What Is Trade Diversion and Its Economic Effects?

Trade diversion is a phenomenon in international trade where the formation of a preferential trade agreement leads to a shift in import sources. This shift occurs when a country moves its purchases from a more efficient producer located outside the trade bloc to a less efficient producer within the bloc. Trade policy, specifically tariff reductions or eliminations among member countries, can inadvertently redirect trade flows. This concept is relevant to the economic and overall welfare implications of regional trade agreements.

Defining Trade Diversion

Trade diversion occurs when a country, due to a preferential trade agreement, imports goods from a higher-cost producer within the agreement instead of a lower-cost producer outside it. This happens because tariffs are eliminated or reduced for goods among member countries, but remain for non-members. Preferential tariff treatment makes products from less efficient partners appear cheaper than those from more efficient external suppliers due to the tariff differential. This deviates from comparative advantage, as the importing country no longer sources from the most efficient global supplier, leading to suboptimal resource allocation.

For example, if Country A imported a product from Country C (a non-member) because C was the most efficient producer, a new trade agreement between Country A and Country B (a less efficient producer) might change this. If Country A eliminates tariffs on goods from Country B but maintains tariffs on goods from Country C, Country B’s product may become artificially cheaper. Consequently, Country A would divert its imports from Country C to Country B, even if Country C still produces the good at a lower global cost. This redirection of trade highlights how agreements alter patterns based on distorted price signals.

Causes of Trade Diversion

The primary cause of trade diversion is the structure of preferential trade agreements, like free trade areas or customs unions. These agreements reduce or eliminate tariffs among member countries while maintaining them for non-members. This differential tariff treatment creates an artificial price advantage for goods produced within the bloc.

For instance, joining a customs union means a country abolishes tariffs with partners but may implement a common external tariff against non-members. This makes previously cheaper imports from outside the bloc more expensive, leading to a switch to higher-cost imports from within the union. Trade agreements, by altering effective prices through tariff adjustments, are the direct mechanism causing trade diversion.

Economic Effects of Trade Diversion

Trade diversion can lead to a misallocation of global resources. Production shifts from more efficient producers outside the trade bloc to less efficient ones within it. This occurs because the tariff advantage within the bloc allows less efficient producers to compete on price, despite their higher true production costs.

For consumers within the importing country, trade diversion can result in higher prices for goods than if they were imported from the most efficient global producer. While the immediate price might seem lower due to the absence of internal tariffs, the underlying cost of production is higher, which can translate into reduced consumer welfare. Non-member countries, particularly those that were previously efficient suppliers, can experience a decline in their export streams to the bloc, potentially impacting their economic growth and development. This can also strain international relationships, as non-member nations may face economic disadvantages due to being excluded from preferential trade terms.

Trade Diversion vs. Trade Creation

Trade diversion is often contrasted with trade creation. Trade creation occurs when a trade agreement shifts from higher-cost domestic production within a member country to lower-cost imports from a partner country within the same trade bloc. This process increases efficiency and economic welfare by allowing countries to specialize in goods where they have a comparative advantage, leading to lower prices and increased consumption.

In contrast, trade diversion shifts imports from an efficient external producer to a less efficient producer within the trade agreement. While internal trade increases, it displaces more efficient trade with non-member countries. Trade agreements can result in both trade creation and trade diversion simultaneously. The net economic effect of an agreement depends on whether the positive effects of trade creation outweigh the negative effects of trade diversion.