After creating a free trade area agreement with its 4 neighboring countries, some companies in Country X switched from low-cost external supplies that they used to have to higher-cost suppliers in one of the member countries (due to zero tariffs). This is an example of __. Group of answer choices C. trade creation. D. protectionism A. trade diversion. B. strategic pricing.
The correct answer and explanation is:
Correct Answer: A. trade diversion
Explanation (300 words):
The scenario described is an example of trade diversion, a key concept in international trade economics. Trade diversion occurs when a country enters a free trade agreement (FTA) and, as a result, begins to import goods from a higher-cost partner country rather than from a lower-cost non-member country, simply because tariffs have been removed within the trade bloc.
In the case of Country X, before joining the free trade area, companies imported goods from low-cost suppliers outside the region. However, once the agreement was signed and tariffs were removed among the member countries, these companies shifted to buying from higher-cost producers within the FTA. Although these new suppliers are more expensive in terms of production costs, the absence of tariffs made their final prices lower or comparable, making them more attractive than the original low-cost external suppliers who still face import tariffs.
This behavior illustrates trade diversion, where the pattern of trade changes not due to comparative advantage or efficiency, but due to the artificial price effect of tariffs and trade agreements. While FTAs aim to enhance trade and economic efficiency, trade diversion is considered a potential downside because it leads to a less efficient allocation of resources. The country or region as a whole may end up paying more for the same goods, which is economically suboptimal.
Here is why the other options are incorrect:
- B. Strategic pricing involves companies setting prices to outcompete rivals, often unrelated to trade policy.
- C. Trade creation refers to replacing high-cost domestic production with low-cost imports due to tariff removal—this increases efficiency.
- D. Protectionism is when countries impose barriers (like tariffs) to protect domestic industries—opposite of a free trade scenario.
Hence, the most accurate and appropriate answer is A. trade diversion.