Trade Diversion

Definition

Trade diversion refers to the shift in trade patterns that occurs when a country joins a regional trade agreement, such as a free trade area or customs union. It happens when the country starts importing more from member countries and less from non-member countries, even though the non-member countries may be more efficient producers. This shift is driven by the preferential tariff rates offered within the trade agreement.

5 Must Know Facts For Your Next Test

1. Trade diversion can lead to a net welfare loss for the country joining the regional trade agreement, as it may start importing from less efficient producers within the bloc instead of more efficient non-member producers.
2. The extent of trade diversion depends on the difference between the tariff rates charged on imports from member countries versus non-member countries, as well as the relative efficiency of producers in each group.
3. Governments may enact trade policies, such as regional trade agreements, to promote trade creation and minimize trade diversion, but there is often a tradeoff between the two.
4. Trade diversion is more likely to occur when the regional trade agreement involves countries at very different levels of economic development, as the tariff preferences may distort trade patterns significantly.
5. Evaluating the balance of trade creation and trade diversion is an important consideration for policymakers when assessing the merits of a proposed regional trade agreement.

Review Questions

• Explain how trade diversion can occur when a country joins a regional trade agreement, such as a free trade area or customs union.
  • When a country joins a regional trade agreement, it starts offering preferential tariff rates to imports from member countries. This can lead to a shift in trade patterns, where the country imports more from the less efficient producers within the trade bloc instead of the more efficient producers outside the bloc. This shift in trade away from non-member countries towards member countries is known as trade diversion, and it can result in a net welfare loss for the country joining the agreement if the trade diversion outweighs the benefits of trade creation.
• Describe the factors that influence the extent of trade diversion that may occur when a country joins a regional trade agreement.
  • The extent of trade diversion depends on several factors, including the difference between the tariff rates charged on imports from member countries versus non-member countries, as well as the relative efficiency of producers in each group. Trade diversion is more likely to occur when the regional trade agreement involves countries at very different levels of economic development, as the tariff preferences may distort trade patterns significantly. Additionally, the design of the regional trade agreement, such as whether it is a free trade area or a customs union, can also impact the degree of trade diversion.
• Analyze the tradeoffs that policymakers must consider when evaluating the potential benefits and drawbacks of a regional trade agreement, particularly in terms of the balance between trade creation and trade diversion.
  • Policymakers must carefully weigh the potential benefits of trade creation against the potential costs of trade diversion when evaluating the merits of a proposed regional trade agreement. Trade creation can lead to increased efficiency and consumer welfare, as more trade occurs between member countries. However, trade diversion can result in a net welfare loss if the country starts importing from less efficient producers within the trade bloc instead of more efficient producers outside the bloc. Evaluating this balance is a critical consideration for policymakers, as they must assess whether the overall economic benefits of the regional trade agreement outweigh the potential costs of trade diversion. This analysis requires a thorough understanding of the relative efficiency of producers, the existing tariff structures, and the potential impacts on domestic industries and consumers.

Related terms

Trade Creation: Trade creation refers to the increase in trade that occurs when a regional trade agreement eliminates tariffs between member countries, allowing more efficient producers within the bloc to expand their sales.

Customs Union: A customs union is a type of regional trade agreement where member countries eliminate tariffs on trade with each other and adopt a common external tariff on imports from non-member countries.

Free Trade Area: A free trade area is a regional trade agreement where member countries eliminate tariffs on trade with each other, but maintain their own tariffs on imports from non-member countries.