplus and government revenue in the home country. Why can we not be sure that welfare in the home country will rise? Under what general conditions would it be likely that this trade-diverting customs union would injure welfare in the home country?