What Is Trade Diversion?
Trade diversion is a phenomenon within international economics where the formation of a preferential trade agreement, such as a customs union or a free trade area, causes trade to shift from a more efficient, lower-cost producer outside the agreement to a less efficient, higher-cost producer within the agreement. This occurs because the internal removal of tariffs and other trade barriers makes goods from the less efficient member country artificially cheaper than those from the more efficient non-member country, even if the latter could supply the goods at a lower pre-tariff price. This reorientation of trade often leads to a reduction in overall economic welfare globally, as resources are allocated less efficiently.
History and Origin
The concept of trade diversion was first introduced by Canadian economist Jacob Viner in his seminal 1950 work, The Customs Union Issue. Viner's theory provided a foundational framework for analyzing the effects of economic integration beyond simple tariff reductions. Before Viner, the conventional wisdom often assumed that any move towards freer trade, such as the formation of a customs union, would inherently lead to welfare gains. Viner's work, however, highlighted that while such agreements could lead to beneficial trade creation, they could also result in trade diversion, where the elimination of internal tariffs redirects trade from more efficient external suppliers to less efficient internal ones, potentially reducing global welfare. His analysis underscored the complex and sometimes ambiguous economic outcomes of preferential trade arrangements.5
Key Takeaways
- Trade diversion occurs when a country shifts imports from a lower-cost, non-member country to a higher-cost, member country within a preferential trade agreement.
- It is a consequence of discriminatory tariff reductions within regional trade blocs.
- This phenomenon can reduce global economic efficiency and welfare because it distorts natural trade patterns based on comparative advantage.
- Trade diversion is often evaluated in conjunction with trade creation, with the net welfare effect depending on which impact predominates.
Interpreting Trade Diversion
Interpreting trade diversion involves assessing the costs it imposes on an economy, contrasting them with any benefits of the preferential trade agreement. When trade is diverted, a country's consumers or industries end up paying more for goods than they would if they were importing from the most efficient global producer, leading to a loss in consumer surplus and overall economic efficiency. This shift can also reduce government tariff revenue from the previously imported goods. The presence of trade diversion signifies that a regional trade agreement may not be purely welfare-enhancing, as it creates market distortions by favoring less efficient partners. Policymakers often analyze the extent of trade diversion to determine the true economic impact of such agreements, striving for arrangements where trade creation outweighs trade diversion.
Hypothetical Example
Consider Country A, which previously imports widgets from Country C, the lowest-cost global producer, at a price of $10 per widget, plus a 20% import tariffs, making the final cost $12. Country B also produces widgets, but less efficiently, at $11 per widget. Without a trade agreement, Country A imports from Country C due to its lower total cost.
Now, Country A forms a free trade area with Country B, eliminating tariffs between them. Country A can now import widgets from Country B at $11 per widget (no tariff). While Country C still produces at $10, Country A's 20% tariff still applies, making Country C's widgets $12. As a result, Country A shifts its imports from Country C (the globally more efficient producer) to Country B (the less efficient, but now tariff-free, partner). This is a clear instance of trade diversion, as the trade has been "diverted" from a lower-cost external source to a higher-cost internal source due to artificial tariff advantages. The overall economic welfare of Country A and the global economy potentially decreases because resources are not being utilized where they are most efficient.
Practical Applications
Trade diversion is a significant consideration in the design and evaluation of international trade policies, particularly concerning the proliferation of regional trade agreements. Governments and economists analyze trade diversion effects when negotiating new pacts, such as the North American Free Trade Agreement (NAFTA) or the European Union's customs union. For instance, the formation of the EU, while leading to substantial economic integration and trade creation among members, has also been scrutinized for instances where internal trade replaced more efficient external trade.4
Recent global trade tensions have also presented real-world examples of trade diversion. For example, tariffs imposed by the United States on goods from China in 2018 led to a shift in US imports away from China and towards other countries, such as Mexico. An IMF Working Paper suggested that such "trade diversion effects from global tensions" might be higher than previously estimated, particularly when considering complex supply chain linkages.3 This illustrates how geopolitical actions can inadvertently trigger trade diversion, impacting global domestic production and trade patterns.
Limitations and Criticisms
While trade diversion is a well-established concept in international economics, its measurement and interpretation come with limitations. Critics point out that real-world trade patterns are complex and influenced by numerous factors beyond just tariffs, such as transportation costs, quality differences, and non-tariff barriers. Isolating the precise impact of trade diversion from overall changes in global trade flows can be challenging.
Furthermore, some argue that while trade diversion might reduce static efficiency in the short run, the long-term benefits of economic integration—such as increased competition, economies of scale, and greater political stability—could outweigh these static losses. However, the World Trade Organization (WTO) and various economists frequently express concern that a proliferation of regional trade agreements might undermine the principle of non-discrimination in the multilateral trading system, leading to more widespread trade diversion and a fragmented global economy. Whe2n importers switch to less efficient suppliers, there's a risk of reduced market diversity, competitive disadvantages for non-member suppliers, and decreased overall global efficiency. Thi1s highlights the ongoing debate about whether regionalism acts as "stepping stones" or "stumbling blocks" to broader global trade liberalization.
Trade Diversion vs. Trade Creation
Trade diversion and trade creation are two primary effects that arise from the formation of preferential trade agreements, such as customs unions or free trade areas. While both terms describe changes in trade patterns, their welfare implications are distinct.
| Feature | Trade Diversion | Trade Creation |
|---|---|---|
| Definition | Trade shifts from a more efficient, non-member producer to a less efficient, member producer due to preferential tariffs. | Trade shifts from a high-cost domestic producer to a lower-cost producer within the trade agreement. |
| Welfare Impact | Generally considered welfare-reducing for the importing country and the global economy, as it moves trade away from the most efficient source. | Generally considered welfare-enhancing, as it promotes specialization based on comparative advantage and increases overall efficiency. |
| Cause | Discriminatory reduction of import tariffs favoring less efficient partners. | Removal of tariffs on efficient imports, leading to consumers buying cheaper goods from a partner country instead of more expensive domestic production. |
| Outcome | Less efficient resource allocation globally. | More efficient resource allocation and increased consumer welfare. |
Confusion often arises because both phenomena involve changes in who a country trades with after a new agreement. However, the crucial distinction lies in whether the new trade pattern leads to a more efficient (trade creation) or less efficient (trade diversion) allocation of resources globally. A trade agreement's net impact on economic welfare depends on the balance between these two effects.
FAQs
Q: Does trade diversion always lead to negative economic outcomes?
While trade diversion typically implies a loss of global economic welfare due to inefficient resource allocation, the overall impact of a trade agreement depends on the balance between trade diversion and trade creation. If the trade creation benefits, such as increased specialization and economies of scale among members, are substantial enough, they can outweigh the negative effects of trade diversion. However, the diverted trade itself is a less efficient outcome.
Q: How do governments try to mitigate trade diversion?
Governments can try to mitigate trade diversion by ensuring that regional trade agreements (RTAs) are designed to be "WTO-consistent," meaning they aim for substantial liberalization of trade among members without creating excessive protectionism against non-members. This often involves reducing external tariffs even as internal tariffs are eliminated, or expanding membership to more countries to broaden the scope of efficient trade.
Q: Is trade diversion related to protectionism?
Yes, trade diversion is a consequence of discriminatory protectionism. By removing import tariffs for goods from member countries but maintaining them for non-member countries, the agreement effectively creates a preferential barrier. This artificial advantage shields less efficient producers within the bloc from competition with more efficient producers outside, thus diverting trade.