Paper 3 question on trade creation and diversion

Lesson notes

This paper three question on trading blocs should be completed in 50 minutes.  While paper three type questions are only part of the higher level syllabus, I will also give paper three exercises to my standard level students to complete, as it provides good practise for all economics students.   The question is based on data and text that the students need to use to answer the different sub-questions. 

Paper 3 style examination question 

Maximum mark for this question 30

Turkey is a middle income country, whose economy has struggled with high rates of inflation and falling living standards in recent years.  As part of a wider policy to grow its economy and reach fully developed status, the nation negotiated membership of the European Free Trade Association in 2018. 

Macroeconomic indicators 2017-2020:

GDP per capita $

Exchange rate $ to TL

Inflation %

2020

8,650

7.62

14.7

2019

9,127

5.66

11.8

2018

9,456

6.5

20.3

2017

10,591

3.5

11.9

They produce bread domestically which they make from a combination of domestically produced and imported corn.  Prior to joining the FTA the government imposed a tariff on corn imports but after joining the organisation they were forced to remove these.  This reduced the price of corn in the country to $ 5 per Kg.

Define the following terms:

(a) i. Preferential trade area (PTA) [1 mark]

PTAs offer preferential (i.e. lower tariff barriers) between participating nations, but not free trade between members.  In some cases the PTA may only apply to a specific industry or sector.

ii. Monetary union [1 mark]

When two or more states creating a single currency area, involving a universal exchange rate and / or a single currency.

iii. Common market [1 mark]

A free trade area which also allows for a relatively free movement of capital and services.

(b) i. Calculate the total revenue spent on corn by consumers prior to joining the FTA? [1 mark]

14m Kgs x $ 7 = $ 98 m.

ii. Calculate the amount spent by consumers on corn after joining the FTA? [1 mark]

17m Kgs x $ 5 = $ 85 m.

iii. Prior to the removal of the tariff what was the level of tax revenue generated by the import tax?  [1 mark]

(14m - 8m) x $ 2 = $ 12m.

iv. Calculate the change in revenue gained by domestic producers and imported producers after the removal of the tariff.  [2 marks]

Domestic producers - (8m x $7) minus (5m x $5) = - $ 31m.

Imports - (12m x $5) minus (6m x $7) = + $ 18m.

v. Which area represents the gain in consumer surplus after the tariff was removed?  [2 marks]

Area d + ($2 x 14m Kgs).

vii. Which area represents the deadweight loss resulting from the imposition of the original tariff?  [2 marks]

Area a + d.

(c) Explain the impact of membership of the free trade area on the following stakeholders:  [4 marks]

  • consumers
  • domestic producers
  • the government.

Two mark for each correct response, with part responses awarded one mark.

Consumers will benefit from free trade membership as they will pay lower prices for their goods and services as well as greater variety of products.  

Some domestic producers may not support the move if their own market share is threatened by cheaper goods and services from overseas.  On the other hand producers relying on imported raw materials and components will benefit from a fall in production costs.   Some domestic producers will also benefit from greater access to export markets after joining the FTA.  Overall there will be both winners and losers amongst domestic firms following the decision to join the FTA.

The government will lose a source of tax revenue. Following the abolition of tariffs on imported goods and services wwhich will leave a hole in public finances.  On the other hand they may benefit should membership of the FTA provide benefits to the economy as a whole.

(d) Explain the difference between a free trade area and a customs union.  [2 marks]

Both free trade areas and a customs union provide tariff free trade between participating members but a customs union also requires members to maintain common external barriers against nations outside of the trading bloc.

(e) Explain the difference between trade diversion and trade creation.  [2 marks]

Trade creation occurs when entry to a customs union means that the production of a good or service switches from a high cost producer to a lower cost one. 

Trade diversion occurs when the production of a good or service diverts from a low cost producer to a higher cost one. 

(f) Based on the information included in the passage and your knowledge of economics, recommend a policy which the Turkish government might employ to grow its economy and improve living standards.  [10 marks] 

Possible policies may include (but are not restricted to):

  • demand side policies
  • supply side policies
  • policies aimed at deregulation of the labour market
  • a combination of policies.

Responses in section (i) should be graded according to the following mark bands:

Maximum mark 10

Level

Descriptor

Mark

0

The response is below the minimum standards described below.

0

1

An appropriate policy has been identified

Little economic theory is included and superficially applied.

The response contains no evidence of synthesis or evaluation

The response contains significant errors.

1 - 2

2

The response identifies an appropriate policy

Some relevant economic theory is included and one policy likely to lead to economic growth is explained

Some relevant economic terms are included

The response contains evidence of superficial synthesis or evaluation.

3 - 4

3

The response identifies and explains an appropriate policy

The response demonstrates a clear understanding of how the recommended policy might contribute to economic growth

Some relevant economic terms are used appropriately

The response contains evidence of appropriate synthesis or evaluation but lacks balance

There are minimal errors included in the response.

5 - 6

4

The response identifies and explains fully a suitable policy

Relevant economic theory is included, with the policy likely to lead to economic growth comprehensively explained and skilfully applied

The response contains evidence of appropriate synthesis or evaluation that is mostly balanced

Any errors are minor and do not detract from the overall quality of the response.

7 - 8

5

The response identifies and fully explains an appropriate policy

The response uses relevant economic theory effectively to support the recommendation Relevant economic terms are used appropriately throughout the response

The use of information from the text/data is appropriate, relevant and supports the analysis/evaluation effectively

The response contains evidence of effective and balanced synthesis or evaluation.  

9 - 10

The paper three type questions above can be accessed as a PDF worksheet at: P3 questions

The P3 mark scheme with responses is available at: Mark scheme

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