Cambridge Syllabus Notes

Globalisation – Trade Creation and Trade Diversion

Learning Objectives (Cambridge AS & A‑Level Economics 9708)

AO1 – Knowledge: Define trade creation and trade diversion; recall the concepts that generate them (comparative advantage, customs unions, free‑trade areas, common external tariff).
AO2 – Application: Draw and label the required diagrams; work through numerical examples that show how trade creation and trade diversion arise when a customs union or free‑trade area is formed.
AO3 – Analysis & Evaluation: Analyse the welfare effects on members and non‑members, link the effects to the balance of payments and exchange rates, and evaluate the overall desirability of integration.

1. Foundations of International Trade (Syllabus 6.1)

1.1 Why Countries Trade

Absolute advantage: producing a good with fewer resources than another country.
Comparative advantage: producing a good at a lower opportunity cost. Gains from comparative advantage are realised when trade barriers are removed – the basis of **trade creation**.
Terms of trade (ToT): ratio of export prices to import prices. An improvement in ToT means a country can import the same quantity of goods for less, a typical result of trade creation.

1.2 How Protectionist Instruments Create Price Differentials (Syllabus 6.2)

Instrument	Effect on Prices	Relevance to Trade Creation / Diversion
Specific / ad‑valorem tariffs	Raise the import price by the amount of the duty.	Removal of internal tariffs enables trade creation; a common external tariff (CET) raises the price of non‑member imports, potentially causing trade diversion.
Quotas (absolute, tariff‑rate)	Limit quantity; the scarcity premium raises price.	Quota removal can generate trade creation; quotas on non‑members act like a CET.
Subsidies to domestic producers	Lower domestic marginal cost, raising competitiveness.	Domestic subsidies can mimic a tariff, reducing the incentive to import from members (reducing trade creation).
Non‑tariff barriers (standards, licences, embargoes)	Increase transaction costs or block entry.	Eliminating NTBs within a bloc can create trade creation; NTBs retained against non‑members act as a CET.

1.3 Balance‑of‑Payments and Exchange‑Rate Links (Syllabus 6.3‑6.4)

Current account (CA): ΔCA = ΔX – ΔM.
- Trade creation reduces imports (ΔM ↓) and can raise exports to members (ΔX ↑) → CA improves.
- Trade diversion raises the effective price of imports from the most efficient non‑member, increasing import expenditure (ΔM ↑) → CA may deteriorate.
Exchange‑rate movements affect the relative price of member versus non‑member goods.
- A depreciation of the member’s currency narrows the price gap with a non‑member, lessening the magnitude of diversion.
- An appreciation can amplify diversion by making non‑member goods relatively more expensive.
Both CA and exchange‑rate effects feed back into welfare through changes in national income and inflation.

2. Types of Economic Integration

Integration Form	Key Features	Typical Example
Free‑Trade Area (FTA)	Eliminates tariffs & quotas between members; each retains its own external tariff.	North American Free Trade Agreement (NAFTA)
Customs Union	FTA + common external tariff (CET) on all imports from non‑members.	European Union (pre‑2002) – “EU Customs Union”

3. Trade Creation

3.1 Definition

Trade creation is the replacement of higher‑cost domestic production (or higher‑cost imports from a non‑member) by lower‑cost imports from a member after internal barriers are removed.

3.2 Mechanism (Step‑by‑Step)

Internal tariffs/quotas are eliminated between members.
Firms compare the marginal cost of domestic production with the price of the same good from a member (including transport and any remaining non‑tariff costs).
If the member’s price is lower, imports from that member increase and domestic output falls.

3.3 Welfare Effects (AO3)

Consumer surplus (CS) rises – price falls.
Producer surplus (PS) in the importing member falls – domestic producers lose market share.
Government revenue may fall if tariffs are removed.
Overall net welfare gain:
ΔW_TC = Gain in CS – Loss in PS – Loss of tariff revenue

3.4 Diagram – Trade Creation

Use a standard supply‑and‑demand diagram for the importing country:

Domestic supply curve S_D.
World (member) supply curve S_M (horizontal at the member price).
Pre‑integration price = P_D; post‑integration price = P_M (lower).
Shade the increase in CS (large triangle) and the loss in PS (small triangle). No dead‑weight loss.

3.5 Numerical Illustration

Country A joins a customs union with Country B. Before the union:

Domestic price of wheat = $220 / tonne (includes a $30 tariff).

After the union:

Member price (including transport) = $190 / tonne.
Quantity imported = 2 million tonnes.

Welfare gain from trade creation:

\[ \Delta W_{TC}= (220-190)\times 2{,}000{,}000 = \mathbf{\$60\;million} \]

4. Trade Diversion

4.1 Definition

Trade diversion is the shift of imports from a more efficient non‑member country to a less‑efficient member country because the member now enjoys preferential (tariff‑free) access while the non‑member faces the common external tariff.

4.2 Mechanism (Step‑by‑Step)

Integration creates a CET on all imports from non‑members.
The CET raises the effective price of the most efficient external supplier.
If the post‑CET price of a less‑efficient member becomes lower than the CET‑adjusted price of the non‑member, imports are diverted to the member.

4.3 Welfare Effects (AO3)

CS may still rise (price falls relative to the pre‑integration domestic price) but the gain is smaller than the potential gain from the cheaper non‑member.
PS in the member may rise because domestic producers are protected from more efficient competition.
Overall net welfare loss:
ΔW_TD = Forgone efficiency gain = (Price of non‑member after CET – Member price) × Quantity diverted
This loss appears as a dead‑weight loss triangle on the diagram.

4.4 Diagram – Trade Diversion

Three supply curves are shown:

S_M – member supply (horizontal at member price).
S_NM – non‑member supply (horizontal at the original non‑member price).
After the CET, S_NM shifts upward by the amount of the CET.
Shade the dead‑weight loss triangle between S_M and the shifted S_NM.

4.5 Numerical Illustration

Country A could import wheat from non‑member Country C at $180 / tonne (no tariff). The customs union imposes a $25 CET on C, so the effective price becomes $205 / tonne. Member Country B supplies wheat at $190 / tonne.

Quantity diverted = 1 million tonnes.

Welfare loss from trade diversion:

\[ \Delta W_{TD}= (205-190)\times 1{,}000{,}000 = \mathbf{\$15\;million} \]

5. Integrated Welfare Evaluation (AO3)

List all possible sources for each good (domestic, member, non‑member).
Calculate the price each source faces after integration (include CET, transport, exchange‑rate effects).
Separate the net change into:
- Trade‑creation component – gain from lower‑cost member imports.
- Trade‑diversion component – loss from moving away from a cheaper non‑member.
Sum the changes in CS, PS and any change in tariff revenue.
Net welfare effect = ΣΔW_TC – ΣΔW_TD.
Consider secondary effects:
- Current‑account impact (ΔCA = ΔX – ΔM).
- Exchange‑rate adjustments that may offset or amplify the welfare change.
- Distributional consequences for workers in protected industries.
- Strategic or political motives (market access, regional stability).

6. Links to the Rest of the Syllabus (6.1‑6.5)

Syllabus Item	Connection to Trade Creation / Diversion
6.1 Reasons for International Trade (comparative advantage, ToT)	Trade creation realises the gains from comparative advantage that were blocked by tariffs; trade diversion distorts the allocation of resources away from comparative advantage.
6.2 Protectionist Instruments (tariffs, quotas, subsidies, embargoes)	Internal tariffs prevent trade creation; the CET (a form of protectionism) is the source of trade diversion.
6.3 Current‑account of the Balance of Payments	Trade creation improves the current account by reducing import expenditure; trade diversion can worsen it by raising the effective price of imports.
6.4 Exchange‑rate Determination	Exchange‑rate movements alter the relative price of member versus non‑member goods, influencing the magnitude of both creation and diversion.
6.5 Policies to Correct Current‑account Imbalances	Forming a customs union may be pursued to address a deficit; the net welfare impact (creation vs. diversion) determines whether the policy is sound.

7. Real‑World Illustrations

European Economic Community (1970s): The customs union generated large trade‑creation gains in manufactured goods, but the CET on agricultural products caused trade diversion from efficient non‑EU suppliers.
NAFTA (1994): Mostly trade creation in automobiles and textiles; some agricultural sectors experienced diversion toward higher‑cost U.S. producers because of differing subsidy regimes.
Mercosur: Evidence of trade diversion in beef – member Argentina supplies at a higher cost than non‑member Brazil after the CET was applied.

8. Evaluation Checklist for Students (AO3)

Explain clearly how trade creation and trade diversion arise from the removal of internal barriers and the imposition of a CET.
Draw and label the two standard diagrams (creation and diversion) and identify CS, PS and dead‑weight loss areas.
Quantify the net welfare effect where data are given – show all steps.
Discuss the impact on the current account, exchange rates and the distribution of income within member countries.
Weigh economic efficiency against political/strategic motives (e.g., market access, regional stability, bargaining power).
Conclude with a balanced judgement on whether a particular integration scheme is likely to be welfare‑enhancing overall.

9. Suggested Diagrammatic Content (for exam practice)

Diagram 1 – Trade Creation: Domestic supply S_D and member world supply S_M. Show price fall from P_D to P_M, shade CS gain and PS loss, note “no dead‑weight loss”.
Diagram 2 – Trade Diversion: Add a third curve S_NM for the non‑member. After the CET, shift S_NM upward; the price paid is now P_M (member) while the efficient non‑member price would have been lower without the CET. Shade the dead‑weight loss triangle between the two supply curves.

10. Practice Question with Solution Outline

Question: Country X forms a free‑trade area with Country Y. Before the agreement, Country X imported steel from non‑member Country Z at $500 per tonne (no tariff). Country Y can produce steel at $520 per tonne. After the agreement a $30 tariff on all non‑members is introduced. Determine whether trade creation or trade diversion occurs, and calculate the welfare impact for Country X assuming it imports 1 million tonnes.

Solution Outline:

Prices after the FTA:
- Member price (Y) = $520 t⁻¹ (no tariff).
- Non‑member price (Z) after $30 tariff = $530 t⁻¹.
Comparison: $520 (Y) < $530 (Z) → imports shift from Z to Y.
Interpretation: This is trade diversion because the cheaper non‑member (Z) is displaced by a higher‑cost member (Y) due to the tariff.
Welfare calculations:
- Price paid rises from $500 to $520 → consumer‑surplus loss = $(520‑500)×1 000 000 = $20 million.
- Government gains tariff revenue = $30×1 000 000 = $30 million (a transfer).
- Producer surplus in Y rises – not quantified here.
- Net efficiency loss (dead‑weight loss) = forgone gain from the $20 million cheaper source = $20 million.
- Overall welfare effect = –$20 million (CS loss) + $30 million (tariff revenue) – $20 million (dead‑weight loss) ≈ –$10 million. Hence, the FTA generates a net welfare loss for Country X due to trade diversion.

11. Summary of Key Points

Trade creation always produces a net welfare gain for the integration bloc because it allows members to exploit comparative advantage.
Trade diversion creates a welfare loss by shifting imports away from the most efficient producer.
The overall impact of a customs union or FTA is the balance between the two effects, plus secondary influences on the current account, exchange rates and distributional outcomes.
Policymakers must weigh pure economic efficiency against political, strategic and distributional considerations when deciding whether to pursue deeper integration.

trade creation and trade diversion