Trade Creation & Diversion
This article focuses on trade creation and trade diversion. The article provides an overview of trade theory including Jacob Viner's theory of the connection between free trade agreements, customs unions, trade creation, and trade diversion. The relationship between economic integration, trade creation, and trade diversion is explored. The issues and outcomes associated with African regional trade agreements will be addressed.
Keywords Common Markets; Customs Union; Economic Integration; Economic Unions; Free Trade Agreements; International Trade; Markets; Nations; Regional Trade Agreements; Tariffs; Trade; Trade Creation; Trade Diversion; World Bank
International Business: Trade Creation
Countries actively use trade policy to control national import and export levels and the economy in general. In the twentieth century, free trade agreements emerged as one of the main forms of trade control and cooperation between nations. Under free trade agreements, also referred to as preferential trade agreements (PTAs), goods and services can be exchanged between countries or regions without tariffs, quotas, or other trade restrictions being levied (Holden, 2003). Trade agreements affect trade in two main ways: Trade creation and trade diversion.
- Trade creation refers to the overall increase in trade that results from the displacement of domestic production.
- Trade diversion refers to the diversion of existing trade that results from the displacement of imported goods and services.
Trade Creation vs. Trade Diversion
Economists and policymakers study the effect that the processes of trade creation and trade diversion have on the economy. Trade creation and trade diversion tend to have very different effects on the aggregate economy.
- Trade creation generally produces a net economic gain. Countries enter into free trade agreements, with trade creation a desired result, primarily when the price of a particular imported good or service is lower than the cost of producing the same good or service domestically. The trade relationship allows countries to purchase goods and services at prices less than they would pay domestically for the same goods or services.
- In contrast, trade diversion generally produces a net economic loss. In trade diversion scenarios, countries pay more for imported goods and services than they would under a trade agreement. Domestic purchasers must pay the cost of the imported item and a government tariff.
Reasons for Forming Trade Agreements
According to the U.S. Congressional Budget Office, countries engage in free trade agreements for two main reasons.
- First, foreign trade agreements stimulate and strengthen the economy. Industrialized countries tend to seek out free trade agreements in the interest of promoting and facilitating trade creation. Free trade agreements strengthen national economies and international relationships through trade creation but sacrifices certain domestic business sectors and international relationships through trade diversion. As long as free trade agreements exist between individual countries rather than as an inclusive global pact, trade creation and trade diversion will remain conflicting and competing forces and outcomes. Global free trade, also referred to as multilateral free trade, would end the problem of trade diversion.
- Second, free trade agreements are a form of foreign policy and alliance building. Wealthier nations enter into free trade agreements with developing nations as a means of building international partnerships and aiding developing economies.
The following section provides an overview of trade theory including Jacob Viner's theory of trade creation and trade diversion. This section serves as a foundation for later discussion of the relationship between economic integration, trade creation, and trade diversion. The issues and outcomes associated with African regional trade agreements are addressed.
Modern trade theory has its roots in the economic theory of the eighteenth century. Eighteenth century economists, such as Adam Smith (1723-1790) and David Ricardo (1772-1823), explored how trade between nations affected national economies. Modern trade theory emerged after World War II. Modern trade theory considers the effect trade barrier removal has on trade flows between countries. Trade theory emerged after World War II as economic theory evolved and grew to address changing global economic relationships. After World War II, economists, world leaders, and governing bodies put trade agreements and economic structures into place, such as the World Bank, United Nations, World Trade Organization, and International Monetary Fund, to prevent the economic depressions and instability that characterized the years following World War I. National agreements promoted and facilitated free trade. Free trade is trade in which goods and services can be exchanged between countries or regions without tariffs, quotas, or other trade restrictions being levied.
Limited Free Trade
Following World War II, the Allied powers, countries in opposition to the Axis powers, promoted a limited form of free trade within a dollar-exchange monetary system. The General Agreement on Tariffs and Trade of 1947 prohibited quantitative restrictions on trade between leading industrialized economies. In the years following World War II, nations have been engaging in trade agreements as a means of increasing economic efficiency, productivity, and growth. Regional trade zones facilitate commercial expansion. Today, trade relationships between nations are also political relationships. Trade relationships, as expressed in customs unions, have become political-economic unions for the world's major trading nations including the United States, the countries of the European Union (especially those in Western Europe), Japan, China, and South Korea, as well as developing nations.
Modern Trade Theory
Economic theory, post World War II, was deeply engaged with real-world trade concerns and relationships. Modern trade theory began with economist Jacob Viner (1892-1970). Viner's theory of customs unions argues that customs unions have two major effects: Trade creating and trade diverting.
- Trade creation refers to the shift of consumption of the importable good from a high-cost domestic producer to a lower-cost external foreign producer.
- Trade diversion refers to a switch from the lowest-cost external producers to a higher-cost producer. Viner's theory argues that trade creation always improves the country's welfare but trade diversion dampens the country's welfare (Parai & Yu, 1989).
Trade creation is characterized by a shift in a high-cost domestic product or service to a lower cost imported product or service. Trade diversion is characterized by a shift from low-cost imports from third-party country to high-cost imports from a member country. Viner believed that all relevant stakeholders in a trade relationship should analyze the economic implications of trade agreements. Trade agreements cause movement between levels of production. This movement can result in a gain or loss of economic efficiency for member nations.
Stakeholders should examine the following variables to judge the economic effect of trade agreements:
- The total volume of trade on which costs have been lowered.
- The total volume of trade on which costs have been raised.
- The degree to which costs have risen on diverted trade.
- The degree to which costs have lowered on created trade, supply curves, and tariffs.
Customs unions and free trade agreements change nations' productive efficiency and consumption habits and levels. Jacob Viner's critics argue that the outcome of customs unions and free trade agreements may reach beyond the fixed outcomes of trade creation and trade diversion (Wexler, 1960).
Trade Creation, Diversion,
Trade creation and trade diversion, as outcomes of trade agreements, are part of a larger process of economic integration. Economic Integration refers to the integration of commercial and financial activities among countries through the abolishment of nation-based economic institutions and activities. Processes of regional economic integration, such as Europe's, have been shaping the economic relations between countries significantly. At the same time, an increasing integration of all national economies into the global economy has affected these economic relations, too (Krieger-Boden & Soltwedel, 2013).
Economic integration among nations includes the following four stages: Free trade agreements (FTA), customs unions (CU), common markets, and economic unions (Holden, 2003). Nations choose different levels of economic integration based on variables such as the strength of their national economy and trade relationships and forecasted trade prospects. Nations may have multiple trade...
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