Trade Creation and 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 & Diversion

Overview

Trade Agreements

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.

Trade Theory

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).

Applications

Trade Creation, Diversion, & Economic Integration

Economic Integration

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 relationships and levels of economic integration with other countries or none at all. Nations that reject or do not pursue the stages of economic integration, as described above, are characterized as autarky.

Autarky, or an autarkic nation, refers to self-sufficient countries that do not participate in international trade. Autarky, which means self-sufficiency in Greek and provides independence from other states, results in both benefits and costs (Anderson & Marcouiller, 2005). The stages of economic integration are rarely fixed or permanent but instead are generally fluid and overlapping. Economic integration, as described below, is an evolving process responsive to the shifting socio-economic climates. The levels of trade creation and trade diversion decrease as countries move toward greater economic cooperation and economic integration.

Free Trade Agreements

Free trade agreements are agreements that state that goods and services can be exchanged between countries or regions without tariffs, quotas, or other trade restrictions being levied. Examples of free trade agreements include the North American Free Trade Agreement (NAFTA) and the Central European Free Trade Agreement (CEFTA). Free trade agreements may be limited to a business or industry sector or be applied to all levels and types of international trade. Free trade agreements tend to impose two main requirements on member nations:

• First, member nations must agree to follow dispute-resolution procedures.
• Second, member nations must agree to follow rules-of-origin procedures for all third-party products entering the free trade area. Rules of origin, which refer to laws, regulations and administrative processes that establish a product's country of origin, make up an expensive process for all free trade agreement member nations.

Free trade agreements tend to be applicable to a geographical region and form a free trade area. A free trade area, according to the Organization for Economic Co-operation and Development, refers to a grouping of countries within which tariffs and non-tariff trade barriers between member nations are generally abolished without instituting common trade policy toward non-members. Free trade agreements result in significant amounts of trade diversion as trade with non-member nations remains an important source of imported goods and services.

Customs Unions

Customs unions, which are free trade areas that also establish a common tariff and other shared trade policies with non-member countries, require trade policy harmony and cooperation between member nations. Customs unions establish a common external tariff (CET) and import quotas on products entering the region from third-party countries but also offer free movement of labor and capital among member nations. Customs unions offer four main benefits to member nations:

• First, customs unions eliminate the need for rules of origin and, as a result, provide member nations with significant administrative cost savings and efficiency gains.
• Second, customs unions establish common trade remedy policies such as anti-dumping and countervail measures.
• Third, customs unions require a level of cooperation that makes trade dispute-resolution procedures between member nations unnecessary.
• Fourth, customs unions work together as a single entity to negotiate multilateral trade initiatives as a single bloc.

The benefits gained from participation in customs unions come at a cost to political and economic independence of member nations. (For example, in 2013 Armenian President Serzh Sargsyan entered his country into a customs union led by Russia-a move that prevents Armenia from being integrated into the European Union.) Member nations exchange their independent trade and foreign policy freedoms for the benefits described above. Trade creation and trade diversion levels in customs unions will vary based on the number of member nations and the remaining trade relationships with non-member nations.

Common Markets

Common markets, as described by the Organization of Economic Co-operation and Development, are customs unions with provisions to liberalize movement or mobility of people, capital and other resources and eliminate non-tariff barriers to trade such as the regulatory treatment of product standards. Common markets are a significant step toward economic integration for member nations. Common markets tend to share labor policies as well as fiscal and monetary policies. Common markets, which facilitate increased economic interdependence, tend to produce increased economic efficiency and economic growth for all member nations.

Economic unions, as the final stage of economic integration, are common markets with provisions for the harmonization of certain economic policies such as macroeconomic and regulatory policies. The European Union is one example of a large-scale effective economic union. Economic unions, the last and greatest stage of economic integration among nations, share nearly all economic policies and regulations including monetary policies, fiscal policies, labor policies, development policies, transportation policies, and industrial policies. Economic unions generally share a common currency and a unified monetary policy that controls and coordinates national interest rates and exchange rates. Economic unions require supranational legal and economic institutions to regulate commerce and ensure uniform application of the economic union rules and regulations. Economic unions, with the highest degree of economic integration, tend to promote and facilitate high levels of trade creation.

Issues

African Regional Trade Agreements, Trade Creation & Trade Diversion

Economic integration efforts among nations characterize international relations at the end of the twentieth and beginning of the twenty-first centuries. Regional economic integration between developing and developed countries is common and believed to lead to economic stability and development. Developing countries and international development organizations, such as the World Bank and the Organization for Economic Co-operation and Development, promote regional trade agreements as a means of facilitating stability, development, and trade creation. Examples of regional trade agreements include European Free Trade Agreement (EFTA), Southern African Customs Union (SACU), Gulf Cooperation Council (GCC) Customs Union, Monetary and Economic Community of Central Africa (CEMAC), European Union Taxation and Customs Union, Southern Cone Common Market (MERCOSUR), and West African Economic and Monetary Union (UEMOA).

Regional trade agreements in Africa are characterized by the developing-nation status of most member nations. Regional trade agreements in Africa began appearing in the 1980s. Two treaties, the Lagos Plan of Action (1980) and the Abuja Treaty (1991), created a framework for regional economic integration in Central, Eastern, Northern, Southern, and Western sub-regions in Africa. A process of trade liberalization and cooperation was developed in the hopes of fostering trade creation, economic development, and, finally, economic integration throughout Africa. Three of the main regional trade agreements in Africa include the Southern African Customs Union, the West African Economic and Monetary Union, and the Monetary and Economic Community of Central Africa. These three regional trade agreements, discussed below, experience different levels of trade creation and trade diversion.

Southern African Customs Union

The Southern African Customs Union, established in the Customs Union Agreement of 1910, includes the five member states of Botswana, Lesotho, Namibia, South Africa and Swaziland. The South African Customs Union agreement was revised in 1969 and 1994. The Southern African Customs Union has multiple goals:

• Regional integration.
• The facilitation of trade between the members of the Agreement.
• Improved Trade Negotiations between SACU and third parties.
• Improved economic development of the Member States.

The Southern African Customs Union, which provides shared decision-making and a sustainable revenue-sharing arrangement, has been very active in the years following the end of apartheid in 1994. The Southern African Customs Union is challenged by the member nations' varying trade policies and trade policy divergences, and by the perception that South Africa displays an avuncular relationship with its much smaller SACU-member wards because of its greater size, wealth, and overall regional economic dominance (African Business, 2013).

The Southern African Customs Union, eager to increase the benefits from economic cooperation, is involved in active trade negotiations with both the European Union and the United States (Kirk & Stern, 2003).

The West African Economic & Monetary Union

The African Western Union Economic and Monetary, established in 1994, includes the member nations of Benign, Burkina Faso, the Ivory Coast, Mali, Niger, Senegal, Guinea-Bissau, and Togo. The West African Economic and Monetary Union facilitates trade through the use of a common currency. The West African Economic and Monetary Union has the following goals and objectives:

• “To reinforce the competitiveness of the economic and financial activities of the member states within the framework of an open and competing market and a rationalized and harmonized legal environment”
• “To ensure the convergence of the performances and the economic policies of the member states by the institution of a procedure of multilateral monitoring”
• “To create between member states a common market based on freedom of movement of the people, the goods, the services, the capital and the right of establishment of the people carrying on an independent or paid activity, like on a common external tariff and a marketing policy”
• “To institute a coordination of the national policies by the implementation of common actions, and possibly, of common policies in particular in the following fields: human resources, regional planning, agriculture, energy, industry, mines, transport, infrastructures and telecommunication”
• “To harmonize, to the extent necessary with the correct operation of the common market, the legislations of the member states and particularly the mode of the taxation" (Diop, 2008, p.1)

The Monetary & Economic Community of Central Africa

The Monetary and Economic Community of Central Africa, established in 1992, includes the six member nations of Cameroon, Central African Republic, Chad, Republic of the Congo, Equatorial Guinea, and Gabon. The Monetary and Economic Community of Central Africa has the following goals and objectives:

• Promote the establishment of a Central African Common Market.
• Eliminate the obstacles to trade between member nations.
• Coordinate development programs to benefit underprivileged countries and areas.

Economists debate the effects of the African regional trade agreements, described above, on the developing economies of Africa. Regional trade agreements in Africa are intended to foster trade creation but may result in trade diversion. For example, Economic Community of Central Africa has experienced greater amounts of trade diversion than trade creation. Goods produced outside the regional trade agreements area are priced high due to tariffs and, as a result, pose an economic hardship on the national economy. Regional trade agreements increase the volume of trade without necessarily facilitating trade in areas with high growth potential. Variables that effect trade creation and trade diversion effects of regional trade agreements include the following (Musila, 2005):

• Exporting country gross national product (GNP).
• Importing country gross national product.
• Exporting country population.
• Importing country population.
• Distance.
• Regional transportation and communication network.
• Common language.
• Willingness of countries to reduce tariffs.
• Willingness of countries to eliminate non-tariff barriers to trade such as visa requirements, and socio-political stability.

Conclusion

In the final analysis, Jacob Viner's theory of trade creation and trade diversion has had a lasting impact on trade theory and trade policy. Trade creation, which refers to the net increase in trade that result from the displacement of domestic production, and trade diversion, which refers to the diversion of existing trade that results from the displacement of imports, have significantly different effects on national economies. The U.S. Congressional Budget Office promotes more inclusive free trade agreements in an effort to eliminate trade diversion and foster trade creation. Ultimately, the hybrid nature of trade policy, a combination of economic and foreign policy, will likely continue so long as a trade policy is a strategic tool for policymakers.

Terms & Concepts

Common Markets: Customs unions with provisions to liberalize movement or mobility of people, capital and other resources and eliminate non-tariff barriers to trade.

Customs Unions: Free trade areas that also establish a common tariff and other shared trade policies with non-member countries.

Economic Integration: The integration of commercial and financial activities among countries through the abolishment of nation-based economic institutions and activities.

Economic Unions: Common markets with provisions for the harmonization of certain economic policies such as macroeconomic and regulatory policies.

Free Trade Agreements: goods and services can be exchanged between countries or regions without tariffs, quotas, or other trade restrictions being levied.

International Trade: The purchase and sale of goods or services between residents of different countries.

Markets: A setting that allows buyers and sellers to obtain information and engage in a voluntary exchange of goods and services.

Nations: Large aggregations of people sharing rules of law and an identity based on common racial, linguistic, historical, or cultural heritage; rarely act unilaterally.

Tariffs: A tax imposed on a good imported into a country.

Trade: the export of goods and services and import of goods and services.

Trade Creation: The net increase in trade that results from the displacement of domestic production.

Trade Diversion: The diversion of existing trade that results from the displacement of imports.

World Bank: An international economic development assistance organization that was founded in 1944.

Bibliography

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Bendavid, N., & Norman, L. (2013, September 5). Armenia jilts Europe, ties trade knot with Moscow. Wall Street Journal - Eastern Edition. p. A9. Retrieved November 3, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=90073634&site=ehost-live

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Suggested Reading

Clausing, K. (2001). Trade creation and trade diversion in the Canada — United States Free Trade Agreement. Canadian Journal of Economics, 34. Retrieved October 30, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=5058772&site=ehost

Hurt, S. R., Lee, D., & Lorenz-Carl, U. (2013). The argumentative dimension to the EU-Africa EPAs. International Negotiation, 18, 67-87. Retrieved November 2, 2013 from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=87427409&site=ehost-live

Koo, W., Kennedy, P., & Skripnitchenko, A. (2006). Regional preferential trade agreements: Trade creation and diversion effects. Review of Agricultural Economics, 28, 408-415. Retrieved October 30, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=21678818&site=ehost-live

Nerozzi, S. (2011). From the Great Depression to Bretton Woods: Jacob Viner and international monetary stabilization (1930-1945). European Journal Of The History Of Economic Thought, 18 , 55-84. Retrieved November 2, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=57867331&site=ehost-live

Switzer, L., & Redstone, J. (1989). The impact of a Canada-US bilateral free trade accord on the Canadian minerals industry. Applied Economics, 21, 273. Retrieved October 30, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=4614607&site=ehost-live