Trade Diversion

Definition

Trade diversion is an economic concept that describes the shift in trade patterns caused by the formation of a customs union or a free trade agreement. It occurs when a country or a group of countries, part of an economic community, start trading more with each other and less with the rest of the world, leading to a change in the direction of trade flows.

5 Must Know Facts For Your Next Test

1. Trade diversion can lead to a decrease in overall economic welfare if the shift in trade patterns results in the replacement of lower-cost imports from non-member countries with higher-cost imports from member countries.
2. The degree of trade diversion depends on the level of pre-existing trade barriers between member and non-member countries, as well as the size and competitiveness of the member countries' economies.
3. Trade diversion can be mitigated by ensuring that the customs union or free trade agreement covers a large enough market and includes countries with complementary rather than competing industries.
4. The formation of the European Union is often cited as an example of trade diversion, as member countries began trading more with each other and less with non-member countries.
5. Policymakers must carefully consider the potential for trade diversion when negotiating and implementing economic integration agreements to ensure that the benefits of increased trade outweigh the costs.

Review Questions

• Explain how the formation of a customs union or a free trade agreement can lead to trade diversion.
  • The formation of a customs union or a free trade agreement can lead to trade diversion by creating a situation where member countries start trading more with each other and less with the rest of the world. This shift in trade patterns occurs because the elimination of tariffs and other trade barriers among member countries makes it more attractive for them to buy goods and services from each other, even if they are not the most efficient or lowest-cost producers. As a result, trade is diverted away from non-member countries, which can lead to a decrease in overall economic welfare if the higher-cost imports from member countries replace lower-cost imports from non-member countries.
• Analyze the factors that influence the degree of trade diversion in an economic integration agreement.
  • The degree of trade diversion in an economic integration agreement, such as a customs union or a free trade agreement, is influenced by several factors. The level of pre-existing trade barriers between member and non-member countries is a key factor, as higher barriers will lead to a greater shift in trade patterns. The size and competitiveness of the member countries' economies also play a role, as larger and more competitive economies will be able to capture a greater share of the trade within the economic community. Additionally, the degree of complementarity or competition between the industries of member countries can affect the extent of trade diversion, with complementary industries being less likely to experience significant trade diversion. Policymakers must carefully consider these factors when negotiating and implementing economic integration agreements to ensure that the benefits of increased trade outweigh the costs of trade diversion.
• Evaluate the potential impact of trade diversion on the overall economic welfare of the countries involved in an economic integration agreement.
  • The impact of trade diversion on the overall economic welfare of the countries involved in an economic integration agreement, such as a customs union or a free trade agreement, can be both positive and negative. On the positive side, trade diversion can lead to increased trade and economic activity among member countries, which can generate benefits in terms of economies of scale, increased competition, and access to a larger market. However, the negative impact of trade diversion can be significant if it results in the replacement of lower-cost imports from non-member countries with higher-cost imports from member countries. This can lead to a decrease in consumer welfare and a loss of overall economic efficiency. Policymakers must carefully weigh these tradeoffs and ensure that the economic integration agreement is designed in a way that maximizes the benefits of increased trade while minimizing the costs of trade diversion.

Related terms

Customs Union: An economic arrangement where a group of countries agree to eliminate tariffs and other trade barriers among themselves, while maintaining a common external tariff on imports from non-member countries.

Free Trade Agreement (FTA): A treaty between two or more countries to establish a free trade area where tariffs, and sometimes even non-tariff barriers, are eliminated on the majority of goods and services traded between them.

Trade Creation: The increase in trade that occurs when a customs union or a free trade agreement leads to the replacement of high-cost domestic production with lower-cost imports from partner countries.