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Home Field Trips Trade Tour Trade Creation and Trade Diversion

Theories

Trade Creation and Trade Diversion

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With the growth of regional trading blocs such as COMESA, the European Union and Mercosur, the question arises; do such arrangements benefit world trade and increase overall welfare? The answer depends upon the difference between the trade creation effect and trade diversion effects.

The trade creation effect is caused by the extra output produced by the member countries. This extra output is generated due to the freeing up of trade between them. Increased specialisation and economies of scale should increase productive efficiency within member countries.

The trade diversion effect exists because countries within trading blocs, protected by trade barriers, will now find they can produce goods more cheaply than countries outside the trade bloc. Production will be diverted away from those countries outside the trade bloc that have a natural comparative advantage to those within the trading bloc.

The diagram below shows the trade creation and trade diversion effects. Zambia has a domestic supply curve for maize Sz. If it forms a trading bloc with South Africa then the supply curve for maize is Sz/sa. The world output of maize is shown by the horizontal supply curve Sw. The Zambian demand curve for maize is Dz.

Assuming no trade the domestic price of maize in Zambia would be Pz and the quantity would be Q1. By forming a trade bloc with South Africa the price of maize would fall to Pz+SA and the quantity produced to Q2. The triangle AEB represents the resulting welfare gain or trade creation effect. If Zambia trade freely on the world market, quantity Q3 of maize could be purchased at the world price of Pw. This has been prevented from happening by the formation of the trade bloc with South Africa, and the imposition of some form of trade barrier. There has therefore been a welfare loss of BFC. This is the trade diversion effect.

A comparison of the two effects enables the overall welfare gain or loss of the formation of the trading bloc to be assessed. The welfare implication of the trade creation and trade diversion effect are summarised in the table below:

From the point of view of LDCs the existence of trading blocs depends rather on firstly whether the country is in the trading bloc and secondly which other countries are also members.

Being outside a trading bloc will often mean that a country loses out through the trade diversion effect. Zambian textile producers will face trade barriers such as tariffs into the European Union and consequently be disadvantaged.

Forming a trade bloc with other LDCs may result in only a small trade creation effect as the share of world trade involving LDCs is so small, that the trade bloc has limited influence on the market price and quantity. If the country joins a trade bloc with a MDC then there may be real advantages to the LDC as resources flow within the bloc to the countries where there are cost advantages and the potential market for exports is significantly expanded.

Next theory - The Formation of Trading Blocs >>

Related Glossary Items:
Economies of Scale
Specialisation
Trading Bloc
Productive Efficiency
Comparative Advantage

Related Issues:
COMESA: a case study of a trading bloc
Zambia's Exports and Imports
Zambia's Trade Policy

Related Theories:
The Formation of Trading Blocs
Economies of Scale and Commercial Farming
Economic Efficiency
The Principle of Absolute and Comparative Advantage