Trade diversion

Definition

Trade diversion occurs when a country shifts its import purchases from a more efficient producer to a less efficient one, typically as a result of trade agreements or tariffs. This phenomenon often happens within preferential trade agreements where member countries benefit from reduced tariffs, leading them to buy from each other instead of from outside sources that might offer better prices or quality. While trade diversion can enhance intra-regional trade, it may also lead to inefficiencies in the overall economy by distorting market signals.

5 Must Know Facts For Your Next Test

1. Trade diversion is often seen as a downside of regional trade agreements because it can lead to higher prices for consumers when imports shift to less efficient producers.
2. This phenomenon can negatively impact global trade dynamics as it may disrupt supply chains and reduce competition.
3. In practice, trade diversion can result in economic inefficiencies because resources are not allocated to their most productive uses.
4. The extent of trade diversion depends on the nature of the trade agreements and the initial conditions of the countries involved.
5. Trade diversion can create unequal benefits among member countries in a trade agreement, often favoring larger or more developed nations.

Review Questions

• How does trade diversion impact the efficiency of international markets?
  • Trade diversion impacts market efficiency by causing countries to import goods from less efficient producers instead of opting for better alternatives available outside a trade agreement. This shift can result in higher prices and reduced consumer welfare since resources are not being utilized in their most productive manner. The overall effect is that while intra-regional trade may increase, global efficiency diminishes due to the misallocation of resources.
• Discuss the relationship between trade diversion and customs unions, including potential benefits and drawbacks.
  • Trade diversion is closely linked to customs unions, which aim to promote trade among member countries by removing tariffs. While customs unions can facilitate lower prices and increased trade within the union, they can also cause trade diversion by leading members to buy from each other rather than from more efficient producers outside the union. This can result in reduced overall welfare if consumers face higher prices due to less competitive pressures on member nations.
• Evaluate the long-term implications of trade diversion on global economic relations and policy making.
  • The long-term implications of trade diversion can significantly affect global economic relations and policymaking by potentially leading to a fragmented trading system. As countries prioritize regional agreements that may result in inefficiencies, this could encourage a rise in protectionist measures globally. Policymakers may need to balance the immediate benefits of regional trade agreements against the risks of creating distortions that harm international competitiveness and hinder global cooperation on broader economic issues.

Related terms

trade creation: Trade creation occurs when a trade agreement leads to the replacement of higher-cost domestic production with lower-cost imports from member countries, thereby increasing overall economic efficiency.

customs union: A customs union is an agreement between two or more countries to eliminate tariffs and allow free trade among themselves while imposing a common external tariff on imports from non-member countries.

non-tariff barriers: Non-tariff barriers are trade restrictions that do not involve tariffs but can include quotas, import licenses, and standards that make it more difficult for foreign products to compete in the domestic market.