Trade diversion

Occurrence

Trade Diversion is a key principle of micro-economics, Primarily it used to calculate the wealth effect.

When a country applies the same tariff to all nations, it will always import from the most efficient producer, since the more efficient nation will provide the goods at a lower price. With the establishment of a free trade agreement, that may not be the case. If the agreement is signed with a less-efficient nation, it may well be that their products become cheaper in the importing market than those from the more-efficient nation, since there are taxes for only one of them. Consequently, after the establishment of the agreement, the importing country would acquire products from a higher-cost producer, instead of the low-cost producer from which it was importing until then. In other words, this would cause a trade diversion.

Term

The term was coined by Jacob Viner in The Customs Union Issue in 1950. In its literal meaning the term was however incomplete, as it failed to capture all welfare effects of discrimnatory tariff liberalization, and it was not useful when it came to non-tariff bariers. Economists have however dealt with this incompleteness in two ways. Either they stretched the original meaning to cover all welfare effects, or they introduced new terms like trade expansion or internal versus external trade creation.

Downside

Diverted trade may hurt the non-member nation economically and politically and create a strained relationship between the two nations. The decreased output of the good or service traded from one nation with a high comparative advantage to a nation of lower comparative advantage works against creating more efficiency and therefore more overall surplus.

Example

An example of trade diversion is the UK's import of lamb, before Britain joined the EU most lamb imports came from New Zealand, the cheapest lamb producer, however when Britain joined the EU the common external tariff made it more expensive to import lamb from New Zealand than countries inside the union, thus France became the majority exporter of lamb to the UK. Trade was diverted from New Zealand, and created between France and the UK.

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