Global Economic Analysis: Trade Creation vs. Trade Diversion Effects

This report delves into the critical global economic issues of trade creation and trade diversion, focusing on the context of customs unions. It begins by defining trade creation as an increase in economic welfare within a free trade area, detailing its benefits through tariff reductions and the resulting consumer and producer surplus gains. The report then explores scenarios where customs unions might incline towards trade diversion, which can lead to net losses by shifting trade to less efficient members. Using diagrams, it illustrates how trade diversion works and explains when custom unions might still choose this strategy to develop net gains. The report concludes by highlighting that custom unions can maximize overall gains by strategically choosing trade diversion when the benefits outweigh the losses. The report includes relevant references from books and journals, providing a well-rounded analysis of these complex economic concepts.

GLOBAL ECONOMIC
ISSUES

TABLE OF CONTENTS
MAIN BODY..................................................................................................................................3
Benefits of a trade creating customs union..................................................................................3
Scenarios under which custom union can be inclined towards trade diverting...........................4
REFERENCES................................................................................................................................6

MAIN BODY
Benefits of a trade creating customs union
Trade creation is basically an increase that arises in the economic welfare when the traders
join a free trade area especially the customs union area (Esposito, 2017). There are various
benefits that arises when the trade creation is promoted by customs union and the following
diagram can be used to further illustrate the concept easily:
Figure 1: Trade Creation
Source: Trade Creation, 2019
 It can be ascertained from the diagram that when the tariff is reduced, then the prices of
imports also go down consecutively from P1 to P2 and this automatically leads to an
increase in the quantity that is being purchased i.e. it shifts from Q3 to Q4 (Trade Creation,
2019). This leads to increase in the consumer surplus which is appositive situation for the
economy.
 Another benefit is that the net welfare gain increases in the economy due to the reduction in
the tariff barriers. The domestic producers would sell lesser goods because the buyers will
tend to buy imports that are cheaper and this will lead to producer surplus as depicted in area
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1 and area 3 consecutively shows the loss of tax revenue to the government. Gain can be
ascertained from area 2 and 4 i.e. increase in the consumer surplus from which tariff revenue
and producer surplus can be subtracted (Trade Creation, 2019).
Therefore, these are some of the benefits that can arise from the trade creation.
Scenarios under which custom union can be inclined towards trade diverting.
Trade diversion can arise when the free trade area diverts the trade i.e. shifts the trade from
the efficient members or suppliers to the comparatively less efficient ones. Normally, trade
diversion is treated as a negative strategy which leads to net loss rather that gain (Deme and
Ndrianasy, 2017). The following example can be used to ascertain how trade diversion works:
Figure 2: Net loss from trade diversion
Source: Trade creation and diversion, 2019
It can be clearly ascertained that UK producers, if they join EU gain consumer surplus at
a, b, c and d but UK farmers lose surplus of a. Further the loss of tariff on imports from new
Zealand also can be identified by c and e. therefore it can be said that overall UK will face loss if
it joins EU as b and d i.e. the gain is less than e which is loss (Trade creation and diversion,
2019).
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However, custom unions might still decide to go for trade diversion when they tend to develop or
incur net gains from the trade diversion and this can be understood from the following example
and diagram:
Figure 3: Net gain from Trade Diversion
Source: Trade creation and diversion, 2019
It can be ascertained form the above diagram where the difference between the supply
without tariff of EU and the supply from New Zealand without tariff has reduce i.e. e part is not
very significant in the difference and it can be further evaluated that the net gain from b and d
collectively is more than that of the loss that is incurred due tariff revenue from New Zealand
imports denoted by e (Trade creation and diversion, 2019). Therefore, in such scenarios it is
better to adopt trade diversification as the overall gains that are generated while comparing gains
from trade creation with the losses from trade diversion are maximised (Deardorff and Sharma,
2019). This makes the custom unions choose the trade diversion strategy that helps in higher
profits over the trade creation strategy.
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REFERENCES
Books and Journals
Deardorff, A.V. and Sharma, R.R., 2019, June. The Simple Analytics of Trade Creation and
Diversion. In Research Seminar and International Economics, Discussion Paper (Vol.
670).
Deme, M. and Ndrianasy, E.R., 2017. Trade-creation and trade-diversion effects of regional
trade arrangements: low-income countries. Applied Economics. 49(22). pp.2188-2202.
Esposito, P., 2017. Trade creation, trade diversion and imbalances in the EMU. Economic
Modelling. 60. pp.462-472.
Online
Trade creation and diversion. 2019. [ONLINE] available through :<
https://www.economicsonline.co.uk/Global_economics/Trade_creation.html>
Trade Creation. 2019. [ONLINE] available through:
<https://www.economicshelp.org/blog/glossary/trade-creation/ >
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