GLOBE

Trade Diversion and Trade Creation

by Steven Suranovic ©1997-2004

Trade 110-2a  

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In this section we present an analysis of trade diversion and trade creation. The analysis uses a partial equilibrium framework which means that we consider the effects of preferential trade liberalization with respect to a representative industry. Later we consider how the results from the representative industry cases can be extended to consider trade liberalization that covers all trade sectors.

We assume in each case that there are three countries in the world, countries A, B and C. Each country has supply and demand for a homogeneous good in the representative industry. Countries A and B will form a free trade area. (Note: trade diversion and creation can occur regardless of whether a preferential trade agreement, a free trade area or a customs union is formed. For convenience we'll refer to the arrangement as a free trade area (FTA)) The attention in this analysis will be on Country A, one of the two FTA members. We'll assume that country A is a small country in international markets which means that it takes international prices as given. Countries B and C are assumed to be large countries (or regions). Thus country A can export or import as much of a product as desired with countries B and C at whatever price prevails in those markets.

We assume that if country A were trading freely with either B or C it would wish to import the product in question. However, country A initially is assumed NOT to be trading freely. Instead the country will have a MFN (i.e., the same tariff against both countries) specific tariff applied on imports from both countries B and C.

In each case below we will first describe an initial tariff-ridden equilibrium. Then, we will calculate the price and welfare effects that would occur in this market if Country A and B form a free trade area. When the FTA is formed, country A maintains the same tariff against country C, the non-FTA country.

Trade Diversion

In general, trade diversion means that a free trade area diverts trade, away from a more efficient supplier outside the FTA, towards a less efficient supplier within the FTA. In some cases, trade diversion will reduce a country's national welfare but in some cases national welfare could improve despite the trade diversion. We present both cases below.

The adjoining diagram depicts the case in which trade diversion is harmful to a country that joins a FTA. The graph shows the supply and demand curves for country A. PB and PC represent the free trade supply prices of the good from country's B and C, respectively. Note that country C is assumed capable of supplying the product at a lower price than country B. (Note: In order for this to be possible country B must have tariffs or other trade restrictions on imports from country C, or else all of B's market would be supplied by C)

We assume that A has a specific tariff tB = tC = t* set on imports from both countries B and C. The tariff raises the domestic supply prices to PTB and PTC, respectively. The size of the tariff is denoted by the green dotted lines in the diagram which show that t* = PTB - PB = PTC - PC.

Since, with the tariff, the product is cheaper from country C, country A will import the product from country C and will not trade initially with country B. Imports are given by the red line, or by the distance D1 - S1. Initial tariff revenue is given by area (c + e), the tariff rate times the quantity imported.

Next, assume countries A and B form a FTA and A eliminates the tariff on imports from country B. Now tB = 0 but tC remains at t*. The domestic prices on goods from countries B and C are now PB and PTC, respectively. Since PB < PTC country A would import all of the product from country B after the FTA and would import nothing from country C. At the lower domestic price, PB, imports would rise to D2 - S2, denoted by the blue line. Also since the non-distorted (i.e., free trade) price in country C is less than the price in country B, trade is said to be diverted from a more efficient supplier to a less efficient supplier.

The welfare effects are summarized in the Table below.

Welfare Effects of Free Trade Area Formation Trade Diversion Cases

  Country A
Consumer Surplus + (a + b + c + d)
Producer Surplus - a
Govt. Revenue - (c + e)
National Welfare + (b + d) - e

Free Trade Area Effects on:

Country A Consumers - Consumers of the product in the importing country benefit from the free trade area. The reduction in the domestic price of both imported goods and the domestic substitutes raises consumer surplus in the market. Refer to the Table and Figure to see how the magnitude of the change in consumer surplus is represented.

Country A Producers - Producers in the importing country suffer losses as a result of the free trade area. The decrease in the price of their product on the domestic market reduces producer surplus in the industry. The price decrease also induces a decrease in output of existing firms (and perhaps some firms will shut down), a decrease in employment, and a decrease in profit and/or payments to fixed costs. Refer to the Table and Figure to see how the magnitude of the change in producer surplus is represented.

Country A Government - The government loses all of the tariff revenue that had been collected on imports of the product. This reduces government revenue which may in turn reduce government spending or transfers or raise government debt. Who loses depends on how the adjustment is made. Refer to the Table and Figure to see how the magnitude of the tariff revenue is represented.

National Welfare Country A - The aggregate welfare effect for the country is found by summing the gains and losses to consumers, producers and the government. The net effect consists of three components: a positive production efficiency gain (b), a positive consumption efficiency gain (d) and a negative tariff revenue loss (e). Notice that not all of the tariff revenue loss (c + e) is represented in the loss to the nation. That's because some of the total losses (area c) are, in effect, transferred to consumers. Refer to the Table and Figure to see how the magnitude of the change in national welfare is represented.

Because there are both positive and negative elements, the net national welfare effect can be either positive or negative. The diagram above depicts the case in which the FTA causes a reduction in national welfare. Visually, it seems obvious that area e is larger than the sum of a and b. Thus, under these condition the FTA with trade diversion would cause national welfare to fall.

If conditions were different, however, the national welfare change could be positive. Consider the adjoining diagram. This diagram differs from the one above only in that the free trade supply price offered by country B, PB, is lower and closer to country C's free trade supply price PC. The description above concerning the pre- and post-FTA equilibria remains the same and trade diversion still occurs. The welfare effects remain the same in direction, but, differ in magnitude. Notice that the consumer surplus gain is now larger because the drop in the domestic price is larger. Also notice that the net national welfare effect, (b + d - e), visually, appears positive. This shows that in some cases, formation of a FTA that causes trade diversion, may have a positive net national welfare effect. Thus, trade diversion may be, but is not necessarily, welfare-reducing.

Generally speaking, the larger is the difference between the non-distorted prices in the FTA partner country and in the rest of the world, the more likely that trade diversion will reduce national welfare.

Trade Creation

In general, trade creation means that a free trade area creates trade that would not have existed otherwise. As a result, supply occurs from a more efficient producer of the product. In all cases trade creation will raise a country's national welfare.

The adjoining diagram depicts a case of trade creation. The graph shows the supply and demand curves for country A. PB and PC represent the free trade supply prices of the good from country's B and C respectively. Note that country C is assumed capable of supplying the product at a lower price than country B. (Note: In order for this to be possible country B must have tariffs or other trade restrictions on imports from country C, or else all of B's market would be supplied by C)

We assume that A has a specific tariff tB = tC = t* set on imports from both countries B and C. The tariff raises the domestic supply prices to PTB and PTC, respectively. The size of the tariff is denoted by the green dotted lines in the diagram which show that t* = PTB - PB = PTC - PC.

Since, with the tariffs, the autarky price in country A , labeled PA in the diagram, is less than the tariff-ridden prices PTB and PTC, the product will not be imported. Instead country A will supply its own domestic demand at S1 = D1. In this case the original tariffs are prohibitive.

Next, assume countries A and B form a FTA and A eliminates the tariff on imports from country B. Now tB = 0 but tC remains at t*. The domestic prices on goods from countries B and C are now PB and PTC, respectively. Since PB < PA country A would now import the product from country B after the FTA. At the lower domestic price PB, imports would rise to the blue line distance, or D2 - S2. Since trade now occurs with the FTA, and it did not occur before, trade is said to be created.

The welfare effects are summarized in the Table below.

Welfare Effects of Free Trade Area Formation Trade Creation Case

  Country A
Consumer Surplus + (a + b + c)
Producer Surplus - a
Govt. Revenue 0
National Welfare + (b + c)

Free Trade Area Effects on:

Country A Consumers - Consumers of the product in the importing country benefit from the free trade area. The reduction in the domestic price of both imported goods and the domestic substitutes raises consumer surplus in the market. Refer to the Table and Figure to see how the magnitude of the change in consumer surplus is represented.

Country A Producers - Producers in the importing country suffer losses as a result of the free trade area. The decrease in the price of their product in the domestic market reduces producer surplus in the industry. The price decrease also induces a decrease in output of existing firms (and perhaps some firms will shut down), a decrease in employment, and a decrease in profit and/or payments to fixed costs. Refer to the Table and Figure to see how the magnitude of the change in producer surplus is represented.

Country A Government - Since initial tariffs were prohibitive and the product was not originally imported there was no initial tariff revenue. Thus the FTA induces no loss of revenue.

National Welfare Country A - The aggregate welfare effect for the country is found by summing the gains and losses to consumers and producers. The net effect consists of two positive components: a positive production efficiency gain (b) and a positive consumption efficiency gain (c). This means that if trade creation arises when a FTA is formed, it must result in net national welfare gains. Refer to the Table and Figure to see how the magnitude of the change in national welfare is represented.

Aggregate Welfare Effects of a Free Trade Area

The analysis above considers the welfare effects upon participants in one particular market in one country that is entering into a free trade area. However, when a free trade area is formed, presumably many markets and multiple countries are affected, not just one. Thus to analyze the aggregate effects of a FTA, one would need to sum up the effects across markets and across countries.

The simple way to do that is to imagine that a country entering a FTA may have some import markets in which trade creation would occur and other markets in which trade diversion would occur. The markets with trade creation would definitely generate national welfare gains while the markets with trade diversion may generate national welfare losses. It is common for economists to make the following statement, "If the positive effects from trade creation are larger than the negative effects from trade diversion, then the FTA will improve national welfare." A more succinct statement, though also somewhat less accurate, is that "if a FTA causes more trade creation than trade diversion then the FTA is welfare improving."

However, the converse statement is also possible, i.e., "if a FTA causes more trade diversion than trade creation then the FTA may be welfare reducing for a country." This case is actually quite interesting since its suggests that a movement to free trade by a group of countries may actually reduce the national welfare of the countries involved. This means that a movement in the direction of a more efficient free trade policy may not raise economic efficiency. Although this result may seem counterintuitive, it can easily be reconciled in terms of the theory of the second-best.

Free Trade Areas and the Theory of the Second-Best

One might ask, if free trade is economically the most efficient policy, how can it be that a movement to free trade by a group of countries can reduce economic efficiency? The answer is quite simple once we put the story of FTA formation into the context of the theory of the second-best. Recall that the second-best theory suggested that when there are distortions or imperfections in a market, then the addition of another distortion (like a trade policy) could actually raise welfare, or economic efficiency. In the case of a FTA, the policy change is the removal of trade barriers rather than the addition of a new trade policy. However, the second-best theory works much the same in reverse.

Before a country enters a FTA it has policy imposed distortions already in place in the form of tariff barriers applied on imports of goods. This means that the initial equilibrium can be characterized as a second-best equilibrium. When the FTA is formed some of these distortions are removed, i.e., the tariffs applied to one's FTA partners. However, other distortions remain, i.e., tariffs applied against the non-member countries. If the partial tariff removal substantially raises the negative effects caused by the remaining tariff barriers with the non-FTA countries, then the efficiency improvements caused by free trade within the FTA could be outweighed by the negative welfare effects caused by the remaining barriers outside the FTA and national welfare could fall.

This is in essence what happens in the case of trade diversion. Trade diversion occurs when a FTA shifts imports from a more efficient supplier to a less efficient supplier which by itself causes a reduction in national welfare. Although the economy also benefits through the elimination of the domestic distortions, if these benefits are smaller than the supplier efficiency loss, then national welfare falls. In general, the only way to assure that trade liberalization will lead to efficiency improvements is if a country removes its trade barriers against all countries.


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©1998-2004 Steven M. Suranovic, ALL RIGHTS RESERVED
Last Updated on 4/1/98