Trade Creation vs Trade Diversion

The benefits and costs of increased trade integration between countries depends on the relative importance of trade creation versus  trade diversion.

 

The concept of whether economic integration between countries reduces wealth was established by Jacob Viner in 1950. His argument was that to measure whether an increase in economic integration is beneficial for a country we have to find out whether the gains from domestic production replaced by cheaper imports from a member nation( Trade creation) are higher than losses of expensive imports from member nations replacing cheap imports from non-members(Trade diversion) or not.
        To explain the effects of integration between countries the diagram can be used. Assuming that Duk and Suk  are the demand and supply of good X in the UK.Sw is the world supply of good X. Therefore the UK puts a tariff and imports X0-X1 and the government is getting a revenue of GCTR. When the UK joins the EU it removes a tariff from EU imports and it stops importing from non-EU countries as the price in the EU is lower than the world price with the UK tariff. Therefore, as a result of joining the EU the price of X in the UK falls from P0 to P1. The volume of imports increases tp X2-X3. It implies that UK consumers are getting good X for a lower price which is beneficial for them and hence they are gaining an increase in consumers surplus( a+b+c+d). This is partly a result of a redistribution from UK producers( a) as they cannot charge P0 anymore and government(c ) as it is not gaining any revenue and partly because of the trade creation ( b+d). Area “e” is also a loss of government revenue but it is not redistributed and hence this is a deadweight loss called trade diversion. Overall the net welfare loss from integration is (b+d)-e. Therefore, it can be argued that the benefits and costs of trade integration between countries depend on the relative significance of trade creation and trade diversion.

 

 

The size of the net effect of trade integration between countries depends on the initial tariff on imports from the rest of the world and the difference in the cost of production between non-members and members of Free Trade Area( FTA). If the initial tariff on imports is relatively high ( as shown on the diagram below) then the effects of trade creation will be more significant. This is because consumers will gain more surplus as a result of trade creation( a+b+c+d). Moreover, if the difference in the cost of production between the members of FTA and the rest of the world is not significant(as shown on the diagram SEU - SW ) negative effects of trade diversion would be decreased to a minimum.

 

 

The net effects of Trade creation and Trade diversion always exist when there is an integration between countries  and need to be taken into account when analyzing economic implications of integration. To make it more clear I would take an example of the USA, Mexico and Canada forming NAFTA(1994). There is a clear evidence that after formation of NAFTA the trade between three countries has increased. For example, US exports to Mexico have increased from 8.9%(1993) to 11.6%(1998), exports to Canada have also increased by 1.2 % at the same period. US import from Mexico have increased by more than 4% from 1993 to 1998.

 

Table l. NAFTA TRADING PATTERNS

 

a. UNITED STATES TRADE

 

U.S. Exports

(billions of U.S. dollars and percent)

 

Year      Total Exports         Exports to Mexico     Percent        Exports to Canada       Percent

 

1980               220.8                        15.1                      6.9                       35.4                     16.0

1985               213.1                        13.6                      6.4                       47.3                     22.2

1990               393.1                        28.4                      7.2                       83.0                     21.1

1991               421.8                        33.3                      7.9                       85.1                     20.2

1992               447.3                        40.6                      9.1                       90.2                     20.2

1993               465.4                        41.6                      8.9                      100.2                    21.5

1994              512.4                        50.8                       9.9                      114.3                    22.3
1995              583.5                        46.3                       7.9                      126.0                    21.6

1996               622.9                        56.8                       9.1                      132.6                    21.3

1997               687.6                        71.4                      10.4                     150.1                    21.8

1998               680.0                        79.0                       11.6                     154.2                    22.7

 

U.S. Imports

(billions of U.S. dollars and percent)

 

Year      Total Imports      Imports from Mexico      Percent      Imports from Canada       Percent

 

1980               257.0                       12.8                        5.0                       42.0                        16.3

1985               361.6                       19.4                        5.4                       69.4                        19.2

1990               517.0                        30.8                       6.0                       93.8                        18.1

1991               509.3                        31.9                       6.3                       93.7                        18.4

1992               552.6                        35.9                       6.5                      101.3                       18.3

1993               600.0                        40.7                       6.8                      113.6                       18.9

1994               689.3                        50.4                       7.3                      132.0                       19.1

1995               771.0                        62.8                       8.1                      148.3                       19.2

1996               817.8                        74.1                       9.1                      159.7                       19.5

1997               898.7                        87.2                       9.7                      171.4                       19.1

1998               944.6                        96.1                      10.2                     178.0                       18.8

 

b. CANADIAN TRADE

 

Canadian Exports

(billions of U.S. dollars and percent)

 

Year       Total Exports       Exports to Mexico      Percent       Exports to U.S.      Percent

 

1980                 67.7                        0.4                       0.6                   41.1                 60.6

1985                 90.8                        0.3                       0.3                   68.3                 75.2

1990                126.4                       0.5                       0.4                   95.4                 75.4

1991                126.2                       0.4                       0.3                   95.6                 75.8

1992                133.4                       0.6                       0.5                  103.9                77.8

1993                140.7                       0.6                       0.4                  114.4                81.3

1994                161.3                       0.7                       0.4                  133.1                82.5

1995                190.2                       0.8                       0.4                  152.9                80.4

1996                200.1                       0.9                       0.4                  164.8                82.3

1997                213.0                       0.9                       0.4                  177.3                83.2

1998                211.4                       0.9                       0.4                  182.8                86.5

 

Canadian Imports

(billions of U.S. dollars and percent)

 

Year       Total Imports    Imports from Mexico       Percent    Imports from U.S.       Percent

 

1980                 61.0                        0.3                          0.5                   41.2                   67.5

1985                 78.7                        1.0                          1.2                   54.1                   68.7

1990                119.7                       1.5                          1.2                   75.3                   62.9

1991                120.5                       2.1                          1.8                   75.0                   62.3

1992                124.8                       2.2                          1.8                   79.3                   63.5

1993                134.9                       2.7                           2.0                   87.8                 65.0

1994                151.5                       3.1                           2.1                   99.6                 65.8

1995                163.3                       3.8                           2.3                  109.0                66.7

1996                170.0                       4.3                           2.5                  114.6                67.4

1997                195.5                       5.0                           2.5                  131.9                67.5

1998                200.3                       5.1                           2.5                  136.8                68.3

 

c. MEXICAN TRADE

(billions of U.S. dollars and percent)

 

Mexican Exports

 

Year    Total Exports       Exports to U.S.     Percent          Exports to Canada      Percent

 

1980               18.0                 12.5                   69.4                          0.1                     0.8

1985               26.8                 19.0                   70.8                          0.4                     1.8

1990               40.7                 32.3                   79.43                        0.2                     0.8

1991               42.7                 34.0                   79.5                          1.1                     2.7

1992               46.2                 37.5                    81.1                         1.0                     2.2

1993               51.8                 43.1                    83.3                         1.5                     3.0

1994               60.9                 51.9                    85.3                         1.5                     2.4

1995               79.5                 66.5                    83.6                         2.0                     2.5

1996               96.0                 80.7                    84.0                         2.2                     2.3

1997              110.4                 94.5                   85.6                         2.2                     2.0

1998              106.8                 87.3                   81.8                         4.9                     4.5

 

Mexican Imports

 

Year    Total Imports    Imports from U.S.      Percent       Imports from Canada       Percent

 

1980               17.7                 10.9                       61.6                         0.3                     1.8

1985               13.4                  9.0                        66.6                         0.2                     1.8

1990               30.0                 19.8                       66.1                         0.4                     1.3

1991               49.9                 36.9                       73.9                         0.7                     1.4

1992               62.1                 44.3                       71.3                         1.1                     1.7

1993               65.4                 46.6                       71.2                         1.2                     1.8

1994               79.3                 57.0                       71.8                         1.6                     2.0

1995               72.5                 54.0                       74.5                         1.4                     1.9

1996               89.5                 67.6                       75.6                         1.7                     1.9

1997              109.8                 82.2                      74.8                         2.0                     1.8

1998              106.9                 79.0                      73.9                         0.9                     0.8

 

Source:  International Monetary Fund, Direction of Trade Statistics, various issues.

 

This data clearly shows that the intra-NAFTA trade have increased as a result of a formation. However, to determine whether there is a positive or a negative net effect of NAFTA formation we can examine whether trade between the rest of the world and NAFTA countries have declined while intra union trade increased as we have already established. According to USITC Trade Data Wed there were very few trade categories in which the trade between NAFTA countries and the rest of the world declined. It cannot definitely be concluded whether this decline was as a result of trade diversion or some other factors but even if it was a trade diversion it was so insignificant that it cannot be taken into account. Hence, using this analysis it can be concluded that in the case of NAFTA trade creation has a higher impact than trade diversion on member countries. Moreover, other technical lines of analysis can be used to measure the impact of the formation of the union. For example, Anne O. Krueger comes to the same conclusion that “ the expansion of trade was trade creating, not diverting”.  This is very important conclusion because she was using different techniques such as gravity equations and shift and share analysis to estimate the effects of this trade integration.

To sum up,  it is clear that the economic effects of trade integration between countries depend on the relative importance of trade creation and trade diversion. Moreover, the differentials in cost of production between members of FTA and non-members alongside with the size of initial tariff determine the extent of the net impact of trade integration. The example of NAFTA shows a positive impact because trade creation exceeds trade diversion.

 

Reference.

 

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Bhagwati,     Jagdish,   and  Anne    O.  Krueger,    l995. The    Dangerous     Drift  to  Preferential  Trade Agreements, American Enterprise Institute Press, Washington D.C.

 

Frankel, Jeffrey A., 1997. Regional Trading Blocs in the World Economic System, Institute for

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Frankel,   Jeffrey   A.,   editor.   1998.  The   Regionalization   of   the   World   Economy,   University   of Chicago Press, Chicago.

 

Hufbauer,     Gary    C.,  and  Jeffrey   J.  Schott,  l992.  North    American     Free   Trade.   Issues  and Recommendations, Institute for International Economics, Washington D.C.

 

Hufbauer,     Gary    C.,  and   Jeffrey   J.  Schott,   l993. NAFTA,       An    Assessment ,    Institute   for International Economics, Washington D. C.

 

Krueger, Anne O., l997a. “Nominal Anchor Exchange Rate Policies as a Domestic Distortion,”

National Bureau of Economic Research Working Paper 5968, March.

 

Krueger,     Anne    O.,  l997b.   “Free   Trade    Agreements     versus   Customs     Unions,”   Journal     of Development Economics, Vol. 54, No. l, October. Pp. 169-187.

 

Krueger,   Anne   O.,   l999.   “Free   Trade   Agreements   as   Protectionist   Devices:   Rules   of   Origin,” Pp.91-102 in James C. Moore, Raymond Riezman and James R. Melvin, editors,  Trade, Theory and Econometrics, Essays in Honor of John S. Chipman, Routledge, London.

 

Kemp, Murray C., and Henry Wan, l976. “An Elementary Proposition Concerning the Formation

 

North    American     Free   Trade   Agreement     between    the  Government of  the  United   States   of  America, the Government of Canada and the Government of the United Mexican States,   1993.

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Viner, Jacob, l950. The Customs Union Issue, Carnegie Endowment for International Peace, New York.

 

World   Trade   Organization,   l995.  Regionalism   and   the   World   Trading   System,       World   Trade Organization, Geneva.

 

Yeats,    Alexander    J.,  l998.  “Does   Mercosur’s    Trade   Performance     Raise   Concerns    about  the Effects   of   Regional   Trading   Arrangements?,”  World   Bank   Economic   Review,   Vol.   12,   No.   l,

 

January. Pp. 1-28. of Customs Unions,” Journal of International Economics, Vol. 6, No. l, February. Pp. 95-97.

 

 

Anne O. Krueger ,“Trade creation and Trade diversion”,Working Paper 7429, Cambridge MA, 1999.