Trade creation and diversion effects

Imagine a group of countries forming a trade bloc, like a Free Trade Area (FTA) or a Customs Union. This arrangement can lead to changes in trade patterns within the bloc and with the rest of the world.

• Trade Creation: When trade increases because member countries can now import goods from each other at lower costs, thanks to reduced or eliminated trade barriers.
• Trade Diversion: When trade shifts from a more efficient external supplier (outside the bloc) to a less efficient supplier within the bloc due to preferential treatment.

Trade Creation

Definition:

Trade creation happens when a trade agreement leads to the replacement of high-cost domestic production with lower-cost imports from a partner country.

Example:

Let’s say Country A produces wheat at ₹40 per kg, while Country B (a trade partner) can produce it at ₹30 per kg. If both countries form an FTA and remove tariffs, Country A will import wheat from Country B, reducing costs and increasing overall trade.

Benefits of Trade Creation:

1. Efficient Resource Allocation: Resources are used where they are most productive.
2. Consumer Benefits: Lower prices and greater variety for consumers.
3. Economic Growth: Increased trade stimulates economic activity.

Trade Diversion

Definition:

Trade diversion occurs when a trade agreement causes imports to shift from a more efficient global producer to a less efficient partner country due to tariff preferences.

Example:

Suppose Country A can import cars from Country C (non-member) at ₹5,00,000 per unit, but after joining a trade bloc, it imports from Country B (member) at ₹5,50,000 due to tariff-free access. While the cost is higher, the tariff benefits make trade with Country B more attractive.

Drawbacks of Trade Diversion:

1. Inefficiency: Less efficient producers are favored.
2. Consumer Loss: Consumers pay higher prices than they would with global suppliers.
3. Global Trade Imbalance: Reduces trade opportunities for non-member countries.

1. Trade Creation Effect: Shows the shift from high-cost domestic production to low-cost imports, leading to reduced prices and increased quantity. The arrows indicate a price drop and a quantity increase.

2. Trade Diversion Effect: Illustrates the shift from an efficient global supplier to a less efficient bloc partner, resulting in increased prices while the quantity remains constant. The arrow indicates the price increase.

Trade Creation vs. Trade Diversion

Examples of Trade Creation and Diversion

1. Trade Creation in the European Union (EU):

   • The EU eliminated tariffs among member countries, leading to increased intra-EU trade. For example, Germany imports wine from France rather than producing it domestically at higher costs.

2. Trade Diversion in NAFTA (Now USMCA):

   • The US started importing certain agricultural products from Mexico instead of more efficient global suppliers, owing to tariff-free access under NAFTA.

Factors Influencing Trade Creation and Diversion

1. Tariff Levels:
   Higher initial tariffs increase the scope for trade creation.

2. Economic Size:
   Larger economies have a greater capacity for trade creation.

3. Trade Policies:
   Favorable policies like subsidies or reduced non-tariff barriers influence trade patterns.

4. Geographical Proximity:
   Closer countries are more likely to benefit from trade creation due to lower transportation costs.

Implications of Trade Creation and Diversion

Positive Implications:

• Boosts regional cooperation and economic integration.
• Encourages specialization and efficiency.

Negative Implications:

• Can harm global trade efficiency.
• Non-member countries may face trade losses.

Trade creation and diversion are like two sides of the same coin in regional economic integration. While trade creation brings efficiency and growth, trade diversion can sometimes lead to inefficiencies and higher costs.