What is trade creation and trade diversion?

Q.  What is trade creation and trade diversion?

Trade diversion and trade creation are key concepts in international economics, particularly when discussing the effects of trade agreements, such as free trade areas or customs unions, on member and non-member countries. These two phenomena are essential for understanding the economic dynamics that occur as a result of the formation of trade blocs and the broader implications on global trade patterns. While both trade creation and trade diversion are terms commonly associated with the theory of customs unions and free trade agreements (FTAs), they can also be observed in other types of economic integration arrangements. These terms help explain the shifts in trade flows and their economic impacts, both on countries within the agreement and those outside it.

To fully understand these concepts, it is important to place them within the broader context of international trade theory. Historically, economists have been interested in understanding how the removal of trade barriers, such as tariffs and quotas, influences the allocation of resources between countries and how such changes affect welfare. The foundational model that explains these dynamics was provided by Jacob Viner in his seminal work in the 1950s, where he introduced the concepts of trade creation and trade diversion in the context of customs unions.

The Basic Theory of Customs Unions and Trade Agreements

Before delving into the specifics of trade creation and trade diversion, it is important to understand the economic concept of customs unions and free trade areas. A customs union is a group of countries that agree to remove internal tariffs and adopt a common external tariff on imports from non-member countries. A free trade area, on the other hand, involves the removal of trade barriers (like tariffs and quotas) between member countries but allows members to maintain their own external trade policies.

Both types of arrangements are designed to increase trade among member countries by reducing barriers to commerce. They also have the potential to increase economic efficiency and promote regional economic cooperation. However, they can also have significant implications for global trade patterns, particularly in terms of trade diversion and trade creation. These concepts describe the way in which the formation of trade blocs influences the flow of goods between member and non-member countries.

Trade Creation: A Positive Outcome

Trade creation refers to the increase in trade that results from the formation of a trade bloc or the removal of trade barriers between countries. When countries form a customs union or enter into a free trade agreement, the removal of tariffs and other trade restrictions typically makes it cheaper for member countries to trade with one another. This reduction in trade costs leads to an increase in the volume of trade, particularly in sectors where the comparative advantage of countries within the bloc is most pronounced.

The concept of trade creation is grounded in the theory of comparative advantage, which suggests that countries should specialize in producing goods in which they have a lower opportunity cost than other countries. As countries lower barriers to trade, goods can flow more freely across borders, and resources are allocated more efficiently. This results in both an increase in overall welfare and a more efficient use of resources in the member countries.

For example, if Country A and Country B are members of a customs union and they reduce or eliminate tariffs on goods traded between them, they will likely experience an increase in trade as each country takes advantage of its respective comparative advantage. Suppose Country A has a comparative advantage in producing machinery, and Country B has a comparative advantage in producing textiles. With the removal of trade barriers, Country A will export more machinery to Country B, and Country B will export more textiles to Country A. This trade creation is mutually beneficial, as both countries can now access cheaper goods and services that they would not have been able to produce as efficiently themselves.

Trade creation leads to greater economic efficiency because resources are allocated according to the principle of comparative advantage. When countries specialize in the production of goods and services in which they are most efficient, the overall level of output increases, benefiting both the countries involved and the global economy. This increased trade also leads to greater competition and innovation within the member countries, further driving economic growth.

Trade Diversion: A Negative Consequence

While trade creation is a desirable outcome of trade agreements, trade diversion represents a more negative consequence. Trade diversion occurs when the formation of a trade bloc leads to the substitution of cheaper imports from non-member countries with more expensive imports from member countries. In other words, the trade agreement, by reducing or eliminating tariffs within the bloc, may encourage trade among member countries at the expense of more efficient producers outside the bloc.

This happens because the reduction in tariffs between member countries makes goods from member countries more attractive, even if those goods are less efficient or more expensive to produce than goods from non-member countries. As a result, trade that would have otherwise occurred between non-member countries, based on their comparative advantage, is diverted to member countries, even though the goods from non-member countries might have been cheaper or of higher quality.

An example of trade diversion can be observed in the case of a hypothetical free trade agreement between two countries, Country X and Country Y, and a non-member country, Country Z. Prior to the trade agreement, Country X imported goods from Country Z at a lower price because Country Z had a comparative advantage in producing those goods. However, after the trade agreement is formed, Country X starts importing the same goods from Country Y at a higher price, simply because Country Y is now part of the free trade area. In this case, trade with Country Z is diverted to Country Y, even though the trade with Country Z was more efficient from an economic perspective. This leads to an inefficient allocation of resources and a reduction in overall welfare.

The impact of trade diversion is particularly problematic when the members of a trade agreement are less efficient at producing certain goods than non-member countries. When this happens, trade diversion leads to a misallocation of resources, as member countries may end up producing goods that they are less efficient at producing, simply because of the tariff preferences granted by the trade agreement. This can result in higher prices for consumers and a reduction in the overall economic welfare of the countries involved.

The Net Impact: Trade Creation vs. Trade Diversion

The net effect of a trade agreement or the formation of a customs union or free trade area depends on the balance between trade creation and trade diversion. If the benefits of trade creation outweigh the costs of trade diversion, the overall effect is positive, leading to an increase in welfare for the member countries and potentially the global economy. However, if trade diversion dominates trade creation, the formation of the trade bloc can result in a net loss of welfare.

For instance, in the early stages of economic integration, trade creation is often more pronounced. As countries begin to remove tariffs and other trade barriers, they typically see an increase in trade between them, which leads to greater economic efficiency. Over time, however, the impact of trade diversion may become more significant, particularly if the trade agreement includes countries that are not as efficient at producing certain goods as non-member countries.

A well-designed trade agreement should seek to maximize the benefits of trade creation while minimizing the negative effects of trade diversion. One way to achieve this is by ensuring that trade agreements are formed between countries with complementary economic structures, such as countries with different comparative advantages. In this way, the trade bloc can stimulate the exchange of goods that each country is efficient at producing, leading to greater specialization and overall welfare gains.

Another important consideration is the size and economic development level of the countries involved. Larger economies with more diversified production capabilities are more likely to benefit from trade creation, while smaller or less efficient economies may experience greater trade diversion. In such cases, it may be necessary to include provisions in the trade agreement that mitigate the negative effects of trade diversion, such as by offering support for industries that are likely to be displaced by cheaper imports from member countries.

Examples of Trade Creation and Trade Diversion

To better illustrate these concepts, it is helpful to look at real-world examples of trade creation and trade diversion resulting from trade agreements and economic integration.

1.    European Union (EU): The European Union is a classic example of a successful customs union that has resulted in significant trade creation among its member countries. The removal of internal tariffs and the establishment of a common external tariff have allowed countries within the EU to trade more freely, leading to greater specialization and efficiency. However, there have also been instances of trade diversion within the EU, particularly in the case of agricultural products. For example, some countries in the EU may produce agricultural goods at higher costs than non-EU countries, leading to trade diversion where goods that would have been imported from more efficient non-member countries are replaced by higher-priced goods from within the EU.

2.    North American Free Trade Agreement (NAFTA): NAFTA, which was replaced by the United States-Mexico-Canada Agreement (USMCA), is another example of a trade agreement that generated both trade creation and trade diversion. The removal of trade barriers between the United States, Canada, and Mexico led to trade creation, particularly in manufacturing and agriculture. However, critics argue that NAFTA also led to trade diversion, especially in the automotive sector, where Mexico’s relatively low labor costs made it an attractive destination for production. This caused some trade to be diverted from other global suppliers to Mexico, even though the United States and Canada could have sourced the same goods from more efficient non-member countries.

3.    Mercosur: The Southern Common Market (Mercosur) in South America is an example of a customs union that has faced significant challenges related to trade diversion. While the creation of Mercosur has promoted trade among Argentina, Brazil, Paraguay, and Uruguay, it has also led to trade diversion, particularly in agricultural goods. The preferential treatment granted to intra-Mercosur trade has led to higher prices for consumers in member countries, as they have been forced to import goods from less efficient producers within the bloc instead of sourcing them from more competitive countries outside the bloc.

Conclusion

In conclusion, trade creation and trade diversion are fundamental concepts in understanding the economic effects of trade agreements and economic integration. While trade creation is generally viewed as a positive outcome that increases efficiency, fosters specialization, and boosts welfare, trade diversion can have negative consequences, particularly when it leads to inefficient trade patterns that reduce overall welfare. The balance between these two phenomena determines the net effect of trade agreements, and policymakers must carefully consider how to design trade arrangements that maximize the benefits of trade creation while minimizing the negative effects of trade diversion. Ultimately, the goal of any trade agreement should be to promote global economic efficiency and welfare, ensuring that countries are able to specialize in the production of goods and services in which they have a comparative advantage while fostering economic cooperation and growth.

• Tweet
• Share
• Share
• Share