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trade creationan increase in INTERNATIONAL TRADE (and economic welfare) that results from the reduction or elimination of trade barriers such as TARIFFS and QUOTAS. Tariff cuts, etc., may be instigated by a single country, by the formation of a CUSTOM UNION or FREE TRADE AREA, or, more generally, by international negotiation (see WORLD TRADE ORGANIZATION).
The trade-creating effect of a tariff cut is illustrated in Fig. 188, which, to simplify matters, is confined to one country (A) and one product.
DD and SS are the domestic demand and supply curves for the product in country A. W is the world supply price of the product. Initially, country A imposes a tariff on imports of the product, raising its price in the home market to Wt. At price Wt, domestic production is shown by OP, domestic consumption by OC, and imports by PC.
The removal of the tariff reduces the price of the product in the home market to W. At price W, imports increase to P1C1, domestic production falls to OP1, and domestic consumption increases to OC1. The home market obtains an increase in economic welfare from this expansion of trade, indicated by the two triangles XYZ and RST XYZ is the ‘production gain’ resulting from the reallocation of factor inputs to more efficient uses; RST is the ‘consumption gain’ resulting from lower prices to consumers.