Explain trade diversion and trade creation. (5)
Trade diversion occurs when lower-cost imports from outside the customs union are replaced by higher-cost imports from another union member. By itself, this reduces welfare because it shifts production away from comparative advantage. A trade-diverting custom union leads to both trade creation and trade diversion and may increase or reduce welfare, depending on the relative strength of these two opposing forces. While on the other hand, Trade creation occurs when some domestic production in a union member is replaced by lower-cost imports from another member nation. This increases specialization in production and welfare in the customs union. A trade-creating custom union also increases the welfare of nonmembers, since some of the increase in its real income spills over into increased imports from the rest of the world.