Trade Creation:

In general, trade creation means that a free trade area creates trade that would not have existed otherwise. As a result, supply occurs from a more efficient producer of the product. In all cases trade creation will raise a country's national welfare. The trade creation effect is caused by the extra output produced by the member countries. This extra output is generated due to the freeing up of trade between them. Increased specialization and economies of scale should increase productive efficiency within member countries. Forming a trade bloc with other Less Developed Countries (LDCs) may result in only a small trade creation effect as the share of world trade involving LDCs is so small, that the trade bloc has limited influence on the market price and quantity. If the country joins a trade bloc with a MDC then there may be real advantages to the LDC as resources flow within the bloc to the countries where there are cost advantages and the potential market for exports is significantly expanded. Trade creation refers to the effect of a customs union in creating or increasing trade between member countries. This new trade results from the reduction in tariffs between the members and is generally welfare-increasing. Trade creation is distinguished from trade diversion, which is the replacement of trade with non-members by trade between members. This occurs because the tariff-free prices of goods from members are lower than tariff-inclusive prices of the non-members who formerly supplied them. Trade diversion is generally welfare-decreasing. A customs union is beneficial to its members in the short run if their gains from trade creation exceed their losses from trade diversion. Trade creation refers to the replacement of expensive domestic production by cheaper imports from more efficient partner countries. Economic integration basically results in a trade creation effect.